The Best Short Term Investments, Factor Funds’ Performance, & US Deficit Investments.

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If you compare factor funds to the broad market are they actually delivering the superior returns that were initially theoretically expected?

The three main choices for investors are to:

  • Track the market - i.e. buy a tracker cheaply and just track the equity markets upwards
  • Pay a fund manager to beat the market - which often they can’t
  • Invest in Factor Funds - put your faith in research that shows that over long periods of time certain types of stock outperform the broader market. (e.g. small caps, low value, etc or a combination)

Because of the period of time you need to invest in a factor fund, as yet it is impossible to say if they are actually providing superior returns.

The UK Vanguard factor funds have only existed since the end of 2015, about 4 years. The graph below is a risk return plot based on figures up to 18th October 2019. Risk is shown by the X axis and the Y axis is the return. Low risk, high return is the ideal position.

From this graph you can see that Minimum Volatility has done the best, but remember the return part is very volatile so in a months time it could be very different on the Y axis, although the risk (X) tends to be stable.

So far the S&P 500 has out performed almost everything apart from the Medium Volatility but the FTSE all-share has not well.

It’s important to remember that some factor funds will under-perform for decades and then they may come back into favour. Therefore if you buy factor funds you need to have an iron will and a complete belief that it works so you don’t lose your nerve and sell.

Dimensional have been providing factor funds over a longer period of time.

They create their funds by firstly finding factors that work through a rigorous research process and then only use the factors that make sense and are proven to work. Once this is done they create their own funds to harvest the particular factors that they have identified.

The drawbacks are:

According to their research (below) they are doing well.  

The drawback is that If you don’t have a financial adviser then you can’t get one, but more funds will come to market offering a cheap way to track factors effectively and iShares World Value (tracks MSCI index) was launched in 2014 with a fee of 0.3%.

Here are 38 funds that are “smart beta” which includes factor funds such as minimum volatility, momentum and value:!type=all&fac=43511&fst=50584&view=keyFacts

What are the short term investment options?  (i.e. 1, 2 or 3 yr) and are there any alternatives to standard money market funds?

If you have a large investment and you need to draw it out within 3 years then it can be very risky. The reason for this is because in the short term markets can crash, but in the long term they tend to drift, meaning the crashing evens itself out and the drifting dominates.

For example, if you look at the S&P 500 over 100 years then you will that it just drifts with a bit of wobble but if you zoom in over a shorter period of time you will see that it is very volatile. Therefore if invest long term you can buy the drift up but over a short period of time you may have to sell during a crash.

To help overcome this for short term investments you need to buy low risk assets. Below is a table that plots the volatility of a number of them. At the bottom are the least risky and at the top the most. Just work your way up the risk table i.e. for short-term start with low-risk investments and the higher the volatility the higher the short term crash probability but in reality the only safe investment for the short term is cash.

Discuss the article by Lyn Alden Schwartzer and the potential impact of US government debt and deficits on a USD exposed portfolio.

The excellent article by Lyn Alden Schwartzer from October 2nd 2019  is here

In summary, the common narrative she is trying to dispel relates to the crowded trade in US Treasuries. A crowded trade is when everybody does the same thing. This is caused because we all listen to the same journalists, read the same newspapers and end up with a kind of `group think’  relating to the best course of action. At the moment, the current common narrative appears to be that we are going into a recession so we should buy Treasuries and US dollars because they are safe but we should stay away from emerging markets.

Her point is that the only way we can get out of the place we are in is if the dollar gets weaker. She believes that the dollar is on a positive momentum trend at the moment but that something will happen to do with US dollar debt that will make it weaker. She goes on to say that there is far too much debt held by US banks and financial institutions and they can't continue buying it. The US government is also issuing too much debt and if this doesn’t stop then the Fed will have to start buying it which will require restarting its quantitative easing programme. Therefore she believes the best investments are to buy gold, as rates will fall and the dollar will weaken and emerging markets would do well in this environment too.

In her article Schwartzer goes into considerable detail with the three main points summarised below:

The Market is self correcting 

In late 2014 the Fed ended quantitative easing,i.e. It stopped "printing money" to buy U.S. government debt from institutions. This removed a significant source of liquidity and left the U.S. economy to stand on its own two feet. Once quantitative easing ended, the dollar shot up.

A country can't have growing deficits and growing debt versus GDP forever without quantitative easing,  but they can do it for a while until a catalyst brings them to a halt. Ironically for the United States, a strong dollar tends to be that catalyst.

She goes on to illustrate that there's a historical inverse correlation between dollar strength and the percentage of U.S. debt that foreign sources hold. Whenever the dollar grows stronger, the U.S. private sector ends up having to fund more of its own government's deficits and foreigners stop buying, and may even begin selling to stabilise their own currencies.

Repo Market

If you look at the amount of debt that banks are holding it is very high and they won't be able to continue buying it so this has caused the recent issues with the repo market (where bonds are sold and repurchased after a day or up to a few weeks later).

Most investors are aware that the overnight repo market has required Federal Reserve intervention every night for the past two weeks. Starting in mid-September 2019, repo rates spiked, implying that banks don't have cash to lend to each other, and it required ongoing liquidity injections from the Fed to push back down.

Some commentators in financial media were panicked  because the last time the repo market was this bad was in September 2008 when U.S. banks were afraid to lend to each other overnight due to the risk that one of them would announce bankruptcy in the morning. That was an acute liquidity crisis due to an insolvent banking system. Other commentators were saying the repo spike was nothing, just temporary timing issues. Quarterly corporate taxes were due mid-month. The U.S. Treasury is sucking up a couple hundred billion dollars in extra debt issuance to refill its cash reserves following this summer's debt ceiling issue that forced the Treasury to draw down its cash levels.

Evidence shows pretty clearly that the issue is somewhere in the middle. It was not and is not an imminent bank collapse liquidity crisis, nor was it purely a one-time thing. Instead, five years of domestic institutions fully-funding U.S. deficits basically saturated the banks with treasuries and they have trouble holding more. Their cash reserves have run low.

In particular, large U.S. banks that serve as primary dealers have been filling up with treasuries and drawing down their cash levels ever since quantitative easing ended.

Primary dealers are the market makers for treasuries. They don't really have a choice but to buy the supply as it comes, and supply is starting to turn into a fire hose and foreigners aren't buying much of it.

The percentage of total assets held as Treasuries at large U.S. banks is now over 20%, which is the highest on record.

Cash as a percentage of assets at those institutions is now down to 8%, which is right at post-Dodd Frank post-Basel 3 lows. They are pretty much at the bedrock; they can no longer continue drawing down cash and using it to buy treasuries. Cash levels can't (and shouldn't) go lower like they did in the 2000's because that's the type of leverage that led to the financial crisis and current regulations require banks to have more cash.

A lot of people are confused at how there can be too much supply of treasuries, because there is clearly investor demand for them, especially long-duration treasuries that have performed very well this year. However, most U.S. debt is short-term, and that sheer quantity of short-term debt has been pressuring the banks all year. Over the past few years, bid-to-cover ratios have been declining leading to some messy treasury auctions this year, and starting this spring, the federal funds rate has gone over the interest rate on excess reserves.

Clearly, this issue has been building for years and has accelerated throughout 2019, and September just happened to be when a couple extra pressures finally caused the system to reach its limit. It doesn't take a repo expert to see that it's not a repo-specific problem. It's a sovereign debt problem.

Dollar’s Apex Is In Sight

As this liquidity squeeze plays out and global economic growth continues to slow, the dollar is still in an upward trend, but these trends historically can reverse very quickly.

Unless the dollar weakens, foreigners are unlikely to resume buying U.S. treasuries at scale. Even though U.S. treasuries pay higher rates than European or Japanese sovereign bonds, currency hedging eliminates that difference, so only investors daring enough to hold un-hedged U.S. treasuries can take advantage of that rate differential. This means that domestic institutions are likely to have to keep funding most the deficits of over $1 trillion per year, and primary dealers already clearly have a liquidity problem and are already holding a record amount of treasuries as a percentage of assets.

There are a few ways this can play out. The most likely outcome is that the Federal Reserve will begin expanding its balance sheet again by 2020 (or perhaps in this fourth quarter 2019) to relieve pressure from domestic balance sheets, which means that the Fed would essentially be monetising U.S. government deficits. This would inject liquidity into the system, take some of the burden off of domestic institutions for absorbing all of those treasuries, and is likely to weaken the dollar which could allow foreign investors to step in and buy some more treasuries as well. 

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October 28, 2019