3 Great Reads

One of the best features of the blogosphere, IMHO, is the wide-ranging topics presented on an ongoing basis.  Here are 3 I especially enjoyed this week:

• What is the best cash rewards card?  How do they compare?  How much can be saved by choosing intelligently?  Here is a great article, "Best Cash Back Credit Cards, August 2012"  from Free Money Finance, examining these questions that anyone with the analytic bug will enjoy.  Be sure to check out the comments section--it includes valuable observations as well.  This article is worth sending to college students, also, since they are on the verge of dealing with these questions.
• From Biz of Life comes a Bloomberg video interview of Jim Grant.  If you watched the Republican Convention, you know that Romney has said he will replace Fed Chairman Bernanke.  The Fed Chairman is said to be the second most powerful position in the world.  Some have said that gold bug Jim Grant should have that position.  I fully agree with Grant's position that the Fed has morphed into a central planning group whose actions mirror those of the old Soviet Union in their ineffectiveness and downright harm.
• I previously covered the poor performance of hedge funds, the bastion of "sophisticated" investors.  In this post, "Couch Potatoes Crush Hedge Funds",  Andrew Hallam, author of the best-selling Millionaire Teacher, goes into greater detail on hedge fund performance and explains how the average investor can do better.

So there it is:  personal finance, economics, investment performance - all in one fell swoop.  Enjoy!

What is Market Efficiency?

Can you beat the monkey?

In a large part of my world, there are 3 types of people  -  those who believe it is possible to beat the market, those who don't, and those who don't understand the question.  I have found that it is less challenging to convert the first group to the second group than it is to get a Democrat converted to a Republican and vice versa.

This is a market efficiency question.  Market efficiency implies that prices reflect all publicly available information and, no matter how much you analyze markets and stocks, you are better off indexing the market.  Market efficiency is clearly a counter intuitive notion.  After all, from the delivery room on, we have been preached the virtues of hard work.  Hard work is the key to advancing in the work world, as an athlete, or even with our relationships in life.  How could it be otherwise in this area?  How could it be, in something as complicated as Capital Markets, that hard work doesn't create an edge.  How can it be that very basic, well-diversified portfolios consistently outperform the professionals with all their resources?  How is it that an average Joe Blow, absent a degree in finance from a top ten school who spends less than an hour a month on investments, outperforms the country's biggest pension funds and hedge fund managers?


Market efficiency is a concept that has produced considerable academic and real world research and discussion.  The research has come at the question from different angles.  One broad area focused on specific metrics.  For example, can you produce exceptional returns by investing in stocks as soon as they announce a stock split, a surprisingly good earnings report, a dividend increase, etc.?  If you can think of  a likely candidate, you can assume that it has been studied.  Although this research finds some minor what are called "anomalies" in some instances, they are small and, once real world factors such as commissions are taken into account, not worth exploiting.

In addition to this academic research on specific approaches, the other broad area has been  performance.  To me this is the most valuable.  I say this because I know a little about statistical analysis, regression analysis, etc. and its shortcomings.  But performance is the bottom line.  If really smart people can analyze publicly available information and beat the market, they would blow away the simplified, indexed approach.  Period.  I say this because I have been on the institutional side of the business.  I have met and known brilliant analysts, investment managers, and strategists.  They are smart and have incredible resources at their finger tips.

Frankly, the average person has no idea how smart the group at Long Term Capital Management, the largest hedge fund into the world whose  efforts led to the need for a Federal reserve bailout, was.  They had Nobel Prize-winning economists as advisors along with "quants" from the isk arbitrage group at Salomon Brothers.  The average person has no idea of the resources former guru Bill Miller had at his finger tips before he imploded.  He could pick up the phone and talk directly to many CEOs of the top companies in the U.S.

Not only do the smartest and the brightest underperform - they go down in flames on a regular basis. Somehow, analyzing publicly available information isn't that easy.

To economists, efficiency isn't a foreign notion.  If some one walks in where I am right now and says that he heard a guy opened a lemonade stand down the road and made $10,000 the first day, an economist understands that trying to do the same will be futile.  Those who got into the Beanie Baby craze understand what I'm saying.  In fact, there have been studies examining whether people gain an advantage by changing lines at the grocery store checkout counter.  Other studies have looked at people changing lanes as they traverse the New Jersey turnpike.  Guess what?  When others are trying to do the same, it doesn't pay on average.

So, the bottom line is there is something else going on here as people try to use publicly available information to get ahead in the markets.  Another way to say this is to point out that the brilliant analysis of the talking head on CNBC right now is useless.  To me, this is elementary because the next talking head in line is just as brilliant but with an opposite point of view on markets as well as specific stocks.

But that's what makes a market.
,
If it is possible to analyze publicly available information and over the long run beat the market, then there would be a lot of investment managers beating the market.  Like seeking a surgeon, the first question we would ask would be for their track record.  Actually, the academics have examined track records and found them to be of no value in predicting future performance.

Great Questions For the Dinner Table

It looks like they are eating broccolli - great meal!

I'm an investment advisor interested in promoting financial literacy so maybe I'm a bit prejudiced, but here are some good questions to bring up at the dinner table - after discussing Aunt Bertha's eccentricities, of course. IMHO, the dinner table is an excellent classroom.  As another thought, trips to Rehoboth work as well - the key is to have the kids and/or other family financial illiterates as a captive audience.

The questions come from an article in the Chicago Tribune by Gregory Karp of Spending Smart,  Quiz:  Your money literacy,  presented online at the Baltimore Sun.  After discussing the questions, you should read Mr. Karp's answers.

1.Would you rather have $1,000 or a penny doubled every day for a month?

2. Do your credit scores rise when you get a higher-paying job?

3. Is a household budget meant to restrict your spending?

4. Should a child's weekly allowance be tied to household chores?

5.  Should I pay off highest interest rate debt first?

6. What is the only official site for getting your credit report?

7.  If a thief steals your credit card and charges $1,000, you're responsible for how much?

8. Which investment is likely to provide the highest returns over time: stocks, bonds or certificates of deposit?

9. True or false: You must buy eyeglasses and contact lenses from an eye doctor.

10. What is the form that discloses how financial advisers are paid?

11. Which is more expensive for a family of four: food or financing a new car?

12. How many credit scores do you have?

13. How large should your emergency fund be?    

Part of the process of course is discussing the terms.  Kids know what an allowance is but probably don't know what a credit report is or even a household budget. 

 

The Value of Retirement Plan Calculators

Source:  Capital Pixel

Usually the longer we have to solve a problem, the better the chances we have of coming up with a viable answer.  This presupposes we actually give it some thought.  Even mulling it over gets its circulating in the subconscious--which neural scientists tell us is a good thing in the problem-solving process.  As a side benefit, maybe it pushes aside some nutty notions floating around in there as well.

Anyway, this seems to me to be a reason for those in their 40s and early 50s to begin playing around with retirement calculators. Although you have plenty of time to go before you exit the work force, you'll see if you are on the right track and, most importantly, you'll be introduced to the important financial determinants of a successful retirement.

There are a number of good calculators online.  One I like is the AARP retirement calculator.  It is simple, straightforward, and asks the basic questions.  It doesn't get you into Monte Carlo analysis and a lot of mumbo jumbo about your portfolio allocation.  It has straightforward assumptions built in, which you can change if you want.

By going through the questions, it focuses you on your saving, social security, when you plan to stop working full time, etc.  It asks about the lifestyle you contemplate in retirement.  An important side benefit is it should get you and your spouse talking and thinking about these issues.

As an advisor, I can tell you that, more often than not, I have seen couples surprised at their spouses' answers when these questions have come up.

The earlier you begin playing around with these kinds of calculators, the easier you will find it to make adjustments to get on the right path.  If you google "retirement plan calculators," you'll come up with several in addition to the AARP calculator.

Hedge Fund Performance

Veblen: author of The Theory of the Leisure Class

Yesterday's buzz on CNBC centered on hedge fund performance and the article Panic in Hedge Fund Land by Lee Brodie that reported that only 11% of the hedge funds tracked by BarclayHedge outperformed the S&P 500.  Hedge funds are available to "sophisticated investors" at a hefty fee.  They are managed by the "Masters of the Universe" of the investment world.

The unsophisticated seek to be sophisticated.  This is a fact of economic life and is just a variation of Veblen's observations on conspicuous consumption.  This is an area where you don't want to be sophisticated.  Stick with the proven low-cost, well-diversified index funds.

Here's some insight into this corner of the investment world:  The 10 Greatest Hedge Fund Implosions of All Time by Thorton McEnery.

Do You Need to Rebalance?

Serious Rebalancing

If you're asking the question on whether you need to rebalance your portfolio, it's probably a good thing.  Admittedly it's a free country and we can ask any question we want, but just asking the question probably presupposes your investments are in order.  You have an asset allocation plan, you  are diversified among different asset classes, and you know what percentage you have invested in each asset class.  You may have technology calculating the percentages for you or you may be doing the calculations the old-fashioned way using spread sheets.  Hopefully, you aren't so old-fashioned you're using pencil and paper.  Anyways...you're ahead of a lot of investors.

Let's look at a simple rebalancing situation.  Assume we started the year with the following allocation:

ETF/SECTOR	%	Amount
SPY/S&P 500	50	$50,000
VEU/Global Stks. Ex. U.S.	10	10,000
AGG/U.S. Bonds	40	40,000

If we go to Yahoo! Finance, we can easily find performance for the ETFs through 7/30.  This is what you get putting VEU in the quote box:

Source: Yahoo Finance

Doing this, we find the following performance data:  SPY +8.90%, VEU +3.85% (shown in graphic at left), and +3.50% AGG.  Multiplying $50,000 by 1.089 gives us $54,450.  This produces the numbers in the table below.


You get these numbers for your situation by going to your account online.

Using the performance data, we calculate that our $100,000 portfolio is now:
 

ETF/SECTOR	%	Amount
SPY/S&P 500	51.3	$54,450
VEU/Global Stks. Ex. U.S.	9.8	10,386
AGG/U.S. Bonds	39.0	41,400

If we chose, we would rebalance by selling SPY to get the percentage down to 50% and spreading the proceeds to the international sector and the bond sector.  For most people, this would be overkill.  For one thing, if you are using ETFs, as indicated here, there may be a commission charge.  Most studies indicate rebalancing once a year is sufficient unless there is a huge change in the market.

Hopefully you see that the rebalancing process automatically gets you to sell the sectors that have done the best and buying into the sectors that have underperformed, i.e. buying low and selling here.  In this example, it would reduce exposure to U.S. stocks and increase exposure to international stocks.  Not easy to do for emotional investors being swayed by news out of Europe!

Disclosure:  This post is for educational purposes.  Individuals should do their own research or consult  a professional before making investment decisions.  My clients and I own ETFs mentioned here.

Is This a Good Time to Invest?

Is this a good time to invest?  Market timers and stock pickers, both pros and individuals, debate this question all the time.  The evidence is that they tend to miss it.  Many times we focus on longer term evidence, but the longer term is made up of the shorter run.

Last year was a great case in point.  In October, it looked like the world was coming to an end.  The U.S. Congress was at an impasse and seemed incapable of increasing the debt limit ceiling.  Europe was falling apart, and it appeared obvious that Greece was on the verge of leaving the European Union with Spain close behind and possibly even Italy down the road.  Abandonment of the euro and its attendant uncertainty was the buzz of the day.  Topping off all of this was economic data suggesting the U.S. may be going back into recession.

With this backdrop, any brilliant, analytical portfolio manager would sell; and, from performance results, it appears they did.  Unfortunately (for them!) the market rose sharply through year end.  As a result, huge state pension funds produced anemic returns and hedge funds got clobbered.  Once again, the brilliant, analytical types were not smarter than the market.

Take A Longer View

There is a different approach.  Rather than trying to outguess the market on a short-term basis, take a longer view.  This approach recognizes that the world 10 -15 years from now will be wildly different from today.  How do we know this?  Just compare today with 15 years ago.  Look at smart phones and tablets.  Tablets of today are the Pong games of yesterday.  Look at automobiles and advances in medicine.

Does anyone doubt that the automobiles we drive 15 years from now will be completely different from today's.  The laptops and other electronic devices will all be replaced with products beyond our imagination.  I know this is hard to grasp for many.  Maybe it requires a certain age.  Fifteen years from now, people will be saying "Merkel who?" as they project the TV program they recorded three hours ago onto the wall from their smart phone.

I am of a vintage whereby graduate school involved going to the "stacks," getting journals, and xeroxing articles that were months old.  Today, students with a laptop have access to the latest research in many areas and the ability, in many cases, to interact with the researchers.

Anyway, to help along these lines, I submit the following video found at Biz of Life's site.  As you watch this video, I suggest you free your imagination and think of the possibilities in the so-called "information age."

Junk Bond Facts

One of my favorite financial writers, a man with a sharp wit and ability to simplify complex investment topics, is John Waggoner at USA Today. Recently, he wrote a column Are junk bonds trash or treasure these days ?  that is loaded with facts useful for the DIY investor. Junk bonds, or as they are more politely called, high yield bonds, represent at least a small portion of most DIY investors' portfolios via exchange traded funds like HYG or JNK.

Here are some of the facts that I garnered from the article:

• junk bonds yield between 7% and 8% versus 1.62% on the 10-year Treasury note (actually the 10-year T yield has since moved up to 1.80%)
• over the past 15 years, the average junk bond fund has gained 5.18%/year versus 4.72% for average large blend stock funds (think S&P 500 comprised of value stocks and growth stocks)
• high rated corporate bond funds gained an average of 5.77% over past 15 years
• long-term government bond funds have trounced junk and corporate bond funds, up an average of 9%/year
• worst 12 months for junk bond funds ended 11/2008, when average junk fund was down -30.1%
• other 12-month losses were 2000-2002 bear market and 1990 - 1991 recession
• today, according to Moody's, junk bonds yield an average +6.83% to Treasuries and the average yield spread is +5.61%
• more companies had ratings upgraded than downgraded in the 1st quarter
• current default rate = 3.1% versus 1.9% in December
• Moody's estimates the default rate will peak at 4% in October and fall to 3% in May
• Worst case is greater than 10% default rate in 5/2013.

Take-Away

The first obvious take-away is that Waggoner's articles are flush with useful information.  Secondly, junk bonds are fairly attractive on a yield spread basis and on an expected default rate basis. Other things equal, a yield spread of +6.83% overcomes 4% default rate. Thirdly, this sector gets pounded in an economic downturn. Thus, if you are expecting the economy to weaken, lessen exposure. If the yield spread to Treasuries gets to less than +5.61%, again think of lightening up a bit - this is the point where you start to not being paid to take the risk. A final point to note is that, when investors get scared, nothing beats Treasuries, as shown by the performance numbers Waggoner reports.

I suggest that DIY investors interested in following markets read Waggoner's column. You may also want to check out his book Bailout.

What is the Bond Price Formula?

Source: Capital Pixel

A basic concept in investing that baffles many investors is how bond prices work.  Even the idea that bond prices go up and down and the fact that the investor doesn't need to hold bonds to maturity seems mysterious to some.  This is not good for the simple reason that investors have been piling into bonds and bonds funds over the past couple of years and will be in for an unpleasant surprise when interest rates rise.

To get a complete understanding, it is sometimes worthwhile to go to the basic math--as I'll show here.

How Bonds Work 
 
A bond is a promise to pay a stream of income over time.  To know the stream of income, you need to know the principal amount, the coupon rate, and the time to maturity.  Suppose, then, that we buy $10,000 principal of a 3-year maturity bond that has a coupon of 6%.  The stream of income, then, is:

Year 1   $600
Year 2   $600
Year 3   $600 + $10,000

There are some real world intricacies to know.  First, bonds typically pay interest twice/year.  Thus the above example would have interest payments of $300 every 6 months until the bond matures. Secondly, if you buy a bond in the secondary market, you'll pay accrued interest to the holder of the bond equal to interest earned since the last interest payment.  Thirdly, bonds are typically sold in $1,000 units but priced in terms of $100 principal.

Here's the key to understanding bond prices:  $600 received one year from now is not equivalent to $600 received today.  After all, if I had $600 today, I could earn interest on it for one year and have a greater amount at the end of the year.  Suppose, then, that I could in fact earn 6%.  Then, if I had $566.03 today, I would have $600 a year from now if I earned 6%.

$566.03 is said to be the present value of $600 to be received a year from now if the discount rate is 6%!

The next question, formulated in terms of our new jargon, is:  what is the present value of $600 to be recieved 2 years from now if the discount rate is 6%?  Again, we think in terms of how much we would have to invest today at 6% compounded to get $600 2 years from now.  That amount is 600/(1.06)^2 = 534.

It is important that you check this out and stick with it until you have a thorough understanding.  Think this through.  If we take $534 and earn 6% for the 1st year we will have $ 566.04 (534 * 1.06).  If we then earn 6% on the $566.04 the second year (note that we are earning interest on interest, i.e. the compounding effect), we will have $600 at the end of the 2nd year.

If you have the hang of this, you see that the present value of $600 to be received 3 years from now is $503.77 and the present value of $10,000 to be received in 3 years is $8,396.2.

Thus, we have the following present values:

Year 1   $566.03
Year 2   $534
Year 3   $503.77 + $8396.20

If you add these up, you get $10,000.  Divide by $100 and you see the price of the bond is $100, i.e. par.

Now, here comes the $64,000 question:  what would happen to the price of the bond if the yield was 5%, and what would it be if the yield was 7%?

For year 1 at 5%, the present value would be $600/1.05 = $571.03.  Complete the calculation and find how much higher the price of the bond would be!  (Answer:  price = $102.72!)

For year 1 at 7%, the present value would be $600/1.07 = $560.75.  Again, complete the calculation and find out how much lower the price would be.

Play around with this until you are completely comfortable with the idea that bond prices and yields move in opposite directions.

General Formula

All of this can easily be generalized in terms of the following formula:

P = cpn./(1 + yld.) + cpn./(1 + yld.)^2 + ... + cpn./(1 + yld.)^n + prin./(1 + yld.)^n

where cpn. = coupon payment ($600 in example above),
yld. = discount yield,
n = years to maturity.

Study this formula and you can see that longer maturity bonds vary more in price as yields change because they have many more terms and the principal gets impacted more.

You can also understand the impact if the probability of default increases.  If instead of getting $1,000  at maturity, assume you only get $.80 on the dollar!
 

2 Must Reads For DIY Investors

Source: Capital Pixel

For this blog, I am constantly on the lookout for succinct articles that I believe offer great education value for DIY investors and point them in a practical direction in their investment process.  One of the benefits of living in the information age is that such articles are at our finger tips.

Here is one from Andrew Hallam, author of Millionaire Teacher, that offers really all the essentials of successful investing.  It tells you how to diversify.  It tells you how to use your time economically.  And it tells you how to rebalance.  Pay close attention because he points out the important point that accumulators really want markets to fall.  It is a 10-minute read. Enjoy!

Millionaire Teacher Prepares to Buy

To build on what you have learned, I suggest you get his book, Millionaire Teacher:  The Nine Rules of Wealth You Should Have Learned in School, and read that.  In a weekend, you will learn about an approach to investing that has outperformed 90% (it's hard to beat the lucky ones! ;)) of professional managers.  Buying the book and spending a weekend with it could turn out to be the best investment you ever make!

On a different front -  here is a good piece from Morningstar on Treasury TIPS:  Are TIPS as Safe as You Think?  It notes there are two points to keep in mind in valuation decisions:  inflation expectations and the overall level of rates.  A case can be made that they are cheap on the first count but expensive (along with the overall bond market) on the second.  Pay special attention to the argument that shorter maturity TIPS may offer a special opportunity.

One point not mentioned is that TIPS can be easily bought from the Treasury at Treasury Direct and, thereby, fund expenses avoided.  It is always worthwhile to think about expenses but especially here where yields are so low.  I also recommend the comments section for Morningstar articles.  The commenters there tend to ask very good questions and offer useful observations.

Investors' #1 Enemy

DALBAR is a widely recognized research firm that tracks investor performance in mutual funds.  They track when investors go in and out of funds. Year in and year out they find a consistency - investors go in at high prices and exit at low prices.  Over the long run, this costs investors approximately 5%/year on average.  This, from their press report on 2011 results:

While the volatility of the 2011 markets ended with large gains for
bond holders and a small profit for equities, the mutual fund investor did not fare as well.

Equity mutual fund investors gave up on the markets shortly before the year-end recovery and
suffered a loss of 5.73%, compared to a 2.12% gain for the S&P 500. This erodes the long-term gains that began to recover from the devastating losses of 2008.

To see this explicitly and to view it in regard to your own investment behavior, consider the following chart of SPY, the low-cost ETF that tracks the S&P 500 over the past 2 years:

Source: Yahoo Finance

CLICK TO ENLARGE
The letters depict peaks and troughs.  What the DALBAR data finds is that the average investor avoids stocks at "A," piles in at "B," exits at "C," etc.

Look at "C" on the chart, September 2011, for a minute. Congress was squabbling over the debt limit, Europe was on the verge of imploding, and data suggested the economy was possibly heading back into recession. Stocks had just fallen sharply.

CNBC watchers were inundated with pundits overladen with confidence predicting a further sharp downturn in equities.  With each passing day, the emotional investor saw a clearer picture - it was obvious his or her retirement assets were on the verge of taking a beating.  The emotional investors were also kicking themselves mentally for not getting out earlier.  In the face of all the bad "news," the obvious course of action was to back off and seek an entry point when the news was better.

Well, from this point, as the chart shows, stocks went 20% higher!

The important point of the chart is to get the big picture.  Over the period, SPY rose 25%!  How did you do?  Did you get in and out at the wrong time?  Did you sit on the sidelines in money markets at 0.1% complaining, still, about 2008?  If you're the average DALBAR investor, you didn't do nearly as well as the market.

Recent posts on the returns of hedge funds and large pension funds suggest that professionals did poorly as well.  But this is consistent with mountains of data that have reached this conclusion.  Over the long term, less than 20% of market timers and stock pickers outperform the market after fees.  Clearly, they have difficulty controlling emotions in the investment process.

What's the solution?  In my view, it is to focus on an asset allocation that rides out the ups and downs over the long term with well-diversified, low-cost funds.  Oh yeah - this is also the view of Warren Buffett, John Bogle, Burton Malkiel, Charles Ellis, Andrew Hallam, and numerous other giants in the field of investing.

Increase the Yield on Your Investment Assets

I see people all the time with six figures in money market funds and low-yield savings accounts - some barely above zero percent.  Some are befuddled by asset allocation models that recommend 40%, say, in fixed income and have no idea where to go from there.  If this sounds like you, or even if you just want to share what you are doing in the fixed income part of the portfolio and are in the area, join us at the Miller branch of the Howard County Library.

At this presentation, I'll present a sample portfolio that carefully monitors risk and still produces a yield exceeding the rate of inflation.  I'll assess other ways to approach this asset sector - after all, there is more than one way to skin a cat.

My bottom line goal is to provide profitable take-away ideas for attendees, both novices and experienced investors.

How Do Treasury Inflation Protected Securities Work?

Inflation protection is an important challenge for investors over the long term.  Recently, I presented the case of Joe who invested in fixed rate 10-year Treasuries 20 years ago, envisioning a financially secure retirement, and then faced declining rates and purchasing power erosion because of inflation.

One way to protect against inflation is to hold Treasury Inflation Protected Securities (TIPs) issued by the U.S. government.  In one fell swoop, this eliminates credit risk and inflation risk.

One of the most confusing aspects of a TIP is its yield, especially today with many TIPs having a negative yield.  Why would anybody want to invest in an instrument that has a negative yield? Wouldn't that mean that we're paying someone to hold our money?  How does that keep up with inflation?

The answer is pretty simple.  The yield isn't indicative of likely return on your investment.  Let's take a specific example and work through how to analyze TIPs.  From the Bloomberg site we find that the yield on the 10-year Treasury is 1.51% and the yield on the 10 year TIP is -.68%.  Obviously, the 10-year Treasury is the better investment, right?

Not so fast.  The TIP's principle gets adjusted every 6 months by the CPI.  For example, if the principal is $100 and inflation is at an annual rate of 6%, then the principal amount after 6 months is $103 ( 6%/2 = 3% adjustment).  This principal adjustment is not part of the yield calculation!  But the yield is still important, as follows.

To think through the relative investment merits of the two issues, you need to first take their difference in yield (1.51 - (-.68)) which is 2.19%.  If inflation averages greater than 2.19% over the next 10 years, then the 10-year TIP will outperform (because its principle increases at the rate of inflation); otherwise the 10-year Treasury will outperform.

To calculate the yield on a specific TIP, use the calculator at FICALC (read user agreement):

Source: FICALC

The yield is calculated in exactly the same way as a normal bond assuming no inflation adjustment. T hus, if inflation was zero over the period ,the yield would be a negative -.68%. Again, this has to be taken in the context of expected inflation.

To gain a bit more perspective l,ook at the performance data on ETFs in the following table, where AGG represents the entire investment grade U.S. bond market, IEF is indexed to the 7-10 year Treasury curve, and TIP is the TIP ETF :

Source: Yahoo Finance

It is worth noting that the duration of IEF at 7.5 years is considerably greater than AGG (4.36 years) and TIP (4.84 years).  Over the periods shown, the TIP ETF has performed well relative to the other ETFs shown. Especially impressive is the 3-year performance - with a considerably lower duration, it outperformed IEF!

In thinking about investment merit, I suggest start by thinking about the 10-year Treasury.  If your objective is to outperform the 10-year Treasury, you next want to examine whether you think inflation will be greater than the difference in the yield between the 10-year Treasury note and the 10-year TIP. If so, then go with the TIP.  Today, investors expect inflation to average 2.19% over the next 10 years.

As usual, I tend to prefer using ETFs, but here it is worth pointing out that TIPs can be bought at auction at no commission at the same prices paid by the big boys by opening an account at Treasury Direct. 

It is also worth knowing that, if you think yields are headed higher because of inflation, you could be better off avoiding both the 10-year Treasury and its corresponding TIP.  You may want to go to the 5-year TIP ,for example, or avoid the sector altogether and utilize a short duration corporate ETF.

Disclosure:  This information is for educational purposes only.  Investors should do their own research or consult a professional before making investment decisions.

July ETF Performance Results

Prognosticating

By carefully selecting ETFs, the DIY investor can construct a well-diversified, low-cost, low-maintenance portfolio.  He or she will have a portfolio that in the past has outperformed most professional portfolios and, combined with a carefully thought-out asset allocation strategy, avoids the number one enemy of investors - emotion.

An important part of the  process is tracking performance.  Here is a resource from ETF Trends that reports returns on ETFs:

Source: www.etftrends.com

CLICK TO ENLARGE   Note that the table includes returns for 2011 and year-to-date 2012 through July - 2 periods investors have found challenging, especially hedge funds and state pension funds, as detailed in previous posts.

One feature I really like about the report is that it groups ETFs by asset category.  For the example, as shown, it has numerous fixed income ETFs grouped together so that it is easy to see how various parts of the bond market have performed.

Source: www.etftrends.com, p. 4

From this list, an investor can quickly  begin researching the expense ratios and characteristics of the underlying index by entering the ticker symbol into the quote box at Morningstar, for example.  The list includes ETFs indexed to various parts of the Treasury yield curve, high grade and low grade corporate ETFs, emerging and high-quality international and muni ETFs.

For the investor who can't resist trying to predict short-term performance on various market sectors, this is an excellent resource also with which to carry out this exercise on paper.  Just pick an ETF from various sectors and rank them.  For example, you might have SPX (large cap), VB (small cap), IEV (Europe), SDY (dividend), DBC (commodity), IAU (gold), and AGG (bonds).  Rank the sectors from 1 to 7, and next month you'll easily begin to see if you have any prognosticating talent.