Socially responsible? The challenges that lie ahead

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SRI or socially responsible investments have been growing in popularity over the past few years and that has been reflected in our writings over the last few months as it seems to become more important by the week.  We have touched upon many topics that are wide ranging but that share an underlying theme.

Change is the theme that resonates throughout the writings. ‘Yield cos’ are corporate structures that address the apparent need for financial vehicles that address the changing alternative energy landscape. Micro-finance structures cover many asset classes and their growth within the profit and non-profit world continue growth to address the changing needs inherent within the third world farming and green products communities.

Mutual funds that seek to invest without exposure to fossil fuel companies are responding to sweeping changes as well are ETFs that seek and index composition with less carbon impact. The products, firms and innovation is growing along side these changes.

There are challenges that accompany this change. SRI investments are still considered by many investors to lack performance legitimacy and to be to opaque to be able to truly define “socially responsible”. We agree that to some extent there is a lot of interpretation with regard to what constitutes socially responsible.

It would be reasonably easier if one simply did not want something in their portfolio such as tobacco or big agriculture but what if an investor wanted a fully diversified portfolio that addressed their ethos and was calibrated to quality Environmental, Social and Governance factors? This is a massive challenge for the majority of wealth managers who have millennials as the next wave of inherited wealth.  How will they be able to service and cultivate those relationships that ask for more than a traditional balanced portfolio?

It becomes even more complicated as the wealth grows and the interests become much more specific such as a desire to allocate 50% toward true impact investments. Will most firms have the capacity to deliver thoughtful solutions within the early stage green tech or organic farming space?

The preparation for the massive wealth transfer to the next few generations and the investment needs will be challenging but most likely rewarding to those who anticipate beyond the next quarter. We look forward to aiding in your preparation.

Sincerely,

Tom Koehler-CIO

“Socially Responsible Investments 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.”

The difficult and painful commodity world

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The commodity complex continues to hurt many investors directly and indirectly. We have written about commodities and the issues with many of the products in the past and most recently about the indirect pain in the high yield market with regard to Oil and Gas exploration companies.

Broad based commodity funds and ETFs have lost 13% or more over the last year in a very tough environment for many commodities such as oil, gold, wheat and base metals such as aluminum. Among other reasons, basic oversupply and lower demand have driven prices down. The Powershares ETF DBC which represents futures contracts in major commodities such as Oil, Gold, Wheat and Aluminum is down and has not provided the inflation protection or the diversification benefits that many advisers have hoped for.

We decided to take a look at the underlying commodities to determine if the futures curves in each are in a state of contango or backwardation. As a review, contango is not an enviable state while backwardation allows for the potential to profit. The key question is whether or not the manager or instrument used has the ability to navigate the futures curve adeptly.

It is important as wealth can be eroded by buying contracts that are part of a futures curve that is in contango and after examining some of the curves for energy and gold at least, there is reason to be concerned as at least a few of these areas display contango.

We recommend that your investment committee take a serious look at the methodology that your ETF or active mutual fund manager employs as a poor process can cause wealth destroying damage. If you would like some assistance in this due diligence project, Zenith would be happy to help out and provide our insight.

Sincerely,

Tom Koehler, CIO

Global Bonds-Where is the value?

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In our last piece we reviewed a few major concerns and attributes with regard to the US fixed income market. The major issues included inflation uncertainty, stretched valuations and overall low real yields.

We will now examine the global debt market landscape to aid advisors and investment committees in their quest to provide reasonable fixed income solutions in an environment that seems very unreasonable.

We begin our international journey by taking a look at the Treasury Bond Index outside of the US.

I-Shares International Treasury Bond ETF (IGOV)
S&P/Citigroup International Treasury Bond Index Ex-US ($)

This ETF holds a yield of .82% yield and a duration of 7.22 and this is to be expected with a 22% weight to Japan. Obviously, this fund tracks an index that possesses an antiquated market weight scheme.

This high duration has helped fuel the 7.65% plus rally in the last year in an otherwise anemic index that has not displayed signs of credit improvement overall. The deflation fears in Europe have helped drive this massive performance as the fundamental picture has not improved enough to warrant this significant performance. There has been and to some degree a hope that this deflationary fear will lead to massive liquidity on the part of the ECB, driving yields to even lower levels.

Some of the least fundamentally strong countries such as Greece have performed the best as this liquidity induced risk on trade has taken the lower credits and driven them in our estimation to long term unsustainable price levels.

According to Lazard, “The outlook on European fixed income is uncertain due to the diverging policy paths of the US Federal Reserve (the Fed) and the ECB. In the
United States, the Fed will most likely continue tapering its bond purchases and the rumors of a rate-hike in 2015 have not subsided. However, the ECB will continue its easy money policy for the foreseeable future.”

“The recovery in Europe remains uneven as the region gradually exits a recession. The European banking system is still in trouble and there has been no progress in the banking union discussion. Uncertainty exists for a number of reasons, including the ECB’s upcoming banking stress tests and the Russian/Ukrainian crisis, which could further dampen sentiment in the European economy. Against this backdrop, it is no surprise that the disinflationary trends in the European economy have accelerated in the last months to the point that there are concerns about deflation.”

“Regardless of how the Fed acts regarding US monetary policy, it is clear that the ECB wants to keep the short end of the yield curve well anchored. But, it is uncertain what
the combination of a tighter Fed policy and an even more accommodative ECB policy means for the European fixed-income market and the euro.”

Zenith feels that this uncertainty and the real possibility of divergent gains moving forward in European Sovereign debt markets, warrants an active manager as opposed to a passive ETF that lacks the nimbleness needed to navigate these areas.

Lazard “expects European core government bonds to continue to trade in the relatively tight range established in the last quarters with the biggest risk a bond bear market in the US.”

Looking forward, “Lazard expects sentiment about spread products to remain positive in third quarter of 2014. The majority of lower-rated spread products are still more attractively valued compared to the extremely low-yielding money market products, core European government bonds, and highly rated covered and corporate bonds. However, we expect the market to become tougher on these relatively low spread levels. We expect the strategic shift from core European bonds into the European periphery and various lower-rated spread products to continue to be a major investment theme. This shift may be enough to earn the carry of the spread products and allow for moderate tightening. In general, we remain overweight to lower-rated, high-beta spread products. However, due to the risk posed by US monetary policy, we plan to remain short in duration, but stay flexible to change course quickly, if necessary, as sentiment can abruptly sour. Recently, there have been signals of over-optimism in the global fixed-income markets, as seen by the deterioration of bond covenants, the printing of ultra-long (100-year maturity) bonds, and the oversubscription of almost all new issues. In addition, despite the return of geopolitical risk in the last quarter, due to the events in Ukraine, Iraq, and Syria, all global risk indicators have fallen to very low levels. Because of this over-optimism, we expect some volatility in the months ahead, at least until the focus on risks returns. As active asset managers, we plan to take advantage of the anticipated turbulence to make tactical asset allocation and market-timing decisions.

In its 2014 Outlook for Financial Markets, Swiss Life Asset Management states, “The meeting of central bankers in Jackson Hole has confirmed our previous view of diverging monetary policies. Hence, we expect the Bank of England and Fed to start hiking in 2015 and the ECB and Bank of Japan to stay accommodative.”

This appears to us to be a bond world that is not necessarily going to be rising in unison as we move forward in 2014 and into 2015. Once again we would like to emphasize the importance in this uncertain policy world to have a manager that is able to analyze the macro landscape as well as the micro credit work.

While the healthy returns could continue, we believe it will take a nimble and adept manager to be able to sort through the risks and potential rewards.

I-Shares USG Emerging Markets (EMB)
J.P. Morgan EMBI Global Core Index

This ETF holds a 4.25% yield and a duration of 7 which has helped it gain over 13% over the last year. The dollar denomination also helped as did a rebound in most Emerging Market risk assets.

I-Shares Emerging Market Local Currency ETF (LEMB)
J.P. Morgan EMBI Global Core Index

This ETF holds a 4.91% yield and a duration of 4.25 and this after a nice 10% plus return over the last year.

Given two ETFs with the exact opposite currency mandate, it becomes difficult to choose unless an investor has the time and infrastructure. to be able to make currency calls. We believe it is more prudent to seek an active manager who can chose the best securities in both worlds.

The outlook for the emerging world is likely to be mixed as there are many countries with varied policies that will affect real rates, inflation expectations as well as credit conditions.

Research Affiliates Shane Shepard delves into the Emerging Market bond space to explain the areas that they find opportunities within fixed income in their latest piece dated July 2014.

“Emerging market sovereign bonds that are issued in local currencies are supported by high real yields and improving credit quality. In addition, their risk-to-reward profile is enhanced by declining currency volatility and a positive long-term outlook for currency appreciation.”

• High real yields-The short- and medium-term “risk-free” government bond rates for the G-5 countries all currently reside in negative territory (see Figure 1). In developed markets, the right to a certain return of capital is actually costing anywhere from –1.5% to –0.5% per year in real purchasing power. On the other hand, real yields in many of the larger emerging market economies reside solidly in positive territory—returning anywhere from about a 1% premium over inflation in Mexico and Russia to more than 6% in the case of Brazil.

• The historical spread for the J.P. Morgan GBI-EM Global Index is just under 7% as the difference between the index yield and the short-term U.S. Treasury rate lies well above its long-term average of 5.2%. But, most strikingly, this spread has rebounded (due to the well-documented “taper tantrum” of 2013) to levels just a touch below its all-time high during the 2008 global financial crisis!

• Currency Appreciation-The volatility of local currencies is undeniably substantial; the currency risk swamps the volatility of the underlying bonds. Nonetheless, the currency exposures may provide an incremental boost to long-run expected return. Because of the differences in productivity growth, in the long run we expect emerging market currencies to appreciate relative to the U.S. dollar and other major developed world currencies.

• Currency volatility-At least for the past five years, a basket of emerging market currencies has contributed no more volatility to an international portfolio than a basket of developed currencies. And as emerging markets continue to do just that—emerge—the convergence of currency risks may be expected to continue.

• Credit quality-The fourth factor is the strengthening credit quality of emerging market bonds. 15 years ago only a handful of countries were in a position to issue local currency debt, and their average credit rating was BBB+. Now many more countries participate in the local currency debt market, and the average credit rating is closer to A–.

There is an interesting dynamic at play in the emerging market debt arena especially after the rate hikes by many of the countries attempting to bolster their currency. The rate hikes have, depending on the basket allowed for a 500 basis point advantage over US Treasuries.

According to Lazard, “Local emerging markets debt has been the bogeyman of the broad asset class for the past three-and-a-half years. Over this period, the local currency index, including spot currency rate changes, carry, and bond moves, has underperformed the dollar-denominated debt index by a whopping 19.1% on a cumulative basis and 4.80% on an annualized basis. The drivers of local market debt’s underperformance have been myriad; however, the key negative factors have been (a) an overvalued starting
point, (b) deteriorating fundamentals that affect local debt, (c) less correlation and duration of local debt to falling US Treasury yields, and (d) a moribund global economy. It is our view that all four factors that have pressured emerging local market returns over the last several years are in the process of turning, and will likely result in local market debt outperforming every part of the emerging markets debt asset class in the second half of 2014 and into 2015. We elaborate on these four factors here: First, emerging markets debt has had one of the greatest bull runs of any asset class from 2003 to 2010. Even including the early years of the financial crisis, external debt returned 10.6% on an annualized basis, while local debt returned 13.6%. Notably, the spot currency portion of local currency debt returned just 2.7%, annualized, over this period, while the carry and yield compression returned over 10%, annualized. By the end of 2010, most emerging markets currency valuations were trading richly to their historic real exchange rate averages, while the real yield differential between emerging markets and the United States had compressed to approximately 2%.

Strategically they are looking for the US Ten Year Treasury to return to its 3% Jan trading level and “this ought to weigh on assets with high correlations to Treasuries, such as global investment-grade and emerging markets hard currency bonds, and favor shorter-duration, more idiosyncratic markets, such as emerging markets local debt.
In summary, while we maintain our defensive stance across emerging markets due to stretched valuations, we certainly plan to add local debt in the second
half of the year to all our multi-asset class portfolios. The key triggers to make that asset allocation decision are an improving US economy that leads to a
deteriorating US current account balance and more attractive entry points following what we expect to be a weak summer for fixed income asset”

This is a very difficult time for investment firms that have to allocate a certain percentage to fixed income and bonds in general. Here is a brief summary with regard to the challenges ahead that will lay the groundwork for our next piece that will have potential solutions.

• US valuations on most debt classes are stretched and spreads are tight by most measures and historical norms.
• European sovereign debt has performed tremendously in spite of weak fundamentals and leaves investors with a diminishing opportunity set.
• Emerging market debt offers real yields higher than their comparable developed market counterparts but also introduce currency risk and uncertainty.
• Central bank uncertainty and direction are causing potentially disastrous imbalances in the rate and currency markets.

In our next piece we will highlight a couple managers who have managed to navigate their area of the debt markets successfully and who have a reasonable mandate to be able to do so in the future.

Sincerely,

Tom Koehler-CIO

Inflation Indexed Notes-Piece Three in our Four Part Series-Actively Managed Fund Review

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In our last piece we reviewed a few ETF options and laid out a basic framework on the various possibilities available to a firm that would like to gain exposure to inflation indexed notes. In this piece we describe a few active managers that hold a significant amount of assets so they can be thoroughly vetted by investment committees at traditional Wealth Management firms, Family Offices and pension funds.

 

ACITX – American Century 3.2Billon in AUM

Investment strategy-Inflation-Adjusted Bond Fund is actively managed to help investors combat the corrosive effects of domestic inflation through holdings in mostly high-quality, inflation-indexed bonds.

Risk (s): In certain interest rate environments, such as when real interest rates rise faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities.

Risk-adjusted Statistics – They are not impressive enough for a placement. Also the statistics are reasonably inconsistent among their own website, Morningstar as well as another provider. Overall their MPT stats are underwhelming for a fund with 4 portfolio managers.

Characteristics

  • The duration allocation is reasonably benchmark constrained.
  • They attempt to generate extra returns through yield curve trades.
  • The funds’ flexibility allows up to 20% in corporate bonds and MBS (investment grade only). However, they can engage in a swaps overlay program with these assets with strict risk controls.
  • This funds’ performance is not impressive enough to warrant a conviction placement.

 

Process and overall assessment

The process is reasonably constrained in a domestic only mandate and a value added proposition is lacking. Given the fees and the size of the management team, there should be more evidence in the ability to consistently beat the index. This fund is not worthy of investment dollars as it does not meet the criteria threshold for an active manager.

Zenith Score-Low

 

VIPSX – Vanguard 25.9 Billon AUM

Investment Strategy

Exclusively invests in U.S. TIPS and only makes changes with regard to small tilts in duration. Their only differentiation or competitive advantage is through their low expense ratio. They attempt to closely track the benchmark.

Risks

In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. Being an exclusively U.S. TIPS fund, Vanguard insulates themselves from outside country risk but retains US inflation risk.

Risk Adjusted Stats: They are not impressive enough for a placement. Also, the statistics are consistent with a fund that hugs a benchmark. Overall their MPT stats are underwhelming for a fund that is part of such a large fund complex.

Characteristics

  • The duration allocation is benchmark constrained.
  • They attempt to generate extra returns through bond price inefficiencies and changes in inflation.
  • The funds’ flexibility allows up to 20% in corporate bonds and nominal Treasury notes (investment grade only). However, this flexibility is rarely exercised.
  • This funds’ performance is reasonable vs. mutual fund competitors.

 

Process and Assessment

This fund is worth consideration if a firm simply wants exposure to mainly the US TIPS market with the chance for marginal value added. We will examine in the comprehensive part 4 of the 4 part series this fund and try to determine if it holds up against passive and active ETFs.

Zenith Score-Low to Medium

 

PRIPX – T Rowe- $342 Million AUM

Investment Strategy

T Rowe invests the majority of their assets in TIPS with 92% in U.S. TIPS. They attempt to achieve alpha through small over weights in corporate bonds and a small allocation to non-U.S. TIPS bonds in countries like Canada and Mexico.

Risks

In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. This fund also has exposure to foreign TIPS debt which creates country risk.

Risk Adjusted Stats- They are not impressive enough for a placement. Also, the statistics are consistent with a fund that hugs a benchmark. Overall their MPT stats are underwhelming for a fund with the resources that T-Rowe possesses.

Characteristics

  • The duration allocation is reasonably benchmark constrained.
  • They attempt to generate extra returns through over and underweights to various portions of the yield curve.
  • They are able to invest in fixed-income securities that are not indexed to inflation or in preferred stocks and convertible securities rated A or better.
  • The manager may also allocate to inflation-indexed securities in non-U.S. markets that we feel offer more attractive real yields and inflation dynamics versus their U.S. counterparts. This is currently only at approximately 3%.

 

Process and Assessment

T Rowe has not achieved standout returns for the somewhat higher fees in spite of the yield curve and geographical flexibility.

We recommend that an advisor look elsewhere as the excess returns are simply not present and the flexible process while generally appealing, does not impress us to be confident in the future to navigate the inflation indexed notes market.

Zenith Score-Low

 

FINPX-Fidelity- $2 Billion AUM

Investment Strategy: Normally investing at least 80% of assets in inflation-protected debt securities of all types. Normally investing primarily in U.S. dollar-denominated inflation-protected debt securities. Engaging in transactions that have a leveraging effect on the fund.

Risks: In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities.

Risk Adjusted Stats: They are not impressivefor a fund complex of this sizethat should have the resources to engage in a more robust process.

Characteristics

  • The duration allocation is reasonably benchmark constrained.
  • They attempt to generate extra returns through over and underweights to various portions of the yield curve.
  • They are able to invest in fixed-income securities that are not indexed to inflation or in preferred stocks and convertible securities rated A or better.
  • The manager may also allocate to inflation-indexed securities in non-U.S. markets that we feel offer more attractive real yields and inflation dynamics versus their U.S. counterparts. This is currently only at approximately 3%.

 

Process and Assessment

Fidelity has an average process that does not do enough to place enough faith into this team for the future nuisances of  the inflation indexed note market. At best we believe this fund can perform in line with the benchmark and the category.

 

Zenith Score-low

 

PRRIX- Pimco Real Return Strategy $15 Billion AUM

Investment Strategy

This fund seeks to outperform its benchmark (Barclays Capital U.S. Treasury Inflation Notes: 10+ year) by accumulating assets with maturities that are longer than the average TIPS funds. The fund also has exposure to non U.S. TIPS funds in Emerging markets and non-U.S. developed in an attempt to gain additional real return over the benchmark.

Risks

Pimco takes on additional risk compared to their peers in this asset class given their exposure to non-U.S. debt, as well as small positions in commodities and corporate bonds. In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities.

Risk Adjusted Stats-Reasonable statistics in a tough investment class. They may have achieved this during times of high interest rates and made solid calls with regard to duration. It may be a tougher market in the future.

 

Characteristics

  • It is reasonably duration allocation benchmark constrained although they do take active bets as much as they can.
  • They attempt to generate extra returns through leverage and duration management as well as through investments in non-US TIPS.
  • Flexibility to invest up to 20% up assets in corporate bonds and MBS (investment grade only)
  • They have had a higher standard deviation than peers in the past.

 

Process and overall Assessment

While we appreciate their deep macroeconomic expertise, the returns are not as compelling as we would like from an active manager. The ability and willingness to invest globally is appealing although we will examine in our next piece this funds viability when stacked up against passive investing and its own active ETF.

Zenith Score-Low to Medium

 

Our overall impression is that most actively managed mutual funds are not capable of regularly adding value above the US centric Inflation Indexed Notes Index. The opportunity set is limited to a heavy overweight in US Tips which may or may not be a solid performing asset class. In part, these funds assets ballooned in assets as the inflation indexed market grew. Early on it seems the largest portion of the inflation notes market was found in the US.

That has resulted in approximately $44 Billion sitting in these active funds that arguably have a limited mandate. As described above, some are able to manage the duration as well as geographic placement although the results are only marginally better or worse in most cases.

A question remains. Are these managers simply victim to a stagnant and US centric asset class? Should investors be satisfied with the risk and return stream that most of these managers provide or should they seek greener pastures with a manager or ETF with a more flexible and dynamic opportunity set and mandate. Given the massive amount of capital in these funds, we highly recommend that firms look at alternative solutions and really delve into their real return exposure.

In part four coming out shortly, we will review and tie together the themes in the first three pieces. We will begin with an inflation overview along with our favorite exposure to this asset class. It is possible that TIPS are too limited and that a more robust instrument with a wider mandate that includes additional asset classes sensitive to inflation may be the answer.

In the meantime, please take the time to examine your current Inflation Indexed Notes exposure and especially determine if the fees are worth having an active manager.

Sincerely,

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.”

Avalanche of products

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Looking out at the forecast that is calling for more snow in California, NY and CO, I am reminded that the same forecast can bring very disparate reactions. In NY our guess is that they would rather not trudge through snow and slush to get to work while in California to some degree they are happy for some precipitation in spite of some of the flooding. Here in Colorado there are some who are ready for spring although by the look of 1-70, some are quite content with some more powder. We will leave it up to the reader to decide if this author is happy or sad at the prospect of more snow.

The mudslides in CA and the potential avalanche in the mountains of CO remind me of the massive amount of investment products that seem to continually build up in the product development departments of major financial institutions until they create and release an avalanche of new “innovative” products. The adviser and investment committee is now buried under the weight of massive amounts of new products and information. Bring your beacon.

Your attitude toward these products is very dependent on your perspective and how useful you deem the deluge of material to sift through. Our unbiased attitude is borne out of years of insight into the construction methodology and intent of use of these products.

A significant amount of the products out there are either chasing the same benchmark with a slight nuance or they are attempting in some cases to provide a “hedge” for your traditional investment portfolio.  In a competitive world where fees and margin in many cases are on the decline, fund houses even create ETFs to express the same views inherent in their flagship funds. This massive flow of funds into ETFs of fund managers who have won by name recognition in a lot of cases is worrisome at best. The well intended fund families who bring new innovative ideas and products need to be fully vetted as many of this is newly created and untested. Back testing against a hypothetical index does not count.

Here are a few thoughts as you sift through the avalanche of information and products.

1. Beware of products being sold as “diversification” tools. Really worry if they are touted as hedging techniques. There are very few pure hedges out there and inverse index products should be approached with caution.

2. Be open but cautious with products that tout their superior intelligence such as “smart beta”. Beta by definition is not that bright.

3. If a fund complex touts active management AND inexpensive passive management, please ask why.

4. Advisers may not get fired for holding big names with mediocre performance but to live up to the highest fiduciary standard takes a extra step or two.  a. Do not be afraid to replace big name managers or entire fund complexes if they have seen better days or if there is too much institutional risk with one firm’s horse (Seabiscut). b. Seek out unique talented managers who do not create product after product until they are the Walmart of fund complexes. That thoughtful non asset bloated manager could just be a great fit for your clients.

5. Really examine your true goal with regard to risk management and what you are attempting to garner out of the capital markets prior to an allocation in a product. Every placement is client capital. Make it count.

Whatever your snow forecast, equip yourselves with a shovel, a plow, some boots or maybe a pair of skis to simply ride over the piles of new snow. There will be a firm-wide retreat this Sunday to go skiing. That is a wrap from Zenith in Colorado.

Sincerely,

Tom Koehler-CIO