Objective research to aid investing decisions

Value Investing Strategy (Strategy Overview)

Allocations for October 2021 (Final)
Cash TLT LQD SPY

Momentum Investing Strategy (Strategy Overview)

Allocations for October 2021 (Final)
1st ETF 2nd ETF 3rd ETF

Bonds

Bonds have two price components, yield and response of price to prevailing interest rates. How much of a return premium should investors in bonds expect? How can investors enhance this premium? These blog entries examine investing in bonds.

How Are TIPS ETFs Doing?

How do exchange-traded-funds (ETF) focused on Treasury Inflation-Protected Securities (TIPS) perform? To investigate, we consider ten of the largest TIP ETFs, all currently available, as follows:

As benchmarks, we consider iShares 1-3 Year Treasury Bond (SHY), iShares 3-7 Year Treasury Bond (IEI), iShares 7-10 Year Treasury Bond (IEF) and iShares 20+ Year Treasury Bond (TLT). To match duration of each TIPS ETF, we assign the one of these four benchmarks with the highest correlation of monthly returns. We focus on monthly return statistics, along with compound annual growth rates (CAGR) and maximum drawdowns (MaxDD). Using monthly returns for the 10 TIPS ETFs and the four benchmark ETFs as available, and concurrent monthly changes in the U.S. Consumer Price Index (CPI), through September 2021, we find that: Keep Reading

Testing a Countercyclical Asset Allocation Strategy

“Countercyclical Asset Allocation Strategy” summarizes research on a simple countercyclical asset allocation strategy that systematically raises (lowers) the allocation to an asset class when its current aggregate allocation is relatively low (high). The underlying research is not specific on calculating portfolio allocations and returns. To corroborate findings, we use annual mutual fund and exchange-traded fund (ETF) allocations to stocks and bonds worldwide from the 2021 Investment Company Fact Book, Data Tables 3 and 11 to determine annual countercyclical allocations for stocks and bonds (ignoring allocations to money market funds). Specifically:

  • If actual aggregate mutual fund/ETF allocation to stocks in a given year is above (below) 60%, we set next-year portfolio allocation below (above) 60% by the same percentage.
  • If actual aggregate mutual fund/ETF allocation to bonds in a given year is above (below) 40%, we set next-year portfolio allocation below (above) 40% by the same percentage.

We then apply next-year allocations to stock (Fidelity Fund, FFIDX) and bond (Fidelity Investment Grade Bond Fund, FBNDX) mutual funds that have long histories. Based on Fact Book annual publication dates, we rebalance at the end of April each year. Using the specified actual fund allocations for 1984 through 2020 and FFIDX and FBNDX May through April total returns and end-of-April 1-year U.S. Treasury note (T-note) yields for 1985 through 2021, we find that: Keep Reading

SACEVS Input Risk Premiums and EFFR

The “Simple Asset Class ETF Value Strategy” (SACEVS) seeks diversification across a small set of asset class exchanged-traded funds (ETF), plus a monthly tactical edge from potential undervaluation of three risk premiums:

  1. Term – monthly difference between the 10-year Constant Maturity U.S. Treasury note (T-note) yield and the 3-month Constant Maturity U.S. Treasury bill (T-bill) yield.
  2. Credit – monthly difference between the Moody’s Seasoned Baa Corporate Bonds yield and the T-note yield.
  3. Equity – monthly difference between S&P 500 operating earnings yield and the T-note yield.

Premium valuations are relative to historical averages. How might this strategy react to changes in the Effective Federal Funds Rate (EFFR)? Using end-of-month values of the three risk premiums, EFFRtotal 12-month U.S. inflation and core 12-month U.S. inflation during March 1989 (limited by availability of operating earnings data) through August 2021, we find that: Keep Reading

Update of Credit as a Tactical Asset Allocation Signal

Do credit portfolio managers adjust their portfolios more expeditiously than equity managers, thereby offering a means to time the equity market? In his August 2021 paper entitled “Credit-Informed Tactical Asset Allocation – 10 Years On”, David Klein updates and enhances the strategy presented in his paper of June 2011 (see “Credit as a Tactical Asset Allocation Signal”). The strategy holds stocks (short-term Treasuries) when stocks appear undervalued (overvalued) relative to corporate bonds based on data from a rolling 6-month historical interval. His proxy for corporate bonds is the ICE BofA Single-B US High Yield Index Option-Adjusted Spread (converted to a default probability) and for stocks is the Russell 2000 Index (with dividends). He hypothesizes that stock prices tend to fall when credit spread widens, and small capitalization stocks are more sensitive to credit conditions than large capitalization stocks. Two enhancements to the original strategy are: (1) shorten the lookback from six to three months; and (2) increase the equity allocation by adding a premium to equity values. A third enhancement is taking a 120% long position in stocks when they are undervalued and a 20% short position in stocks when they are overvalued (with 2% estimated annual costs for implementation). Updating and enhancing this strategy with 10 years of new daily data through June 2021, he finds that:

Keep Reading

Testing a Term Premium Asset Allocation Strategy

A subscriber asked about the performance of a strategy that each month allocates funds to pairs of exchange-traded fund (ETF) asset class proxies according to the term spread, as measured by the difference in yields between the 10-Year constant maturity U.S. Treasury note and the 3-Month U.S. Treasury bill (T-bill). Specifically:

Also, how does the performance of this strategy (Term Spread Strategy) compare to that of a portfolio that each month allocates 50% to Simple Asset Class ETF Value Strategy (SACEVS) Best Value and 50% to Simple Asset Class ETF Momentum Strategy (SACEMS) equal-weighted (EW) Top 2. We begin the test at the end of June 2006, limited by SACEMS inputs. We ignore monthly rebalancing frictions for both strategies. Using monthly dividend-adjusted prices for the specified ETFs starting June 2006 and monthly gross returns for 50-50 SACEVS Best Value and SACEMS EW Top 2 starting July 2006, all through July 2021, we find that: Keep Reading

Evaluating Country Investment Risk

How should global investors assess country sovereign bond and equity risks? In his July 2021 paper entitled “Country Risk: Determinants, Measures and Implications – The 2021 Edition”, Aswath Damodaran examines country risk from multiple perspectives. To estimate a country risk premium, he considers measurements of both country government bond risk and country equity risk. Based on a variety of sources and methods, he concludes that: Keep Reading

Credit Spread as an Asset Return Predictor

A reader commented and asked: “A wide credit spread (the difference in yields between Treasury notes or Treasury bonds and investment grade or junk corporate bonds) indicates fear of bankruptcies or other bad events. A narrow credit spread indicates high expectations for the economy and corporate world. Does the credit spread anticipate stock market behavior?” To investigate, we define the U.S. credit spread as the difference in yields between Moody’s seasoned Baa corporate bonds and 10-year Treasury notes (T-note), which are average daily yields for these instruments by calendar month (a smoothed measurement). We use the S&P 500 Index (SP500) as a proxy for the U.S. stock market. We extend the investigation to bond market behavior via:

Using monthly Baa bond yields, T-note yields and SP500 closes starting April 1953 and monthly dividend-adjusted closes of VUSTX, VWESX and VWEHX starting May 1986, January 1980 and January 1980, respectively, all through June 2021, we find that: Keep Reading

Real Interest Rates and Asset Returns

How sensitive are returns of stocks, bonds and gold to levels real interest rates (nominal rates minus inflation)? To investigate, we consider three nominal interest rates and two measures of inflation, as follows:

These choices offer six alternative real interest rates. We use end-of-month interest rates and inflation measures lagged by one month to account for release delay. We use the S&P 500 Index (SP500) capital gain only, the 10-year yield (with bond prices moving inversely) and spot gold price, all measured end-of-month, to represent returns for stocks, bonds and gold. We then relate monthly changes in real interest rates to asset class monthly returns in two ways: (1) calculate correlations of monthly real interest rates to asset class returns for each of the next 12 months to get a sense of how real rates lead asset returns; and, (2) calculate average asset class monthly returns by ranked tenths (deciles) of prior-month real interest rates to discover any non-linear relationships. Using monthly PCEPI and Core PCEPI since January 1961, interest rates since January 1962, SP500 level since December 1961 and spot gold price since December 1974 (when controls are removed), all through May 2021, we find that:

Keep Reading

Best Safe Haven ETF?

A subscriber asked which exchange-traded fund (ETF) asset class proxies make the best safe havens for the U.S. stock market as proxied by the S&P 500 Index. To investigate, we test 14 ETFs as potential safe havens:

Utilities Select Sector SPDR (XLU)
iShares 20+ Year Treasury Bond (TLT)
iShares 7-10 Year Treasury Bond (IEF)
iShares 1-3 Year Treasury Bond (SHY)
iShares iBoxx $ Investment Grade Corporate Bond (LQD)
iShares Core US Aggregate Bond (AGG)
iShares TIPS Bond (TIP)
Vanguard REIT ETF (VNQ)
SPDR Gold Shares (GLD)
PowerShares DB Commodity Tracking (DBC)
United States Oil (USO)
iShares Silver Trust (SLV)
PowerShares DB G10 Currency Harvest (DBV)
SPDR Bloomberg Barclays 1-3 Month T-Bill (BIL)

We consider three ways of testing these ETFs as safe havens for the U.S. stock market based on daily or monthly returns:

  1. Contemporaneous return correlation with the S&P 500 Index during all market conditions at daily and monthly frequencies.
  2. Performance during S&P 500 Index bear markets as defined by the index being below its 10-month simple moving average (SMA10) at the end of the prior month.
  3. Performance during S&P 500 Index bear markets as defined by the index being -20%, -15% or -10% below its most recent peak at the end of the prior month.

Using daily and monthly dividend-adjusted closing prices for the 14 ETFs since respective inceptions, and contemporaneous daily and monthly levels of the S&P 500 Index since 10 months before the earliest ETF inception, all through late April 2021, we find that: Keep Reading

Simple Term Structure ETF/Mutual Fund Momentum Strategy

Does a simple relative momentum strategy applied to tradable U.S. Treasury term structure proxies produce attractive results by picking the best duration for exploiting current interest rate trend? To investigate, we run short-term and long-term tests. The short-term test employs four exchange-traded funds (ETF) to represent the term structure:

SPDR Barclays 1-3 Month T-Bill (BIL)
iShares 1-3 Year Treasury Bond (SHY)
iShares Barclays 7-10 Year Treasury Bond (IEF)
iShares Barclays 20+ Year Treasury Bond (TLT)

The second test employs three Vanguard mutual funds to represent the term structure:

Vanguard Short-Term Treasury Fund (VFISX)
Vanguard Intermediate-Term Treasury Fund (VFITX)
Vanguard Long-Term Treasury Fund (VUSTX)

For each test, we allocate all funds at the end of each month to the fund with the highest total return over a specified ranking (lookback) interval, ranging from one month to 12 months. To accommodate the longest lookback interval, portfolio formation commences 12 months after the start of the sample. We focus on compound annual growth rate (CAGR) and maximum drawdown (MaxDD) as key performance metrics. Using monthly dividend-adjusted closing prices for BIL since May 2007, for SHY, IEF and TLT since July 2002 and for VFISX, VFITX and VUSTX since October 1991, all through March 2021, we find that: Keep Reading

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