AssetPreserver News

No surprise. Bond index funds win again. Equity index funds win in most categories.

Standard & Poors released its semiannual study on index funds vs. managed funds (SPIVA). It covers 1, 3, and 5 years.

The study found that on an asset-weighted basis — measuring returns by the invested dollar rather than percentage of funds — index returns beat actively-managed fund returns in all 13 fixed-income categories over one and three years, and in 11 of 13 categories over five years.

One surprise was mortgage-backed securities. The index won around 98% of the time for 1, 3, and 5 year periods.

Index funds generally have much lower costs than managed funds, often 1% or more.

For index bond funds, there is usually less than 0.1% difference in cost between the index bond fund and the index it tracks.

What does this mean for me?

For mortgage-backed securities, the answer is easy: the index fund won 98% of the time.

Since bond index funds have low expenses, they have a much better advantage than managed bond funds, especially long term.

Managed REIT funds have an advantage over corresponding index funds.

For the most part, equity index funds beat managed funds.

Resources

View the full S&P SPIVA study

Even Fidelity has denounced them. So has Schwab.

“Leveraged products are complex, carry substantial risks and are intended for short-term trading,” a warning to customers on Fidelity’s Web site said. “Most reset daily and seek to achieve their objectives on a daily basis. Due to compounding, performance over longer periods can differ significantly from the performance of the underlying index.”

Many brokers are putting restraints or downright not offering them.

FAIR Canada Executive Director Ermanno Pascutto said: “The longer you hold a leveraged or inverse Exchange Traded Fund (ETF), the greater the likelihood that you will lose money, regardless of which direction you bet.”

The Financial Industry Regulatory Authority (FINRA) in June (2009) issued a reminder to brokers and advisers, urging them to use care in selling inverse and leveraged ETFs. FINRA states that they are “unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”

What is a leveraged ETF?

These ETFs use borrowed money to amplify their return, whether positive or negative. They follow a well-known index but their movement is 2 or 3 times the amount, depending on the ETF.

Leveraged ETFs are implemented using financial derivatives, such as options, swaps, and index futures. All of these tools are available to individual investors, but are much more complex than traditional share buying and selling and require larger amounts of capital. Thus, the advantage of the leveraged ETFs for many investors is a reduction of complexity and lower capital requirements.

Since most leveraged ETFs reset each day, it is difficult to gauge long term returns; twice the daily return of an index is not twice the annual return. This means the ETFs double the daily value, not necessarily the annual value.

What’s the difference? Assume that one day the market goes up 10%, and the next day it falls 10%. The two-day loss for the index is 1%, but the loss for the leveraged fund is 4%. Here’s why:

Index: (1 + 10% ) x (1 – 10%) = 1.1 x 0.9 = 0.99, 1% loss
X2 Fund: (1 + 20%) x (1 – 20%) = 1.2 x 0.8 = 0.96, 4% loss

Thus over a two day period, this fund’s losses are 4x the amount of the index, not 2x. This example comes from the ProShares prospectus, and is a clear indication that investors in 2X funds should not expect their investment to provide double the return of the S&P 500 for any period longer than one day.

How does a leveraged ETF work?

In order to deliver 2x the results, management must hold half the assets as debt. For example, if the fund is 10m in the fund, the fund must borrow 10m in order to invest 20m, or 2x, the amount in the underlying daily return of the index. Instead of borrowing, the fund uses financial derivatives, such as swaps, options, and futures.

Every day the market moves and the assets in the fund either increase or decrease in value, throwing off the leverage ratio because total assets are no longer equal to total debt. In order to attain 2x, a corrective action must be taken. And this action is to buy or sell millions of dollars of shares every day, dramatically raising transaction costs of the fund and short-term capital gains.

Whenever the market makes a big move downward, the fund sells shares and reduces its debt level in order to maintain its target leverage ratio. This locks in losses and reduces the fund’s asset base, making it much harder to recover gains in the next market upturn. Note that this situation is called the constant leverage trap and is a well-known problem in financial modeling. Investment portfolios that try to maintain constant levels of leverage over time perform very poorly in bad market conditions because they sell off large percentages of their assets.

How have leveraged ETFs performed?

Not very well over the long term. Here is one example (as of 30 June 2009):

UltraBull is supposed to maintain 2x performance over the S&P 500 index.
SD = 5 year standard deviation

What does this mean for me?

Leveraged ETFs are reset daily to maintain their advertised ratio.

Leveraged ETFs are intended for short-term trading: a few days at the most…day traders.

Do not expect 2x (or 3x) long-term performance out leveraged ETFs.

Understand the fund’s objectives, how it works, their expense ratio, volatility, and performance. Then decide.

Cash for clunkers, officially known as car allowance rebate system (CARS) is the hot topic these days. It is time AP weighs in.

Philosophically, I am against government meddling in most things in our lives as it ends up falling far short of expectations. The engineer in me decided to take a look at the cash for clunkers program, touted as a success or failure, depending on your news source. I read too many articles and hundreds of interesting comments on the subject.

The CARS program

CARS officially started on July 24, 2009 with 1 billion dollars allocated to the program. It runs until Nov 1, 2009 or until the money runs out. On July 31, 2009 an additional 2 billions dollars was approved by the House.

Goal of the CARS program

Cost to the taxpayers

1 billion dollars allocated originally which is borrowed money (meaning interest payments of $50 million/year assuming financing occurred through 30 year Treasury bonds). An additional 2 billion dollars ($100 million interest/year) is being allocated as we speak. As with all government borrowed money these days, the principal (federal debt) is never paid back. Tax money is used to service the interest only.

The trade-in rebate is $4500 or $3500, flat rate, regardless of how much the clunker is worth.

Should taxpayers pay $4500 for a clunker worth $100?

Synopsis of a poignant Edmunds.com press release

Edmunds.com’s research shows that typically 200,000 vehicles worth less than $4,500 are traded in for new vehicles every three months. These are the cars that qualify for clunkers.

According to Edmunds.com, about 200,000 old low mileage (mpg) cars would normally be traded in, every 3 months, in exchange for more efficient higher mileage (mpg) cars, without this program.

if all buyers have qualified for the higher $4,500 rebate, the “cash for clunkers” program will mean a marginal increase in car sales of 22,000 this quarter. $1 billion divided by 22,000 means a net cost to the government of $45,354 per car.

If all buyers only qualify for the $3,500 rebate, it means a marginal increase in sales of about 86,000, or a net cost to the taxpayers of $11,628 per vehicle. In all likelihood, however, there will probably be a mix of vehicles qualifying for various rebates between $3,500 and $4,500. Based upon that assumption, Edmunds.com estimates that the average cost to the taxpayer will be about $20,000 per vehicle. Even most of the marginally extra sales really represent people who were going to buy a new car eventually anyway. They are just buying a bit sooner than they expected. Old clunkers don’t last forever, and they are almost all eventually replaced. The government is shifting tomorrow’s demand to today, stealing from tomorrow to pay for today, but at great cost to the taxpayer.

Rebuttal

If 200,000 cars are “normally” sold with trade-ins during a quarter, you would most likely not have had that number “normally” this time. Many of the automakers’s sales figures have been running 25%-50% below last year. Applying this number to the 200,000 “normal” amount of trade-ins, you would get 140,000 if you used a conservative factor of -30%. If an average of $4000 were used per trade-in, this equals $880M for 220,000 cars. The incremental number of cars would be 80,000 (roughly). This would equate to about $11,000 per incremental sale. This is hardly the 10-fold number a lot of people have been quoting.

On top of that, the cash for clunkers program is generating a lot of interest in buying cars. There were (and will be) likely incremental sales beyond just the increased trade-in sales. When you factor all of this in, you may have likely brought the subsidy cost per incremental car sale down to near the $5000/car range. You should also take into account that the extra people manufacturing, servicing, and selling those extra cars will then be able to pay more taxes. They will also be spending more money in other areas of the economy.

Another suggestion was to make the rebates as tax credits so only people that pay taxes (i.e. fund the program) get the benefit.

Oil savings

Assuming that the average car drives 10,000 miles a year, and the average swap generates a mileage improvement from 15 mpg to 27 mpg, junking 750,000 clunkers will save 30 million barrels of crude a year, 1.5 days of our total annual consumption, or three days of imports.

In 2007 there was 136 million cars, 110 million trucks, about 1 million buses for a total of 247 million registered vehicles. (U.S. DOT)

Resources

Link to Edmunds press release

Results (as of Aug, 2009)

The government refuses to release any information about the success of the program.

The program ran out of money shortly after starting.

60% of new cars bought were foreign.

The effect on lowering dependence on foreign oil is less than negligible.

Many dealers raised their prices just before the program started.

Our local news reported that filling out paperwork for the program took around 5 hours. They also reported problems with the government web site.

The EPA changed their fuel economy ratings in the middle of the CARS program, disqualifying thousands who already made a deal, although many cars that did not qualify before, do now.

Most comments I read were people that are furious at subsidizing their neighbor’s new car.

Many dealer showrooms had a lot of people traffic.

If you trade in your car, sign the papers, and CARS runs out of money, you are on the hook to make up the $3500/$4500 rebate.

Is CARS worth it?

Has this been a good use of taxpayer money?

We vote no.

I love charts like this. They are so insightful.

Since the current boom started in 1997, I wonder if a perspective homeowner saw this chart in 2005 whether they would have bought a house. You could clearly see the housing bubble and if you believe markets revert to their norm that the house value fall would be brutal. As it is turning out. I do not like to speculate but in this case it seemed a sure bet in 2005.

Thanks to Steve Barry, a regular reader of the Big Picture Blog, who took the long-term Case Shiller chart dating all the way back to 1890 and then adding his own projected red dotted line showing how much further would need to fall until it reverts to its mean.

Note the Federal Reserve was invented in 1913 (one year before WW1) with one of its purposes being to prevent bank runs and depressions, seven of which this Country suffered through in the 1800s.

As of May 2009 the index was at 139 (the index is posted 2 months after). In looking at the home prices at the 20 cities involved in the index, most have stopped falling and actually (slightly) started an upward trend.

Home prices – S&P/Case-Shiller home price indices