Taper but no initial tantrum

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  • The Federal Reserve decided to lessen monthly purchases to $75 billion from $85 billion.
  • They said further measured steps are possible on tapering.
  • They said exceptionally low rates until jobless rate well below 6.5%.

            We sense that they gave a very token reduction in the pace of purchases since $75 billion worth of debt purchases is going to continue to grow the Fed’s balance sheet.

           They likely did this for a few reasons and most importantly to foster a sense of credibility. Data dependency is their mantra for the decisions they make and a better jobless number apparently warranted a slight taper. If they seriously thought the economy had full wind in its sail, they would have taken $20-$25billion off of the table.

            The big key is the last of the three statements in terms of what we feel is a bargain with the market. To mitigate the risk of a tantrum such as the one in Spring when bonds sold off significantly, they are anchoring rate expectations for quite some time while they take their foot off the accelerator ever so slightly. Bonds are broadly softer this morning although a massive unwinding is unlikely at least for now.

            This Fed action simply let some air out of the ever growing “anticipation balloon”. Now we know they can taper based in part on improving data. Here is a thought. What if in their tapering campaign, data comes out that is both deflationary and recessionary sometime in late 2014 for instance?   Will they begin to ramp up again?

            While some believe this is the first in a series of measured reductions, we feel that the path and direction of the Fed’s purchase program is not likely to be a linear move. The data both for inflation and labor markets is too uncertain to predict such an exact policy change.

            Bonds continue to be one of the most difficult areas of the capital markets to invest in as investors are “forced” into credit products that are in many cases overvalued and into reasonably unknown areas such as Emerging Market debt where clarity of policy is even more uncertain and less studied.  

            A small bit of evidence with regard to the difficulty that bond investors face came to us as we examined a few ETFs.  Here are two brief examples.

AGG-I-Shares US Total Bond Market

  • 2.21%  SEC yield
  • 5.06 duration
  • 60% weight to Treasuries and Mortgage Backed securities
  • AUM $15 Billion

            This is evidence of either a strong belief in this ETF with 60% of the portfolio highly influence by Fed policy or or a degree of discomfort with more robust options. Even if this $15 Billion of investor money liked mortgage backed debt, why not utilize an adept active manager in this space? That 2.21% is wiped out with that duration as high as it is if rates move up.

IGOV-I-Shares International Treasury Bond

  • 1.41%  SEC yield
  • 6.76 duration
  • 18% weight to Japanese debt and 37% in “other”
  • AUM $603 Million

         This is even more vexing as I am not sure how $603 Million worth of investor money can hold any conviction on a product where 37% is other and 18% is Japanese Debt. Possibly a move is proving difficult in a market where spreads have come in and EM Debt is perceived as too precarious.

            We would absolutely sell these products as soon as your team is able to formulate a well vetted alternative solution. They do not in our opinion represent a solid risk to reward scenario.

            This is our last blog of the year and while that is a relief for some who are weary of Zenith’s insight;), we will be back in the new year identifying solidly good situations as well as the poor ones such as the two listed above.

            Our closing thoughts are as disparate as the markets we cover. As the year comes to a close we wish for a few things.

  • A solid resolution to the Ukrainian revolutionary storm so that the people can develop as a nation free and prosperous.
  • The projected global wine shortage does not occur.
  • That every and all ski resorts continue to receive regular and heavy snowfall through spring.
  • The US Ski Team dials it up and does well in Sochi. This holds for all of our athletes.




Tom Koehler-CIO



“Bond markets represent a complex asset class and while we covered a small amount, there is a lot more information needed prior to making an investment decision. Let us know if we can provide more information to help in that process.”



Commodity Issues


There are really two major avenues to gain exposure to commodities. Since buying physical commodities such as wheat, oil and copper is not practical, an investor is limited to two choices.

o The companies that produce the commodities
o The futures contracts underlying the commodities

There is a wide range of options with both of these segments and given the complexity of this asset class, it is important to look under the hood of both areas. We will begin with the commodities themselves.

Generally, there are 3-5 main segments that are represented.

o Energy-Oil and natural gas
o Agriculture-Wheat and corn
o Base materials-Copper, steel
o Precious Metals-Gold and Silver
o Soft-sugar and coffee

The weighting of each of these segments and of the individual commodities varies by the manager or passive ETF provider. Remember, all or some of these are represented by a group of futures contracts.

The best example to illustrate a futures contract is that of a farmer who has a soybean crop for instance. Assume in June a farmer expects to harvest at least 10,000 bushels of soybeans during September. By hedging, he can lock in a price for his soybeans in June and protect himself against the possibility of falling prices.

Another example is that of a speculator who believes that oil will rise in price in the future and with limited ability to go and lease an oil tanker, they proceed to buy a futures contract to express this view. It can be profitable; however the magnitude and timing of the rise in price will help determine the gain or loss on this strategy.

In the case of a mutual fund or ETF that needs to have representation across a number of commodities, this entails buying futures contracts as they come due within energy, agriculture, base metals, precious metals and soft commodities. Some “roll” the contracts every 3 months, while others have the flexibility to buy contracts farther out on the calendar. There is no way to completely mitigate the major risk with these commodity futures contracts which is called “roll risk”.

Roll yield is the gain or loss caused by rolling into higher priced or lower priced contracts. A term call Backwardation is where there is a positive roll yield from buying cheaper contracts, meaning that prices are lower as the investor buys contracts to take delivery farther out in the future. Rolling future contracts in this market condition can be profitable as the fund is able to purchase more contracts at lower prices.

The risk is if the market moves into a condition where prices are higher for contracts taking delivery further out. This market condition is called Contango and negatively affects funds with a rolling futures contract strategy. This will cause the contracts to depreciate in value.

Another risk is that the “collateral yield” diminishes as it has in recent years as short term interest rates have very low yields. In the past this collateral that managers have used against the futures contracts helped to boost yield when rates were higher but that portion of the return is low.

Current summary of risks:

• These are very disparate markets from energy to precious metals combined in one broad basket.
• Any and each of these can possess contango which is a value erosion condition.
• Interest rates can remain low dampening collateral yield.
• Traditionally bought as inflation hedges, only some of the broad basket is statistically positively correlated to inflation and if inflation wanes, the broad basket of commodities may come under pressure.
• Commodities have at times been an investment to hedge against dollar weakness and so the investment becomes a currency bet to some degree.
• World supply and demand for the commodity complex is in glut condition lessening the price appreciation potential for the underlying commodity.
• Structure-They can be “grantor trusts”, partnerships(3c1) which can have unique tax issues for your clients.

We at Zenith feel that an investment in a commodities fund with futures as the underlying investment possess characteristics that make a profitable investment very difficult to obtain. The due diligence by their nature is more involved than that for a US equity fund for instance and an investment should not be made unless there is a firm understanding of the product. In later pieces we will choose our “favorite” and our least favorite as well as make a comparison to owning the underlying commodity producers.


Tom Koehler-CIO

Fed Taper Guess

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We would love to hear your comments with regard to the timing and magnitude of Federal Reserve purchase reduction potential.

Back ground economic information that the Fed monitors and weighs heavily

They are uncomfortable with the low level of inflation and that argues for continued monthly purchases with little to no taper.

Unemployment is lower but the participation rate is lower as well. Since it hit the 7% threshold, that argues in favor of a taper.

Housing is showing signs of weakening but certainly not of falling off a cliff. Uncertain earnings guidance from a major homebuilder is worrisome and their stock is reflective of that as they are down in some cases over 2-3% today. This has been an area of strength so they may not want to burst this bubble.

Budget “deal” is reached and stocks sell off as taper has now been moved to the Dec time frame  (they meet next week) according to traders.

1. Does the Fed curtail purchases within the next 6 months?

2 How much do they decrease?


1. Will they be forced by deflationary forces to maintain?

2. Do they possibly increase?

We welcome predictions and thoughts in the comment section.



Tom Koehler-CIO

Real Estate

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Real Estate Fund Comparison

We outline below some basic qualitative characteristics of a fund that holds a low Zenith Score and one that holds a high Zenith score. It is interesting to note that the lowly scored fund has about 1.5x more assets.

Low score Real Estate Fund

  • They are 80% invested in REITS under normal conditions-This is too high and can limit the opportunity set.
  • Property sector selection into areas such as office, malls, self storage-While appealing as an over or underweight technique, this can be costly and their weights are not varying enough. Not enough tracking error for Zenith.
  • Bottom up security selection is utilized to identify the best in each sector. This is not always value additive.
  • Benchmark sensitive portfolio construction-We view this as dependency on benchmark weighting as their names are highly similar to most REIT ETFs.
  • They have added value at times with sector and security selection but not as consistently as we would prefer. It often times detracts and at a high fee structure.
  • They have a high turnover of investments and does not fit a benchmark hugging theme. They are attempting to invest with a keen sense of the benchmark but at the same time trying to adeptly over and underweight whole sectors.
  • This is an expensive fund with high turnover with a constrained mandate.
  • If REITs are overvalued, they are “forced” to make placements.
  • That can mean buying REITs with a historically low dividend yield and companies trading at a premium to Net Asset Value(NAV).


High score Real Estate Fund

  • Broad and flexible mandate beyond REITS and can include;
    • Equity and debt securities (debt no more than 20% of total assets)
    • International companies (up to 25% of total assets)
    • Companies of all market capitalizations
    • Since REITS are approximately 48% of US real estate related companies, they go beyond REITS in their investment universe to potentially add value and to decrease risk when REITs are not compelling investments.

 Examples of the broader opportunity set include;

  • hotel and leisure
  • real estate service companies
  • real estate operating companies
  • They posses a thesis with a number of underpinnings to develop the portfolio and their performance is dependent on these major areas;
  • continued strength in overall corporate credit
  • continued housing strength
  • continued supply constraints with regard to hotel rooms and overall commercial real estate building.
  • Despite these risks we like the fact that they believe in the companies operationally, thematically and from a disciplined intrinsic value approach.
  • They deliver solid creative performance with a reasonable fee given their broad focus and with a lower turnover.


REITs and Real Estate have done exceptional since the 2008 disaster and our favored fund has benefited from some seriously strong tailwinds. However, we do believe that it is an excellent time to examine your current real estate fund especially if it is REIT centric and to explore other funds that may have a more robust process and opportunity set.


Tom Koehler-CIO