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Quiz!

Would you expect emerging markets investments to go up or down when interest rates go up in the US?

  1. Up.
  2. Down.

Do Rising U.S. Interest Rates Hurt Emerging Markets?

There is a widely held belief that when the US Fed (Federal Reserve) raises interest rates, emerging markets investments should decline.

Why do people expect emerging markets to get hurt when US rates go up?

  1. Stronger dollar: When US rates go up relative to rates in other countries, people can earn a higher rate on savings in the US. This would lead to money flowing from other countries to the US, which would strengthen the dollar.
  2. Higher borrowing costs for emerging markets: Many emerging markets companies borrow in dollars. If a Chinese company earns money in yuans and borrows in dollars, a stronger dollar would make the loan more expensive in yuans, hurting the company.

Reality is the opposite!

While the logic seems sound, reality in the past 20 years has been the opposite. The table below tracks the returns of ET (Extended-Term Component), a portfolio focused on emerging markets, in periods of rising and declining rates in the US:

Period Start

Period End

Change in US rates

ET Returns

12/31/1998

5/16/2000

+1.75%

+58%

5/16/2000

6/25/2003

-5.50%

-11%

6/25/2003

6/29/2006

+4.25%

+169%

6/29/2006

12/15/2015

-5.25%

+20%

12/15/2015

9/28/2018

+2.00%

+50%

Observations & notes:

  1. In all rising-rate periods, ET gained substantially.
  2. In declining-rate periods, ET had much worse results, with negative to low-positive returns.
  3. Market tops and bottoms didn’t coincide perfectly with the borders between the periods. Measured from the turning points in the portfolio, the results are substantially stronger.

Why do emerging markets go up when US interest rates go up, and vice versa?

The Fed reacts to the world economies when setting the interest rates. It focuses on the US, but considers the rest of the world as well. Specifically:

  1. When the economy shows signs of weakness after a period of expansion, the Fed lowers rates, to support the economy.
  2. When the economy turns around after a period of contraction, the Fed raises rates to moderate the expansion.

While I wouldn’t count on emerging markets to go up perfectly whenever US rates go up, the data is useful in avoiding expecting the opposite.

Quiz Answer:

Would you expect emerging markets investments to go up or down when interest rates go up in the US?

  1. Up. [The Correct Answer]
  2. Down.

Explanations: Read this month’s article for an explanation.

Disclosures Including Backtested Performance Data

Quiz!

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

  1. -50%
  2. No impact.
  3. +50%

How to Use Volatility to Make Money

Investment volatility is the investment’s movements up and down away from its average growth. It is commonly viewed as a negative, but for a disciplined long-term saver, it is typically a positive. A hypothetical example can demonstrate it. Let’s compare 2 portfolios with identical returns, and different volatility:

Portfolio 1

Portfolio 2

Year 1

0%

-50%

Year 2

0%

100%

Average

0%

0%

If you start with $100, both portfolios will be worth $100 after 2 years. Specifically, Portfolio 2 will go through the following values: (Year 1) $100 – 50% = $50. (Year 2) $50 + 100% = $100. The portfolios have identical average growth, but Portfolio 2 is far more volatile.

Let’s see the final balance if you add $100 in the beginning of each year:

Portfolio 1

Portfolio 2

Year 1

($100 + 0%) = $100

($100 – 50%) = $50

Year 2

($100 + $100) + 0% = $200

($50 + $100) + 100% = $300

Even though both portfolios have the same average growth, when adding to both portfolios identical amounts each year, the more volatile portfolio ended up 50% higher ($300 vs. $200).

How is this possible? The percentage going back up is greater than the original percentage going down. When a portfolio recovers from a 50% decline it goes up 100%. This is because the percentage going up is relative to a lower starting amount. While old money simply recovers, new money that was invested low goes up $100 – double the -$50 impact of the decline.

Notes:

  1. Some investors lose faith in their portfolio after declines, and hold off on investing (or even sell). If you do that, you can negate the entire benefit of volatility and even hurt your returns.
  2. Even with discipline, there is a special case that can lead to a negative effect. The case involves no up period after a down period, for example, only up years followed by only down years. This is not a concern for disciplined lifelong investors, because such a sequence is limited to one cycle or less.

Quiz Answer:

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

  1. -50%
  2. No impact.
  3. +50% [The Correct Answer]

Explanation: See this month’s article for an analysis of this scenario.

Disclosures Including Backtested Performance Data

Quiz!

Who are the winners when a country increases taxes on imports (tariffs) from another country?

  1. The country taxing imports.
  2. The other county (the exporter).
  3. Neither country.
  4. Both countries.

The Winners and Losers of Tariffs

Tariffs hurt specialization across borders, limit global trade, and increase the costs to consumers – it’s a losing proposition for everyone involved. So, why would the US seek to increase tariffs? I believe that it is a negotiation tactic by the US, to try to reduce the trade imbalance with other countries (the US imports more than it exports). If I am correct, this can go on while each country involved figures out the extent of its power. I believe that once all the information is available and the negotiations are complete, any buildup in bilateral tariffs would be removed to everyone’s benefit.

Supporting my opinion is the fact that the world is very interconnected economically. Let’s view two big players in these negotiations: the US and China. I will point out several mutually beneficial connections in the table below.

Action

Benefit to the US

Benefit to China

The US imports from China a lot more than it exports

US consumers get cheaper products, thanks to cheaper labor in China.

China gets more buyers for their products

China loosely pegs the yuan (its currency) to the dollar. They get dollars from exports to the US, and buy US treasuries to keep the dollar’s value high enough relative to the yuan.

The US government gets cheap loans from China, to support its huge budget deficit. China is the largest lender to the US government.

By buying dollars, China keeps its currency low, to make its exports cheaper in dollars, and be more competitive.

Quiz Answer:

Who are the winners when a country increases taxes on imports (tariffs) from another country?

  1. The country taxing imports.
  2. The other county (the exporter).
  3. Neither country. [The Correct Answer]
  4. Both countries.
Disclosures Including Backtested Performance Data

Quiz!

Which of the following are common to Warren Buffett and Quality Asset Management?

  1. Value investing
  2. Home bias
  3. Profitability bias
  4. Reduced volatility

Warren Buffett’s Strategy vs. Quality Asset Management’s

Warren Buffet is one of the greatest investors of all times. Given that his fund, Berkshire Hathaway, holds a small number of stocks, you may think that his strong performance was the result of superior stock selection (a.k.a. alpha). A study that was published in 2013 (https://www.nber.org/papers/w19681) found that the benefit of his stock selection was statistically insignificant, attributing virtually the entire performance to structural decisions. Below I review the sources of his performance that are in common with Quality Asset Management (QAM), and those that are different.

In common:

  1. Value: Both invest in companies with a low price relative to the company’s book value (low P/B).
  2. Quality: Both invest in profitable companies.
  3. Reduced Volatility: Buffett buys low volatility stocks that historically resulted in excess returns. QAM achieves similar results (reduced volatility, excess returns) by excluding extremely small and expensive (high P/B) stocks as well as stocks experiencing negative momentum.

Buffett’s benefits:

  1. Leverage: Buffett employs leverage of 1.4 to 1.6, with very low costs of borrowing thanks to using capital from his insurance business (premiums received until claims where paid), and interest-free loans: differed tax on depreciation, accounts payable and option contract liabilities. QAM helps clients use home mortgages & HELOCs (home equity lines of credit) to generate leverage, when desired, possible (the client can qualify for the loans) & subject to a risk analysis. In addition, it invests deferred obligations, including income taxes until due (e.g. when the client pays 110% of past year’s taxes in estimated taxes, and enjoys faster growing income). QAM uses very low cost margin for loans backed by unused HELOCs, and other sources. While there are some similarities, this strategy is not used for all of QAM’s client’s, and the leverage level declines with the growth of the portfolio relative to the client’s home value. In addition, the interest rate that Buffett gets from his insurance arm is lower than the interest rates that QAM’s clients get. Therefore, this is usually a benefit to Buffett relative to QAM.

QAM’s benefits:

  1. Size: Early on, Buffett focused on small companies. Given the size of his fund, he cannot practically focus on a small number of small companies, and he developed a bias towards large companies. QAM has a bias towards small companies that is likely generate a return premium relative to Buffett. This benefit is likely to be sustainable for a very long time, given QAM’s strong diversification.
  2. Country: Buffett has a bias towards American companies. QAM doesn’t have this bias, and it focuses on companies from less developed countries. This is likely to generate a return premium.

Quiz Answer:

Which of the following are common to Warren Buffett and Quality Asset Management?

  1. Value investing [Correct Answer]
  2. Home bias
  3. Profitability bias [Correct Answer]
  4. Reduced volatility [Correct Answer]

Explanations: Please read the article above for explanations.

Disclosures Including Backtested Performance Data