Category: Nonprofit Investing

Nonprofit Investing

The Cult of Equities is Dying – Again?

Over the month of August you likely saw headlines about the European debt crisis and economic slowdown, China’s weakening growth, feeble corporate earnings outlooks, and hiring in the U.S. that remains too weak to help the economy.

Bill Gross, the celebrated bond manager at PIMCO, even came out and said at the beginning of the month that stocks can’t continue to perform as well in the future as they have over the past 100 years and that “the cult of equities is dying.”

However, despite all of these negative news items and predictions, world stock markets were up for the month.  U.S. equities gained 2.5% and international equities were up 2.2%. 

Investors are constantly challenged by negative news stories and doomsday predictions about equities.  It is difficult to be able to look past the very short term and remain focused on the broader picture.  However, by staying disciplined to an appropriate investment strategy and rebalancing investments to their targets, investors have consistently been proven to avoid financial pitfalls.  The question remains if they will continue to benefit.

Looking back at Bill Gross’ prediction on equity markets it might sound familiar.  He made two similar pronouncements; once at the end of 2002 and again in February of 2009.  Both times, if investors did the exact opposite of what he was suggesting, they would have had terrific performance.  This is because when he made these predictions stock prices were at the very bottom of market cycles.  Again, after his comments were made at the beginning of August, stocks hit highs last seen in 2008.

A similar refrain was echoed in a 1979 Businessweek cover story.  The article stated that future conditions were poor for stocks as inflation would eat away at any return potential.  They believed it wasn’t worth it for investors to have their money in equities.  Of course since the article was written stocks have had an annualized real return of 7.6%.  Equities have proven prognosticators wrong time and time again.

We don’t know what the future holds for equities and we have no doubt that there will be periods of severe losses.  However, over longer periods of time a diversified portfolio of equities has performed very well and provided returns that have strongly outpaced inflation.  We have every reason to expect this to continue.  By staying disciplined to your investment allocation and tuning out the day to day proclamations of pundits, one can resist the emotional temptation to tinker with your investment approach.  By staying the course an investor in a well diversified portfolio stands a much greater chance of reaching their investment goals than those who let emotions and headlines guide their decisions.

Index Performance                                   August     YTD    Trailing 1 Yr       

US Stock (Russell 3000)                                   2.50%      13.15%        17.03%        
Foreign Stock (FTSE AW ex US)                      2.15%       6.95%        -1.62%        
Total US Bond Mkt. (BarCap Aggregate)        0.07%       3.85%         5.78%         
Short US Gov. Bonds (BarCap Gov 1-5 Yr)     0.05%       0.90%        1.19%
Municipal Bonds (BarCap 1-10yr Muni)         -0.01%       2.73%         4.76%
Cash (ML 3Month T-Bill)                                 0.01%       0.06%         0.06%

Do Dividend Focused Strategies Pay?

A popular strategy being mentioned currently in the financial press is to seek out high dividend paying stocks to increase your portfolio’s yield.  Does earning a higher yield provide a safer, more reliable investment strategy?

To start, if a portfolio maintains a diversified U.S. and international stock allocation it will include dividend paying stocks.  So an investor will already have an allocation to them in their portfolio.  However, if an investor wants to move to heavily weight or exclusively hold dividend paying stocks, their portfolio would represent roughly 20% of the total U.S. stock market.  This severely reduces the equity allocation’s diversification and therefore increases its risk level.  In an attempt to make the portfolio “safer” by focusing on dividends, the portfolio actually becomes more risky. 

The riskiness of a dividend focused strategy can be viewed another way.  There are 320 funds in Morningstar’s universe of large cap funds that have a higher dividend yield than the S&P 500.  Of those funds, 71% are large cap value funds.  Thus, value stocks tend to pay higher dividends.  This stands to reason as stocks that have high dividend yields have dividends that are a greater percentage of their stock prices and therefore their stock prices tend to be lower.   Stocks with a lower price also tend to have a lower price to earnings ratio.  If two stocks have the same earnings level, but one has a lower stock price, the cheaper stock would have a lower P/E ratio.  Stocks with low P/E ratios, or lower than the market average, are known as value stocks.  Value stocks are more risky given their standard deviation has historically been higher.  Comparing the standard deviation of a Large Cap Value Index* with a Large Cap Neutral Index** shows that the value focused benchmark has a standard deviation 16.30%, while the neutral benchmark’s standard deviation is 15.80%.  The value benchmark, which has a higher dividend yield, also has a higher standard deviation and is therefore more risky.

In addition, excluding companies that do not pay dividends from a portfolio’s holdings could result in missing out on a stock that could have great future growth potential and pay dividends in the future.  A company that does not issue dividends can reinvest the earnings into the company and increase its value, which then increases the value of a stock holder’s shares.   Cisco Systems did not offer a dividend from the time of its IPO in 1990 until March of 2011.  Over that time the company grew massively.  If an investor purchased 100 shares of the stock at its IPO and held it through March 2011 (when Cisco began issuing dividends) they would have had a cumulative gain of $507K.  An investment fund focusing on dividends would likely have avoided investing in this stock and thus would have missed out on its immense return.

We take a total return approach to investing, seeking to maximize return from both asset appreciation and dividends and income on a risk adjusted basis. Yield only makes up a portion of investment returns.  An investor should be focused on the performance of their total portfolio.

Looking at historical data supports this view.  Over the last 30 years a portfolio of dividend paying U.S. stocks has had an annualized total return of 12.15%, while a portfolio with a broad U.S. stock allocation had an annualized total return of 12.31%.

By focusing intensely on yield, it is unlikely an investor will receive the most from their investments at the end of the day.  Instead, diversifying your portfolio is the best way to reduce risks and position it for long term growth.

*Fama/French US Large Value Research Index
** Fama/French US Large Neutral Research Index

Index Performance                                       July         YTD     Trailing 1 Yr       

US Stock (Russell 3000)                                        0.99%     10.40%          7.33%        
Foreign Stock (FTSE AW ex US)                          1.49%       4.69%        -11.96%        
Total US Bond Mkt. (BarCap Aggregate)          1.38%        3.78%          7.25%         
Short US Gov. Bonds (BarCap Gov 1-5 Yr)     0.39%       0.85%          1.86%
Municipal Bonds (BarCap 1-10yr Muni)          0.92%       2.75%          6.28%
Cash (ML 3Month T-Bill)                                        0.01%       0.05%          0.07%

Diversification Isn’t Just for Clients

We at Raffa Wealth Management preach investment diversification.  By diversifying your investment portfolio broadly and efficiently it helps reduce portfolio volatility and keeps your investment portfolio on a road towards its goal.  However, not all those in the financial industry have practiced this time tested formula for success.

Recent research by Bloomberg has shown that employees of five of Wall Street’s largest banks keep a significant portion of their 401(k) retirement portfolios invested in company stock.  The average employee invests roughly 13.0% of their retirement portfolio in their firm’s stock.  As a result, the group collectively lost over $2 billion last year as financial firms stock fared poorly.  Wall Street bank employees hold only slightly less company stock than the general population with the option to invest in their company, according to Callan Associates Inc. – the general population holds 13.4%.  

These supposed financial experts ignored one of the basic tenants of investing by allocating heavily to one very specific investment, and suffered the consequences.  The allocation is doubly bad in this situation as their human capital, their future earnings, are also tied directly to the firm.  If the company does not perform well they are less likely to receive raises or bonuses just as the firm’s stock price is likely to fall.  While this specific loss scenario deals with employees of the 5 largest Wall Street banks, the same problems can befall those in other fields that have a large amount of their portfolios tied up in company stock, or a concentrated position in general.

This is a clear example of what not to do.  Developing a total portfolio investment allocation, well diversified across asset classes and periodically reviewing and rebalancing to that target keeps you on the path to investment success.

Index Performance                                     June         2Q         YTD             

US Stock (Russell 3000)                                  3.92%      -3.15%    9.32%                  
Foreign Stock (FTSE AW ex US)                     5.85%     -7.51%      3.16%                
Total US Bond Mkt. (BarCap Aggregate)       0.04%      2.06%     2.37%                  
Short US Gov. Bonds (BarCap Gov 1-5 Yr)   -0.05%      0.56%     0.45%         
Municipal Bonds (BarCap 1-10yr Muni)        -0.08%      1.27%      1.81%          
Cash (ML 3Month T-Bill)                                 0.01%      0.03%     0.04%

Should International Bonds be a Part of Your Fixed Income Portfolio?

The benefits of international investing expand beyond equity markets.  Including an allocation to international bonds provides positive diversification benefits and can improve the risk adjusted performance for a portfolio as well.

While the U.S. is a prominent portion of the global investment grade fixed income market place, it only represents roughly 30% of the total outstanding world debt.  Thus, 70% of the global bond market is unrepresented in a U.S. only bond portfolio.  Investing in a more globally diversified bond portfolio that provides exposure to market forces that expand beyond the U.S. market would require holding fixed income positions from issuers outside the U.S.  However, until the past decade investing in bonds outside of the U.S. has been limited by high costs and illiquidity.  More recently, increased globalization and a desire by governments to issue debt abroad has helped to ease the barriers to entry to this asset class.

In order to benefit a portfolio, the addition of international bonds would need to show low levels of correlation with U.S. fixed income.  This is certainly the case.  The U.S. has consistently shown to have low correlations with other countries with the large debt issuances over the 1999 to 2012 time period, ranging from 0.24 with Japan on the low side to 0.77 with Canada on the high side. 

While the low correlation is great, how has it helped in practice?  The benefits of the low correlation have been borne out historically.  When intermediate term U.S. government bonds, as represented by the Citi World Gov. Bond Index U.S. Component 1-10 years, have had a negative monthly performance, international intermediate government bonds, as represented by Citi World Gov. Bond Index ex U.S. 1-10 years, have shown slightly positive performance.  A portfolio of 75% U.S. bonds and 25% international bonds with currency risk hedged has had a lower standard deviation (3.71%) compared to a U.S. only bond portfolio (4.20%.)  This results in the more fully diversified portfolio having a higher Sharpe Ratio and, therefore, better risk adjusted performance.

Similar to equity markets, correlations in fixed income markets have risen over more recent time periods.  For example, the correlation between the U.S. and international bonds over the 1985 to 2012 time period was 0.63, while the correlation over the 1999 to 2010 time period was 0.69.  With the globalization of the world’s economies, a higher level of correlation than what long term historical averages suggest is likely.  However, each country has its own monetary policies and will likely find themselves in different stages of the business cycle creating imperfect correlations between countries that will continually fluctuate.

This diversification benefit can be removed if the global bonds held are not hedged for currency fluctuations.  The high volatility related to exchange rates eliminates the diversification benefit of holding international bonds.  The volatility of the Citi World Gov. Bond Index 1-30 year unhedged is 9.90%, which is over three times more volatile than the hedged version of the index.  This carries over to a simple diversified portfolio as well.  When adding unhedged international bonds to a portfolio that holds U.S. and International stocks and U.S. Bonds (represented by broad asset class benchmarks and their standard deviations over the past 25 years) it results in a more volatile portfolio.

Return Standard Deviation Chart World Ex US Bonds

One practical issue with hedging currency risk is the added cost.  If the costs are high they can undermine the benefits of the hedge and discourage investment in the asset class.  However, the cost of hedging has trended downwards over the past decade with costs a third lower than they once were.  The bid/ask spread between for contracts to hedge a foreign currency in U.S. dollars has dropped from approximately 0.24% in 2000 to 0.15% in 2011.With the increased technological efficiency of markets we expect this to continue.  At current levels the costs are not prohibitive and will not produce a significant drag on yield.

As it has been shown that adding an international bond allocation to a portfolio has been advantageous, what degree of allocation will allow a portfolio to fully realize the diversification benefit?  By performing an efficient frontier analysis and reviewing data over various time periods it is apparent that the ideal level of international fixed income is in the 20% to 40% range.  With an allocation below 20%, historically, a fixed income portfolio would not be benefiting fully from the diversification potential of the allocation, and with an allocation above 40%, foreign bonds have shown to deliver little additional benefit.  The best level will only be know in hindsight, but historically maintaining an allocation to currency hedged international bonds within that range has yielded the best risk adjusted performance.

Given international bonds increased diversification benefits and potentially higher levels of return; we believe including a dedicated allocation to the asset class and hedging for currency risk will improve an investor’s risk adjusted performance and help them achieve their long term investment goals.



Index Performance                                        May         YTD     Trailing 1 Yr       

US Stock (Russell 3000)                                   -6.18%        5.20%         -1.87%        
Foreign Stock (FTSE AW ex US)                    -11.27%      -2.54%       -20.25%        
Total US Bond Mkt. (BarCap Aggregate)          0.90%        2.33%         7.12%         
Short US Gov. Bonds (BarCap Gov 1-5 Yr)       0.17%       0.51%          2.26%       
Municipal Bonds (BarCap 1-10yr Muni)           0.43%        1.90%         6.39%        
Cash (ML 3Month T-Bill)                                   0.01%         0.03%        0.05%       




Past performance is not a guarantee of future results and there is always a risk that an investor may lose money.  Information contained has been gathered from sources we believe to be reliable, but we do not guarantee the accuracy or completeness of such information. Indices are not available for direct investment and performance does not reflect expenses of an actual portfolio.

All economic and performance information is historical and not indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this material, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from Raffa Wealth Management or any other investment professional.  Further, the charts and graphs contained herein should not serve as the sole determining factor for making investment decisions.  To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with Raffa Wealth Management.  All information, including that used to compile charts, is obtained from sources believed to be reliable, but Raffa Wealth Management does not guarantee its reliability.   All performance results have been compiled solely by Raffa Wealth Management, are unaudited, and have not been independently verified. Information pertaining to Raffa Wealth Management’ advisory operations, services, and fees is set forth in Raffa Wealth Management’ current disclosure statement, a copy of which is available from Raffa Wealth Management upon request.

Financial News 5/6/12 – 5/12/12


-Consumer credit surged in March up 10.2%.  It was the largest jump in borrowing in more than 10 years. 5/8

-Jobless claims dropped for the week beating expectations, and the 4 week moving average fell to 379,000.  5/11

-Spain is requiring banks to set aside $38.8 billion to meet potential loan losses and quicken the sale of troubled assets.  5/12

-China’s growth slowed in April, resulting in analysts dropping GDP expectations for the quarter and increasingly the likely hood that Chinese officials implement stimulus measures.  5/12

-Wholesale prices in the U.S. fell for the first time in 2012 dropping 0.2%.  The fall was a result of reduced energy prices.  5/12


-HSBC’s profit rose 25% in the first quarter excluding onetime charges on its investment banking and emerging markets operations, but its costs remain high. 5/9

-Disney’s fiscal second quarter saw earnings gains of 21% led by its theme parks and cable channels offsetting weakness in its movie division.  5/9

-News Corp earnings rose 47% due to growth from its cable networks.  5/10

-Cisco’s earnings gained 20%, but had a cautious outlook. 5/10

-Fannie Mae had a $2.7 billion profit for the quarter, its best quarter since it was bailed out nearly 4 years ago, and will be repaying $2.8 billion it owes the government. 5/10

-Spain announced it will take a stake in troubled Spanish bank Bankia SA to rescue the weak bank.  5/10

-J.P. Morgan admitted to a $2 billion trading loss as a result of a complex trade of its own capital that depended upon a continued economic recovery.  5/11


-Gas price continue to fall and are down for the 5th straight week.  The average price for a gallon is down to $3.79 from $3.94 at the beginning of April. 5/8

-The U.S. Stock market showed little concern over the election results in France and Greece with the S&P 500 up 0.04%.  Both countries saw changes in top leaders which are not as friendly to the austerity cuts the countries have undertaken to fight their sovereign debt issues. 5/8

-The price of oil has continued to fall as it dropped to $97.01 a barrel on Tuesday.  It is down $9 for the month.  5/9

-Markets continued to fall as jitters over Europe, and specifically Greece’s change in government, were more pronounced.  The Dow dropped for the 5th straight day falling 0.6% and the S&P fell 0.4% to 1363.7, its lowest close in close to a month.  European markets fell more abruptly with concerns the Greece may reject the austerity plan that had been developed for them.  Europe as a whole fell 1.7%. 5/9

-U.S. markets continued to fall as worries over Greece and Spain weighed on markets.  The Dow fell 0.8%, the S&P fell 0.7%.  Europe as a whole hit its lowest level in three months and Spain’s stock market reached an 8 and a half year low.  In response to growing global concerns a 10 year U.S. treasury auction resulted in the lowest yield on record of 1.855% and in the secondary market the 10 year U.S. Treasury yield dropped to 1.835% a three month low.  5/10

-Europe agreed to release a portion of a bailout payment to Greece, but held back $1.3 billion as a warning to the country to get its government in order.  5/10

-On European concerns and the trading loss for J.P. Morgan U.S. markets had a down week.  The Dow has its worst week in 5 months falling 1.7%. The S&P 500 fell 1.1% for the week.  Internationally, Japan was down 4.6% and Europe fell 0.4%.  Commodities continued to retreat with Oil falling 1% to $96.123 a barrel and gold dropped to $1,583.60 a troy ounce.  The 10 year rallied over the course of the week finishing at 1.841%.  5/12