Investing Archives

Negative Interest Rates

October 31, 2016 by Justin M. Follmer, MBA, CFP®, AIF®

Nominal interest rates are currently below zero in many countries, including Germany, Denmark, Switzerland, Sweden, and Japan. With new acronyms like ZIRP (Zero Interest Rate Policy) and NIRP (Negative Interest Rates Policy), these levels have turned the common belief that zero is the lower bound for such rates on its head. While negative interest rates are a relatively new phenomenon, periods of widespread negative real returns across countries have been quite common.

WHAT ARE AND WHY CARE ABOUT REAL RATES OF RETURN?

In 1970, a loaf of bread cost 25 cents. A gallon of gas cost 36 cents. Today, an average loaf of bread and a gallon of gas each cost around two dollars.¹When the prices of goods and services increase, consumers can buy fewer of them with every dollar they have saved. This is called inflation, and it eats into investors’ returns.

Real rates of return are adjusted for inflation, so they account for changes in the purchasing power of a dollar over the life of an investment. Because inflation affects the cost of living, investors must consider the inflation-adjusted—or real—return of their investments. When inflation outpaces the nominal returns on an investment, investors experience negative real returns and actually lose purchasing power.

BRIEF HISTORY: TREASURY BILL RETURNS

Exhibit 1 shows the annual real returns on one-month US Treasury bills. From 2009 to 2015, the annual real return was negative. This circumstance is not unprecedented. Since 1900, the US has had negative real returns in over a third of those years. And negative real returns on government bills are not exclusive to the US. All countries listed in Exhibit 2 have had negative real returns on their respective government bills in at least one out of every five years from 1900 to 2015.

Exhibit 1. Annual Real Returns of One-Month US Treasury Bills

Source: Dimson, Marsh, and Staunton (DMS); Morningstar.

Exhibit 2. Percent of Years with Negative Real Returns on Government Bills, 1900-2015

Source: Dimson, Marsh, and Staunton (DMS); Morningstar.

BOND INVESTORS MAY GET MORE THAN THE BILL RETURN

In the current low-yield environment, rolling over short-term bills may not seem appealing to investors keen on protecting their purchasing power. Exhibit 3 shows that the return of one-month US Treasury bills has not kept pace with inflation² over the past 10 years. But even when the real return on bills is negative, a relatively common occurrence, bond investors may still achieve positive expected real returns by broadening their investment universe. The bond market is composed of thousands of global bonds with different characteristics. Many of those bonds allow investors to target global term and credit premiums, which in turn may provide positive real returns even in low interest rate environments. Exhibit 3 also shows that the Barclays Global Aggregate Bond Index has outpaced inflation while maintaining low real return volatility of 3.4% annualized over the past 10 years.

Exhibit 3. Trailing Annualized Returns

Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Trailing returns are as of June 2016. The Barclays Global Aggregate Bond Index is hedged to USD. Real Return = [(1 + Nominal Return)/(1 + Inflation)] − 1. Sources: Barclays, Morningstar. Barclays indices copyright Barclays 2016.

Global diversification is often thought of as a tool for reducing risk. However, when it comes to fixed income, global portfolios can also play an important role in the pursuit of increased expected returns. Even if the expected real returns of bonds in one country are negative, another yield curve may provide positive expected real returns. The flexibility to pursue higher expected returns by investing in bonds around the world can be an important defense against low, and even negative, yields.

SUMMARY

The goal of many investors is to grow some (or all) of their savings in real terms. Even in a low or negative interest rates environment, there may be bond investments that can still achieve this goal. In particular, investors who target global term and credit premiums should be better positioned to pursue higher expected returns.

During our on-boarding process, there is extensive analysis of the current portfolio positions. We often ask new clients to explain the reasons they own certain mutual funds or other positions in their portfolios. The most common answer is “not sure, our financial advisor did it.” And this lack of attention is precisely why I do what I do. I believe education surrounding the “why” in a client’s portfolio is crucial to a positive investment experience. Owning just U.S. stocks or just U.S. bonds is doing yourself a disservice. There is a world of opportunity to invest in that can match your long-term financial goals and risk tolerance. We work with all types of wonderful people and if you want to experience a different way of investing, get in touch today.

1. Source: Bureau of Labor Statistics

2. Measured as changes in the Consumer Price Index (CPI), which is defined by the US Department of Labor, Bureau of Labor and Statistics.

3. Written by Dimensional Fund Advisors with edits by Coastal Wealth Advisors, LLC.

Presidential Elections and the Stock Market

October 24, 2016 by Justin M. Follmer, MBA, CFP®, AIF®

Next month, we head to the polls to elect the next president of the United States. Unless you don’t watch the news or spend time on social media, you know how heated this presidential election cycle has become. While the outcome is unknown, one thing is for certain: there will be a steady stream of opinions from pundits and prognosticators about how the election will impact the stock market, and thus your investment and retirement portfolio. As we explain below, investors would be well‑served to avoid the temptation to make significant changes to a long‑term investment plan based upon these sorts of predictions.

SHORT-TERM TRADING AND PRESIDENTIAL ELECTIONS RESULTS

Trying to outguess the market is often a losing game. Current market prices offer an up-to-the-minute snapshot of the aggregate expectations of market participants. This includes expectations about the outcome and impact of presidential elections. While unanticipated future events—surprises relative to those expectations—may trigger price changes in the future, the nature of these surprises cannot be known by investors today. As a result, it is difficult, if not impossible, to systematically benefit from trying to identify mispriced securities. This suggests it is unlikely that investors can gain an edge by attempting to predict what will happen to the stock market after any presidential elections.

Exhibit 1 shows the frequency of monthly returns (expressed in 1% increments) for the S&P 500 Index from January 1926 to June 2016. Each horizontal dash represents one month, and each vertical bar shows the cumulative number of months for which returns were within a given 1% range (e.g., the tallest bar shows all months where returns were between 1% and 2%). The blue and red horizontal lines represent months during which presidential elections were held. Red corresponds with a resulting win for the Republican Party and blue with a win for the Democratic Party. This graphic illustrates that election month returns were well within the typical range of returns, regardless of which party won the presidential elections.

Exhibit 1: Presidential Elections and S&P 500 Returns, Histogram of Monthly Returns, January 1926 — June 2016

LONG-TERM INVESTING: BULLS & BEARS ≠ DONKEYS & ELEPHANTS

Predictions about presidential elections and the stock market often focus on which party or candidate will be “better for the market” over the long run. Exhibit 2 shows the growth of one dollar invested in the S&P 500 Index over nine decades and 15 presidencies (from Coolidge to Obama). This data does not suggest an obvious pattern of long-term stock market performance based upon which party holds the Oval Office. The key takeaway here is that over the long run, the market has provided substantial returns regardless of who controlled the executive branch.

Exhibit 2: Growth of a Dollar Invested in the S&P 500, January 1926–June 2016

Past performance is not a guarantee of future results. Presidential Elections. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. The S&P data is provided by Standard & Poor’s Index Services Group.

CONCLUSION

Equity markets can help investors grow their assets, but investing is a long-term endeavor. Trying to make investment decisions based upon the outcome of presidential elections is unlikely to result in reliable excess returns for investors. At best, any positive outcome based on such a strategy will likely be the result of random luck. At worst, it can lead to costly mistakes. Accordingly, there is a strong case for investors to rely on patience and portfolio structure, rather than trying to outguess the market, in order to pursue investment returns.

We perform a wide range of services for our clients outside of building, managing, monitoring, and rebalancing investment portfolios. One of the most important of these services, in our opinion, is the conversation we have surrounding behavioral finance, risk tolerance, and their impact on emotional decision making. As you can see by this post, we always turn to “the data” to help guide our advice. If you’re working with a financial advisor today who has positioned your portfolio to try to outguess the presidential elections, give us a call. We’re confident that our approach makes for a more positive investment experience.

1. Content written by Dimensional Fund Advisors, LP with edits by Coastal Wealth Advisors, LLC.

Should Recent Events Change your Investment Strategy?

August 31, 2016 by Justin M. Follmer, MBA, CFP®, AIF®

Should recent events change your investment strategy? Should anticipated future events change your investment strategy? When news breaks and markets move, content-starved media often invite talking heads to muse on the repercussions. Knowing the difference between this speculative opinion and actual facts can help investors stay disciplined during purported “crises.”

At the end of June this year, UK citizens voted in a referendum for the nation to withdraw from the European Union. The result, which defied the expectations of many, led to market volatility as participants weighed possible consequences.

Journalists responded by using the results to craft dramatic headlines and stories. The Washington Post said the vote had “escalated the risk of global recession, plunged financial markets into free fall, and tested the strength of safeguards since the last downturn seven years ago.”²

The Financial Times said “Brexit” had the makings of a global crisis. “[This] represents a wider threat to the global economy and the broader international political system,” the paper said. “The consequences will be felt across the world.”³

It is true there have been political repercussions from the Brexit vote. Theresa May replaced David Cameron as Britain’s prime minister and overhauled the cabinet. There are debates in Europe about how the withdrawal will be managed and the possible consequences for other EU members.

But within a few weeks of the UK vote, Britain’s top share index, the FTSE 100, hit 11-month highs. By mid-July, the US S&P 500 and Dow Jones Industrial Average had risen to record highs. Shares in Europe and Asia also strengthened after dipping initially following the vote.

Yes, the Brexit vote did lead to initial volatility in markets, but this has not been exceptional or out of the ordinary. One widely viewed barometer is the Chicago Board Options Exchange Volatility Index (VIX). Using S&P 500 stock index options, this index measures market expectations of near-term volatility.

You can see by the chart above that while there was a slight rise in volatility around the Brexit result, it was insignificant relative to other major events of recent years, including the collapse of Lehman Brothers, the eurozone crisis of 2011, and the severe volatility in the Chinese domestic equity market in 2015.

None of this is intended to downplay the political and economic difficulties of Britain leaving the European Union, but it does illustrate the dangers of trying to second-guess markets and base an investment strategy on speculation.

Now the focus of speculation has turned to how markets might respond to the US presidential election. CNBC recently reported that surveys from Wall Street investment firms showed “growing concern” over how the race might play out.⁴

Given the examples above, would you be willing to make investment decisions based on this sort of speculation, particularly when it comes from the same people who pronounced on Brexit? And remember, not only must you correctly forecast the outcome of the vote, you have to correctly guess how the market will react.

Should recent events change your investment strategy? We don’t believe so. Should anticipated future events change your investment strategy? In our opinion, your investment strategy should change only when your long-term financial goals change. What we do know is that markets incorporate news instantaneously and that your best protection against volatility is to diversify both across and within asset classes, while remaining focused on your long-term investment goals.

The danger of investing based on recent events is that the situation can change by the time you act. A “crisis” can morph into something far less dramatic, and you end up responding to news that is already in the price.

Journalism is often described as writing history on the run. Don’t get caught investing the same way.

Working with a fiduciary can sometimes shed light in a new way, thereby, providing a perspective you may have been missing. Give us a call today and perhaps we can show you a few things about your current strategy and what changes, if any, could help you build more purpose to your financial goals.

Image Credit: frankieleon

Post authored by Jim Parker, Outside the Flags, with edits by Coastal Wealth Advisors, LLC. Original article here.
“Brexit Raises Risk of Global Recession as Financial Markets Plunge,” Washington Post, June 24, 2016.
“Brexit and the Making of a Global Crisis,” Financial Times, June 25, 2016.
“Investors are Finally Getting Nervous about the Election,” CNBC, July 13, 2016.

Positive News Articles

June 15, 2016 by Justin M. Follmer, MBA, CFP®, AIF®

Where are all the positive news articles? Do you ever listen to the news and find yourself thinking that the world has gone to the dogs? The roll call of depressing headlines seems endless. But look beyond what the media calls news, and there also are a lot of things going right.

It’s true the world faces challenges in maintaining stable and well-functioning social, environmental, and economic systems. The legacy of the financial crisis is still with us, and concerns about climate change and sustainability are widespread.

Europe is grappling with a refugee crisis; China faces a difficult transition from an export and industrial-led economy to one driven by domestic demand; and the US is preoccupied with a sometimes rancorous election campaign.

But it’s also easy to overlook significant advances in raising the living standards of millions, increasing global cooperation on sustainability, and efforts to build greater transparency and trust in financial institutions.

Many of the 10 developments cited below don’t tend to make the front pages of daily newspapers in the form of positive news articles or the lead items in the TV news, but they’re worth keeping in mind on those occasions when you feel overwhelmed by all the grim headlines.

So here’s an alternative positive news articles bulletin:

Over the last 25 years, 2 billion people globally have moved out of extreme poverty, according to the latest United Nations Human Development Report.¹
Over the same period, mortality rates among children under the age of 5 have fallen by 53%, from 91 deaths per 1000 to 43 deaths per 1000.
In September 2015, all members of the UN set 17 sustainable development goals for 2030, including targets for eliminating poverty and hunger and lifting standards in health, education, water, energy, and infrastructure.
Global trade has expanded as a proportion of GDP from 20% in 1995 to 30% by 2014, signaling greater global integration.²
Global bank regulators recently announced that since the financial crisis they have implemented reforms to reduce leverage, address systemic risk, and build capital buffers into the banking system.³
The world’s biggest economy, the US, has been recovering. Unemployment has halved in six years from 10% to 5%.⁴
Global oil prices, while about 80% up from January’s 13-year lows, are still 50% below where they were two years ago. While bad news for the oil sector, lower prices also raise real incomes for consumers, increase profits outside energy, and decrease costs of production.
While fossil fuels still play a major role in the economy, renewable energy sources—such as solar and wind— accounted for nearly 22% of global electricity generation in 2013 and are seen rising to at least 26% by 2020.⁵
We live in an era of rapid innovation. One report estimates the digital economy now accounts for 22.5% of global economic output and projects digital technologies could generate $2 trillion of additional output by 2020.⁶
The growing speed and scale of data are increasing global connectedness and transforming industries as new discoveries are made in such areas as engineering, medicine, food, energy, and sustainability.

No doubt many of these advances will lead to new business and investment opportunities. Of course, not all will succeed. But the important point is that science and innovation are evolving in ways that can help mankind. The world is far from perfect. The human race faces major challenges. But just as it is important to be realistic and aware of the downside of our condition, we must also recognize the major advances that we are making.

Just as there is reason for caution, there is always room for hope. And keeping these positive news articles and trends in mind can help when you feel overwhelmed by all the bad news. Working with an investment advisor and financial planner can help you keep a perspective on the positive news articles that have an impact on your portfolio and long-term financial plan. Looking at the daily barrage of negativity through traditional media outlets as well as Facebook and other social media platforms can seriously dampen your mood. A constant state of depressed emotions and feelings can have lasting negative effects on the decisions you make with your money. One of the core investment philosophies of Coastal Wealth Advisors is keeping emotions in check – thereby helping to prevent our clients from making poor decisions at the worst times. Let us be your fiduciary; let us help you towards a more meaningful investing and planning experience. Get in touch today to learn about our unique financial planning process.

Image credit: Nitin Dhumal

1.”Human Development Report 2015: Work for Human Development,” United Nations.
2.”International Trade Statistics 2015,” World Trade Organization.
3.”Finalising Post-Crisis Reforms: An Update,” Bank for International Settlements, November 2015.
4. Bureau of Labor Statistics, May 26, 2016.
5. “Renewable Energy Statistics,” International Energy Agency, March 2016.
6. “Digital Disruption: The Growth Multiplier,” Accenture and Oxford Economics, February 2016
7. Authored by Jim Parker of Dimensional Fund Advisors. Original article here.

Low Cost Index Funds

June 3, 2016 by Justin M. Follmer, MBA, CFP®, AIF®

Low cost index funds are an innovative solution for investors that provide diversified investments at low fees. On any given day, an investor can observe the performance of indices from providers such as MSCI,¹ S&P,² or Russell³—and that means it’s easy to monitor whether or not an index fund manager replicated the index’s performance (gross of fees and expenses). However, an index fund manager’s strict adherence to an index comes at a cost in the form of reduced discretion around trading.

Most indices revise their list of index constituents periodically (e.g., annually or quarterly), at which time securities may be added or deleted from the index. This process is commonly referred to as index reconstitution. For example, the annual reconstitution of the widely tracked Russell indices will occur on June 24, 2016. Russell index fund managers will need to buy additions and sell deletions for the indices they track in order to minimize tracking error⁴ relative to the index. Any deviation of the fund from the index, over days or even hours, could result in different returns from the index.

The effect on volume from index rebalance trades is apparent in a huge volume spike on trade reconstitution day. Exhibit 1 illustrates average trade volume for additions and deletions in four major indices during the 80-day period surrounding reconstitution. Each of the charts shows a marked increase in trade volume on the effective date of reconstitution relative to the surrounding days. The effect is pervasive across the market capitalization spectrum as well as geographic region.

Exhibit 1: Equal-Weighted Average Trade Volume for Index Additions and Deletions

For each index, this large liquidity demand tends to drive up the prices of securities with greater purchase demand (generally additions to the index) relative to the other securities in the index. It also tends to push down prices of securities with greater sell demand (generally deletions from the index) relative to the other securities in the index. Thus, for an index being tracked by a large amount of assets, the index has generally added securities at higher prices and deleted securities at lower prices than it would have if no assets had been tracking it. This phenomenon is the result of low cost index fund managers’ demanding liquidity on or around the index reconstitution date.

After the reconstitution of an index, as the liquidity demands of low cost index fund managers decline, research shows this price effect tends to reverse. That is, additions tend to underperform the index while deletions tend to outperform. As a result, low cost index fund managers’ implicit trading costs can result in a performance drag on the index and, consequently, low cost index funds tracking the index.

A simple experiment in delaying reconstitution allows us to estimate how much this price pressure has impacted index performance. Exhibit 2 compares average monthly returns for two sets of Russell indices; one set is rebalanced on the June-end reconstitution date and the other three months later. As shown in the final three columns, delaying rebalancing improved average returns between 0.15% and 0.73% per month from July through September—the three months between the rebalance date of the standard indices and their delayed counterparts. For all calendar months, including October through June when holdings are identical for both rebalancing methods, this amounts to a performance benefit ranging from 0.04% to 0.18% per month, or approximately 0.45% to 2.21% per year.

Exhibit 2: Effect of Delaying Reconstitution Month

Russell data © Russell Investment Group 1995–2016, all rights reserved. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Low Cost Index Funds: Summary

Low cost index funds may be a good option for investors seeking investments with low fees. However, in an attempt to match the returns of an index, a low cost index funds manager sacrifices trading flexibility. Because of high liquidity demands around index reconstitution dates, low cost index funds may incur high trading costs that do not appear in expense ratios but do affect net returns. The funds’ goal of minimizing tracking error may come at the expense of returns. Investors should consider the total costs, both in terms of expense ratio and trading costs, when evaluating investment options. Working with our Johns Island Investment Advisor can help you build a low cost portfolio using non-index funds in favor of evidence-based portfolios. Give us a call for a free consultation today!

Morgan Stanley Capital International.
Standard & Poor’s Index Services Group.
FTSE Russell is wholly owned by London Stock Exchange Group.
Tracking error is the standard deviation of the return differences between a fund and its benchmark
Source: Dimensional Fund Advisors LP.