Secrets Of Success: Keep sight of the bigger bond picture
Saturday 03 February 2007
For a reminder of how fickle and volatile market expectations can be, look no further than the changing expectations about the course of bond prices and bond yields this year. On Wednesday, the Federal Reserve left interest rates unchanged, which was expected. It is the fifth month running that short-term US interest rates, the only ones that the Federal Reserve can control directly, have remained the same.
This would seem to bear out Bill Miller's common sense observation before Christmas that the Fed is not too unhappy with the way that the two variables it is mandated to watch - namely inflation and economic growth - are moving. But note how far market expectations of interest rates have moved in the same period. A few months ago, the consensus was that another cut was on the cards in March and maybe a second one in June. Now it seems that the market is coming to think that there might not be any cuts at all this year. All those who were buying longer-term bonds in the expectation that yields would start to fall as a result, producing capital gains in the process, suddenly don't look so smart. But who knows what will happen to bond yields over the course of this year? Nobody, including the Federal Reserve itself. You can paint plausible scenarios either way.
Ultimately, it depends on what happens in the real world: the pace of economic growth; the extent of inflation; oil prices; etc - plus the dynamic interplay of investor sentiment. The whole contains too many variables to lend itself to reliable prediction. Mr Market, as Ben Graham referred to investor sentiment, remains, on the other hand, a highly excitable individual whose opinions never stand still from one month to the next. His is the ultimate bipolar personality.
One day he loves this or that stock (prides soar); the next he won't touch it with a bargepole (they slump). Just as nature abhors a vacuum, so markets - especially markets that can be traded continuously around the clock, and around the globe - abhor inactivity. Without activity, traders and those who serve them, such as brokers, will starve.
That is one reason why, as Robert Shiller has noted, the stock market is so many times more volatile than the economic variables it is seeking to reflect. Another contributory factor is the intellectual challenge that trying to beat the market provides. Fund managers, in aggregate, trade far more often than they should, perhaps because if they did not, someone might stop to ask what on earth they were being paid for.
Some academic research I happened to read this week stated that fully half of the total active stock bets that are made by US mutual fund managers every year are cancelled out by equal and opposite bets made by rival mutual fund managers. In other words, mutual fund investors collectively are paying half their hefty annual fees so that their fund managers can swap stocks amongst themselves, with the brokers picking up a commission every time that it happens. No wonder that is so hard for fund investors to beat the market.
Jack Bogle, the founder of the indexing firm Vanguard, says the total "take" of the various intermediaries that stand between investors and the market return in the US has now reached around $400bn (£203bn) every year. How much of this is attributable to bond fund managers trading bonds, I don't know, but it is not an insignificant amount.
The game of trying to guess which way the Federal Reserve is going to jump and how bond markets will react is one of the biggest games in the world. The size of the global bond market exceeds that of the global stock market by some distance. Yet there is even less value-added in bond fund management than there is in equity fund management. Whereas a small minority of equity funds do outperform their benchmarks consistently over shorter time periods (in part because they are beneficiaries of changes in investment styles), in bonds the proportion is so small as to be negligible.
With bond yields on average back to historically normal levels today, Mr Market is still alive and well, and as active as ever in trying to shape expectations and create trading opportunities. The chief distinguishing feature of most bonds is their simplicity: hold them until maturity and they will deliver a return, in nominal terms, that is knowable from the moment you buy them.
That is both their greatest advantage (predictability) and their biggest disadvantage (how much that nominal return will actually be worth to you depends heavily on what happens to inflation in the meantime).
If you assume that 2.5 per cent is the "real" yield you should expect from bonds, to buy a current long government bond in the UK on a yield of 4.4 per cent, on fundamental grounds you are making an assumption that inflation will average under 2 per cent over the life of the bond.
That may turn out to be right, but it still looks a pretty daft bet at the moment, given that you can now get more than 5 per cent by putting cash in the bank, and more also for buying a shorter-dated bond. It is true that you will make a bigger profit proportionately from every 1 per cent drop in long-bond yields than you will from buying shorter-dated bonds (that is the nature of the instrument), but nobody is forcing you to trade bonds at all. In fact, you need a good reason to want to do so.
The game of trading bonds - trying to prove you are smarter than the other guys in the market - continues to keep thousands of highly paid professionals active every day. It is not totally without value. Any market requires a measure of trading to ensure liquidity and fair pricing. But you also need to keep sight of the bigger picture. Some bond pundits have been more right than others. Expectations ebb and flow. Profits have been made and lost. But it is still a zero sum game.
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