Category: Portfolio Strategy

Portfolio Strategy

Individual Bond Portfolios vs. Bond Mutual Funds

There are two different schools of thought when it comes to the fixed income holdings in a portfolio; one is to invest in a portfolio of individual bonds, while the other is to gain exposure through investing in bond mutual funds.  While there are positives and negatives to each strategy, we recommend investing in fixed income mutual funds and exchange traded funds (ETFs) in your portfolio as the preferred method to gain exposure to bonds for several reasons. 

Bond funds provide for greater diversification than could practically be achieved through owning individual securities.  With more assets in a fund it can invest in more types of bonds, or more types of certain issuers, credit qualities, maturities, and characteristics which reduces the non systemic risk of a portfolio.  This occurs to a greater degree than in a separately managed individual bond portfolio.  It allows a fund to spread the risk of less credit worthy issuers across a range of issues.  A Lehman Brothers study suggested that owning a portfolio of 100 bonds would constitute a well diversified portfolio.  Having this number of securities in a separately managed portfolio of individual bonds is unlikely, would require a significant amount of research, and would require constant supervision.  Thus, it is not as likely the account would be as well diversified.

One can create a fully diversified bond portfolio with one purchase using a bond fund, whereas using individual bonds it takes time to build a full portfolio.  All of the issues that would be required to attain the desired characteristics of a portfolio might not all be available at the same time, or costs to purchase the bonds may be prohibitive to be done all at once.

Income can be more quickly reinvested when using funds, whereas proceeds from individual holdings likely need to accumulate as cash until it is sufficient for a round lot purchase or the desired bond becomes available.  Bond funds then avoid the issue of being un-invested and likely earning a lower return.  Typically, income is held in cash or money market funds under a separately managed account, which would lower the bond portfolio’s performance.  This is especially applicable in the mortgage backed securities market as payments, and the breakdown between interest and principal within the payments, is constantly fluctuating based on interest rates.  A bond fund can better handle the fluctuations by reinvesting the proceeds in new securities that have different coupon rates.

A bond fund can also maintain its characteristics better than a portfolio of individual bonds.  Whereas the separately managed accounts may have to wait to purchase a particular bond for the portfolio to maintain its characteristics when a bond matures, maturing bonds represent a much smaller portion of a bond fund and therefore their characteristics are not as affected.  This is important because the duration of a separately managed portfolio may fluctuate more than the desired target and the result could hurt the portfolio’s performance.  

Bond funds have higher liquidity than investing in individual bonds.  If a partial liquidation is needed a portion of shares in a bond fund can be sold, however selling one bond alters the characteristics of the portfolio in a separate account.  Otherwise small portions of each bond type will need to be sold, which would not be possible.  Also, some bonds are less liquid than others thus one might be precluded from selling or forced to take a deep discount.

It is often stated that the benefit of owning an individual bond is that regardless of if the security’s value rises or falls you will receive your principal back at the maturity of the issue.  With a bond fund you do not have that same guarantee as there is no ending date to the fund.  However, this is a simplistic view.  Holding a bond to maturity does not provide added value to selling a bond that is currently below its par value as, excluding transactions costs, one can buy a newly issued bond with a similar maturity that will have a higher coupon rate.  While the bond value will appreciate one forgoes the higher coupon payments that would be gained by selling the existing bond.  If a bond is above the principal balance there won’t be a real economic gain because you will be reinvesting in a bond that has a lower coupon.  In addition, if one is holding a bond to maturity and they are simply reinvesting those proceeds, and not using the principal to fund a cash flow, then there are no benefits to holding a bond to maturity.

Bond funds are also superior when one considers costs.  Funds typically have lower management costs as the costs for the fund’s legal, administrative, management, etc. needs can be spread across a greater asset base than with a separately managed account with individual bonds.  With higher expenses it is more likely to underperform an index.  Funds, due to their size, can also command better bid-ask spreads than a separately managed account with smaller bond portfolios, however when separate account managers are large institutions they can command similar spreads.

The benefits to owning individual bonds are derived from increased control and known payments.  One can make security specific ownership decisions and will be able to match future liabilities with specific bonds that have the same maturity and face value when owning an individual bond portfolio. 

The value at any point in time is uncertain with a bond fund where it is a known quantity with individual bonds.  Therefore, one can purchase a bond that exactly matches a future liability so that when the security matures the funds will match the liability.  This asset-liability matching does not take into consideration inflation however.  Matching longer term liabilities therefore is a harder exercise and can result in the liability being over or underfunded.  The strategy works better for known liabilities and for shorter time frames. 

Separately managed accounts also enable the investor to hold highly customized portfolios like targeting a specific credit quality and/or characteristics. Bond funds are typically more diverse amongst their sector, but if an investor has a specific liability to hedge against, a more customized portfolio may be necessary.

With a bond mutual fund you won’t know exactly what income you will be receiving over the course of the year whereas with holding a portfolio of bonds you will know the specific coupon payments and the timing of each.  One can then be better able to plan ahead for the year with a known income stream. 

There are many benefits to holding bond funds over individual bonds.  Bond funds provide greater, more easily achieved diversification, better liquidity, income can be more quickly reinvested, the characteristics of a fund are more easily maintained, and they are more cost effective.  While there are some more customized situations where owning a portfolio of individual bonds may be preferable, in the vast majority of cases we recommend deriving a portfolios fixed income allocation from bond funds.

The Debt Ceiling and your Portfolio

As you have no doubt seen, lawmakers have yet to arrive at an agreement to lower the deficit and in turn allow the debt ceiling to be raised before the August 2nd deadline.  While the delay in a deal is concerning, the market has collectively shrugged its shoulders.  The 10 year treasury remains near historic lows and the U.S. stock market remains within shouting distance of its post financial crisis high reached at the end of April.  Global investors have not shown much concern for the issue, but the prospect of a default is ominous.  

When looking at this issue its important to consider that a retirement plan is very long term, whereas the debt ceiling debate is temporary in nature and, after much wrangling in Washington, will get resolved.  Thus, a retirement portfolio should not be revised to react to short term issues in the market.  It’s imperative to establish an overall risk tolerance and strategy for a retirement portfolio that reflects its long term goals.  Making drastic adjustments to ones portfolio can throw your long term plans off course.  If a move to a very conservative portfolio is made one might find them self woefully unprepared for retirement.  In addition, trying to time the market usually has negative results.

It is our recommendation that a retirement investor diversifies their investment portfolio broadly to reduce risk and establish a target allocation based on one’s risk tolerance and goals.  This should include asset classes such as U.S. equity, international equity, both developed and emerging, fixed income, and real estate, and can include commodities such as precious metals and energy as well.  It is important to remain diversified amongst these investments and to not become too concentrated in one corner of the market.  An investor that maintains their portfolio’s allocations close to their targets and adjusts the allocations as they move closer to retirement can expect a higher probability of achieving their retirement goals.

By taking a long term view of one’s investment portfolio they can stay the course despite any short term fluctuations in the market.

Investment Committee Meeting: Commodities Inclusion in a Portfolio

Raffa Wealth Management’s Investment Committee convened on February 3rd 2011 to discuss the inclusion of commodities in the firms overall investment strategy.  The meeting covered the many issues surrounding investing in commodities and was a lively and thoughtful discussion.

The topics covered included the viability of commodities as an investment and as an asset class, whether a commodities allocation provides improved returns, better diversification, an inflation hedge and a hedge against event risk.  Issues related to taxes and fees, practical problems with ETFs and funds, the change in market dynamics, behavioral considerations, and indirect commodity investing were also assessed.

The following committee members were in attendance and participated in the discussion:

Bill Snider, CFA, Co-founder and Managing Partner at BroadOak Capital Management

Philip English, Ph.D., CFA, Assistant Professor American University, Department of Finance and Real Estate

Alexandre M. Baptista, Ph.D., Associate Professor of Finance, Dean’s Research Scholar, at The George Washington University School of Business

Robert J. Willen, CFA, Portfolio Manager at Wagner Bowman Management Corp.

Andrew Kline, CPA, CFP®, Managing Member of ARK Financial Services

Gergana Jostova, Ph.D., CFA, Associate Professor of Finance at the George Washington University School of Business

Steven K. Heger, CLU, President of Raffa Financial Services, Inc.

Investment Committee Outcome

After weighing the merits of the issues the Investment Committee was able to reach a consensus.  Commodities are an asset class – if only in practice and not necessarily in fact.  Their returns will provide diversification benefits to a portfolio of stocks and bonds – namely that they will reduce overall portfolio volatility and in some cases provide hedges against significant event risk and inflation. The challenge, however, is that while they may provide these benefits, their inclusion will almost certainly decrease the portfolio’s return over time and this will likely include short periods of dramatic underperformance due to the extremely speculative nature of investment in this class.  Such speculative behavior will cause the class to be significantly overbought at times – evidenced by the current contango effect.

Our conclusion, therefore, is that commodities may be recommended on a client by client basis after a collaborative judgment is made that the benefits to that client outweigh the cost.

In an effort to determine an ideal commodity allocation RWM has back- tested their inclusion as part of the RWM strategy and evaluated other studies on preferred commodity allocations.  We have determined that the optimal level for commodities in an investor’s portfolio is from 10% to 12.5% of an investor’s allocation to equities.  The investment to commodities would reduce the portfolio’s allocation to U.S. Stocks.

You may visit to download the white paper titled “For and Against the Inclusion of Commodities” and review the comprehensive analysis of this subject.


Raffa Wealth Management is an independent investment advisor providing nonprofit organizations, high net-worth investors, and qualified retirement plans with a full range of investment consulting services.  We were established to fill the need for transparency, clarity, and vision in the professional management of investment assets.   Visit us at

David Swensen’s Guide to Sleeping Soundly

Financial wisdom for troubled times — plus strong opinions on the current crisis — from Yale’s in-house Warren Buffett
by Marc Gunther

In just under a quarter-century as Yale’s chief investment officer, David Swensen ’80PhD has generated Bernard Madoff-like returns — except that Swensen made his money honestly. Under his leadership, Yale’s endowment has generated an astonishing 20 consecutive years of positive returns, from 1988 to 2008.

President Obama has named Swensen to his new Economic Recovery Advisory Board.

That streak will likely come to an abrupt end because of last fall’s financial crisis. Yale had already lost $5.9 billion this year as of December. But these losses should not tarnish Swensen’s reputation as one of the world’s great money managers. When Swensen, at the age of 31, left a well-paid job on Wall Street for Yale in 1985, the endowment was worth a little more than $1 billion. Last June 30, it was worth $22.9 billion. Today, it is worth about $17 billion.
Perhaps the most striking evidence of Swensen’s contribution to Yale is this: When he began managing the endowment, investment returns provided $46 million in support, or about 10 percent of the university’s operating budget. This year, the endowment is providing $1.15 billion, which is nearly 45 percent of the budget.
The son and grandson of chemistry professors, Swensen earned his PhD from Yale in economics. He could have made much more money at an investment bank or a hedge fund, but he takes great pride in working to benefit Yale. His unorthodox approach to institutional investment, which has reshaped the way other large-scale endowments are managed, is described in a revised edition of his book, Pioneering Portfolio Management (Free Press, 2008). He is also the author of Unconventional Success: A Fundamental Approach to Personal Investment (Free Press, 2005), a much-praised guide to the markets for individual investors. President Obama has named Swensen to his new Economic Recovery Advisory Board, designed as an independent group of beyond-the-Beltway thinkers.
Swensen is soft-spoken yet passionate about his beliefs. In early February, we spoke about the endowment, the economy, how his investment principles could have saved Wall Street, and the most common mistakes made by individual investors.

Yale Alumni Magazine: Has it been a difficult time for you?
Swensen: In some ways, yes. I absolutely love the idea of producing ever-increasing levels of support for Yale. Looking ahead to the next few years, that’s not going to be in the cards. That’s a difficult reality to deal with.
But in terms of the day-to-day work, managing through this economic and financial crisis is absolutely fascinating. It’s exhausting, but fascinating.

Y: It may be fascinating to you, but it’s discouraging for those of us who have watched our 401(k) values plummet. Given all the turmoil and uncertainty, what should individual investors do?
S: If an individual investor followed the program I outlined in Unconventional Success [see box], they probably did reasonably well, through the crisis, thus far. They’d have 15 percent of their assets in U.S. Treasury bonds. They’d have another 15 percent in U.S. Treasury inflation-protected securities. Those two asset classes have performed well.
Of course, the other 70 percent of assets are in equities, which have not done well. With all assets, I recommend that people invest in index funds because they’re transparent, understandable, and low-cost. So, the equity holdings have gone down step-by-step with the declines in the market.

I recommend that investors rebalance.

But I also recommend that investors rebalance. Rebalancing is even more important amidst these huge declines in the stock market because it presents a great opportunity. People can sell the Treasury securities that have appreciated dramatically to bring their allocation to the 15 percent target, and they can redeploy those funds into domestic equities and foreign equities and emerging market equities and real estate investment trusts, all of which are now much cheaper, and therefore have higher prospective returns.

Y: Explain this idea of asset allocation, please.
S: Asset allocation is the tool that you use to determine the risk and return characteristics of your portfolio. It’s overwhelmingly important in terms of the results you achieve. In fact, studies show that asset allocation is responsible for more than 100 percent of the positive returns generated by investors.

Y: How can that be?
S: It’s because the other two factors, security selection and market timing, are a net negative. That’s not surprising. They’re what economists would call zero-sum games. If somebody wins by buying Microsoft, then there has to be a loser on the other side who sold Microsoft. If it were free to trade Microsoft, the amount by which the winner wins would equal the amount by which the loser loses. But it’s not free. It costs money. It costs money in the form of market impact and commissions if you’re trading for your own account, and it costs money in terms of paying fancy fees if you are relying upon an investment advisor or mutual fund to make these security-specific decisions. For the community as a whole, all those fees are a drag on returns.
That’s why the most sensible approach is to come up with specific asset allocation targets that you can implement with low-cost, passively managed index funds and rebalance regularly. You’ll end up beating the overwhelming majority of participants in the financial markets.

Y: So people should not be afraid of stocks now?
S: Not only should they not be afraid, they should be enthusiastic. One of the great ironies is that if you had talked to the average investor 18 months ago, he or she would have thought it was a pretty good idea to buy stocks. In recent months, the same investors despair about their portfolio and are fearful about putting money into the equity market.
That’s 180 degrees wrong. They should have been cautious 18 months ago, when prices were much higher than they are now. They should be enthusiastic today.

Y: That runs counter to human nature.
S: That’s one of the really tricky things about the investment world. It’s very different from a lot of things we deal with, day in and day out. If you talk to a businessman, a businessman is going to feed the winners and kill the losers. But in the investment world, when you’ve got a winner you should be suspicious about what’s next. And if you’ve got a loser, you should be hopeful — although not naively hopeful.

Y: You’re asking people to be contrarians, which is hard. I assume that’s one reason why you don’t believe that most investors should be picking stocks.
S: That’s absolutely right. There’s no way that spending a few hours a week looking at individual securities is going to equip an investor to compete with the incredibly talented, highly qualified, extremely educated individuals who spend their entire professional careers trying to pick stocks. It’s just not a fair fight. You know who’s going to win before the bell rings.

The approach that I recommend is boring.

The most important difference, in terms of categories of investors, is between those who can make high-quality active management decisions and those who can’t. Pioneering Portfolio Management is for those who have the ability to manage portfolios actively. Unconventional Success is a book for the overwhelming number of individual and institutional investors who cannot manage a portfolio actively.
Almost everybody belongs on the passive end of the continuum. A very few belong on the active end. But the unfortunate fact is that an overwhelming number of investors find themselves betwixt and between. In that in-between place, people end up paying high fees whether to a mutual fund or a stockbroker or another agent. And they end up with disappointing net returns.

Y: Maybe we need new language, David. No one wants to be in the “passive” group.
S: No, they don’t. The basic problem is, it’s boring. The approach that I recommend is going to give you absolutely nothing to talk about at a cocktail party. You’re going to be in a corner by yourself, and no one will pay any attention to you. But you’ll end up with a better-funded retirement.

Y: So you can host the cocktail party.
S: Right.

Y: Unconventional Success delivered a scathing critique of the mutual-fund industry. You rightly pointed out that the vast majority of mutual funds charge high fees, trade too frequently, and under-perform the markets. How did the industry react?
S: I’ve heard stories of people in the fund management business being irate about the book. That’s not surprising. The mutual fund industry is not an investment management industry. It’s a marketing industry. And if somebody interferes with your marketing, you’re not going to like that. So I was pleased to hear that there were senior people in the industry who were very, very unhappy with me and my book.

Y: We should note that there’s a distinction between the for-profit mutual fund industry and companies like Vanguard and TIAA-CREF.
S: One of the fundamental points in Unconventional Successis that there’s an irreconcilable conflict in the mutual fund industry between the profit motive and fiduciary responsibility. There are two major organizations, Vanguard and TIAA-CREF, which operate on a not-for-profit basis. That conflict between profit and fiduciary duty disappears. Vanguard and TIAA-CREF are dedicated to serving their investors. They are shining beacons in this otherwise ugly morass. As a matter of disclosure, I’m on the board of TIAA.
But the sad fact is that this book, along with books written by Jack Bogle and Burt Malkiel and a handful of others, are relatively small voices when set against the cacophony of the fund management world. Look at Fidelity and Schwab with their full-page advertisements. Or Jim Cramer [host of CNBC’s Mad Money]. The investor is bombarded with staggering amounts of information, staggering amounts of stimuli that are designed to get the investor to buy and sell and trade, to do exactly the wrong thing, to create excessive profits for these intermediaries that aren’t acting in the investor’s best interests.

Y: I was hoping you’d mention Cramer. In the new edition of Pioneering Portfolio Management, you write: “Educated at Harvard College and Harvard Law School, Cramer squanders his extraordinary credentials and shamelessly promotes stunningly inappropriate investment advice to an all-too-gullible audience.”
S: Jim Cramer exemplifies everything that’s wrong with the advice — and I put advice in quotation marks — that is given to individual investors. Investing is a serious business. We’re talking about retirement security of American citizens, and he turns it into a game. It’s a game where his listeners lose. It’s ridiculous. These high-turnover, rapid trading strategies enrich the brokers. If you look at Jim Cramer’s approach on an after-fee, after-tax basis, the individual doesn’t have a chance.

Y: You were just named to President Obama’s Economic Recovery Advisory Board. When do you foresee a recovery?
S: We can’t start talking about a sustained recovery in the economy until the credit markets are fixed. Right now, the credit markets are broken. They’re not functioning.

Y: Meaning businesses can’t get loans?
S: It’s commercial bank lending to corporations and individuals. It’s the commercial paper market. It’s the bond market. About the only market that seems to be functioning is the market for Treasury securities. That’s exactly what you’d expect in a financial crisis. It happened in 1987. It happened in 1998. Right now, it’s happening in a much more intense, much more pervasive fashion. Investors are selling risky assets of all types.

Y: Speaking of risky assets, I want to read you a line that jumped out at me from the appendix of Pioneering Portfolio Management about fixed-income securities. You write: “Asset-backed securities involve a high degree of financial engineering. As a general rule, the more complexity that exists in a Wall Street creation, the faster and farther investors should run.” Can I conclude from this that Yale avoided exposure to the mortgage-backed securities and collateralized debt obligations — the so-called toxic assets — at the heart of the financial meltdown?
S: That’s correct. One of the pieces of advice that I’ve had in my books, going back ten years now, is that investors in bonds should invest only in “full faith and credit” securities. Bonds that have call options or bonds that have credit risks or bonds that are highly structured, like the asset-backed securities and CDOs, just don’t belong in the portfolios of sensible investors.

Y: Both institutional and individual investors?
S: Correct. There’s just systematic mis-pricing of credit and options and complexity. Now it’s obvious when I say that. It wasn’t so obvious when I wrote it ten years ago, and then again in Unconventional Success, and now again in the new version of Pioneering Portfolio Management.

The activities that I rail against are so profitable.

People on Wall Street who are structuring these securities are more sophisticated than the people to whom they are selling them. With that kind of dynamic, when really smart, highly compensated, very clever people are on one side of the trade, and less highly compensated, less clever people are on the other side, you know who’s going to end up in the soup.

Y: And yet the very same institutions that were packaging and selling these instruments ended up holding large quantities of them, to their dismay.
S: Stunning, isn’t it? Maybe they’re not as clever as I thought they were. I suppose complacency is one explanation. Or maybe they were blinded by greed.

Y: They must not have read your book.
S: The activities that I rail against are so profitable. Even though people may have read and believed what I wrote, they took the Chuck Prince [former CEO of Citigroup] attitude — that while the music’s playing, you’ve got to dance. The music played for a long time.

Y: What will we learn from this experience?
S: After 1987 [the stock-market crash] and after 1998 [the collapse of hedge fund Long-Term Capital Management], we learned nothing. I think the reason that there was not a sensible regulatory response to the issues that were quite apparent in 1987 and 1998 is that the markets and the economy bounced back quickly. We had a significant regulatory response after the Great Depression, because the country suffered for a protracted period.
I’m cautiously optimistic that we will have some sensible regulatory reforms prompted by this economic and financial crisis. Of course, the devil’s in the details.

Y: What kind of regulation makes sense?
S: Having a universal financial regulator makes an enormous amount of sense. Why would you balkanize markets and have different regulatory regimes for different markets? And then you have to regulate every type of institution that could pose a systemic risk. It stuns me that we even ask the question about whether we should regulate hedge funds or not. Look at Long-Term Capital. How could we not have figured that out? The financial system almost collapsed because of a hedge fund, and today we haven’t gathered even the most basic information about the activities of hedge funds.

Y: There’s no transparency, even to investors, as we learned from Madoff.
S: It’s stunning. It’s the religion of the free market.

Y: Many young people today believe they will never be as prosperous as their parents. Should young adults have hope?

S: I’m an incredible optimist. We should be careful not to underestimate the resilience of this economy. I think we could have, in the next couple of years, a very hard slog. Looking five or ten years down the road, I’m very optimistic that we will come out of this strong and better.

Yale’s Investor Keeps Playbook

An excerpt from an interview with Yale endowment CIO, David Swensen is outlined below. The entire article can be reviewed by following this link;

He isn’t a household name. But as the Yale University’s endowment’s chief investment officer for two decades, has earned a reputation as one of the world’s savviest and most successful investors. Yet even Yale hasn’t escaped the financial crisis.

The university estimated late last month that the endowment had lost 25% of its value since the end of June. That is expected to lead to budget cuts and puts Mr. Swensen in line for his first negative fiscal year since 1988. Other endowments that have set out to follow the strategy he has advocated are also suffering.

He spoke to The Wall Street Journal about the financial crisis, hedge funds, scandal-scarred money manager, and ill-fated efforts to mimic Yale’s investment strategy. Here are questions and his answers, edited for context and clarity.

WSJ: Does the poor performance of most assets last year suggest you need to tinker with the endowment’s portfolio to better withstand another year like 2008?

Mr. Swensen: I don’t think it makes sense for an institutional investor with as long an investment horizon as Yale’s to structure a portfolio to perform well in a period of financial crisis. That would require moving away from equity-oriented investments that have served institutions with long time horizons well.

Craig Karmin WallStreet Journal Tuesday January 13, 12:52 pm ET