Editor’s Notebook 14 June 2011

Apart from having the lowest cost index funds around, one of the reasons why Vanguard has grown to become the largest fund management group in the world, with more than $1.3 billion funds under management, is that it addresses issues in investment on the basis of the way things actually are, rather than the way the world would like them to be. This stems directly from its business model, which precludes it from paying commission to intermediaries, and also from its mutual ownership structure, which allows their fund investors to own a share in the management company, thereby eliminating most of the agency problems that characterize the rest of the fund management business.

When it comes to making comments on the market, the same discipline applies. While for purposes of reputation and marketing it suits the managers of most actively managed funds to offer a view on where the world is heading, everyone knows that the reality is that short term market movements cannot be predicted with any accuracy – and that even longer term outcomes are always matters of probability rather than certainty. Vanguard is one of the few companies which casts its views on market behavior in the form of probability functions rather than single point estimates (otherwise known as “best guesses”, or “fingers in the wind”).

Addressing its London investment symposium last week, Gus Sauter, the Chief Investment Officer of Vanguard, offered us his perspectives on the market through this realist’s prism. What he offered were slides like the one below which represents Vanguard’s assessment of the likely ten-year returns from US bonds and equities. The left hand axis shows the probability of each band of possible return outcomes, and the return ranges themselves are shown on the horizontal axis. The central shared area shows the most likely range of outcomes. As you can see no clear or violently obvious message emerges from this chart.

Thus the most likely outcome for bonds, in Vanguard’s view, is a return of 3.0% – 3.5% per annum (which they rate at just over a 20% probability) and for equities 8.0% – 10% (a 12% probability). The potential range of outcomes for equities is, as always, wider than that for bonds. This overall picture is no particular surprise. The current yield of Government bonds is nearly always the best estimate of its 10-year future returns, so with the current yield bang in the middle of the 3.0% to 3.5% range, the Vanguard projection is right in line with that general rule of thumb. For equities, the projected return is also right in line with the long term returns that equities provide, which is what you would expect when the market is more or less fairly valued, which most analysts take it to be at the moment.

Turning to the economic outlook, Mr Sauter offered the view that he was “cautiously optimistic”, cautious because the rate of economic recovery in the leading economies is clearly slowing down, as evidenced by the rate of jobs growth and other recent data, but optimistic because, despite the poor recent numbers, as yet there is no firm evidence of a double dip recession. In fact the normally reliable leading indicators Vanguard use to monitor point to no clear upward or downward trend. Economic growth in the US and UK, on their central case, will slow in the second half of 2011, but not go negative.


The message, in other words, is fundamentally still dull. It is too early to be bullish and too early to be wholly negative. The world goes on and the picture from the data is not yet clear. That, I think, is pretty much where we are, and was precisely the story that came out last week from another big conference event, the Morningstar annual conference in Chicago. The world according to Vanguard is not always the most riveting story, but that may be just the way things are at the moment.

Notwithstanding this general stance, it cannot be denied that the flow of economic data has been poor in the last few weeks, “a horror story” according to the bond experts at M&G, writing a few days ago. “It seems that almost every bit of data about the health of the US economy has disappointed expectations recently” they comment.  “US house prices have fallen by more than 5% year on year, pending home sales have collapsed and existing home sales disappointed, the trend of improving jobless claims has arrested, Q1 GDP wasn’t revised upwards by the 0.4% forecast, durables goods orders shrank, manufacturing surveys from Philadelphia Fed, Richmond Fed and Chicago Fed were all very disappointing.  And that’s just in the last week and a bit”.

The Citigroup Economic Surprise Index for the United States as a useful indicator of bond market performance in these circumstances. The chart below plots the readings from the “surprise index” against US Treasury government bond yields. A reading above zero reflects a positive economic data surprise, while a reading below zero constitutes a negative surprise.  “The sharp swing from positive territory at the beginning of this year into negative territory is almost as bad as the collapse in economic data that began in October 2008”, the M&G guys point out.  


“The lesson” the analyst concludes “is that whatever your long term macro views are regarding hyperinflation vs deflation or the risk of the US defaulting (and I’m not denying any of these are possible), the reality is that if you want to have a view about government bond prices, the best thing you can do is look at the economic data to see what’s actually going on.   And right now, the economic data is suggesting that however measly you may think a 3% yield is on a ten year Treasury, the yield should probably be a fair bit lower given what’s going on in the US economy”.  He thinks that points to the likelihood of more Quantitative Easing by the Federal Reserve – which, if it happens, will most likely send equities back up again, and bond yields down, in the second half of the year, just as happened last year.


Speaking of the outlook for Government bonds, another observer, Michael Boyd of Seilern Investment Management, points out to me that the risk of US government debt losing its AAA rating is not entirely unprecedented. “Although the common perception is that the US has never defaulted, this is not true. In 1933, US Congress removed the option for US Treasury investors to be repaid in gold thereby causing the US dollar to collapse and international investors to lose their shirts”. Nevertheless, in spite of the US’s recent attempts to debase the value of its bonds by borrowing to its own internal debt limits and its currency by flooding the market with liquidity through QE1 and QE2, US Treasuries still retain the status as the most globally-adopted risk-free benchmark.

But for how long? It has not escaped investors’ attention, says Boyd, that the corporate sector has been generally extremely prudent in managing balance sheets in recent years. That is now paying off as the best corporate issuers of bonds are now able to borrow at extremely close to “risk-free” interest rates. Take, for example, triple A-rated healthcare business, Johnson & Johnson, which raised $3bn in varying bond maturities in the middle of May. On the 24th May, its two year bond issue yielded a “staggeringly low” three basis points (0.03%) more than the directly equivalent US Treasury bond. Google (AA-) also issued three year bonds in the same week yielding a mere 28 basis points more than the comparable Treasury.

“Are high quality global companies such as these the new risk-free assets against which other investments should be benchmarked and risk-adjusted?” Boyd asks, reasonably enough. “If so, then why on earth are the shares of Johnson & Johnson trading on a free cash flow yield and a dividend yield of 7.6% and 3.4% respectively or 12 times and 5 times as much as its two year bond yield of 0.6%? Either the bonds are expensive or the shares are cheap, or a combination of the two”. This, I dare say, is the voice of self-interest speaking – the Seilern funds are choc a block with safe high yielding blue chip equities – but that doesn’t mean he hasn’t got a point about the relative values. 


One of the other topics that Mr Sauter touched on in his speech was the timeless phenomenon of investors chasing past performance. Vanguard is one of the few fund management groups which on occasions decides to close its funds to new investment if it feels that they are getting too popular, or simply too expensive on fundamental grounds. This happened during the Internet bubble, for example, and also more recently to its actively managed mining fund shortly some time before prices peaked in 2008. (It is a myth that Vanguard only offers index funds: it has a full range of low cost actively managed funds as well, employing a multi-manager model).


Look at chart above, which shows how the flow of investor money always reaches a peak at the end of a strong cyclical upturn and continues for some time after that peak has been reached. This is how hot money works – investors piling in too late in a cycle and waking up too late to the fact that the game is over. The example above charts the performance of the Nasdaq (the blue line) against the inflow of money (the other solid line). What investors should have done – their cash flow profile had they known with perfect foresight what was going on – is shown by the dotted line. The mismatch between optimal and actual investor behavior could not be more clear or more marked. Something similar, I am sure, will in years to come be seen in the chart of investor flows into developed country sovereign debt.