Foreign Bond Funds: To Hedge or Not to Hedge (Unhedged)

Continuing with a theme I started in my last installment, if you are an investor who wants to diversify your investment portfolio outside the US dollar without using the foreign exchange market (forex), consider investing in unhedged foreign (international) bond funds. Foreign bond funds can have two types of returns, from the bond itself and from currency fluctuations. If the bond fund hedges against currency fluctuations the bond fund return will come only from the bond itself. When the bond fund uses foreign currencies hedging, it removes the currency risk from the bond fund and acts as a normal fixed income investment. If the bond fund does not hedge against the foreign currencies, you will also receive the benefit of the currency fluctuation return. It is important for you to know if the bond fund hedges or does not hedge against foreign currency fluctuations.

If the foreign bond fund is unhedged you are investing in the weakness of the US dollar versus the foreign currency of the underlying bonds. When the US dollar strengthens the fund will go down. When the US dollar weakens, the fund will go up. If you don’t want the volatility of the foreign currency market you need to buy foreign bond funds that are hedged in the local currency.

Examples of unhedged and hedged foreign bond funds:  PIMCO has both unhedged and hedged foreign bond funds. 

PIMCO Foreign Bond Fund (Unhedged) - PFUIX: The fund invests in intermediate maturity non-U.S. fixed income securities instruments. The return of the fund has been the following:

1 year              3 Year              5 Year

18.94%            8.82%              9.06%

A comparison of PFUIX versus UUP (tracks the performance of Deutsche Bank long US dollar future index) using charts shows it is the inverse of performance. Since UUP is bullish on the US dollar, when the performance strengthens, PFUIX will show weakness. When UUP show weakness, PFUIX will strengthen.

PIMCO Foreign Bond Fund (U.S. Dollar Hedged) - PFORX: The fund invests in intermediate maturity non-U.S. fixed income securities instruments. The return of the fund has been the following:

1 year              3 Year              5 Year

4.47%              8.39%              6.63%

It is very important that you understand whether the fund is hedged or unhedged before investing in a foreign bond fund. If you are adding the investment to your fixed income portfolio you want the foreign bond fund to be hedged. If you are also interested in diversifying your investment outside of US dollars you want the foreign fund to be unhedged. Investing in unhedged foreign bond funds is only a good investment strategy if the US dollars declines versus the foreign currencies the bond fund is invested in.

Do you think the US dollar will continue to show weakness against foreign currency? Is investing in foreign bond funds that are unhedged a good investment strategy? Please chime in with your comments.

© 2011

Paul Cusick

Foreign Currency Certificates of Deposit (CDs)

If you are an investor who wants to diversify your investment portfolio outside the US dollar without using the foreign exchange market (forex), one way is to invest in foreign currency CDs. Another is through foreign stocks or Exchange Traded Funds. I currently have several foreign ETFs in my portfolio (for example VEU and VWO) as well as Canadian energy company stocks (such as AAV and PWE) which help to diversify my portfolio outside the US dollar. Foreign exchange rate changes can have a significant effect on foreign stock returns over short-term periods. A weaker dollar versus the foreign currency of the country that you are invested in will lead to higher returns for the US investor. Foreign stocks that grow in local currency are worth more when converted back into cheaper US dollars (a strengthening dollar will have the opposite effect – it will lead to lower returns).

With all the issues presently barraging the US dollar and economy – large government and trade deficits, the credit crunch, etc. – investing in foreign currency CDs may be a way for my investment portfolio to diversify and hedge against the US dollar. After googling “Investing in Foreign Currency CDs” I found that one US bank, EverBank, offers Federal Deposit Insurance Corporation (FDIC) insured foreign currency CDs. Please note that the FDIC insurance will cover loss because of bank failure but not currency fluctuation losses. Like any investment strategy there are risks and rewards.

So what are the advantages and disadvantages of investing in foreign currency CDs using EverBank?

Advantages:
• Diversify your investments outside the US dollar.
• You don’t need to open a bank account outside the US to invest in foreign currency CDs.
• FDIC insurance
• Multi-currency CDs. For example, the Commodity Basket CD includes the Australian dollar, Canada dollar, New Zealand dollar and South African rand. Using index currency CDs helps to diversify the currency risk versus the US dollar.
• If you allow your CD to renew, you will not be charged a currency conversion fee.
• Available in IRA accounts.
• Gives you access to emerging countries’ currencies, for example, Brazilian real, Indian rupee and South African rand.


Disadvantages:
• Currency conversion will be within 1% of the available market rate for the selected foreign currency.
• Risk of loss of principal due to changes in currency exchange rates. For example, if you invest in the Canadian dollar CD and Canada’s currency exchange rate decreases versus the US dollar, you would lose some of your principal investment when the CD reaches its maturity should you decide not to renew and it is converted to US dollars.
• Examples of EverBank’s 3 month CD interest rates (as of May 6, 2011) are the following: Brazilian real interest rate is 3%, Swiss franc interest rate is 0% and New World Energy CD (Australian dollar, Canada dollar and Norwegian krone) interest rate is 1.1%.

Please remember there is no free lunch. The interest rates will be higher when there is more risk in investing in the foreign currency.

After reading this, what do you think I should do? Should I invest in EverBank CDs to diversify my portfolio? What foreign currency CD should I buy? Should I buy single or multi-currency CDs? Please chime in with comments.

© 2011
Paul Cusick

What to Do With a Million Dollars - Investing

Ever ask yourself, “What would I do with a million dollars?” A good friend of mine recently sold some stock in a company for which she had worked a number of years. The sale generated around $1,000,000 after taxes. This person asked my advice on how to invest the money and, naturally, I was only too happy to oblige.

My friend is 55 years old and would like to take moderate risk in investing the money to help to pay for her children’s college tuition, assist her parents and save for her retirement (she does not have a private pension only social security. The proceeds of the sale are in a taxable account (not in a 401K or IRA accounts).

The first thing I suggested my friend do is read Random Walk Down Wall Street by Burton G. Malkiel. It is required reading and the best source of information I have found for the average investor who intends to invest for retirement, child education, etc. Malkiel does an excellent job of revising and updating the book every four or five years to keep the information current and relevant. It is the classic explanation of how financial markets work, and why investing in non-managed (index) funds is better than investing in managed funds. Random Walk Down Wall Street is on my top three list of all time investment books, the other two of which are targeted to more advanced investors: Common Stocks and Uncommon Profits (classic book on growth investing) by Philip A. Fisher and Security Analysis (classic book on value investing): the 1936 or 1940 edition by Benjamin Graham and David Dodd

If you have read any of my other articles you know that I like index Exchange Traded Funds (ETFs) over Mutual Funds (MFs) and have written a number of articles showing the advantages and disadvantages of ETFs versus MFs. There are three major reasons I like ETFs versus MFs for my friend’s stock allocation portion of her portfolio:

· MF performance versus index: Studies have suggested that actively managed funds (MFs) cannot out-perform index funds (ETFs). Whatever the category, active managed funds cannot beat their index benchmark.

· Tax advantages (for non tax exempt accounts): ETFs do not distribute capital gains every year like mutual funds (except on rare occasions) so you will only have to pay the capital tax when you sell the fund.

· Significant cost advantage: Expense ratios are generally lower for ETFs than for comparable MFs. Vanguard offers very similar ETFs and MFs that follow the same index but the ETFs have much lower expense ratios.

Malkiel’s recommended portfolio allocation for a person in their mid fifties would be the following:

· Stock 55%: One half in US and the other half in international stocks.

· Bonds 27.5%: This would include zero coupon treasuries, no load high grade bond funds, and Treasury Inflation Protection Securities (TIPS).

· Cash 5%: Money market funds and short term bond funds (less than 2 years)

· Real Estate 12.5%: This would include Real Estate Investment Trusts (REITs).

My recommendation is a little more aggressive than Malkiel’s. I would allocate more to stocks and less to bonds and REITs. The following are my recommendations:

· Stocks 70%: 75% US market index, 12.5% international non US index and 12.5% emerging market index. This differs from Malkiel’s allocation. A large number of US companies make over 40% of their revenue from international sales; I think you can have less allocation in foreign stocks because of US companies’ diversification.

· Bonds 18%: A large allocation of my bond fund investments will be in short to medium average duration bond funds because of the current economic environment (bond funds have interest risk)

· Cash 5%: Money market fund and short term ladder Certificates of Deposits (CDs).

· Real Estate 7%: All invested in one or two REIT index ETFs.

I recommended to my friend that she open a Vanguard brokerage account. Vanguard is the low cost leader for ETFs and MFs with 30 years of tracking stock indexes. They are well known for selecting the best target markets and tracking them very closely. You pay no stock commission fee when you buy Vanguard ETFs.

I recommend the following for the stock allocation – all are Vanguard index ETFs:

· US stock market index (75%): Vanguard Total Stock Market ETF (VTI). The current dividend yield (as of February 18, 2011) is 1.9%.

· International non US market index (12.5%): Vanguard FTSE All-World ex-U.S. ETF (VEU). The current dividend yield (as of February 18, 2011) is 1.92%.

· Emerging market index (12.5%): Vanguard MSCI Emerging Markets ETF (VWO). The current dividend yield (as of February 18, 2011) is 1.20%.

Because the money to be invested is coming from selling stock, my friend could invest all the money at one time or she could invest every month in, for example, 6 increments (dollar cost averaging strategy) if it’s looking like there could be a pull back in the market. Since the trades are commission free there will be no commission cost for doing this.

The following are my recommendation for the bond allocation:

· Short term bond fund (35%): Vanguard Short Term Bond Index Fund Investor Shares (VBISX). The average duration of the bond fund is 2.6 years. The current yield (as of February 18, 2011) is 1.14%.

· Short term bond ETF (35%): Vanguard Short Term Bond ETF Fund (BSV). The average duration of the bond fund is 2.6 years. The current yield (as of February 18, 2011) is 1.25%.

· Corporate and government bonds of all maturities fund (30%): Vanguard Total Bond Market Index Fund (VBMFX). The average duration of the bond fund is 5.1 years. The current yield (as of February 18, 2011) is 2.91%.

The following are my recommendation for the cash allocation:

· Money market fund (50%): Vanguard Prime Money Market Fund (VMMXX). The current yield (as of February 18, 2011) is .07%.

· Layered CDs (50%): Portfolio of layered 3 month (90 day) CDs. The current yield (as of February 18, 2011) is .2%.

For the real estate allocation I recommend the following:

· REITs (100%): Vanguard REIT Index Fund (VGSIX). This fund invests in REIT companies that buy and lease office buildings, apartments, hotels, medical buildings and other types of real estate. The current dividend yield (as of February 18, 2011) is 3.13%.

Once a year the portfolio allocation should be reviewed and rebalanced in keeping with changes in the economic picture and personal circumstances. For example, if interest rates are forecasted to decrease, my friend may want to reallocate some of the bond fund allocation to more long duration bonds. This portfolio should generate about $15,000 to $20,000 in cash every year (between dividends and interest payments). This cash can be used to rebalance the portfolio.

Please chime in with your comments on my investment recommendations for my friend. Is there too much risk in the portfolio, should there be different portfolio allocation recommendations, should I have suggested different ETF recommendations, etc.


© 2011

Paul Cusick

ETF (Exchanged Traded Funds) versus Mutual Funds (MF)

From the outside Exchange Traded Funds (ETFs) and Mutual Funds (MFs) look like the same financial products. A closer look at each of them reveals the many advantages and disadvantages of ETFs versus MFs. As for MFs I am only discussing open ended funds, not closed end funds. Regarding ETFs I will not consider exotic funds (for example, interest rate swaps and forward one month future contracts) or precious metals funds as these ETFs have different tax consequences.

Advantages of ETFs:

Significant cost advantage: Expense ratios are generally lower for ETFs than for comparable MFs. Vanguard offers very similar ETFs and MFs that follow the same index but the ETFs have much lower expense ratios. For example, the MF that tracks the Standard and Poor (S&P) 500 VFINX has an expense ratio of .18% versus ETF VOO for which the expense ratio is .06%. This is only a saving of US $12 on an investment of US $10,000 per year, but compounded over time it can add up to thousands of dollars coming out of investors’ pockets. There can also be a commission fee every time you buy an ETF (since you are buying a stock), but many brokerage firms will waive the fee if you buy their ETFs.

Buy or sell at any time: ETFs are just like stock – you can buy or sell them whenever you wish. Mutual Funds are processed once a day at the next closing net asset value (usually at the end of the day). Another advantage is you can place limit buy or sell orders (same as for stock).

Tax advantages (for non tax exempt account): ETFs do not distribute capital gains every year like mutual funds (except on rare occasions) so you will only have to pay the capital tax when you sell the fund.

No minimum investment amount: You can buy 1 ETF share or 100,000 shares. Most (if not all) MFs have an initial minimum purchase amount, for example, US $5,000 as well as a minimum reinvestment amount, for example, US $100.

You can short an ETF: Just as with stocks, you can short ETFs.

Disadvantages of ETFs:

No automatic dividend reinvestment feature: You have to reinvest the dividends (just like stocks). For most MFs you choose to automatically reinvest the dividends.

ETFs are only as good as the index: ETFs are passive (non-managed) funds that try to duplicate the performance of an index, for examples, S&P 500, Russell 2000, and others. This may be a positive since not all MF managers beat the appropriate index benchmark with which they are compared.

Can have high bid / ask spreads that are thinly traded and have small market capitalization: Always check if an ETF you are interested in is thinly traded or has a small market capitalization. The ETF liquidity could disappear in severe market conditions. Also, the spread between the bid and ask price can cause more expense when you are selling.

Advantages of MFs:

Automatic dividend reinvestment feature: As a mutual fund investor you can choose to automatically reinvest your dividends in the mutual fund.

Activity managed by MF manager (if not index fund): MF managers try to out-perform the comparable benchmark and peer funds through their selection of investments. This has the potential for out-performing the market.

Lower cost if buying shares on a monthly basis (no stock transaction cost): MF can have lower cost if buying shares every month.

Disadvantages of MFs:

High fees and sales loads: With MFs there can be sales charges on buying (front-end sales load) and redemptions (back-end sales load). These loads can be a maximum of 8.5% (most MFs do not charge the maximum). Mutual funds have higher fees than ETFs. The following are examples of the fees: management fee, non-management expense, and 12b-1/non-12b-1 fees.

Distribute capital gains every year (for non tax exempt accounts): Mutual funds are required by law to distribute capital gains each year (MFs must distribute 95% of the gains to shareholders). The capital gains distribution is a result of an MF selling shares. For example, if the market is going down the MF manager may have to sell shares because of the need to raise cash for shareholder redemptions.

Shares can only be sold when the market closes: Mutual Funds are processed once a day at the next closing net asset value (usually at the end of the day).

High minimum investments and reinvestments can be required: MFs can have high minimum initial investments. For example, Vanguard MFs have a minimum of US $3000 for initial investment.

Please chime in with comments about exchange traded funds versus mutual funds. Which ones have you been investing in lately?

© 2011 Paul Cusick

Paul

Long Average Duration Bond Funds and Interest Rate Risk

If you are an investor who thinks bond funds are always a safe investment in which you cannot lose money, guess again. Every investor should understand why the average duration for bond funds is important to interest rate risk. Having a good understanding of the correlation between interest rate and average duration for bond funds means you will make fewer financial mistakes and you will increase your overall net worth. Bond fund values move in the opposite direction of interest rates, so when interest rates go up, your bond fund principal will decrease. Conversely, when interest rates decline, the principal of your bond fund will grow.

Here’s why: for every 1% increase in interest rates the bond fund will go down in value by the average duration of the bond fund (it works the opposite if interest rates go down). For example, if the average duration for the bond fund is 7 years and interest rates go up 2%, the value of your investment will decrease 14% (average duration X interest rate change = gain / loss). Another example, suppose you have $10,000 invested in a bond fund with the average duration of 7 years; if the interest rate goes up 2% you just lost $1400 of your Investment. If the situation is reversed and the interest rate goes down by 2%, you just made $1400.

Here’s a ‘real life’ example of when interest rates go down and bond fund principal increases. Vanguard’s Long Term Treasury Investor Shares (VUSTX) average duration is 13.1 (this is the current average duration of the fund; I do not know the average duration in 2008). On October 31, 2008 the share price was $11.11, on December 18, 2008 the share price was $13.74 this is a gain of 23.7% to the principal. The treasury 20 year bond price deceased by 1.88% (from 4.74% to 2.86%) during the same time period. This is very close to the calculation (1.88 x 13.1) gain of 24.6%. If you had been an investor in long average duration bond funds at the start of the 2008 financial meltdown you would have been a very happy investor indeed. An investor in short average duration bond funds would have had much lower gains. For example, if you invested in a short average duration bond fund with average duration of 3 years, your gain would have been around 5.64%.

The opposite ‘real life’ example occurs when interest rates increase and bond fund principal decreases. Using the same bond fund, Vanguard’s Long Term Treasury Investor Shares (VUSTX) average duration is 13.1. October 1, 2010 the share price was $12.49, on December 31, 2010 the share price was $11.07 this is a loss of 12.8% to your principal. The treasury 20 bond price decreased by .81%. It is reasonably close to the calculation loss of 10.61%. If you ]had been invested in long average duration bond funds during the last quarter with the start of QE2 and all the Bush tax cuts being extended by 2 years you would not have been a happy investor. This is one of the reasons why investors are pulling money out of bond funds. More than $20 billion have been pulled out of bond funds since mid-November 2010, with the weekly outflow in mid-December marking the biggest in more than two years.

The greater the average duration of a bond fund's holdings, the more its share price will fluctuate when interest rates change. This why there is risk in investing in bond funds. Average duration is a very useful measurement of bond fund sensitivity to changes in rates. To make it simple, the greater the average duration of a fund's holdings, the more its share price will fluctuate when interest rates change. To make it even simpler, a rising interest rate climate is not good for bond fund investors. If you think interest rates are going to increase you want to be invested in short average duration bond funds. It is the opposite if you think interest rates are going to increase; in that case you want to be in long average duration bond funds.

Buying individual bonds can take some risk out of investing in bonds. Assuming the issuer is still solvent when the bond matures, you collect the face value of the bond. You will not experience the principal fluctuations to which bond funds are subject.

© 2011 Paul Cusick

Paul’s Gang 2010 Blog Summary

I would like to thank everyone who read my blog, and also those who wrote comments and sent me email on it in 2010. My hope is that everybody gained a bit more investment knowledge, made fewer investing mistakes and increased their investment gains as a result of reading my blog. I had a great time writing Paul’s Gang and learned a great deal myself over the last year.

Some interesting statistics:
• 36 blogs published, comprised of 120 pages of writing
• Over 19,000 visitors to the Paul’s Gang blog site
• Visits came from 75 countries/territories
• Visits came from all 50 US states, Washington DC, Guam and Puerto Rico
• Visits came from all 10 Canadian provinces and 2 territories. I am still waiting for a visit from Canada’s newest territory, Nunavik (population 11,627).

Top 5 countries visiting, not including US:
• Canada
• United Kingdom
• Singapore
• India
• Spain

Top 5 page views (blogs):
• Netflix (NFLX)
• High Dividend Yielding Stocks
• Investment US TAX Changes for 2011
• Tradable REITs Investing – Office Building
• Best Investment for Stagflation

Top 5 longest times spent on a page (blog):
• High Dividend Yielding Stocks (over 15 minutes)
• Brazil
• Tradable REITs Investing – Office Building
• 401K Rollover
• Best Investment for Stagflation

Visits from interesting countries / territories:
• Macedonia (FYTOM)
• Saint Lucia
• USA Virgin Islands
• Andorra
• Cayman Islands
• Vietnam

Top 5 keyword searches (46% of traffic came from searches):
• Best investment for stagflation
• Tax changes for 2011
• What to invest in stagflation environment
• 2011 tax changes
• High dividend yield stocks

I sincerely wish everyone a happy and prosperous 2011 for you and your families and a year of successful investing.

© 2011 Paul Cusick