With interest rates near historical lows, some investors may be anxious about a possible rate climb and its potential impact on their fixed income investments. Rising interest rates typically cause existing bonds to lose value. While investors might hold short-term instruments to manage this risk, an interest rate decline could spoil this strategy by forcing investors to reinvest in lower yields when their short-term instruments mature.

Rate movements in either direction affect portfolio returns. This is true in any market environment, regardless of the current rate level. The larger question is how to manage the risk. As you read the financial headlines and evaluate your current fixed income exposure, it may be helpful to consider these principles about fixed income investing:

Interest rate movements are unpredictable.

Academic research offers strong evidence that the bond market is efficient, and that bond prices and interest rates are not predictable over the short term.¹ This uncertainty is reflected in the often-contradictory interest rate forecasts offered by economists, analysts, and other market watchers.²

Even when the experts share similar views on the direction of the economy and credit markets, reality often proves them wrong. Last year’s Wall Street Journal forecasting survey offers a recent example.³ Among fifty economic forecasters surveyed in 2009, forty-three expected the ten-year US Treasury note yield to move higher over the next year, with an average estimate of a 4.13% yield. Only two respondents predicted rates to fall below 3.00%. The ten-year Treasury yield slumped to 2.95% on June 30, 2010, and rates on thirty-year mortgages fell to their lowest level since Fannie Mae began tracking them in 1971.

Today’s bond prices already reflect expectations for tomorrow’s business conditions and inflation, and these expectations can change quickly in response to new information. This new information is unknowable. Investors who accept market efficiency should not be surprised when the credit markets foil the experts. If prices were easy to forecast, you should find a host of fixed income managers with market-beating returns. But most of them underperform their respective benchmarks over longer time periods.⁴

Since no one has a reliable method for determining whether interest rates will rise or fall in the near future, investors should avoid making fixed income decisions based on a forecast, media coverage, or their own hunches.

Pursuing higher expected returns requires more risk taking.

The strong link between risk and return appears in all properly functioning capital markets. When investing in stocks, bonds, or other assets, investors must accept more risk to pursue a higher potential return.

In the fixed income markets, earning a return above short-term government instruments is usually a function of assuming more term and credit risk. Term risk refers to a bond’s maturity, and credit risk refers to the creditworthiness or default potential of the borrower. Bonds with longer maturities and lower credit quality are usually considered riskier and have offered higher yields and returns to compensate investors for higher risk.

On the term side, investors who commit their capital for longer periods of time are exposed to the amplified effects of changing interest rates. Bond prices and interest rates move in the opposite direction: When rates rise, the value of an existing bond declines; when rates fall, bond values rise. The market adjusts the price to match the yield available on a new instrument. The longer the bond’s maturity, the greater the price adjustment for a particular interest rate change. A long-term bond is more exposed to rate changes than a short-term instrument, and usually (but not always) offers a higher yield to compensate investors for the extra risk. Also, lower-coupon bonds are more affected by interest rate changes than higher-coupon bonds. For example, if rates move 1%, a bond that pays 3% will experience a greater gain or loss than one paying 5%.

On the credit risk side, the government is considered the strongest borrower in the market, so it has a lower cost of capital relative to other issuers. The most creditworthy companies are considered relatively safe, but they must still offer a higher rate than the government to compensate investors for taking more default risk. The weaker a corporate borrower’s financial condition, the more it must pay in yield to attract investors. Investors seeking higher returns on the credit spectrum must bear a higher risk of default.⁵

Investment strategy should drive fixed income decisions.

Investors may hold fixed income securities for a variety of reasons—for example, to reduce portfolio volatility, generate income, maintain liquidity, pursue higher returns, or meet a future funding obligation. Each objective may involve a different portfolio approach, or a combination of strategies to manage tradeoffs. For example, investors who want to maximize current income may not be strongly concerned with the effects of short-term price volatility. They may extend maturity or accept slightly lower credit quality when the market offers a yield premium for doing so. On the other hand, investors seeking long-term wealth appreciation may commit most of their portfolio to equities and keep their fixed income investments short term and high quality to buffer the volatility of stocks.

Regardless of your approach, you should know the difference between controlling risk and avoiding it. You cannot eliminate risk, but you can manage your exposure by diversifying across maturities, industries, countries, and currencies to reduce the impact of rates, inflation, currency fluctuations, and other risks. Your decision to take more term and default risk may depend on the current state of the yield curve and credit spread.

Many factors influence the direction of interest rates and performance in the bond markets, and these are too complex for anyone to reliably predict. Rather than placing your faith in the experts or reacting to economic news, manage your fixed income component from a portfolio perspective. Your strategy should reflect your overall investment goals, risk tolerance, and other personal financial considerations. This is a solid approach to managing your portfolio in an uncertain interest rate market.

1. Eugene F. Fama, “The Information in the Term Structure,” Journal of Financial Economics 13, no. 4 (December 1984): 509-528. Also: Robert R. Bliss and Eugene F. Fama, “The Information in Long-Maturity Forward Rates,” American Economic Review 77, no. 4 (September 1987): 680-692.

2. Mark Gongloff, “Two Treasury Forecasts: a Grand Canyon-Size Gap,” Wall Street Journal, April 10, 2010.

3. Wall Street Journal Forecasting Survey, www.wsj.com, accessed July 7, 2010.

4. Christopher R. Blake, Edwin J. Elton, and Martin J. Gruber, “The Performance of Bond Mutual Funds,” Journal of Business 66, no. 3 (July 1993): 371-403. Also see Standard & Poor’s Indices Versus Active (SPIVA) Scorecard for the US, Canada, Australia, and Europe (http://www.standardandpoors.com/indices/spiva/en/us).

5. The yield curve plots the current relationship between rates and maturity, and the credit spread plots the risk-return relationship across the range of credit qualities. The curves offer a current snapshot of how markets are pricing term and credit exposure.

Proponents of active management believe that skilled managers can outperform the financial markets through security selection, market timing, and other efforts based on prediction. While the promise of above-market returns is alluring, investors must face the reality that as a group, US-based active managers do not consistently deliver on this promise, according to research provided by Standard & Poor’s.

S&P Indices publishes a semi-annual scorecard that compares the performance of actively managed mutual funds to S&P benchmarks. Known as the SPIVA scorecard¹, the report analyzes the returns of US-based equity and fixed income managers investing in the US, international, and emerging markets. The managers’ returns come from the CRSP Survivor-Bias-Free US Mutual Fund Database, and the managers are grouped according to their Lipper style categories.²

The graph below features fund categories from the most recent SPIVA scorecard—all US equity funds, international funds, emerging market funds, and global fixed income funds—and shows the percentage of active managers that were outperformed by the respective S&P Indices in one-, three-, and five-year periods. These are only four of thirty-five equity and fixed income fund categories. But a deeper analysis confirms that the active manager universe usually fails to beat the market benchmarks over longer time horizons. Underperformance of active strategies is particularly strong in the international and emerging markets, where trading costs and other market frictions tend to be higher.

Over the last five years, about 60% of actively managed large cap US equity funds have failed to beat the S&P 500; 77% of mid cap funds have failed to beat the S&P 400; and two-thirds of the small cap manager universe have failed to outperform the S&P Small Cap 600 Index. Furthermore, across the thirteen fixed income fund categories, all but one experienced at least a 70% rate of underperformance over five years. In 2009, active funds experienced more success over a one-year period, and proponents typically highlight those results in the SPIVA scorecard. However, one-year results are not consistently strong from year to year, and investors should not draw conclusions from short-term results. Over three- and five-year periods, most fund categories have not outperformed their respective benchmarks. This poor track record appears in other research, as indicated in the graph below. This study compared the same actively managed funds in the CRSP database to the Russell benchmarks and showed similar results over the three- and five-year periods. Over the past five years, about 65% of all US equity managers failed to outperform their respective Russell Indexes, and 84% of fixed income managers failed to beat their respective Barclays Capital Indices.

Of course, the results of these studies will fluctuate over time, and a majority of funds in a given category might outperform over the short term. But the message is clear:  As a group, actively managed funds often struggle to add value relative to an appropriate benchmark—and the longer the time horizon, the greater the challenge for active managers to maintain a winning track record.

1.  SPIVA stands for Standard & Poor’s Indices versus Active Funds. The report covers US equity, international equity, and fixed income categories. The actively managed funds are grouped according to Lipper style categories.

2.  The Center for Research in Security Prices (CRSP), at the University of Chicago Booth School of Business (Chicago GSB), is a nonprofit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks listed on the NYSE, Amex, and NASDAQ exchanges. The Survivor-Bias-Free US Mutual Fund Database includes a history of each US mutual fund’s name, investment style, fee structure, holdings, asset allocation, and monthly data, including total returns, total net assets, net asset values, and dividends. All data items are for publicly traded open-end mutual funds and begin at varying times between 1962 and 2008, depending on availability. The database is updated quarterly and distributed with a monthly lag.

Past performance is no guarantee of future results. This article is provided for informational purposes only and should not be construed as an offer, solicitation, or a recommendation from Dimensional Fund Advisors.

Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission.

©2010 Dimensional Fund Advisors

Real estate as a wealth generator is hardly a new idea. People owned property long before the advent of stock exchanges and other capital markets. In more recent times, large corporations and institutions have held commercial real estate in their portfolios.  

But individual investors have not traditionally had ready access to a professionally managed, diversified real estate portfolio. This has changed in the last few decades with the development and growth of real estate investment trusts, or REITs. Now individuals can add a real estate component to their portfolio to improve overall diversification. 

What is a REIT?

A REIT is a company that owns, operates, and/or finances real estate property.¹ Most of this discussion will address equity REITs, which manage different types of income-producing properties, such as hotels, office buildings, industrial facilities, apartments, and shopping centers. As commercial landlords, equity REITs typically generate dividend income from the rent paid by tenants. Many REITs in the US are traded on the public stock exchanges.  

Publicly traded REITs offer investors several potential benefits: 

·         Real estate exposure. While publicly traded REITs account for only a small portion of the real estate investment universe and the equity market, academic evidence suggests that REITs have similar returns to the overall real estate market .²

·         Low correlations with financial assets. Over longer periods of time, historical correlations of REITs and stocks have been generally low. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.) 

·         Diversification. A REIT holds a portfolio of properties, which may specialize by property type and industry, or be broadly diversified according to industry and region. With the more recent advent of real estate securities overseas, investors can further diversify their exposure among foreign developed markets.

·         Higher yield, regular income, capital appreciation. Since REITs have to pay out a large fraction of earnings as dividends, they tend to offer higher-dividend income than equities, and this may benefit certain income-oriented investors. Total return of the shares is tied to income and change in market value. 

·         Distinct asset class. While REITs are considered equity vehicles and can have significant exposure to the size and value risk factors, they are generally considered to be a separate asset class, due to their low long-term correlations with stocks.

·         Liquidity and transparency. Publicly traded REITs can be bought or sold whenever the stock market is open for business. The availability of market-determined share prices can reveal information about the market’s assessment of the company’s prospects, including the ability of the firm’s management team. 

·         Tax treatment. REITs operate as “pass-through” corporations in which most income goes directly to shareholders. They typically pay little or no taxes on corporate income.³ 

Investing in REITS

A REIT mutual fund that manages a portfolio of REITs typically offers more diversification than owning a single REIT. Most REIT funds are either actively managed or indexed. An active fund manager seeks to pick securities that appear undervalued—an approach that often results in over-concentration in a single category, which may raise risks and potential costs, including transaction costs and management fees. On the other hand, an index fund tries to replicate a benchmark, such as the FTSE NAREIT Equity REIT Index or the Dow Jones US Select REIT Index. Although index funds may have lower fees, securities held in the portfolios may experience buying and selling pressure when indexes are reconstituted. 

Our preferred approach is a structured strategy. Rather than trying to replicate an index, a manager may choose securities based on risk-return characteristics, diversification benefit, and favorable price negotiation. By keeping costs low and trading efficiently, a structured REIT strategy seeks to generate improved returns over time. Advantages of this approach include broader, more systematic exposure to the REIT universe at a lower cost. 

Adding a real estate component to a portfolio may be a good diversification move. But strategy and implementation are crucial, and before investing, you should consider how a real estate strategy and the REIT you select may affect your portfolio. Some factors that may come into play: 

·         Asset coverage. Most actively managed stock funds and indexes include REITs in their equity holdings. This creates the potential for overlapping asset class exposure for investors who add a REIT component in their portfolio. Treating REITs as a separate and distinct strategy helps you achieve more precise risk exposure in the asset class weights. For example, investors with significant direct ownership in real estate may want to exclude REITs from the equity component in their portfolio to better control their overall exposure. 

·         REIT category. Equity REITs may operate property in a specific area of expertise, such as retail, office and industrial, hotels, or health care facilities. Residential REITs own and operate apartment buildings and multi-family commercial dwellings, rather than single-family homes. Mortgage REITs, which lend money directly to real estate owners or invest in existing mortgages or mortgage-backed securities, are generally excluded from the equity REIT universe because they perform more like fixed income instruments, with income based on interest payments. Hybrid REITs combine the strategies of equity and mortgage REITs. 

·         Diversification. As with financial assets, owning a broad mix of REITs can help reduce specific risk in a portfolio. This diversification eliminates exposure to a single REIT category, manager style, or geographic region. Also, adding international real estate can further enhance the potential diversification benefit.⁴ Correlations among international REITs are low across countries, regions, and equity markets, making them a useful complement to equities in developed and emerging markets.

Risk Considerations

REITs carry stock market risk, as well as risks specific to individual real estate properties, sectors, regional markets, and the operating firm. The securities are also subject to market pressures that may push share prices above or below the value of the underlying real estate. However, identifying a market premium or discount in a REIT is difficult since the underlying asset value reported by a REIT is based on an appraisal, which may be several months old. REIT returns also depend on the buying, selling, and operating decisions of management.  

A manager may adopt risky strategies, such as heavy leveraging or lack of diversification. They may pay too much for properties, acquire poorly performing properties, change strategies regarding property mix, or make other business decisions that compromise performance. Investors holding foreign REITs or REIT funds are also exposed to risks specific to the country, such as legal structure, investment restrictions, ownership rules, tax treatment, and currency risk. 

All of this underscores the importance of knowing your risk tolerance, carefully analyzing REIT fund managers, and diversifying to eliminate exposure to a single REIT manager or category. 

Endnotes

1. Equity REITs make up about 91% of the REIT market. Mortgage REITs, which compose about 7% of the market, loan money to real estate owners or invest in existing mortgage-backed securities. Hybrid REITs combine the strategies of equity and mortgage REITs and make up about 1% of the market. Source: National Association of Real Estate Investment Trusts, Inc. (NAREIT). 

2. Joseph Gyourko and Donald B. Keim, “Risk and Return in Real Estate: Evidence from a Real Estate Stock Index,” Financial Analysts Journal 49, no. 5 (September-October 1993): 39-46. 

3. A US REIT must invest at least 75% of its assets in real estate and derive at least 75% of its income from real estate property or interest on real estate financing. It must also distribute at least 90% of its income to shareholders to maintain tax-advantaged status. This pass-through provision allows REIT investors to have access to the same cash flows as investors in private real estate equity. REIT shareholders, however, generally must pay taxes on income they receive from a REIT. 

4. Over the 20-year period from 1990 to 2009, the annual return correlation between US REITs and the US stock market was 0.498 (1.0 denotes exact positive correlation in returns). 

Disclosures

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. 

Diversification neither assures a profit nor guarantees against loss in a declining market.  

REITs vs. US StocksAnnual Returns: 2000-2009

US Equity REITs are represented by the Dow Jones US Select REIT Index.
The US equity market is represented by the CRSP 1-10 Index. 

Average Annualized Returns: 1990-2009

Returns in USD. Inception dates for Dow Jones US Select REIT Index is January 1978; CRSP Deciles 1-10
Index inception date is January 1926. 

Indices are not available for direct investment, and performance does not reflect the expenses associated with the management of an actual portfolio.

Past performance is no guarantee of future results. 

The Center for Research in Security Prices (CRSP), at the University of Chicago Booth School of Business (Chicago GSB), is a nonprofit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks—active and inactive—listed on the NYSE, Alternext, Amex (formerly AMEX), NASDAQ, and ARCA exchanges. OTC bulletin board stocks are not included.

Thanks to the American Health Lawyers Association for this update 

Healthcare Reform Reconciliation Bill
By Julie Barnes*

Late yesterday, Democratic leaders of the U.S. House of Representatives released the language of a 153-page reconciliation bill that makes several changes to the healthcare reform bill that the U.S. Senate passed on Christmas Eve. Access the reconciliation bill.

The House Rules Committee will meet tomorrow morning to finalize the procedural rules for the vote that is expected to take place on Sunday, March 21, 2010. House Democratic leaders need 216 votes to pass the legislation before the Senate begins its own reconciliation process.

The changes to the Senate healthcare reform bill reflect President Barack Obama's recently announced priorities for the healthcare reform overhaul:

Coverage

Tax credits are increased for middle-income families to buy private insurance; the tax penalty for an individual's failure to purchase insurance is adjusted; the exclusion from gross income for employer-provided health coverage is extended to include adult children up to age twenty-six. The bill is expected to create new avenues to buy and provide new subsidies for private insurance coverage to thirty-two million Americans.

Access

Mandatory funding for community health centers is increased to
$11 billion over five years.

Insurance Reforms

The prohibition of lifetime limits, prohibition on rescissions, limitations on excessive waiting periods is extended, and a requirement to provide coverage for non-dependent children up to age twenty-six to all existing health insurance plans begins six months after enactment. For group health plans, preexisting condition exclusions and annual limits are prohibited beginning in 2014.

Drugs

The underlying 340B expansion to inpatient drugs and exemptions to group purchasing organization exclusion is repealed and orphan drugs are exempt from required discounts for new 340B entities.

Federal Programs

Medicare

A $250 rebate will be given to all Medicare Part D enrollees who enter the coverage cap (donut hole) in 2010 and increases discounts on brand-name drugs gradually to close the donut hole by 2020. Medicare Advantage (MA) payments will be frozen in 2011, and reductions to MA benchmarks will be phased in over time. Medicare disproportionate share hospital cuts are to begin earlier, in fiscal year 2014.

Medicaid

The Nebraska special deal to receive 100% federal matching rate for Medicaid costs of newly eligible individuals is removed and applied to all states until 2016. Medicaid payment rates to primary care physicians will be increased to 100% of Medicare payment rates in 2013 and 2014.

Waste, Fraud, and Abuse

Funding for the Health Care Fraud and Abuse Control Fund will be increased by $250 million over the next decade.

Revenue

The biggest revenue-raiser in the bill is a fixed (rather than adjusted for inflation) Medicare payroll tax on unearned income for joint filers earning $250,000 or more and individuals making more than $200,000. Beginning in 2018, the excise tax on high-cost health plans will be applied to policies that cost more than $10,200 per year for individuals and $27,500 for families. Slightly delayed industry fees include a fee assessed on brand-name pharmaceutical sales, a 2.9% excise tax on medical devices, and a health insurance fee. The bill eliminates a tax credit received by cellulosic biofuel producers for unprocessed fuels known as "black liquor."

*We would like to thank Julie Barnes, Esquire (New America Foundation, Washington, DC), for providing this email alert.

Hot off the press from the American Health Lawyer's Association 

CBO Completes Preliminary Estimate for Healthcare Reform Bill
By Julie Barnes*

This is the week of the "up or down vote" on a comprehensive healthcare reform bill in the U.S. House of Representatives. The Democratic leadership has been eagerly awaiting a "good score" from the Congressional Budget Office (CBO)—meaning that CBO certifies that it will reduce the deficit over the next two decades. With a good CBO score, the more moderate members of the Democratic Party may be persuaded to vote for the bill.

Today the CBO completed a preliminary estimate of the "spending and revenue effects of an amendment in the nature of a substitute to H.R. 4872," otherwise known as the Reconciliation Act of 2010. This estimate is considered preliminary because CBO must review the language of the reconciliation proposal and further refine their budgetary projections.

The score is based on the Senate-passed version and several additional provisions that are White House-driven compromises between the Senate and House bills. The additional provisions are being promulgated through the budget reconciliation process to avoid a filibuster under the U.S. Senate rules of procedure. In its letter to Speaker Nancy Pelosi (D-CA), CBO states that enacting both H.R. 3590, the "Patient Protection and Affordable Care Act" as passed by the U.S. Senate on Christmas Eve (see CBO's score of this bill) and the House's reconciliation proposal would cost $940 billion over ten years, and produce a net reduction in federal deficits of $138 billion over ten years and $1.2 trillion in the second ten years. These scores seem to bode well for efforts by House Democratic leaders to gather enough "yea" votes to feel confident holding a floor vote on the bill, likely to take place this weekend.

In April 2009, the House passed the 2010 Budget Resolution which instructed the House to pass a reconciliation bill with healthcare reform and education reforms in one package this year. Accordingly, the reconciliation bill will not only include comprehensive healthcare reform, but also provisions that will eliminate the role of private lenders in college loans. If this reconciliation bill passes, students will receive their loans directly from the U.S. Department of Education starting July 1, 2010. The education reform legislation means substantial savings to the federal government, which is expected to help convince fiscally conservative Democrats to vote for the reconciliation package who may otherwise have been reticent to vote for the healthcare reform bill.

*We would like to thank Julie Barnes, Esquire (New America Foundation, Washington, DC), for providing this email alert.

Choosing a basic stock-bond mix is an important first step in portfolio design. Although the decision may appear simple, it can have a profound impact on your wealth. 

Portfolio theory explains the value of making a deliberate, strategic decision about the proportion of stocks versus bonds to hold in a portfolio. This decision has roots in the “separation theorem,” which was proposed by Nobel laureate James Tobin in the late 1950s.¹ The separation theorem proposes that all investors face two important decisions: (1) deciding how much risk to take, and then (2) forming a portfolio of “risky” assets (equities) and “less risky” assets (fixed income) to achieve this risk exposure.  

Your stock-bond decision implements this risk position. 

The Rationale

The theorem proposes that all investors who are willing to take stock risk should begin with a diversified market portfolio. Each investor then can dial down total risk in the portfolio by adding fixed income to the mix. The greater the bond allocation relative to stocks, the less risky the portfolio and the lower the total expected return; the greater the stock allocation relative to bonds, the higher the portfolio’s expected return and risk.  

Investors who want to take even more risk than the market can increase exposure through borrowing on margin and/or tilting the stock portfolio toward asset groups that offer higher expected returns for higher risk. 

So, how does one confidently allocate between stocks and bonds? A common method is to evaluate model portfolios along the risk-return spectrum. A riskier portfolio holds 100% stocks, and the least volatile portfolio holds 100% bonds. Between these extremes lie standard stock-bond allocations, such as 80%-20%, 60%-40%, 40%-60%, and 20%-80%.² Then you compare the average annualized return and volatility (standard deviation) of each model portfolio for different periods, such as one, three, five, ten, and twenty years. Volatility is one of several risk measures investors may want to consider. With this in mind, the analysis should feature average returns, as well as best- and worst-case returns for the various periods. 

While this technique relies on historical performance that may not repeat in the future, and does not consider various investment costs, it may help you think about the risk-return tradeoff and visualize the range of potential outcomes based on the aggressiveness of your strategy. 

Refining Your Stock Allocation

After establishing the basic stock-bond mix, investors turn their attention to refining the stock allocation, which is where the best opportunities to refine the risk-return tradeoff are found.  Investors who are comfortable with higher doses of equity risk can overweight or “tilt” their allocation toward riskier asset classes that have a history of offering average returns above the market. Research published by Eugene Fama and Kenneth French found that small cap stocks have had higher average returns than large cap stocks, and value stocks have had higher average returns than growth stocks. By holding a larger portion of small cap and value stocks in a portfolio, an investor increases the potential to earn higher returns for the additional risk taken.  

The final step in refining the stock component is to diversify globally. By holding an array of equity asset classes across domestic and international markets, investors can reduce the impact of underperformance in a single market or region of the world. Although the markets may experience varying levels of return correlation, this diversification can further reduce volatility in a portfolio, which translates into higher compounded returns over time. 

Fixed Income Strategies

Research shows that two risk factors—maturity and credit quality—account for most of the average return differences in diversified bond portfolios. Long-term bonds and lower-quality corporate bonds typically offer higher average yields to compensate investors for taking more risk. But keep in mind that these premiums are considerably lower than the market, size, and value premiums documented in the equity world. 

Investors generally hold fixed income to either (1) reduce overall portfolio volatility, or (2) generate a reliable income stream. These objectives typically lead to different investment decisions. The first approach, volatility reduction, is an application of separation theorem (i.e., hold equities for higher return and use fixed income to temper portfolio volatility). Rather than increasing risk to maximize yield, these investors want to hold fixed income securities that are lower risk. Certain fixed income asset groups are better suited for this strategy. 

With this in mind, some long-term investors may seek to earn higher expected returns by shifting risk to the equity side of their portfolio. With an eye to minimize maturity and credit risk, they hold short-term, high-quality debt instruments that have historically offered lower yields with much lower volatility. 

The second purpose for holding bonds is to generate reliable cash flow. Income-oriented investors, including retirees, pension plans, and endowments, may not worry as much about short-term volatility in their bond portfolio. Their priority is to meet a specific funding obligation in the future. Consequently, they design a portfolio around bonds and accept more volatility in hope of earning higher yields, which they pursue by holding bonds with longer maturities and/or lower credit quality. 

Whether investing for total long-term return or for income, a portfolio should be diversified across issues and global markets to avoid uncompensated risk from specific issuers and to capture differences in yield curves around the world.  

Summary

The stock-bond decision drives a large part of your portfolio’s long-term performance. During portfolio design, evaluating different stock-bond combinations can help you visualize the risk-return tradeoff as you consider the range of potential outcomes over time. Once you determine a mix, it can guide more detailed choices of asset classes to hold in the portfolio. And as your appetite for risk shifts over time, you can revisit the mix to estimate how shifting your portfolio mix may impact your wealth accumulation goals in the future.  

Endnotes

¹ James Tobin, “Liquidity Preference as Behavior Towards Risk,” The Review of Economic Studies 25, no. 2 (February 1958): 65-86.  

² The basic stock component may be reflected by the S&P 500 Index, or preferably, by a broader market proxy, such as the CRSP 1-10 Index. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca exchanges. The S&P 500 Index offers a proxy of the large cap US equities market. The fixed income component may be represented by an index of short-term US government securities or government and corporate bonds.   

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.

 Disclosures

Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. A bond is a loan that an investor makes to a corporation, government, federal agency, or other organization. Also known as debt or fixed income securities, most types of bonds pay interest based on a regular, predetermined coupon rate that is set when the bond is issued. 

Although investors may form their expectations from the past, there is no assurance that future investment results will model historical performance.  

Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. 

Stocks offer a higher potential return as compensation for bearing higher risk. However, this premium is not a certainty and investors should not expect to consistently receive higher returns from stocks. In fact, market history shows extended periods when stocks did not outperform bonds.  

Diversification neither assures a profit nor guarantees against loss in a declining market. 

A bond portfolio designed for income also carries significant risks, including default and term risk, call risk, and purchasing power (inflation) risk. Foreign securities also are exposed to currency movements.  

As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt. Many people are asking how they can prepare for potentially higher inflation. This article explores two basic ways to address inflation uncertainty and highlights asset groups that may prove useful. 

As you consider strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market’s expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage. 

Hedging vs. Total Return Strategies

Investors can prepare for unexpected inflation by following one of two basic strategies—hedging the immediate effects of inflation or earning a total return that outpaces inflation over time. 

Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)  

Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection. 

In a total return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. This investor is willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks. 

To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS). Let’s consider each of these: 

Stocks

Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year.¹ To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return. 

Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.  

Fixed Income (Bonds)

Higher inflation can hurt bondholders in two ways—through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.  

Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth. 

Treasury Inflation-Protected Securities (TIPS)

Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation. 

TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.  

However, keep in mind that TIPS prices also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase. 

Commodities

Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging. 

Investors should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broad-based stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.  

Summary

While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio.  

As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:

 ·         Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.

·         Hedging unexpected inflation has a cost. Investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks—and some have much higher volatility.

·         Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility. 

Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.  

 Endnotes

¹ Real return calculation:  (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago.     

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.

 Disclosures

Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics. 

Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes. 

CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included. 

The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money. 

Diversification neither assures a profit nor guarantees against loss in a declining market.

Helpful information from the American Health Lawyers Association 

President Obama Signs Into Law a Temporary Fix
to Physicians' Medicare Reimbursement
By Jeffrey Moore**

On December 19, 2009, President Barack Obama signed the Department of Defense Appropriations Act, 2010 (H.R. 3326), into law, which freezes Medicare physician payments for two months, avoiding a 21% payment cut to physicians' Medicare reimbursement scheduled to go into effect
on January 1, 2010. The House previously approved H.R. 3326 on December 16, 2009, while the United States Senate passed H.R. 3326 on December 19, 2009.

Because the Department of Defense Appropriations Act, 2010, is only a temporary fix to the Medicare physician payment issue, Congress will be forced to address this payment issue in early 2010, as the Medicare physician payment cuts are set to go back into effect on March 1, 2010.

**We would like to thank Jeffrey S. Moore, Esquire (Phelps Dunbar LLP, Tupelo, MS), for providing this email alert, and the Regulation, Accreditation, and Payment Practice Group for sharing this email alert with the Physician Organizations Practice Group.

Thanks to the American Health Lawyers for this piece. 

Requirement For Americans To Get Insurance Is Central To Health Overhaul
But past experience suggests government mandates don't necessarily ensure compliance
By Phil Galewitz

If Congress passes a law that requires Americans to buy health insurance, Rebecca Antonelli already knows what she'll do: Just say no and pay a penalty instead.

"It comes down to an economic decision, and I'd be more inclined to save the money and take a risk of getting sick," says Antonelli, 46, a marketing consultant in Raleigh, N.C., who dropped her insurance policy last year when her business slumped.

Both the House and Senate health care overhaul bills require most Americans to carry health insurance or pay a penalty. Yet government mandates don't necessarily ensure compliance: Not all Americans buckle up, or get their children vaccinated.

Some health experts worry the proposed penalties are too low and that many younger, healthier people may agree with Antonelli, opting to pay the fee and gamble on their health. That could drive up the costs of covering older and sicker people.

"If you get too many young and healthy people who slip through, all the insurance market reforms start to unravel and the whole health bill unravels," says John Holahan, director of the Urban Institute's Health Policy Research Center.

Yet Congress risks a political backlash if penalties are too steep, particularly among those who earn too much to qualify for subsidies, Holahan says. Under the Senate bill, people who don't buy coverage would face a maximum penalty of $95 beginning in 2014. That would jump in 2016 to $750 or two percent of their annual income up to the cost of the cheapest health plan, whichever is greater. In the House bill, violators would pay as much as 2.5 percent of their annual income up to the cost of the cheapest plan beginning in 2013.

When people buy health insurance on their own rather than through employers, the average cost in 2016 is projected to be $5,500 for an individual policy and $13,100 for family coverage, according to the Congressional Budget Office.

Both health bills would provide a sliding scale of subsidies to individuals who earn less than $43,320 or families of four who earn less than $88,200. The bills also exempt millions of people from the mandate, including for religious reasons and financial hardship.

Massachusetts' example

White House budget director Peter Orszag says penalty size isn't the only factor in determining whether people buy coverage. He predicts the mandate will help create societal expectations that everyone gets health insurance, just as most people feel obligated to buckle their seat belts.

He points to Massachusetts, which in 2007 became the first state to require that most residents have insurance. Since then, the percentage of uninsured has declined to four percent from about seven percent.

The Massachusetts penalty for failing to buy insurance this year is $1,068--about half the cost of the lowest annual premium. About
96 percent of tax filers in the state in 2008 reported they had coverage; only one percent paid a penalty.

The nonpartisan Congressional Budget Office, which assesses the impact of legislation, says the number of people opting to pay the penalty instead of buying coverage would be "limited."

Others aren't so sanguine.

"Engineering social norms is hard," says Jeffrey Munn, a principal with the consulting firm Hewitt in Washington. "We may need to temper our expectations around what an individual mandate can actually accomplish."

A recent CBO report provides a few examples of Americans who don't follow existing mandates:

Most states have required seat belt use for about two decades, yet 18 percent of Americans still don't buckle up.

Schools have required children to get immunized for chickenpox since the 1990s, but 15 percent don't get vaccinated.

Nearly every state requires drivers to have car insurance, but 15 percent don't comply.

Views of the uninsured

The promise of health benefits could convince some of the uninsured to buy coverage, including Dulsi Beaslin.

Beaslin, 39, owns a nail salon in Holladay, Utah, and has gone without insurance for four years. She says she'd likely buy coverage under the mandate, particularly if it's subsidized. "These new benefits will take the sting out of the mandate and help me to purchase coverage that I will want to have," says Beaslin, who hasn't been able to pay for insurance on her $30,000 annual income.

Others say they'll defy the mandate.

"I will not purchase the health insurance, and I will not pay the penalty," says Charles Moore, who does database programming in Houston and leads jeep tours in the Rocky Mountains. Moore, 54, hasn't had health insurance since leaving the Air Force in 1984.

"Everyone succumbs to some major illness at some point," Moore says, "and if I can't pay for it, then I don't want to stick my hand in someone else's pocket."

Thanks to the American Bar Association’s Physician Interest Group for the following summary of the “final” Medicare Fee Schedule issued today.   

Unless Congress acts, the 21.2% statutorily mandated reduction of overall physician fees will be implemented effective January 1, 2010.  The “final” regulation contains the following provisions of particular interest to physicians:

 *          Eliminates the use of all consultation codes (inpatient andoffice/outpatient codes for various places of service except for telehealth consultation G-codes) on a budget neutral basis by increasing the work relative value units (RVUs) for new and established office visits, increasing the work RVUs for initial hospital and initial nursing facility visits, and incorporating the increased use of these visits into practice expense (PE) and malpractice RVU calculations.

*          Finalizes the proposal to remove physician-administered drugs from the definition of "physician services" for purposes of computing the physician update formula.  This long-awaited administrative step mitigates the size of future Medicare Part B reductions.

*          Phases in new PE RVUs over four years using revised survey data that will result in significant increases and decreases to the PE values of many codes.

*          Establishes a Physician Quality Reporting Initiative (PQRI) reporting mechanism via qualified electronic health records.

*          Defines the size of a group practice as at least 200 providers for purposes of the new PQRI group-practice reporting option.

 *          Increases the utilization assumption for diagnostic equipment priced at more than $1 million, which will decrease the technical component payment for services performed on this equipment.  This change will be phased in over 4 years.