Reconsidering the “Total Market” ETF
Despite all of the various people who have advocated investing in the “total market” ETF, I think that people should be very cautious about doing so. John Bogle and friends have claimed that the safest way to invest is to just buy an instrument that mirrors the performance of the market. This is a prudent thing to do if and only if you expect that the market will perform well, on average, over the long term. If you have strong reason to believe that the market will perform poorly over the long term, this strategy is very bad. If the market has permanently changed for the worse, you are far better off investing in something that has the inverse performance of the market.
Over the last 5 years, an investment in the S&P 500 was not profitable:
The Japanese have had it even worse than we have. In 2010, the NIKKEI 225 was at around the same price it was at in 1985, not accounting for inflation! Since 1990, it has been on a somewhat downwards trajectory:
Meanwhile, India’s SENSEX index has nearly tripled in the last five years:
The point I am trying to make is that if you invest in the “total market”, there is no guarantee that your investment will do well. If you think your market has some serious flaws, you are far better off putting your money somewhere else for the time being. All the studies that talk about the long-term performance of the U.S. market tend to look at events over the past eighty years or so. In the scheme of things, this is not a very long period of time. As looking at the cases of Japan and India show, it is possible for different countries to have very different performances over the long term. Over the past decade, the U.S. market has barely budged, while the Indian market has soared and the Japanese market has tanked. Slow, steady, compounding performance is far from certain.
In: ETFs · Tagged with: ETF, John Bogle, NIKKEI, S&P 500, SENSEX, total market
Bonds vs. Bond ETFs
As people become more risk-averse, financial institutions have been rolling out bond exchange traded funds. While these funds serve a certain purpose, bonds are about as similar to bond ETFs as fruit is similar to fruit snacks. Sure, fruit snacks are “made from real fruit”, but their nutritional properties sure are different!
What is a bond?
Simply put, a bond is a debt contract with a company or municipality. The debtor agrees to either pay you a series of payments (coupons), a lump sum at the end (the par value), or a combination there of, in exchange for receiving money now that can be used to finance something. The risk that you take on is that if the debtor is unable to pay back the debt, you may only receive part of the money you are owed by the contract. Furthermore, you might try to resell the bond before its contract has been fully realized. If the interest rates change, you might get more (if the interest rates go down) or less (if the interest rates go up) than you had originally paid for it. If you plan on holding it until it matures (the contract has been completed), your only risk is that the company or municipality won’t be able to pay you back.
What is a bond ETF?
Two financial advisors suggested to me that I consider bond ETFs as a way of diversifying my portfolio with bonds. After analyzing the situation, I can’t think of a worse idea. One popular bond ETF is the “Vanguard Total Bond Market ETF” (BND). According to Yahoo! Finance’s summary:
The investment seeks to track the performance of a broad, market-weighted bond index. The fund employs a passive management, or indexing investment approach designed to track the performance of the Barclays Capital U.S. Aggregate Float Adjusted index. It invests by sampling the index. It invests at least 80% of assets in bonds held in the index. The fund maintains a dollar-weighted average maturity consistent with that of the index, ranging between 5 and 10 years.
Got that straight? What the misguided financial advisors thought that this does is provide me with a diverse portfolio of bonds that I could essentially buy a fraction of in order to decrease my risk. They thought that this would have a similar effect to my simply owning a diversified portfolio of bonds. These thoughts could not be further from the truth. As the summary flat out says, BND is designed to “track the performance of a broad, market-weighted bond index”.
What causes the value of that index to shift? Changes in the interest rate, as well as changes in the ratings (predicted default rates) of the underlying bonds. While a company in the portfolio might continue to make its payments as always, if the interest rate goes up, the resale value of that bond goes down. No one that plans to hold that bond to maturity cares about the resale value – that’s why bonds are a fixed income investment that provide senior citizens with the stability that they desire. But, if you are investing in an index whose value changes with the resale value of the underlying bonds, you are getting anything but a stable investment. Given that the Federal Funds Rate is 0.25% (as of June 7th, 2010), it can only either remain the same or go up. When it goes up, the resale value of bonds issued in the past will decline and this ETF will go down. So, investing in BND not only exposes you to the default risk of the bonds; it also exposes you to the risk that their ratings will change or that the interest rate will change. Not exactly a stable, fixed income investment after all.
So, how has BND performed?
5 Day Performance
3 Month Performance
1 Year Performance
As you can see from these charts, BND is anything but a stable, steady investment. Instead, it is a proxy for a rather volatile index. The beta of BND is 0.06, indicating that the direction in which BND moves is nearly perfectly uncorrelated with the movements of the stock market.
To Conclude
Bond ETFs differ from bonds in that bond ETFs expose you to the risk of changes in bond prices, in addition to the risk of bonds defaulting. Their behavior is far more like that of stocks than of the bonds that they contain. Bond ETFs are not a suitable investment for an investor looking for a stable, fixed income investment. They are, however, a great way to diversify a portfolio by exposing it to the resale price of bonds. Given the difficulty that small investors have in buying bonds (investments in a given issue of bond usually have approximately a $10,000 minimum for corporate and municipal bonds), they seem like an appealing way to diversify. But, they have different characteristics than bonds and investors should be aware of this.
As the yield of investment-grade bonds is now very low, I would recommend that people considering buying bonds who cannot afford to purchase a diverse portfolio of them to put their money in a high-interest savings account if they are seeking a stable, fixed-income investment. Interest rates will likely go up in the near future, and doing this will provide the ability to purchase bonds or CDs at more favorable rates of return in the future. Under no circumstances would I recommend a bond ETF to someone seeking an investment with a stable rate of return.
Note: Bond mutual funds appear to have the same behavior as bond ETFs. But, they tend to leave you worse off as they have higher management fees associated with them.
In: ETFs, General, Savings Accounts · Tagged with: bond ETFs, bonds, fixed income
Negotiation Strategy: Why I Need Several Tailors
For the past three years, I have purchased tailored clothing from a tailor that I met in Hong Kong. Each time I purchase from him, it seems like he increases the prices ever so slightly. Given that I have few good alternatives, I have complied. In negotiation class, I learned that one can only strike a deal as good as their “best alternative to a negotiated agreement“. That is, if the Hong Kong tailor wants to charge me $35, and the only other tailor I know wants to charge me $120, the Hong Kong tailor is not at risk of losing my business until his price reaches that of the alternative. One can never negotiate unless one is willing to walk away at a certain point and seek an alternative. As different tailors take measurements in slightly different ways, it is preferable to be measured on-premises (versus ordering online). If you have a direct relationship with a tailor, it is far cheaper than going through a middle man online tailor, so these online tailors do not offer a viable alternative (they tend to be $60-90).
How will I derive new alternatives? My plan is to visit several tailors during my next trip to China and to have them take my measurements. (My size doesn’t change much over time.) That way, when I arrive at home, I will be able to compare prices and inform the tailors that they face competition. However, it is important for me to not be unrealistic, as it is possible for the tailors to shirk on both the quality of materials and craftsmanship.
In: General · Tagged with: alternatives, BATNA, China, Hong Kong, negotiation, tailoring