For example highly rated bonds, usually not considered the riskiest of investments, are sensitive to prevailing interest rates.  AGG, a bond ETF is currently yielding around 3.7% annualized interest.  Its duration, a term that defines the average time until maturity for the bonds in the fund is around 4.    The duration metric quantifies how sensitive a bond investment is to interest rate fluctuations. In general, the price of a bond will drop by the duration amount in percent if applicable interest rates (intermediate time frame in this example) go up by one percent.   So, if interest rates go up by one percent, which is almost certain to happen, the bond fund like AGG will lose 4%.  Interest rate increases of several interest points could easily happen.   AGG’s  3.7% interest rate starts looking like an inadequate return given the risk.   Of course you could start adding things like protective puts, but those add commissions and costs that reduce your upside, and are typically very expensive if you are trying to completely limit your risk.

Some investment advisors might promote their asset allocation approach as not requiring predictions about the future, but their strategies are full of predictions (e.g., long term growth of stocks,  interest rates going down when equities go down, stocks in emerging markets growing faster than USA based stocks).

So realistically our only way to make better than CD level returns is to make good predictions about the future.   If you think interest rates are going to stay low for the next year, then AGG is not a bad investment–especially when compared to CDs and the like.  There are a quite a few things that can be predicted beyond just interest rates (e.g, short term stock direction, stock gains over 10 year periods, volatility, volatility skew,  “black swan” events, earnings reports, commodity prices, inflation rates, correlation between stocks, correlations between stocks and their sectors).

I am certainly not saying that we should forget strategies that limit/manage risk–I’m quite fond of those.     I’m just saying that managing risk is only part of the story, we also need to be right with our predictions most of the time.

So what are my predictions?   In general I tend to be pretty good at the longer term predictions,  usually not patient enough with the middle term predictions (e.g., 3 months),  not bad at the week level, and no better than a coin toss intra-day.

My 12 month predictions:

• No double dip recession
• Bull market starting back up again in the fall

My 3 month prediction:

• Sideways market.  S&P highs lows near 1020, highs near 1140

The remainder of this week:

• 20% chance upside breakout for S&P > 1120
• 50% chance sideways movement the rest of the week, closing in 1090 to 1120 range
• 30 % chance fallback into the 1070 range

I don’t think this is a bad strategy, but it does make the assumption that the future will be like the past (e.g., equities average around 10% growth per year over multi-decade periods, and that some assets classes like bonds and commodities tend to counterbalance trends in equities. For at least equities, the 2000 to 2010 time period has not been kind to this strategy—ignoring dividends the growth has been negative on the broad based markets.   Another trend is the recent synching up of commodities, and lower quality bonds with the equity markets.  This may be due to the rise of the ETF, which has made it much easier to get in, and out of things like gold, oil, and bonds.   Instead of counter balancing each other, they are increasingly moving in tandem—which increases the potential gains and risks.

Summarizing, from a risk management standpoint this approach has a fair number of issues:

1. I don’t think the past reliably predicts the future.  There are underlying assumptions about asset correlation and long term growth that look increasingly suspect
2. Although this is the probably the predominate investment strategy in the USA–because the vast majority of people just do what their broker recommends—it delivers truly gut wrenching poor performance during big bear markets.  People have their entire life savings invested in alignment with this strategy, and they see many years of gains erased in a few months.   The doomsayers come out in force, the press headlines the losses, and the conventional wisdom states that stocks are dead.   The end result is that a significant number of people capitulate near the bottom—bailing out of their investments at the worst possible time.

One of things I do like about diversified asset allocation is that its disciplined periodic rebalancing  takes profits on winners and reduces your exposure to the hot sector.  While an anathema to the momentum player, taking some of your winnings off the table periodically reduces your exposure to speculative bubbles.  The bursting of these bubbles is notoriously hard to predict, and they go south very quickly when they do.

I filled the equity orders between 9:30am and 10:00 EDT.  The mutual funds, as is their custom, closed at the end of the day (arrgh..).

Trades    USO  33.47
SPY  109.16
VT    39.88
IGNAX  16.39
TVRVX   20.45

Regarding the market for the next couple of days, I think there is too much fear out there for a sustained rebound, but other than that I don’t have strong opinions on what’s going to happen.  I’m about 80% in cash, and happy to be there right now.  Not losing money isn’t a glamorous goal, but from first hand experience a week like last week is no fun for the buy and hold crowd.  When markets go down, they go so fast—even without the help of warring computerized trading programs.

The 2003/2004 vs 2009/2010 tracking for SPY got back in sync on last Thursday—when SPY matched its 6 year old value again.   If I had only bet on my own hypothesis (that SPY 2010 will continue to roughly track SPY 2004) I would have made a boat load of money going short last week.  If the synchronicity continues SPY in  2010 will show much wider swings than 2004.  Looking at the graphs, the big question is whether the 2004 bottom trend line will be the 2010 bottom line too, or will my already projected 2010 bottom line turn out to be more like it.

SPY 2003/2004 vs 2009/2010, click to enlarge

Ex-dividend and pay / distribution information for XLU is here.

XLU Dividend History, click to enlarge

My tendency is to react too quickly to the market’s moves—so I’m trying to be patient.    I wouldn’t be surprised to see this correction last a bit longer, the market seldom jumps back up immediately after a blow-off day like last Friday.    The VXX continues to build popularity on down days—it traded over 22 million shares on Friday—which looks to be 7 million over their previous record.

SPY 2004 vs 2010, click to enlarge

• Management  fees are usually lower.  For example for inflation protected bonds the Schwab mutual fund SWRSX has a .5% expense ratio and the iShares Barclay equivalent TIP has an expense ratio of .2%.
• Instead of trades executing at the end of the day they can be bought or sold at any time the market is open (including pre and after market trading)
• No penalties for selling or restrictions on timing/ durations of round trips
• Low or no commissions – Schwab has introduced some commission free funds and Fidelity offers 25 ETFs for commission free.  These ETFs enable people to dollar-cost-average by buying relatively small amounts every month without getting eaten up by commissions.
• Many can be sold short (in standard taxable accounts)
• Options are available on the mainstream ETFs  (opens up protective put, covered call strategies)
• Standard tools (e.g., charts) work better with ETFs vs Mutual funds.  ETF quotes are updated in real-time during trading hours, vs once per day updates on mutual funds.
• Inverse index funds exist as ETFs – for specific indexes they move in the opposite direction as the index on a daily percentage basis (e.g., SDS is double inverse of the S&P 500).  For popular indexes these are available in single, double, and triple multipliers.   They can be bought/sold in tax protected accounts (IRAs) – so you can go short the indexes if you want to.
• Some indexes (e.g., VIX) have no mutual fund coverage  — VXX/VXV  are the available ETFs that are related to the VIX S&P 500 volatility index.

Disadvantages of ETF index funds

• They have a bid/ask spread, although for popular ETFs during regular market hours this is usually only $.01

Anyone with money can capture a dividend—you buy the stock (or ETF) before the ex-dividend date and hold it until the ex-dividend date. The challenge is to close out your position with a profit that is worth the risk. Typically the stock will drop by about the dividend amount when it starts trading on the ex-dividend day, but if the stock has a generally up day your overall profit can be better than the dividend. You lose money if the stock drops by more than the dividend amount (ignoring commissions)—and if the market goes bad you can lose many months worth of dividends in a hurry.

There are two ways to deal with this kind of risk, you can try to predict the future, or you can hedge. If you are any good at predicting the future then you don’t need to be messing around with dividends, you should just be buying and selling based on your predictions. With hedging you try to reduce, or better yet eliminate your risk by also investing in something that moves in the opposite direction of the stock so that the price movements cancel out. Some high quality hedges for a stock or ETF:

Hedges that can reduce your risk, but only provide medium protection include:

I have used one approach that offers a reasonable payoff, with reasonable risk—using deep-in-the-money stock option calls to capture the dividend amount.   More about this in my next post.

Ex-Dividend   1-Feb-10    1-Mar-10    1-Apr-10 3-May-10   01-Jun-10   1-Jul-10   2-Aug-10   1-Sep-10   1-Oct-10   1-Nov-10   1-Dec-10   28-Dec-10   1-Feb-11

Pay Date  2-Jan-10   5-Feb-10   5-Mar-10   8-Apr-10 7-May-10   07-Jun-10   8-Jul-10   6-Aug-10   8-Sep-10   7-Oct-10   5-Nov-10   3-Dec-10   04-Jan-11   5-Feb-11

AGZ      iShares Barclays Agency Bond Fund (AGZ)
CFT      iShares Barclays Credit Bond Fund (CFT)
CIU      iShares Barclays Intermediate Credit Bond Fund (CIU)
EMB     iShares JPMorgan USD Emerging Markets Bond Fund (EMB)
GBF      iShares Barclays Government/Credit Bond Fund (GBF)
GVI      iShares Barclays Intermediate Government/Credit Bond Fund (GVI)
MUAA iShares 2012 S&P AMT-Free Municipal Series (MUAA)
MUAB iShares 2013 S&P AMT-Free Municipal Series (MUAB)
MUAC iShares 2014 S&P AMT-Free Municipal Series (MUAC)
MUAD iShares 2015 S&P AMT-Free Municipal Series (MUAD)
MUAE iShares 2016 S&P AMT-Free Municipal Series (MUAE)
MUAG iShares 2017 S&P AMT-Free Municipal Series (MUAF)
MBB     iShares Barclays MBS Bond Fund (MBB)
MUB    iShares S&P National AMT-Free Municipal Bond Fund (MUB)
NYF     iShares S&P New York AMT-Free Municipal Bond Fund (NYF)
SUB      iShares S&P Short Term National AMT-Free Municipal Bond Fund (SUB)

Looking for ex-dividend information for other ETFs?   Check this page.

The most notable change in the curves since my last update on the 18th of March  is the big drop in normalized volume–something we didn’t have till the Summer of  2004.    Volumes have been low recently, so this drop-off isn’t surprising.  If the 2004 pattern holds true, the 30 day moving average of volume will drop during rising prices, and start increasing a couple weeks before rallies occur.