Junk Bonds vs Treasury Bonds Backtest

Aug 31, 2012 in Backtest | Bonds

Credit markets don't appear to be too concerned about recession in United States.   Junk Bonds have been outperforming Treasury Bonds lately.

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Survivor Bias

Aug 19, 2012 in Backtest

Survivor bias is a real problem in individual stock backtesting.   A quick statistic:   ~30% (90 / 308) of the stocks in the DJ Financial services index on Dec 31, 2007 have since been removed from the index.     

Said another way, if you were running a stock backtest using all of the current individual stock components of this index as a starting point to backtest today, you would have a massive positive bias in your study.   Your list would not include names like:   

Wachovia (failed bank), Merrill Lynch (likely insolvent in 2008),  Fannie Mae (insolvent), Lehman Brothers (bankrupt), Washington Mutual (failed), Bear Stearns (insolvent), Countrywide (BofA acquisition disaster), MF Global (bankrupt) etc...

Nearly 1/3 of the list is gone. That is a TON of survivor bias.

Back up a few years and it was names like Worldcom (bankrupt), Enron (bankrupt), Global Crossing (bankrupt) along with all the other Tech, Media & Telecom (TMT) companies that lost -98% of their value and were removed from their respective indices.

Of course, if you operate at a level of long-established indices (as with ETF backtesting), you can largely avoid the survivorship bias problem as the historical index data reflects all of the securities that left the index due to bankruptcy and/or similar resons.   That is, while the DJ Finanicals Index no longer has those 90 companies in the index -- the index RETURN of course does indeed reflect the effect of all those failed/insolvent firms.   Survivorship bias is no longer relevant if using established index ETFs. This is one key benefit you get with using securities that actually traded at the time --- and not just theoretical indices (an index is NOT an investment, an index FUND is what you invest in).

The issue in ETFs is that of newly-created indices that were created only to sell a financial product.   Many of these are going away and the ETF analyst should differentiate between what is a 'real' index and what is a financial gimmick. Does anyone think that the S&P Financial Sector Index isn't going to still exist in 10-20 years? It will. MSCI Emerging Markets -- yes it will too.

New important indexes do come along -- but you should be discerning in this and really focus most of your efforts on long-established indices. Learn about new ETFs as part of your efforts -- but spend 95% of your time on what is already out there.

RIP these Direxion ETFs: Direxion Decides To Close 9 3x ETFs

Note also that having valid indices is no guarantee that YOU will be the provider of choice --- Russell Investments is giving up on its ETF effort after starting far too late and hence gaining virtually zero traction in the marketplace: Russell Pulls Plug On ETFs


See Also: New ETF Tracking Error Nuances

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Update on Hedge Fund Index

Aug 07, 2012 in Hedge Funds

Bloomberg Hedge Fund Index through July 31, 2012.    While there may be room until most managers get back above their high-water marks -- eventually you run into the same core problem --  2+20% of profits will be taken away from investors and go to the fund managers.   Upside is therefore quite limited.  Downside is limited as well but so is the case with a good, risk-managed allocation.


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How 'long-term' are we talking about?

Aug 02, 2012

How long-term is long-term?  Everyone says they are long-term -- but the question of time horizon is a tricky one.

Certainly a good deal of your portfolio can be very long-term buy and hold oriented.  But what if your portfolio is structured poorly?  You can rationalize almost anything saying 'yes but it's long-term so I don't care about that' and if you are long-term, then you don't actually admit to mistakes until its been many years -- and that can be catastrophic if you portfolio strategy is flawed.  

The bond market is good for understanding return and risk because its so structured.   10-year bonds are clearly a lot more volatile than 5-year bonds.  20-30 year bonds move around a lot as they are quite volatile (often more volatile than stocks).

So let's back up to November 2011.  Is the time from November 2011 to today long-term?   Most would probably say no.   However, an awful lot has happened in terms of movement since then.   So we have two very different ideas.   One is acting in a useful and realistic timeframe.   The other is essentailly ignoring 8-9 months of movement and claiming nothing can be done about such a short timeframe. A core-tactical portfolio structure acknowledges there is some validity in both ideas. Multi-faceted portfolios may not lead the world in performance -- but they will help you reach your goals.

On November 30, 2011 --- the stated Yield-To-Maturity of one of iShares main intermediate investment-grade bond funds (LQD) was listed at 4.3%.   A treasury bond fund with similar duration (IEF) was listed at 1.8%.

Since that date, LQD has achieved a total return of 12.5%.   IEF is up 6.2%.    So each has achieved a return that is 3x its stated yield --- and its only been 8 months.

Looking at an extreme case,  a long-term treasury bond fund (EDV) is up +65% over the last 12 months.   A year ago it yielded 4%.   So the actual achieved return in that case was 15x the stated yield to maturity.

For the amount of times we hear about how low yields are -- very little is said about the uselessness of YTM as a predictor of INTERMEDIATE-term return.   I guess its just not 'long-term' enough.   It is the sensitivity to changes in interest rates (duration) that dominates the return.   The best way to both grow (and protect) a portfolio is to blend stocks and bonds together in a way with both the long AND intermediate term in mind.

We are involved in stocks in the first place because over the long-run, stocks are a good way to grow capital.   So we are long-term just like everyone else.   However, the long-run orientation is frankly a 'given' --- what we are really talking about is the intermediate-term tactical moves and in this regard, the returns and volatilities of intermediate moves are substantial.    Saying TLT has a yield to maturity of 3.0% is an interesting piece of information --- it is just not in any way a reliable indicator of the 6-18 month total return.  

Below is a quick snapshot of various bond funds stated YTM's from November 30, 2011 and their ACTUAL total return since that date.   If back then you thought YTM was an accurate predictor -- you're 'only' off by 3x in 8 months.

Summary:   It helps to understand the basic mechanics of portfolio management.    Indeed, portfolio structure and PM techniques are just as important as anything in investing.   Bonds are a useful way to understand different ideas like volatility.   We want to be in equities long-term and for the core long-term portfolio, it is perfectly reasonable to do that.   But there is clearly more opportunity than that in the intermediate-term timeframe. 



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