What is the Risk of Your Fixed Income Holdings?

One of the first lessons you learn in investing is that every investment opportunity has a risk and reward profile. One of the foundations of finance is that when comparing different investment opportunities an investment that is riskier should potentially offer a higher return. One measurement of risk is the standard deviation of a fund. Standard deviation is a measurement of the historical range of returns for a fund. Virtue Asset Management reviewed the 10 year average returns and standard deviations of the following Vanguard bond funds: Short-Term, Intermediate-Term, Long-Term and High Yield. We included the GMO Emerging Country Debt mutual fund because Vanguard’s Emerging Debt mutual fund is not 10 years old. Below is a graph outlining the risk vs reward profile of each bond fund. This graph is what you would expect to see, the fund with the lowest standard deviation has delivered the lowest annual return and the largest standard deviation fund has the highest return. In fact, other than high yield bonds, everything is very close to the best fit curve.

We have also reviewed the 10 year average returns and standard deviations of the following iShares equity index funds: Large Cap, Mid Cap, Small Cap, International and Emerging Markets. In the graph, the risk/reward relationship breaks down when we add the equity index funds to the bond mutual fund graph.
This graph indicates that all five equity indexes offer a worse risk/reward profile than the bond curve. Every single bond mutual fund has a lower standard deviation than the stock indexes. There is a simple answer to what has distorted the market. The Federal Reserve, starting in November 2008 and ending in 2014, purchased $4.5 trillion in bonds. Clearly, these routine purchases have lowered the volatility of the bond market compared to the equity market.

In our experience, most investors can’t tell you the historical standard deviation of their portfolios. However, most investors can remember the worst one year performance of their portfolios. Our goal is to prevent clients from panicking and to properly understand the downside risk of both their individual investments and their overall portfolio. We believe the Federal Reserve bond purchases have artificially lowered the standard deviation for bond funds. Therefore, we chose to replace the standard deviation as the risk measure with the worst one-year return over the last 10 years.

When you replace standard deviation with the one-year loss you see a graph that displays the risk/reward profile that resembles the foundation of finance. The higher returning assets have had the higher risk when using the one-year loss. Virtue Asset Management feels that if you use standard deviation as the risk profile, it will skew your asset allocation models. We worry that investors are using standard deviation to make their asset allocation decisions. We feel this process is underestimating the risk in fixed income and specifically Emerging Country Debt and High Yield. We worry that investing in these asset classes is akin to picking up pennies in front of a steam roller. The risk of losing your arm is not worth the reward of pennies. Therefore, we currently recommend zero weighting to these asset classes. Contact us to discuss further.

2016 Investment Review and 2017 Outlook

The US Stock market showed surprising strength and velocity in the eighth year of the current bull market. The S&P 500 returned 11.96% in 2016. This strong performance was driven in part by a 4.98% increase in the S&P 500 since November 9th, the day after the election. The strong post-election results have been driven by optimism on Wall Street. This optimism should not come as a surprise. Recently, every Wall Street analyst in Barron’s predicted an up market for 2017. Unfortunately, if you go back every year since 1998, when Barron’s first published predictions, we see the same result: every analyst predicting an up market. Of course, it is easier to sell products with an optimistic sentiment and a rising stock market. In our view, there is a potential conflict of interest when Wall Street manages money and is trying to sell their own products.

Wall Street’s annual optimism, in our view, creates two major problems. First, they aren’t looking for early signs from the market that a pullback is happening. Second, their bureaucratic structure makes it slow for them to adjust portfolios when the pullback happens. We believe that our current asset allocation continues to provide protection in the event of a pullback. We continue to recommend significantly overweighting US stocks compared to international stocks. This asset allocation worked well in 2016 with US Large Cap returning 11.96%, US MidCap returning 20.74% and US Small Cap returning 26.56%. This compares to International Stocks returning 4.5% and Emerging Markets returning 10.87%. We continue to favor US Large Cap stocks with a lower P/E ratio than the overall market.

Despite the strong year in equities, fixed income still provided a positive return. The Barclays Aggregate Bond Index returned 2.65% for 2016. Protecting the portfolio for inflation paid off in 2016 with Treasury Inflation Protected Securities returning 4.68% for 2016. The traditionally riskier asset classes of fixed income provided stronger returns for the year. High Yield returned 13.41% and Emerging Market Bonds returned 9.26%. We still feel that most investors don’t understand the risk in these fixed income asset classes which has been distorted with governments purchasing bonds. We recommend avoiding High Yield and Emerging Market Bonds in 2017.
The historic optimism of Wall Street is why we don’t use forward earnings when valuing companies or the stock market. We prefer to look at the actual earnings of companies and the overall market. Over the last 12 months the S&P 500 has earned roughly $101 a share. If you take the value of the S&P 500 at the end of 2016 it was 2238.83. This gives you a trailing Price/Earnings (P/E) ratio of 22.17. Over the last 10 years the average trailing P/E has been 17.14.

Source: S&P Dow Jones Indices

Wall Street’s optimistic earnings estimates vary, but they average approximately $125 per share for the S&P 500. Yes, that is approximately a 25% increase in earnings in 2017. This scenario must assume every positive aspect of the new Trump presidency and ignore any risk. It is true that lower taxes and less regulations will help the economy and most company’s earnings. There is still the risk of getting the legislation passed and the question of how long it takes to implement the legislation and any unintended consequences.

If you use a P/E ratio of 20 to value the S&P 500, which is still higher than the 10-year historical average of 17.4, then you get a target of 2500 for the S&P 500. This would provide a return of 11.67% for 2017. This is our upper range scenario for 2017. We view more realistic earnings estimate for 2017 as $110 a share. If you apply a P/E ratio of 20 to these earnings you get a target of 2200 for the S&P 500 which is a decrease of 1.7% from the end of year level. Finally, if you use the 10-year historical average P/E of 17.14 and earnings of $110 you get a lower range scenario of 1885. This would be a decrease of 15.80% from the end of year level. These assumptions are based on increased earnings and are ignoring some of the worst-case scenarios possible with a Trump presidency. We view any trade wars or tariffs as a negative for the economy and these actions would lower earnings in 2017.

Our upper range scenario is an increase of 11.67% and our lower range scenario is a decrease of 16.61%. Given this outlook, we recommend that investor’s stock exposure is at the lower end of their acceptable equity range. We also caution clients to be prepared for increased volatility in both equity and fixed income markets in 2017.

Capital Preservation

You worked hard to acquire your wealth and there is no need to take additional risks with it. One financial instrument that is not utilized by most investors is option contracts. The first exchange-traded stock option traded on April 26, 1973 at the Chicago Board Options Exchange. Despite a history of over 40 years most investors are not familiar with call and put options. You’ve insured your house, your car and your life. Why not insure your portfolio?

Buying options gives the owner the right, but not the obligation, to buy or sell a specified amount of an underlying security at a specified price within a specified time. Option contracts can be purchased for both indexes and individual stocks. For example, assume a client owns shares of the Russell 1000 Small Cap index (ticker: IWM) and it is trading at $111 a share. If the index goes up 36% the client will see 36% gain in his holdings. Conversely, if the index goes down 37% the client will see a 37% loss in his holdings (see figure 1).

You could purchase a put option to protect your downside risk. The protective put protects against losses during a price decline in the index and allows for capital appreciation if the stock increases in value. The flexibility of option contacts allows you to choose how much upside potential to give up for downside protection. For example, you could purchase a $110 put on the index. For every dollar the index trades below $110 the client would receive a dollar. If the index dropped to $90 the client would receive $20 a share for the option contract. In this example, the client would cap their losses at 10% and give up 10% of the upside (see figure 2).

Put options can be used to protect the downside of the portfolio and in some cases even profit in a down market. This is a great technique for low cost basis investments or to help protect your portfolio during a downturn in the market.

Investment Objectives

These investment objectives are a starting point in the conversation. To achieve a heightened level of customization for each client in a cost efficient manner, we create diversified portfolios using individual stocks and bonds combined with exchange traded funds (ETFs). When appropriate, we will utilize mutual funds and options. Our portfolios are tax-optimized with a focus on maximizing after-tax returns on a risk-adjusted basis.


For the investor who seeks both modest capital appreciation and income from their portfolio. The main objective of an individual within this range is to achieve steady portfolio income. This objective is designed to preserve investor’s capital while fluctuations in the values of portfolios may occur over a market cycle.


You are seeking stable growth and income from your investable assets. The main objective of an individual within this range is to achieve portfolio growth while managing fluctuations to less than those of the overall stock markets over a market cycle.


If you have a relatively high tolerance for risk and a longer time horizon. The main objective of an individual within this range is to achieve capital appreciation with little need for the current income. The investor should be able to tolerate fluctuations in portfolio values over a market cycle.

Aggressive Growth

This range will best suit the investor with a high tolerance for risk and longer time horizon. The main objective of an individual within this range is to achieve high growth with little need for the current income. The investor should be able to tolerate substantial fluctuations in portfolio values over a market cycle.




First Half 2016: Investment Review & Outlook

The first half of the year was volatile with the S&P 500 down 11.44% on February 11th and up 3.75% on June 8th. The double digit drop in February was fueled by lower oil prices and slower economic growth. The Gross Domestic Product (GDP) for the United States in the 4th quarter of 2015 grew 1.4% and for the 1st quarter of 2016 it grew 1.1%. The stock market, like most people, hates uncertainties. The uncertainties make it harder to value stocks and the market in general. After the Federal Reserve raised rates in December, there was a belief by the market that they would continue to raise rates. The prospect of higher rates, lower economic growth and an upcoming presidential election drove the markets down. In the beginning of the year the market believed we would see fed rate hikes in 2016. This view has changed and the market has now priced in zero rate hikes for the year.

The prospect of continued low rates for the year helped to drive the market from the lows of February with the S&P 500 ending the first half of the year up 2.69 percent excluding dividends. Unfortunately, we have now seen earnings growth decrease in 5 of the last 6 quarters. In the chart below you can see the price of the S&P 500 versus the quarterly earnings of the S&P 500. Quarterly earnings peaked in the 3rd quarter of 2014 while the market reached all-time highs in June of this year.

The price to earnings ratio (P/E) of the S&P 500 is calculated by dividing the price of the S&P 500 (numerator) by the earnings of those companies (denominator). When the earnings (denominator) have stagnated, or gone down, but the market has gone up that means the P/E ratio has increased.  On Junes 21st, Janet Yellen mentioned that “[f]orward price-to-earnings ratios for equities have increase to a level well above their median of the past three decades.” This quote brings back memories of Alan Greenspan on December 5, 1996 and his famous “irrational exuberance” quote. The S&P 500 rallied 105% percent from his quote to the peak on March 24, 2000 before experiencing the infamous tech bubble bursting.

We have the self-awareness to recognize that we could never call a top in the market. What we can do is utilize the tools available to us to try and protect our portfolios. The first strategy is to avoid what we view as risky asset classes that are not providing an attractive risk/reward profile. We are avoiding high yield, emerging market debt and most emerging market countries. The second tool is finding individual large cap stocks trading at a lower valuation than the S&P 500. This is why we focus on attractively priced companies that have had a history of book value growth greater than the S&P 500. Finally, when appropriate we can utilize options to protect the downside of stocks, asset classes and portfolios.

There is some optimism for the upcoming 12 months. We will know the results of the presidential election and the results will remove some uncertainty from the stock market. We believe that a significant pull back in the market will lead the Fed to an easier monetary policy. However, the uncertainty of the market has increased with the recent Brexit vote. The Brexit vote combined with the upcoming US presidential election points to more volatility in the next six months. Given valuations and market uncertainty, we are recommending most clients’ portfolios to be positioned at the lower end of their recommended equity range. Until we see growth in earnings, we will continue to keep a conservative stance in our portfolios.

Tax Loss Harvesting

Tax loss harvesting is an active portfolio management tool that Virtue Asset Management utilizes to potentially lower current and future taxes. The tax code allows you to sell securities at a loss and you can use these losses to offset capital gains and reduce taxable ordinary income up to $3,000 a year. Another advantage of tax loss harvesting is that you can buy back the exact security you sold in 31 days.

The goal of tax loss harvesting is to sell securities at a loss to capture the losses for income tax purposes. If you sell a stock after holding it over a year, the highest capital gains rate you can pay is 23.8% if you are subject to the net investment income tax. The net investment income tax is a Medicare surtax of 3.8% on investment income. If you purchased a stock two years ago for $20,000 and sell it in a taxable account for $25,000 you will create a capital gain of $5,000. That $5,000 is then taxed at the capital gains rate and at the maximum rate of 23.8% the tax owed is $1,190. However, if you had another stock in your portfolio at a loss of $5,000 you could sell it in a taxable account and create $5,000 in capital losses. The $5,000 in losses offsets the $5,000 in gains and eliminates the tax of $1,190.

When you sell a security you have held for less than a year, you are taxed at your federal income tax rate. The highest federal income tax rate is 43.4% if you are subject to the net investment income tax. The short term rate is much higher than the previously discussed long term rate of 23.8%. This large difference in taxes creates a dilemma for investors when a recently purchased stock appreciates quickly. The question becomes: is it worth the risk to hold the stock for a year to only pay 23.8% in capital gains versus 43.4%. If the portfolio had created $5,000 in capital loss harvesting from a prior sale those losses could be used to offset $5,000 in short term gains and a cash savings of $2,170 ($5,000 multiplied by the maximum rate of 43.4%).

If you don’t have any capital gains for the year you can still take advantage of tax loss harvesting. The tax code allows you to take up to $3,000 a year in carryover losses to reduce your ordinary income. If you have more than $3,000 in losses, the losses rollover to future years or can be used to offset future capital gains from sales of stocks.

Tax loss harvesting is a valuable tool in a market pull back. Here at Virtue Asset Management we understand the concept and have the time and expertise to execute it correctly. For this scenario, consider a $1 million portfolio and the market drops 10%. In scenario 1 outlined below, the portfolio manager can sell the securities at a loss and purchase similar but not identical securities. After a 10% drop the portfolio manager realizes losses of $100,000. By purchasing similar but not identical securities the portfolio should appreciate at a similar rate if the securities weren’t sold. If the market then appreciates by 20% the portfolio is up to $1,080,000. The portfolio has $80,000 in gains which could be sold, if needed, and the $100,000 in losses would offset the gains. Therefore, the client would have zero capital gain taxes and $20,000 in carryover losses. In scenario 2 outlined below, the manager doesn’t make any sales. The portfolio has $80,000 in gains with no capital gain losses. If the client needed $80,000 they could pay as much as $19,040 in capital gain taxes (23.8%).


Scenario 1 (Tax Loss Harvesting) Scenario 2 (Static Portfolio)
Starting Value $1,000,000 $1,000,000
Value after 10% drop $900,000 $900,000
Tax Losses Harvested $100,000 $0
Value after 20% increase $1,080,000 $1,080,000
Taxes on $80,000 in sales $0 $19,040