Fidelity Increases Commission-Free ETFs to 31

Consumers everywhere agree – price wars are the best wars on the planet.  The ETF trading commission price war makes ETF investors happy and their wallets a little thicker.  Fidelity today (2/16/11) announced the addition of five more iShares ETFs to its $0 commission lineup.  This brings the total quantity of commission-free ETFs for Fidelity’s online customers to 31, consisting of Fidelity’s own Nasdaq Composite Tracking Stock (ONEQ) and 30 iShares products.

The complete list of iShares with free online trading at Fidelity now includes these ETFs:

• iShares iBoxx Yield Corporate Bond (HYG)
• iShares Dow Jones Select Dividend (DVY)
• iShares Dow Jones EPAC Select Dividend (IDV)
• iShares Dow Jones Real Estate (IYR)
• iShares MSCI ACWI ex US (ACWX)

Sixteen months ago, the first salvo in this war was yet to be fired.  Today four major players have a lot at stake.  The history is brief but eventful:

Schwab Creates Watershed Event with Commission-Free ETFs on 11/3/09 by launching its first ETFs and introducing commission-free trading.  Schwab has since extended its lineup several times.

Fidelity responded three months later on 2/2/10 by teaming up with iShares to offer 26 Commission-Free ETFs at Fidelity while lowering commissions on other ETFs.  Fidelity expanded its menu today.

Vanguard Entered the ETF Free Trading War three months later (5/4/10) by making its own line of ETFs available to Vanguard Brokerage customers without commissions.  Vanguard continues to aggressively launch new ETFs with no commissions for its brokerage customers.

The Launch of Ameritrade’s ETF Supermarket on 10/8/10 was the most sweeping to date, including eight different sponsors and 101 ETFs and ETNs.

Disclosure I am Long HYG shares. 

Can Fixed Income ETFs Recapture Any Mojo?

At the end of August, every imaginable Fixed Income ETF had cracked the top half of the exchange-traded universe in relative strength percentile rank. Here on Thanksgiving Thursday, these same investments from the fixed income world have all dropped into the bottom half. In a “risk-on-risk-off” environment, few may find the change in momentum all that surprising. After all, stocks rocketed throughout the months of September and October; riskier assets have managed to hold onto those gains after three-and-a-half weeks in November. Yet even in November of 2010, where stocks have had their troubles, several different types of Bond ETFs have failed to act as “safe havens.” Consider the following examples:

1. International Bond ETFs and Emerging Market Bond ETFs. Fears of a sovereign nation failing to pay back its creditors have weighed heavily on international treasuries and international corporate bonds. Meanwhile, the US$ has bounced higher against the “euro” as well as emerging market currencies, creating some weakness in emerging bond offerings.

Popular International Bond and Emerging Market Bond ETFs (10/25/10-11/24/10)
						Approx %
SPDR Barclays International Treasury Bond (BWX)						-4.4%
SPDR Barclay International Corporate Credit Bond (IBND)						-4.4%
SPDR DB International Inflation Protected Bond (WIP)						-3.6%
JP Morgan Emerging Market Bond (EMB)						-2.9%
PowerShares Emerging Market Sovereign Debt (PCY)						-2.5%
WisdomTree Emerging Market Local Debt (ELD)						-2.0%
S&P 500 SPDR Trust (SPY)						1.6%

2. Muni Bond ETFs. You’d have to classify the recent mauling of state and national munis as bearish. Investors may be taking their cues from the bond crisis in the European Union. Is California next? Even though a massive wave of defaults inside of diversified baskets is improbable, the time spent waiting for bailouts may surpass shareholder pain thresholds.

Popular State Muni Bond and National Muni Bond ETFs (10/25/10-11/24/10)
						Approx %
SPDR Barclays California Muni (CXA)						-4.9%
Market Vectors High Yield Muni (HYD)						-4.7%
PowerShares Insured New York Muni (PZT)						-4.6%
iShares S&P National Muni (MUB)						-3.9%
SPDR Barclays National Muni (TFI)						-3.5%
Market Vectors AMT Free Intermediate Muni (ITM)						-2.8%
S&P 500 SPDR Trust (SPY)						1.6%

3. High Yield Bond ETFs. In my estimation, high yield is just about where it should be on the relative strength rankings… higher than the rest of the fixed income offerings and a little lower than the S&P 500. Yet that doesn’t change the fact that 7- and 10-year yields have actually climbed since the QE2 announcement, while the long end of the treasury bond yield curve has surged. It follows that high yield bond ETFs are starting to see detractors.

Popular High Yield Bond ETFs (10/25/10-11/24/10)
						Approx %
SPDR Barclays High Yield Bond (JNK)						-1.0%
iShares High Yield Corporate Bond (HYG)						-0.9%
PowerShares High Yield Corporate (PHB)						-0.7%
S&P 500 SPDR Trust (SPY)						1.6%

For the time being, I am committed to diversified high yield. I also believe SPDR Convertible Bond (CWB) remains an attractive alternative to Treasury Bond ETFs.
Nevertheless, the higher intermediate and long-term investment grade yields climb, the greater the threat to credit spreads. The smaller the spread between investment grade and “junk,” the further out on the risk spectrum you may need to go. (That may not be a bad thing… as “aristocratic” dividend payers have phenomenal earnings yields.)

Disclosure I am long SPY, JNK, HYG, PHB, CWB, MUB and PCY.

Diversified Approach to Play Corporate Bond ETFs

As strength of a sustainable economic recovery continues to remain wary, unemployment remains high, and consumer demand grows at a snail’s pace, corporate bonds, and the exchange-traded funds (ETFs) that track them, could pose an opportunity for investors.

A notable play of the corporate bond market is the SPDR Barclays Capital International Corporate Bond ETF (IBND), which tracks the Barclays Capital Global Aggregate ex-USD > $1B: Corporate Bond Index, carries an expense ratio of 0.55%, and gives investors exposure to debt that's denominated in local currencies.

IBND focuses on investment-grade corporate bonds and gives exposure to the following currencies: Euro, Australian Dollar, Canadian Dollar, New Zealand Dollar, British Pound, Japanese Yen, Swiss Franc, Swedish Krona, and the Danish and Norwegian Krone. Although IBND excludes US Dollar-denominated bonds, it does include bonds issued by US companies, which are payable in other currencies. In fact, according to the fund’s prospectus, the US has the largest country weighting at 17.5%, followed by Germany at 16.1% and the United Kingdom at 12.5%.

In regards to sector weightings, IBND is heavily focused on financials, industrials, and utilities, which constitute 46.9%, 39.5%, and 11.6% of its asset base, respectively. Additionally, the underlying index that IBND seeks to track boasts a yield of 3.05%, which can be expected if IBND tracks its underlying index accurately.

Of the holdings in the newly traded ETF, all the bonds in the fund are rated Baa or higher, with nearly half of them carrying a rating of A or better. The average maturity for the bonds is 5.3 years with a modified duration of 4.4 years.

Another notable mention regarding the international bond market is that PowerShares has also filed the necessary paperwork to launch the International Corporate Bond Portfolio (PICB), which will seek to replicate the performance of the S&P International Corporate Bond Index and give exposure to international corporate bonds.

Another way to play corporate bonds is through the Vanguard Short-Term Corporate Bond Index Fund (VCSH). This ETF seeks to replicate the Barclays Capital US 1-5 Year Corporate Index, a benchmark that includes US dollar-denominated, investment-grade, fixed-rate, taxable securities issued by industrial, utility, and financial companies with maturities between one and five years

The majority of VCSH’s coupon rates lie between 4% and 6% and debt ratings of underlying holdings primarily lie between BBB and AA.

Although an opportunity may prevail in corporate bond ETFs, it's a good idea to have an exit strategy that helps mitigate the risks that they carry.

Disclosure I do not any of the above mentioned etfs I however have been watching IBND for a bit.

ETF to Watch: Treasury Ladder Fund (PLW)

The fixed income ETF space has grown considerably over the past two years, as investors worried about a slowdown in developed markets have bought up bonds despite record low yields. The first 11 months of 2010 saw cash inflows of approximately $100 billion into the ETF industry, and about $29 billion of that total went to bond products. The prices of bonds have skyrocketed in recent months on risk aversion, leading many analysts to worry a bond bubble is forming -- though these fears have somewhat calmed as equities have made a push to end 2010 on a positive note. Recent events have raised new concerns about the fixed income space, as Treasury prices fell and yields spiked to the highest level in quite some time.

From Monday to Wednesday, yields on the 10-year notes surged by 30 basis points, the largest two day run-up since the fall of the Lehman Brothers in 2008. But why the sudden spike in Treasury yields across the board, especially given ongoing worries in Europe? It seems that the general consensus is that the U.S. is not properly dealing with its budget deficit, with President Obama and the Congressional Republicans appear to be close to nearing an end to a tax-compromise deal that aims to jump-start consumer spending and growth, but at the same time increase the already massive deficit with the issuance of more debt.

This was further confirmed by a 10-year T-Bill auction that took place earlier in the week when the debt issuance failed to attract a solid number of investors. "It is extremely revealing of just how poor conditions are when we get one of the weakest 10-year auctions on record, even after the worst two day downdraft in 10-year yields since the turbulent, dark days of September 2008," said strategists at Nomura Securities. Focus will now shift to the long-term side of the market as the Treasury will issue 30-year bonds. Hopefully these notes will be better received than their shorter-term counterparts, but there is a fair amount of skepticism.

The 30-year auction will be closely followed today, putting all funds in the Treasury Bonds ETFdb Category in focus. In addition to dozens of funds honing in on various stretches of the maturity curve, there are a few ETFs that spread exposure throughout the Treasury market, including the PowerShares 1-30 Treasury Ladder Portfolio (NYSE: PLW). This fund follows the Ryan/Mergent 1-30 Year Treasury Laddered Index, which measures the potential returns of the U.S. Treasury yield curve based on approximately 30 equally weighted U.S. Treasury issues with fixed coupons, scheduled to mature in a proportional, annual laddered structure. If today's bond auction attracts a low level of demand, prices may take yet another hit, sending this fund down. But if the auction goes well and the recent sell-offs in Treasuries attract opportunistic buyers, the Treasury bond space could be due for a bounceback on Thursday.

Disclosure I am long PLW shares and have been for quite some time.

Alerian MLP Index Concludes Stellar Decade

In the last decade (January 1, 2001 to December 31, 2010), the MLPs had one of the best gains ever for any industry group. Below are the beginning and ending values for the Alerian MLP Index along with the previous record reached in 2007.

Date -- AMZ -- AMZX - Yield
12/31/00 - 131 - 191 - 8.8%
07/13/07 - 342 - 750 - 5.4%
12/31/10 - 363 - 1026 - 6.2%

The Alerian MLP Index, AMZ, almost tripled, very impressive considering how many quality companies had little or even negative appreciation in this decade. Dividend Aristocrats (with a minimum history of 25 years of annual increased dividends) such as General Electric (PFE) and Bank of America (BAC) reduced dividends during the recession, resulting in their removal from this elite group. AMZX, the comparable index including reinvested income, had a superb performance, rising more than five times the original value, with an equivalent compounded annual growth rate of more than 18%.

An alternative measure of performance is to begin with the record value reached in July 2007 (what turned out to signal the first wave of the financial market meltdown). The index is up 21 (6%) while the index including reinvested income rose 37% (equivalent to a compounded annual growth rate of 13%). Gold is one of only a few investments with higher growth rates since then.

The business model of MLPs has remained intact during the financial meltdown and recovery. Funds were raised to finance expansion of pipelines and other fixed assets while many companies had difficulty securing financing.

In 2009, a number of closed end funds and mutual funds were started to track MLP indices or concentrate on MLP investments. They give an averaging effect for the investor but do not have tax hassle (and lack tax benefits) associated with owning MLP units. AMJ is one of the oldest tracking funds (almost two years old). For AMJ, 10 shares approximate the value of AMZ with a current yield of almost 5%. Dividends are paid from distributions received net of fund expenses. There are a number of tracking funds but one, MLPL, needs to be singled out for its high risk. This fund's goal is to double the yield and capital appreciation (capital losses are also doubled). But added potential gains bring added risks. Doubler funds have poor records of tracking their base funds over the long term. In addition higher interest rates on borrowed funds, used to achieve doubler effects, will reduce net income for MLPL.

There are other ways to participate in MLP growth by purchasing shares in corporations. Kinder Morgan (KMR) and Enbridge Energy (EEQ) are stocks created by these MLPs. Shares track the comparable unit prices and pay stock dividends based on the distributions to the respective units, making them very tax efficient.

The rapid rise for MLPs in the last two years could cause them to run into headwinds in 2011. Higher values bring lower yields. The yield on the index has fallen to 6.2%, the lower region in its 15 year history. MLPs remain yield investments and low yields suggest topping in market prices. In the last two months the index was sluggish after reaching new record levels, while Treasury rates rose sharply (1 percentage point for the yield on the 10 year Treasury bond).

The long term outlook for the industry remains excellent, but it will be difficult to replicate the performance of the last decade. Growth rates could slow. Derived investment income from the index has risen at an annual rate of 5½% in the last three years which may be representative of the rate going forward, implying investment income of 38.50 in 2020. Today's low yield of 6.2% projects an ending value of 620 for the index, a 71% gain in this decade. Different assumptions will change the ending value, but it's logical to assume that the growth rate of income will slow for a more mature industry. Existing unit holders ought to be happy with this growth but new investors should be prepared for slower growth of distributions and higher yields which would further limit growth of unit prices (and the index).

Disclosure I am long GE, PFE and AMJ.

ETF Shorting Bonds Up 11% This Year; Treasury Yields Slipping Today

With bond yields rising, returns of the iShares Barclays 20+ Year Treasury Bond ETF (TLT) have dropped nearly 5.7% so far in 2011.

By contrast, the ProShares UltraShort 20+ Year Treasury ETF (TBT) has gained more than 11.3% entering today’s session, according to Morningstar data.

TLT’s shares are on a slight rebound in the early going, up by 0.2% as yields slip ahead of government auctions of 10-year notes and traders start to digest word of Fed Chair Ben Bernanke’s statements before Congress this morning.

Disclosure I am Long TLT shares. 

The Future of Build America Bond ETFs

Build America Bond issuance may surge next month, however, the Republican mid-term election gains could imperil the future of the program and its exchange traded funds (ETFs).
The Republican landslide in U.S. House elections may work against  efforts to extend the Build America Bond program. President Barack Obama’s stimulus has helped pump $158 billion into local public-works projects, so there are many who would like to see this program continue.

There could be a savior to the program coming: The Investing In American Jobs and Closing Tax Loopholes Act — HR 5893 — would extend BABs for two years. Also, the legislation would gradually reduce the subsidy rate for BABs from the current 35% level to 32% for bonds sold in 2011, and 30% for those sold in 2012. BABS come in a range of maturities, from 1-5 years on up to more than 25 years.

The prospect of expiration isn’t stopping new issues. State and local governments are accelerating debt sales to December and will more than quadruple borrowing under the program. Build America Bond issuance may surge next month to $40 billion as borrowers rush to take advantage of the expiration, reports Alexandra Harris for Bloomberg.

If the program does expire, the number of bonds available in the market could be limited and may negatively impact the value of the bonds, so be mindful of this situation if you’re holding these funds. There are two ways to get exposure to Build America Bonds with ETFs:

• PowerShares Build America Bond Portfolio (NYSEArca: BAB): Yields 5.43%
• SPDR Nuveen Barclays Capital Build America Bond (NYSEArca: BABS): Yields 5.7%

Disclosure I am Long BAB and BABS shares.

Bond ETFs Are Good…If You Understand Them

If you’ve eyed the current 4.57% yield on the 30-year Treasury bond, you might be tempted to buy. But hold on: chasing yields in your exchange traded funds (ETFs) can hurt you if you’re not careful.
In hopes of getting halfway decent yields, millions of investors have gone far out on the curve. However, bonds and bond ETFs aren’t insured by the Federal Deposit Insurance Corporation (FDIC), so you’re at risk of losing principal when the Federal Reserve raises rates.

Short-term bond ETFs don’t have the most appealing yields – 3-month bonds are 0.12%; 3-year bonds are 1% – but they will be less impacted when rates jump.

Constance Gustke at Bankrate drilled down into a few of the pros and cons when it comes to bond ETFs:

• Pro: They’re liquid – you can buy and sell them anytime markets are open.
• Pro: There are so many options – any type of bond is now available in ETF form, and there’s about to be more soon: BulletShares is launching a suite of BulletShares High Yield Corporate Bond ETFs on Thursday.
• Con: You can lose money. Bonds are considered “safe” relative to other investments, but that doesn’t mean they won’t hurt you.
• Con: There’s risk. It ranges from safe (Treasuries) to super risky (junk bonds). 

Disclosure none

A Cheaper Dollar Will Open The Door For These Chinese Investments (UUP, MUB, TCK, CCJ, GMO, PWR)

On January 18th and 19th, the top officials of the two most powerful  nations on Earth are to meet in matters of far reaching significance.   There will be not one but two dinners.  One is to be a grand dinner  of state with all of the military and business leaders of both sides in  attendance.  The other is to be an “intimate” dinner.  Oh, to be a fly  on the wall of that private meeting.


Behind the photo-ops and the speeches there is one basic reality,  China and America are joined inseparably at the hip in a single entity,  which I am calling “The Chinamese Twins.”  As in all such pairings each  head can have their own separate and distinct personalities.  The fact  remains you can call one capitalism and the other communism, but both  heads are mutually dependent on a single life support system.  The world  financial network provides circulatory nourishment to both heads whose  interests are complementary.
 
Washington needs the cheap dollar (NYSE:UUP) to pay off colossal  debts.  China needs to revalue its Yuan to counter domestic inflation in  such areas as food and basic consumer goods.  The Chinese have raised  interest rates and bank reserve rules, to little avail.  At the same  time the Chinese do not want to dry up credit which would impede their  growing economy or slowdown exports.
A current headline in the Wall St. Journal reads, “The Bank Of China  Moves to Make Yuan a Global Currency.”  This will come as no surprise to  goldstocktrades.com readers.  In an article I wrote back in November, I spoke about China and Russia beginning to trade in Yuan and Rubles causing the need for the Yuan to be revalued higher.

The Chinese economy is thriving and they can well afford to revalue  the Yuan higher.  This stronger yuan will make North American resource  assets cheaper and put China in the driver’s seat to control many of the  large undeveloped assets.  At the same time they are buying gold,  silver and uranium assets hand over fist to hedge themselves from a U.S.  dollar decline, in which they own the largest interest.  In 2009 the  Chinese Investment Corporation, a state owned company, took large  ownership positions in Teck Cominco (NYSE:TCK) and Penn West Energy  Trust (NYSE:PWR). Recently in June, China National Nuclear signed a  contract with Cameco (NYSE:CCJ) to supply 23 million pounds of uranium.   Hanlong Investments took a large stake in General Moly (AMEX:GMO), one  of the leading North American molybdenum developers.

They want more  gold and silver to support the Yuan in order to ensure that when the  Yuan becomes the major world currency, it will be more resistant to the  swings encountered by fiat currencies.  Additionally, they also want  more precious metals to buttress its fiscal balance sheet and what they  feel is the eventual replacement of the U.S. Dollar as the world’s  reserve currency.  They are also rapidly developing and modernizing  increasing their use of uranium, potash, molybdenum, rare earths, coal  and oil and gas.

By revaluing the Yuan higher, China will be able to control inflation  and rising costs.  A higher Yuan will also benefit the Chinese  investment side which has already been active making deals in North  America.  The U.S. dollar will significantly be cheaper for the Chinese  which would allow them to acquire North American assets for pennies on  the dollar.  Just recently the Chinese Investment Corporation, whose  focus is to look for investment opportunities abroad opened its first  international branch in Toronto, which is the North American epicenter  of resource  companies.   Its one billion plus people can enjoy more  purchasing power through a higher yuan and a higher standard of living  with a supply of North American natural resources which could fuel their  rapid development.

Beyond the blustering and posturing at these dinners the trade off is  that they want carte blanche to enter more strongly into the heart of  capitalism and the North American resource sector.  Here the Chinese can  get all the gold, silver and natural resource deals they want.  Doors  will quietly swing open and everyone will go home happy.  The Chinese  will have their desired access to buy gold and natural resource stocks,  while The Americans receive a weaker dollar with which to pay off their  burgeoning debts.  If you are thinking that such a Byzantine arrangement  can’t be done, be assured it has all happened before.  During the  1980’s the USSR sold large amounts of gold secretly in New York.  It  took three years to become public knowledge.

Another part of this “Chinamese” agreement concerns rare metals, on  which the Chinese head wants to maintain its strategic grip of over 95%  of the world’s supply.  I feel the U.S. will not make this an issue.   The U.S. will accommodate China in order to persuade them to raise the  Yuan higher and the dollar lower.  I feel this revaluation will be done  in a series of two or three steps in 2011, which should eventually move  precious metals into new high territories and crush the U.S. dollar.   Volatile sell offs in gold and silver like I predicted in November and  December, which we are currently experiencing now, may present long term  precious metal investors with buying opportunities.

Underneath all of the media hype and adversarial stories between  China and America, I read a front page story in the New York Times of  1-17-11, “GE To Share Jet Technology With China In A New Joint  Venture.”  Expect to hear more deals in 2011 in which the Chinese  continue to invest in natural resource assets in North America, while  the U.S. continues to search for a way out of the financial  crisis.   

  We may see further bailouts from the federal government as  many states are in danger of defaulting.  The bankrupt states are  already asking Washington for assistance.  This devaluation of the  dollar that Geithner and Obama are asking for is to help the US pay off  its debts and be able to raise its debt ceiling with cheap devalued  dollars.  This should be bullish for precious metal prices where  investors will seek shelter from soaring government deficits and a loss  of the U.S. dollar as the world reserve currency.  See the iShares  S&P National AMT-Free Muni Bond ETF (NYSE:MUB) chart below:

Disclosure None

New Junk Bond ETFs

New Junk Bond ETFs
Wednesday February 9, 2011

Today we have 4 new target-date junk bond ETFs from Guggenheim (formerly known as Claymore)...

* BSJC - The Guggenheim Bulletshares 2012 High Yield Corporate Bond ETF
* BSJD - The Guggenheim Bulletshares 2013 High Yield Corporate Bond ETF
* BSJE - The Guggenheim Bulletshares 2014 High Yield Corporate Bond ETF
* BSJF - The Guggenheim Bulletshares 2015 High Yield Corporate Bond ETF

The company had seven similar ETFs launch last June, but they were not high yield corporate bond ETFs like these. And Guggenheim has plans for some more of these target-date ETFs, that extend beyond these years.

There's no doubt junk bond ETFs are popular as of late, but investors must be careful in the analysis and research. And as of today these bond ETFs are trading around $25-$26.

Disclosure NONE

Why Stocks Outperform Bonds

Stocks provide greater return potential than bonds, but with greater volatility along the way. You have probably heard that statement so many times that you simply accept it as a given. But have you ever stopped to ask why? Why have stocks historically produced higher returns than bonds? Why are bonds typically less volatile? Understanding the reasons behind these trends could help you become a better investor. Read on to learn more.


A Basic Example

Imagine that you are starting up a business. You are the sole owner and the only employee. It will take $2,000 to start operations and you only have $1,000, so you borrow the other $1,000 from a friend, promising to pay that friend $100 per year for the next 10 years, at which time you will repay the original $1,000 loan amount. The first year, after all expenses have been paid, including your own salary, you find that your business has earned $500. You pay your friend the $100 promised and keep the remaining $400. Your friend has earned 10% (100/1000) on his loan to you, but you have earned 40% (400/1,000) on your investment.

The next year does not go as well and after all expenses have been paid you find that the business has only earned $100. You pay that $100 to your friend, who has again experienced a 10% return. You on, the other hand, are left with a 0% return, although your two-year return is still around 20% per year. And so it goes.

With each year, you have the opportunity to earn more or less than the friend who loaned you funds. If the business becomes wildly successful, your return will be exponentially higher than your friend's; if things fall apart, you may lose everything. The loan is a contractual arrangement, so if you have to close up shop, whatever money may be left goes to your friend before it goes to you. As such, your position involves greater risk, but with the opportunity of greater return. If there was no possibility of greater return, there would be no reason for you to take the greater risk.

Expanding the Basic Example

Bonds are essentially loans, as in the example above. Investors loan funds to companies or governments in exchange for a bond that guarantees a fixed return and a promise of the return of the original loan amount, known as the principal, at some point in the future.

Stocks are, in essence, partial ownership rights in the company that entitle the shareholder to share in the earnings that may occur and accrue. Some of these earnings may be paid out immediately in the form of dividends, while the rest of the earnings will be retained. These retained earnings may be used to build a larger infrastructure, giving the company the ability to generate even greater future earnings. Other retained earnings may be held for future uses like buying back company stock or making strategic acquisitions. Regardless of the use, if the earnings continue to rise, the price of the stock will normally rise as well.

Stocks have historically delivered higher returns than bonds because, as in the simplified example above, there is a greater risk that, if the company fails, all of the stockholders' investment will be lost. On the flip side, however, there is a return to stockholders that could potentially dwarf what they could earn investing in bonds. Stock investors will judge the amount they are willing to pay for a share of stock based on the perceived risk and the expected return potential – a return potential that is driven by earnings growth. Being predominantly rational as a group, they will calibrate their investments in a manner that properly compensates them for the excess risk they are taking.

The Causes of Volatility
If a bond pays a known, fixed rate of return, what causes it to fluctuate in value? Several interrelated factors influence volatility:

Inflation and the Time Value of MoneyThe first factor is expected inflation. The lower/higher the inflation expectation, the lower/higher the return or yield bond buyers will demand. This is because of a concept known as the time value of money. The time value of money revolves around the realization that a dollar in the future will buy less than a dollar today because its value is eroded over time by inflation. To determine the value of that future dollar in today's terms, you have to discount its value back over time at some rate.
Discount Rates and Present Value

To calculate the present value of a particular bond, therefore, you must discount the future payments from the bond, both in the form of interest payments and return of principal. The higher the expected inflation, the higher the discount rate that must be used and thus the lower the present value. In addition, the farther out the payment, the longer the discount rate is applied, resulting in a lower present value. Bond payments may be fixed and known, but the constantly changing interest-rate environment subjects their payment streams to a constantly changing discount rate and thus a constantly fluctuating present value. Because the original payment stream of the bond is fixed, the changing bond price will change its current effective yield. As the bond price falls, the effective yield rises; as the bond price rises, the effective yield falls.

The discount rate used is not just a function of inflation expectations. Any risk that the bond issuer may default (fail to make interest payments or return the principal) will call for an increase in the discount rate applied, which will impact the bond's current value. Discount rates are subjective, meaning different investors will be using different rates depending on their own inflation expectations and their own risk assessment. The present value of the bond is the consensus of all these different calculations.

The return from bonds is typically fixed and known, but what is the return from stocks? In its purest form, the relevant return from stocks is known as free cash flow, but in practice the market tends to focus on reported earnings. These earnings are unknown and variable. They may grow quickly or slowly, not at all, or even shrink or go negative. To calculate the present value, you have to make a best guess as to what those future earnings will be. To make matters more difficult, these earnings do not have a fixed life. They may continue for decades and decades. To this ever-changing expected return flow, you are applying an ever-changing discount rate. Stock prices are more volatile than bond prices because calculating the present value involves two constantly changing factors - the earnings stream and the discount rate.

The Pricing Process Is (Usually) Rational
 Hopefully you now have a better understanding of why stocks and bonds behave the way they do. This knowledge should place you in a better position to make more informed investment decisions. The pricing of all the thousands and thousands of stocks and bonds is essentially rational. Market participants apply their cumulative knowledge and best estimates as to future inflation, future risks and known or unknown income streams to arrive at present-day valuations. These valuations are constantly fluctuating based on continually changing expectations. In hindsight, one can see that emotions, even in the aggregate, can cause these expectations, and thus valuations, to be incorrect. For the most part, however, they are correct based on what is known at any given point in time.

Conclusion
Bonds will always be less volatile on average than stocks because more is known and certain about their income flow. Over time, stocks should generate greater returns than bonds because there are more unknowns. More unknowns imply greater potential risk. If stocks do not return more, then investors have become truly irrational and taken needless risk with their investment dollars.

Build America Bond ETFs May Get a Second Chance

The popular Build America Bonds program may get a second chance at life if President Obama’s budget passes in its current incarnation.

The budget not only calls for the program to be revived, but it wants to make the program permanent. Last year, however, Republicans blocked efforts to extend the program and it could meet with similar resistance this time, says Bloomberg.

Since the program’s end, Build America Bond ETFs got caught up in a selloff and performance suffered. PIMCO Build America Bond Strategy (NYSEArca: BABZ), PowerShares Build America Bond Portfolio (NYSEArca: BAB) and SPDR Nuveen Barclays Capital Build America Bond (NYSEArca: BABS) have all lost between 1.5% and 2% in the last month.
Municipal bond ETFs reacted nicely to the news late last week when another bill to restore the Build America Bonds program was introduced. The iShares S&P National AMT-Free Municipal Bond ETF (NYSEArca: MUB) and the iShares Barclays 20+ Year Treasury Bond ETF (NYSEArca: TLT) were both up last week by 2.3% and 0.7% respectively on the news.

Randall Forsyth for Barrons reports that the bill is the brainchild of Rep. Gerald Connolly, D-Va. His bill proposes to extend the BABs program through 2012 at subsidy rates of 32% in 2011 and 31% in 2012. The ending of the BABs program was a big reason for the large sell-off  in the muni market.

Disclosure I am long BAB, BABS and NBB shares.

Shorting Inflation Protection with TPS New Inverse Etf

ProShares on Thursday (2/10/11) introduced the first ETF to track the inverse performance of TIPS – Treasury Inflation Protected Securities.  ProShares UltraShort TIPS (TPS) seeks daily investment results that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital U.S. Treasury Inflation Protected Securities Index Series-L.

TPS is designed for investors looking to hedge against a decline in TIPS or potentially benefit from a downturn in the index.  It is not an out-and-out bet on deflation.  Investors that hold TIPS to maturity receive income plus an adjustment to the principal for increases in the CPI.  However, they do not lose capital if the CPI were to decrease during the term of the security.  In other words, TIPS provide inflation protection without a deflation penalty.  By the same token, inverse TIPS are a deflation play only to a limited extent.

The 0.95% expense ratio may be reduced by interest income earned on cash and financial instruments since the fund will get its desired exposure with leveraged swaps while maintaining a large cash position.
Additional information is available in the press release, overview, and prospectus.  Potential investors need to understand the impact of -2x leverage with daily reset that TPS uses.  The ProShares website has an informative piece on The Universal Effects of Compounding and Leveraged Funds.

Disclosure None

Weekend Reading Links - February 13, 2011

For your weekend reading pleasure, the articles listed below contain some of the best dividend and value investing insights found on the web. They were written by various members of the Dividend Investing and Value Network over the past week:

Articles From DIV-Net Members

• Dividends Value presented Building Yield: 15 Consumer Goods Dividend Stocks
• Dividend Growth Investor presented How to select dividend stocks?
• Barel Karsan presented Cash Levels High Or Low?
• Buy Like Buffett presented The Beginners Investing Roundup To Help You Make Money Investing
• The Dividend Guy presented ScotiaBank BNS Dividend Stock Analysis
• The Div Guy presented January Dividend Income Update
• Disciplined Approach to Investing presented Dividend Payers Underperform In January
• Triaging My Way To Financial Success presented DivG Purchases - January 2011
• 40percent 20years presented Screener, better corporate filters, latest reports!
• EPIC INVESTOR presented Why Abbott Looks Cheap
• Value Walk presented EBITDA: Warren Buffett Versus Everyone Else
• The Market Capitalist presented Becoming An Investor - Yes, You Can.
• Dividend Monk presented AGL Resources (AGL) Dividend Stock Analysis
• Wax Inc presented Waldo Thinks Ahead
• Frankly Speaking presented Small Firms Repurchase Strategically
• The Dividend Pig presented February Industry Analysis Announcement
• Dividend Ninja presented Creating Monthly Dividend Income

There are some really good articles here, please take time and read a few of them.

Disclosure None

3 Stocks Insiders Are Buying Like Crazy

For the past eight weeks, Insider Monkey has been publishing articles about the stocks insiders were buying like crazy. The stocksthey  listed in the first 6 articles have performed spectacularly compared to the S&P 500. Having slightly underperformed the S&P 500 index during the seventh week.

Overall, insiders are better at investing than outsiders because they know more about their companies than do most investors. This holds especially true for smaller companies, which are either followed by only a few analysts or none at all. Academic studies conducted during the past 40 years confirm that stocks bought by several insiders outperform the market by about 7 percentage points per year in those studies.

Last week, I brought 3 more companies insiders are buying to your attention. Here are their performance numbers since we highlighted them:

1. A. Schulman Inc (SHLM): Barington’s James Mitarotonda bought more than 15,000 shares during the past few days. In his last transaction, he paid $21.35, which was also the closing price for the stock on Friday, Jan 21st. Schulman’s Chief Marketing Officer, Paul R. Boulier, purchased 1,200 shares at $21.08 a few days earlier than Mitarotonda did. Schulman lost 0.7% during the past five trading days, underperformed the S&P 500 index which lost 0.5%.

2. Advanced Photonix Inc (API): Advanced Photonix made our list about a month ago. That time it returned 21% in one week, reaching $1.9 per share. API lost 0.6% last week.
3. Winmark (WINA): Winmark also underperformed the market last week, losing 1.4%.
This has been the worst weeks so far for our insider purchases. The average return for these three stocks was -0.9% vs. -0.5% for SPY. Currently insiders aren’t buying a lot of stocks. They are contrarian investors. They usually buy after large price declines, not price increases.

1. Trustco Bank Corp (TRST): This is a solid bank with a 4.3% dividend yield, and a P/E ratio of 15.9. It doesn’t seem to be a cheap stock, yet an insider purchased 5,000 shares at around $6.15 per share. On Friday, the stock closed at $6.05. There were several insider purchases in this stock a year ago when the stock price was around, you guessed it, $6. The stock underperformed the market last year, and we don’t think it’s going to deliver 20+% returns per year. It seems like a solid dividend stock which is more attractive than bonds. For the sake of following insiders’ performance, we won’t exclude this stock from our calculations.

2. Bank of Hawaii (BOH): This is also a solid bank with a 3.8% dividend yield and a P/E ratio of 12.3. It seems like a better long term buy then TRST. Insiders have been buying since the end of October when the stock price was $43.5. The latest insider purchase was on Wednesday, at $45.76. The stock closed the week at $46.76. Bank of Hawaii was downgraded on Tuesday, and this triggered a two day slide. This also gave our insider an opportunity to buy company shares at a small discount. A year ago the stock was trading at around the same level and there were several insider purchases. BOH also seems like a solid dividend stock which is more attractive than bonds.

3. RLI Corp (RLI): These are the types of insiders Insider Monkey likes. RLI Corp reported its fourth quarter earnings on Monday night and the results exceeded analysts’ expectations by a large margin. The consensus was earnings of $0.98 per share, but RLI reported $1.66 per share. The company’s P/E ratio is 10 based on its operating earnings and it is less than 9 based on its comprehensive earnings. The company’s management is taking steps that will benefit shareholders rather than themselves. They paid a special dividend of $7 per share in December, in addition to their regular dividend which has a 2.2% yield. Recently, they acquired a Seattle based private insurance company for $137 million which should contribute to their earnings as well.

Disclosure: I do not own any of these stocks at the time of this writing no plans to buy any in the future.

Nuveen Build America Bond Fund: A Good IRA Holding

This is one of a series of articles on specific municipal bond closed-end funds. I have already written several reports describing tax-exempt funds. But for this report, I’ve selected Nuveen Build America Bond Fund (NBB), which is a taxable municipal bond fund.

NBB is a national fund that primarily invests in high quality taxable municipal bond holdings issued as part of the Build America Bonds (BAB) program. The BAB program began in April, 2009. The interest income from BAB bonds is taxable at the Federal level, but a tax benefit of 35% of coupons paid goes to the issuers who receive a subsidy from the federal government.

The BAB program ended on December 31, 2010. There is still a fairly large secondary market of issued BABs worth about $200 million, but unless there is new legislation, no more new BABs will be issued. As existing bonds mature or are called, there may eventually develop an extra scarcity value for the existing BAB bonds.

I will be discussing the same 14 factors that I use to evaluate other municipal bond closed-end funds.

Factor #1: What is the distribution rate?

NBB is a high quality fund and currently has a distribution yield of 7.84%. It pays a regular monthly dividend of $0.117 per share or an annual distribution of $1.404.
For someone in a 28% tax bracket or higher, the after-tax yield for NBB is less than for leveraged tax exempt bond funds with equivalent risk levels like NPM. For example, the after-tax yield for NBB is 5.64% for someone in the 28% tax bracket, and only 5.10% if you are in the 35% tax bracket.
But in an IRA, or for those in lower tax brackets or for tax exempt investors like non-profit charities or foundations, NBB can be a good holding.

Factor #2: What is the likelihood the fund can raise its monthly dividend?

To determine this, I look at the Average Earnings/Current Dividend Ratio. This ratio tells you whether or not a fund is earning its current dividend. If the value is well above 100%, it means the fund can easily afford to raise its distribution rate.
For NBB, the average earnings over the last three months is $0.1138, so the Average Earnings/Current Dividend ratio= 97.3%.
Normally this factor would be somewhat of a red flag for NBB. But there is a positive value for “Undistributed Net Investment Income” or UNII of +0.0437 which is not bad for a new fund like NBB that launched less than a year ago in April 2010.

Factor #3: What is the expense ratio?
I look at the baseline expense ratio which does not include leverage costs. NBB has a baseline expense ratio of 0.88% which is below average for Nuveen funds. This is a positive factor for NBB. Since there will be no new issuance of BAB bonds, I expect the turnover ratio for NBB to be quite low which should reduce trading expenses.

Factor #4: What is the discount to NAV?
NBB is currently selling at a 2.0% discount to NAV which compares to a 6 month average premium of 0.6%. There is no one year Z-Statistic available, since NBB was only launched nine months ago. The maximum discount for NBB since it was issued has been as high as 6%, so it may be worthwhile to wait for the NBB discount to widen a bit before purchasing it.

Factor #5: How much leverage is used, and what is the preferred share asset coverage?
NBB currently uses 24.73% effective leverage. The preferred asset coverage ratio is currently 367% which provides a large margin of safety. I would not be concerned unless this ratio dips below 225%. The average cost of leverage is 0.78% which is pretty cheap.

Factor #6: What is the AMT exposure?
Since NBB is a taxable fund, this factor is not applicable.

Factor #7: What is the credit quality?
I look at the breakdown of AAA, AA, A, BBB, Below BBB & Unrated.
This is the ratings breakdown for NBB:

AAA	10.5%
AA	56.0%
A	27.8%
BBB	4.4%
BB & Below	1.2%	Includes unrated.

NBB is a very solid fund with an average credit rating around AA-. I like to see the lowest rating category below 10%, and NBB qualifies easily. NBB does not hold any pre-refunded bonds.

Factor #8: What is the interest rate exposure?
NPM has an average duration of 12.98 years. This is above average, and I would prefer a somewhat lower duration below ten years. If the overall interest rates rise by 1%, the price of NBB would fall by about 13%. The leverage adjusted duration is 10.7 years which would apply if the fund used no leverage.

Factor #9: What is the call exposure?
Here is a table with the call dates for bonds in NBB:

Non callable	62.0%
1-5 years	0.2%
6-10 years	2.0%
11-15 years	35.9%

NBB has little call risk over the next ten years. Because most bonds have been recently issued, the average bond price is 99.76.

Factor #10: For a national fund, what is the breakdown by state?
The fund did not report a portfolio breakdown by state. I took a look at the top portfolio holdings, and the fund seemed to be well diversified. The six largest holdings were from- Louisiana, Tennessee, Michigan, California, Texas and New York.

Factor #11: How good is the trading liquidity?
NBB has an average daily volume of 169,400 shares, and an average dollar volume of $3.0 million. You should be able to buy $100,000 of NBB in one day fairly easily without a major impact on the price.

Factor #12: What percent of the portfolio is in Housing-Multifamily bonds?
I did not see any housing bonds in the portfolio. There were very small amounts invested in tobacco bonds (0.32%) and in the commercial bank sector (1.63%).

Factor #13: Fund management
NBB is co-managed by Daniel J. Close and John Miller. Daniel joined Nuveen in 2000 and has earned the CFA designation. He received his B.S. in Business from Miami University and his M.B.A. from Northwestern University’s Kellogg School of Management.
John is Chief Investment Officer of Nuveen Asset Management and joined Nuveen in 1996 and has also earned the CFA designation. He has a B.A. in Economics and Political Science from Duke University, an MA in economics from Northwestern University and an MBA with honors in Finance from the University of Chicago.

Factor #14: Other analyst coverage
NBB is covered by the Merrill Lynch closed-end fund team and is rated as a buy.
Based on the above 14 factors, I believe that NBB is a good holding in IRA or other tax deferred ot tax exempt accounts. A good time to buy NBB is when the discount to NAV is 5% or more.

Disclosure: I am long NBB.

Blackrock Health Sciences (BME): Safe haven in a 'healthly' ETF Closed End Fund

"The current market volatility makes us want to run for shelter, a safe haven," notes Richard Lehmann, editor of The ETF Investor. One such haven he sees is health science, and offers an ETF for the sector.

Notice The Awesome Dividend History Above

"Other than Treasury bonds, which have their own risks, cash is certainly the safest. One might think of gold or natural resources as a safe haven, but once economies slow down, demand there will fall as well. Either way these safe havens are likely to be volatile in the near future.

"The health care sector is not as dependent on the overall economy and may be a safe harbor for now. There are a number of ETF's and closed end funds that cover this sector.

"The one we find most compelling is the Blackrock Health Sciences Trust (NYSE: BME) mainly because it captures the value in volatility by writing options on their holdings. The option writing activity moderates price swings and adds income to the fund.

For the love of GOD I can see a thing Wrong with this track record!~!

"It invests in healthcare providers, healthcare equipment, pharmaceuticals and biotech companies. The fund is currently trading at $27.80 a –6.84% discount from its net asset value. The yield is 5.53%, which helps as an additional cushion. The expense ratio is high at 1.13%, but is somewhat offset by the –6.84% discount from net asset value."

Strategy & Objective 

The BlackRock Health Sciences Trust, BME, is a perpetual closed-end equity fund. BME commenced operations in March 2005 with the investment objective of providing total return through a combination of current income and capital appreciation. Under normal market conditions, the Trust will invest at least 80% of its total assets in equity securities of companies engaged in the health sciences and related industries and equity derivatives with exposure to the health sciences industry. Companies in the health sciences industry include health care providers as well as businesses involved in researching, developing, producing, distributing or delivering medical, dental, optical, pharmaceutical or biotechnology products, supplies, equipment or services or that provide support services to these companies. Equity securities in which the Trust anticipates investing include common stocks, preferred stocks, convertible securities, warrants, depository receipts and equity interests in real estate investment trusts that own hospitals.

Disclosure I am long BME shares and purchasing more shares next week. 

New Weeks Hot action DCA on yet another week

Well hello I spend the better part of the week hunting looking and examining my current holdings to determine what is to be done this week for my sharebuilder tuesday investing day. I am still using the $12.00 per month 12 trade plan so my trading fees run approx. $144.00 a year, which includes 144 buy chances at $1.00 per trade try to beat that with a stick.

So first I am taking a initial plunge into TPZ Tortoise Power n Energy Infrastructure. Currently has approx 7 million shares outstanding. Was created on 07/29/2009, with average daily volume of 1.25 million a day. Inception price was $20.00 per share with a NAV of $19.50 per share, today the price is $23.62 witha  nav of $24.97. The thing the really knocked my socks off not the monthly dividend of 6.35% or 12.5 cents per month per share of stock owned, no not any of that it was the amazing fee of a mere .60 basis points oh my that is sweet. Go try and get a MLP (master limited partnership) for anywhere near that cost.

Top 10 Holdings (as of 10/31/10)
Percentage of
Holding(1) Investment Securities(2)
Kinder Morgan Management, LLC (equity) 8.6%
Enbridge Energy Management, L.L.C. (equity) 8.4%
Inergy, L.P. (equity) 3.8%
Midcontinent Express Pipeline LLC (fixed income) 3.3%
NRG Energy, Inc. (fixed income) 3.2%
PPL Capital Funding, Inc. (fixed income) 2.9%
TransCanada Pipelines Limited (fixed income) 2.9%
Source Gas LLC (fixed income) 2.8%
Energy Transfer Partners, L.P. (equity) 2.7%
Dominion Resources Inc (equity) 2.7%

So I will buy a single share to get warmed up in this name and will buy more along da way as I seem fit. I truly enjoy recieving many dividends each month sure makes compounding real easy to see working.

Buy #2  CTL CenturyLink, Inc. adding $15 to my Current Holding. Up 24.12% on this holding.

CenturyLink, Inc., together with its subsidiaries, operates as an integrated communications company. The company provides a range of communications services, including local and long distance voice, wholesale network access, high-speed Internet access, other data services, and video services in the continental United States. Its services include local exchange and long distance voice telephone services, as well as enhanced voice services, such as call forwarding, conference calling, caller identification, selective call ringing, and call waiting; network access services; data services, including high-speed Internet access services, and data transmission services over special circuits and private lines; and fiber transport, competitive local exchange carrier, security monitoring services, other communications, and professional and business information services.

The company also offers other related services, such as leasing, selling, installing, and maintaining customer premise telecommunications equipment and wiring; provides billing and collection services to third parties; participates in the publication of local telephone directories; and provides printing, database management, direct mail services, and cable television services. In addition, the company provides network database services, as well as switched digital video services and wireless broadband Internet services. As of December 31, 2009, it operated approximately 7.0 million telephone access lines. The company was formerly known as CenturyTel, Inc. and changed its name to CenturyLink, Inc. in May 2010. CenturyLink, Inc. was founded in 1968 and is based in Monroe, Louisiana.

Buy #3 IID Ing Intl High Div Equity Inc. adding $15 to my Current Holding. Up 10.46% on this holding.

The Fund seeks current income with long term capital appreciation by investment in dividend producing securities or derivatives and through utilizing an options strategy.

ing international High Dividend Equity Income Fund (the Fund) is a non-diversified, closed-end management investment company. The Fund's primary investment objective is to seek current income and current gains, with a secondary objective of long-term capital appreciation. The Fund seeks to achieve its investment objectives by investing at least 80% of its managed assets in dividend-producing equity securities of foreign companies and/or derivatives linked to such securities or indices that include such securities, and by selling call options on selected international, regional or country equity indices or futures, and/or on foreign securities.

Securities of foreign companies includes securities issued by companies that are organized under the laws of, or with principal offices in, a country other than the United States, or whose principal securities trading markets are outside the United States. The Fund's investment advisor is ING Investments, LLC.

4th and final purchase for the 16th is the etf PFF, also adding $15.00 to this one too. Currently up 2.49% to date,  iShares S&P U.S. Preferred Stock Index.

The investment seeks to track the price and yield performance, before fees and expenses, of the S&P U.S. Preferred Stock index. The fund invest at least 90% of assets in securities that comprise the index. The index measures the performance of a select group of preferred stocks listed on the NYSE, AMEX, or NASDAQ. It includes companies with a market capitalization over $100 million. The fund is nondiversified. Expense ratio is a mere .48 basis points.

FORD CAP TRST II	3.58%
BARCLAYS BANK PLC	3.36%
BANK OF AMERICA CORP	2.38%
WELLS FARGO & CO	2.35%
MERRILL LYNCH & CO INC	2.22%
METLIFE INC	1.93%
WELLS FARGO CAP	1.92%
JPMORGAN CHASE CAPITAL XXVI	1.84%
BARCLAYS BANK PLC	1.79%
HSBC HOLDINGS PLC	1.75%
Total	23.11%

Big dividend this week was KMP other dividends this week were JNK,ABT,IGD,IID,PG and the O. Finished out da week up 0.92% not including dividends. Also purchased one cd for $15.76 a 6 month 1.00% cd. That is it for da week.

Junk Bunks The Yield is Dynamite is it time to Dip ya toes??

Junk bond exchange traded funds (ETFs) have been on a tear this year. If you’ve been thinking about getting some exposure to high-yield debt, read on.

We’re in the midst of a full-blown junk bond bull market. From the market’s low on March 9, 2009 until Oct. 8, 2010, junk bonds have returned a cumulative average of 68%, reports Jeffry Kosnett for Kiplinger. That beats all other fixed-income categories.

High-yield returns have also beaten out investment-grade bond returns in the last three months. The last time that happened was during a five-month winning streak ending in July 2009, says Sapna Maheshwari for Bloomberg.

Junk bond ETFs have served to be an appealing way to get exposure to this market. They give investors a safe place to put their capital while providing yields that are tough to come by these days.

That’s why I own SPDR Barclays Capital High-Yield Bond (NYSEArca: JNK) for my accounts.

While junk bonds are riskier than other bond types, a strategy such as trend following can help you manage the risk by providing you with a sell point. If you think the junk bond rally is overheated, think again: you can’t fight the trend and right now, it’s up.

* iShares iBoxx $ High Yield Corporate Bond (NYSEArca: HYG): yields 7.97%
* SPDR Barclays Capital High-Yield Bond (NYSEArca: JNK): yields 8.44%
* PowerShares Fundamental High Yield Corporate Bond (NYSEArca: PHB): yields 6.77%

 Disclosure I am Long HYG,JNK shares.

Time for 100% Stock Allocation??

Every so often, a well-meaning individual or publication will come along and espouse the idea that long-term investors should invest 100% of their portfolios in equities. Not surprisingly, this idea is most widely promulgated near the end of a long bull trend in the U.S. stock market. Consider this article as a pre-emptive strike against this appealing, but potentially dangerous, idea.

The Case for 100% Equities

The main argument advanced by proponents of a 100% equities strategy is simple and straightforward:

"In the long run, equities outperform bonds and cash; therefore, allocating your entire portfolio to stocks will maximize your returns."

To back up their views, supporters for this view point to the widely used Ibbotson Associates historical data, which "proves" that stocks have generated greater returns than bonds, which in turn have generated higher returns than cash. Many investors - from experienced professionals to naive amateurs - accept these assertions without giving the idea any further thought. (For an in-depth view of this topic, see The Stock Market: A Look Back.)

While such statements and historical data points may be true to an extent, investors should delve a little deeper into the rationale behind - and potential ramifications of - a 100% equity strategy.

The Problem With 100% Equities

The oft-cited Ibbotson data is not very robust. It covers only one particular time period (1926-present day) in a single country - the United States. Throughout history, other less-fortunate countries have had their entire public stock markets virtually disappear, generating 100% losses for investors with 100% equity allocations. Even if the future eventually brought great returns, compounded growth on $0 doesn't amount to much. (To read more about Ibbotson's theories, see Investors Need A Good WACC.)

It is probably unwise to base your investment strategy on a doomsday scenario, however, so let's assume that the future will look somewhat like the relatively benign past. The 100% equity prescription is still problematic because although stocks may outperform bonds and cash in the long run, you could go nearly broke in the short run!

Market Crashes

For example, let's assume you had implemented such a strategy in late 1972 and placed your entire savings into the stock market. Over the next two years, the U.S. stock market crashed and lost about 40% of its value. During that time, it may have been difficult to withdraw even a modest 5% per year from your savings to take care of relatively common expenses, such as purchasing a car, meeting unexpected expenses, or paying a portion of your child's college tuition, because your life savings would have almost been cut in half in just two years! That is an unacceptable outcome for most investors and one from which it would be very tough to rebound. Keep in mind that the crash in 1973-1974 wasn't the most severe crash, considering the scenario that investors experienced during 1929-31. (To learn more about crashes, see The Greatest Market Crashes and How do investors lose money when the stock market crashes?)

Of course, proponents of all-equities-all-the-time argue that if investors simply stay the course, they will eventually recover those losses and earn much more. However, this assumes that investors can stay the course and not abandon their strategy - meaning they must ignore the prevailing "wisdom", the resulting dire predictions and take absolutely no action in response to depressing market conditions. We could all share a hearty laugh at this assumption, because it can be extremely difficult for most investors to maintain an out-of-favor strategy for six months, let alone for many years.

Inflation and Deflation

Another problem with the 100% equities strategy is that it provides little or no protection against the two greatest threats to any long-term pool of money: inflation and deflation.

Inflation is a rise in general price levels that erodes the purchasing power of your portfolio. Deflation is the opposite, defined as a broad decline in prices and asset values, usually caused by a depression, severe recession, or other major economic disruption (think Japan in the 1990s). (To learn more about inflation and deflation, see All About Inflation and What does deflation mean to investors?)

Equities generally perform poorly if the economy is under siege by either of these two monsters. Even a rumored sighting can inflict significant damage to stocks. Therefore, the smart investor incorporates protection - or hedges - into his or her portfolio to guard against these two significant threats. Real assets - real estate (in certain cases), energy, infrastructure, commodities, inflation-linked bonds, and/or gold - could provide a good hedge against inflation. Likewise, an allocation to long-term, non-callable U.S. Treasury bonds provides the best hedge against deflation, recession, or depression. (Read more about hedges in A Beginner's Guide To Hedging, Introduction To Hedge Funds - Part One and Part Two.)

Fiduciary Standards

One final cautionary word on a 100% stocks strategy: If you manage money for someone other than yourself, you are subject to fiduciary standards. One of the main pillars of fiduciary care and prudence is the practice of diversification to minimize the risk of large losses. In the absence of extraordinary circumstances, a fiduciary is required to diversify across asset classes. Would you like to argue before a judge or jury that your one-asset-class portfolio was sufficiently diversified shortly after it loses 40-50% of its value? "But, your honor, if you just wait eight to 10 years …" Odds are you would soon be wearing an orange jumpsuit and making new friends in an exercise yard.

Solution

So if 100% equities is not the optimal solution for a long-term portfolio, what is? An equity-dominated portfolio, despite my cautionary counter arguments above, is reasonable if you assume that equities will outperform bonds and cash over most long-term periods. However, your portfolio should be widely diversified across multiple asset classes: U.S. equities, long-term U.S. Treasuries, international equities, emerging markets debt and equities, real assets and even junk bonds. If you are fortunate enough to be a qualified and accredited investor, your asset allocation should also include a healthy dose of alternative investments - venture capital, buyouts, hedge funds and timber. (To learn more, read The Pros And Cons Of Alternative Investments.)

This more diverse portfolio can be expected to reduce volatility, provide some protection against inflation and deflation, and enable you to stay the course during difficult market environments - all while sacrificing little in the way of returns.

Disclosure I am long the stock market