Fund Spotlight

Last week was relatively slow, with only four trading days thanks to the Juneteenth holiday. Furthermore, there were only a couple of major news announcements after the market reopened on Tuesday. The first major news event occurred on Thursday with the reveal of unemployment claims numbers from the last seven days.

It showed that there were 264,000 claims made over the period compared to an estimated 261,000. This was the second consecutive week in which 264,000 unemployment claims were made.

On Friday, S&P Global released its Purchasing Managers Index (PMI) numbers for both the manufacturing and service sectors. The manufacturing PMI number was 46.3 percent, which was down from 48.4 percent last month and was below the 48.6 percent estimate. The services PMI was 54.1 percent compared to 54.9 percent last month and was slightly higher than the 53.9 percent expected by analysts. These numbers suggest that there is a slowdown occurring in the manufacturing sector while the service economy still has room to grow.

On Wednesday and Thursday, Federal Reserve Chairman Jerome Powell offered prepared remarks to members of the Senate. The main takeaways from his testimony were that the service sector was running too hot and was likely contributing to inflation, which is still too high for his liking.

Therefore, it is expected that there will be additional interest rate hikes in the coming months. According to Powell, there will not be a pivot toward lower interest rates soon. He also said that there was a chance that the economy would achieve a soft landing. In other words, prices could be reined in through rate hikes without triggering a recession.

Some have suggested that the Fed may be forced to consider further hikes because of actions taken by other banks around the world. The Bank of England (BOE) raised rates to 5 percent after recent CPI data in that country found that inflation had increased to 8.7 percent. The Swiss central bank also increased its interest rate to 1.75 percent last week. It’s expected that the European Union (EU) will continue to raise rates in response to recent data that inflation is still a key issue there.

The only outlier in the quest to contain inflation is Japan, which has a base rate of -.10 percent. This has caused the yen to depreciate significantly against the dollar as well as other currencies. At the end of trading on Friday, a single dollar could be traded for 144 yen. Although the Bank of Japan (BOJ) has indicated that it may intervene to stop the currency from sliding much further, it is also against raising rates. This is because it is a popular tool for those who want to engage in carry trades.

The S&P 500 was down 1.9 percent last week to finish at 4,348 on Friday afternoon. It reached its highest point of the week on Tuesday afternoon when it hit 4,397 and would slowly lose ground on Wednesday, Thursday and Friday.

Last week was also unkind to those who were invested in companies listed on the Dow 30. The index finished down 2.19 percent to finish at 33,727. As with the S&P 500, the Dow hit its high of the week on Tuesday before slowly falling on Wednesday, Thursday and Friday.

Finally, the NASDAQ would also have a losing week as it finished 2.08 percent lower. The market would hit its high of the week on Tuesday at 13,679 and end the day on Friday at 13,492.

This upcoming week sees the release of consumer confidence, GDP and consumer price figures. On Wednesday, Jerome Powell will be speaking about the state of the economy and may offer clues about his next moves. On Friday, revised consumer inflation expectation data will also be released, which could have an impact on what the Fed does during its July meeting.

Ask most investors about the year 2022, and they’ll probably talk about the decline in stocks even though last year wasn’t a historically bad year. Outside technology-laden sectors, the other sectors spent little to no time around the 20 percent loss line that most use to define a bear market.

The same cannot be said for bonds. They entered a major bear market in 2020, and it accelerated in 2022. If one investment bank is correct, the 10-year U.S. Treasury bond suffered its worst performance since 1788, a year when much of the world assumed the fledgling United States could fail. Last year, the 30-year Treasury bond suffered larger losses than the Nasdaq 100 Index.

Those losses stopped in October 2022 as investors digested the turn in inflation. Monthly inflation numbers peaked in June 2022 and slumped quickly before accelerating slightly in 2023. If the recent slide in crude oil holds, monthly numbers will turn down again. Crude oil is a very reliable indicator of future inflation, and the current slump could help drag CPI numbers below 4 percent. At that point, the Federal Reserve would very likely hold interest rates steady because the current level of interest rates is a historically normal level for a CPI of between 3 and 4 percent.

Higher interest rates are good news for savers and investors looking to buy bonds. After years of offering zero percent returns, many short-term bond and money market funds offer yields of 4 percent or more. For the bond sleeve of a portfolio, there are a great many potential investments after the rise in rates, with even short- and intermediate-term government bonds offering decent income.

One corner of the bond market that remains volatile is long-term government bonds. These bonds have the longest duration in the market, meaning they have the greatest amount of interest rate risk. The 30-year, zero-coupon bonds are the highest risk. They’ve tumbled more than 50 percent since peaking during the pandemic. At that time, those bonds were “return-free risk,” as some banks are learning these days. It made no sense to have these bonds even as a trade because the upside was highly limited and the downside was not. Pimco 25+ Year Zero Coupon U.S. Treasury (ZROZ) and Vanguard Extended Duration (EDV) have these types of bonds in their portfolios, while iShares 20+ Year Treasury (TLT) has interest-bearing bonds that have somewhat lower duration.

These bonds remain highly aggressive for an investor’s bond sleeve because of their volatility. However, given the decline in the bonds and the relative valuation of equities, there is a case for holding them in place of some growth stock exposure.

There are four ways two assets can behave in relation to each other. Both increase; both decrease; one rises, and the other falls; one falls, and the other rises. In 2022, Invesco QQQ (QQQ) and the three aforementioned long-term bond funds — TLT, EDV and ZROZ — all lost more than 30 percent. Due to inflation and rising rate concerns last year, both bonds and stocks traded similarly.

One possibility is that these bond funds and QQQ will continue sliding together. They stayed largely correlated until the bank failures in March. If they remain correlated moving forward, then we expect the risk for stocks will exceed that of bonds. As the interest rate rises, bonds lose money in a fairly linear manner. However, as we saw with banks in March, at certain levels of interest rates, companies can start going bankrupt. If inflation and interest rates are headed for new highs, bonds will do poorly, but stocks probably will fare worse.

If this scenario plays out, cash or short-term bonds would be a better alternative to either stocks or long-term bonds.

The next possibility is that both stocks and long-term government bonds rally. Both tumbled in 2022, and both have done well in 2023. The Nasdaq pulled ahead as of March 16, with a 15.22 percent return in 2023, while TLT had a gain of 6.27 percent, the lowest of the three bond funds. Investors may not have as much upside with bonds as stocks, but stocks cannot rally much if bonds sell off again.

The next possibility is that bonds fall and stocks rise. We see this as highly unlikely right now. A significant move lower in bonds will pull stocks lower as well though. Investors have already started increasing bond and cash allocations because they offer good income.

The final possibility is that bonds rise and stocks fall. A recession and/or a bear market in stocks could be one way this happens. We have seen this scenario play out multiple times during previous corrections and bear markets. If a recession lowers inflation, it will likely play out again because the Federal Reserve will have some room to cut rates.

In theory, anything is possible, but inflation has peaked for now. The oil price drop in March will help put a lid on inflation in the near term. The past 50 years of economic history show rapid increases in inflation and interest rates, along with a deeply inverted yield curve as we have now, have almost always been followed by a recession within about two years at the latest. However, the last time similar conditions existed was in the early 1980s, and at that time, a recession was almost immediate once the yield curve started steepening. The banking troubles hint at the stress in the financial system. Finally, the Federal Reserve hasn’t thrown in the towel yet. While they did start a bailout for some banks, they aren’t bailing out the whole financial system. That day may come, but it will take greater losses in the financial markets, losses that will likely trigger a rally in government bonds.

Duration

Duration is a measure of interest rate risk. Measured in years, it gives a rough estimate of how much a bond fund or an individual bond will move for a 1 percent move in interest rates. A bond with a duration of 10 would be expected to rise or fall 10 percent for a 1 percent drop or rise in the relevant interest rate.

TLT has a duration of 17.64, EDV 24.23 and ZROZ 26.18.

Volatility

TLT has a standard deviation of 14.82, EDV 19.32 and ZROZ 20.75. TLT has a beta of 2.04 versus the average bond fund, EDV 2.61 and ZROZ 2.73.

ZROZ is riskier than EDV, and both are riskier than TLT.

Performance  

Over the past year, TLT declined 16.64 percent, EDV 21.97 percent and ZROZ 23.84 percent. QQQ fell 10.84 percent.

Year to date, TLT, EDV and ZROZ have increased 8.22 percent, 10.84 percent and 11.49 percent. QQQ gained 14.89 percent.

From their peak in 2020, TLT lost more than 40 percent, while EDV and ZROZ slid 55 percent.

Income

TLT has a 30-day SEC yield of 3.79 percent and pays monthly dividends.

EDV has a 30-day SEC yield of 3.82 percent and pays quarterly.

ZROZ has a 30-day SEC yield of 3.30 percent and pays quarterly.

Outlook

The Federal Reserve launched a depositor bailout program in March. Traders immediately bid up Nasdaq stocks, cryptocurrency and some of the riskiest stocks in the market on the expectation of further stimulus. They also pushed the 30-year Treasury bond back near its 2023 high, along with many short-term bonds.

Aggressive investors might be tempted to buy growth stocks or ETFs  such as Invesco QQQ (QQQ) for exposure. Long-dated government bonds offer solid upside though, while also offering some opportunity if a recession or financial crisis develops. For this reason, investors who want added equity exposure in areas such as growth and technology may be better served by allocating part of that equity slice to longer-term government bonds.

For years, bond and fixed-income investing were simplified by the Federal Reserve’s zero interest rate policy. Many bonds offered zero or near zero interest. Bank CDs weren’t much better. After a brutal 2022, many parts of the bond market reset the table. Bonds became a great way to achieve income investing goals again, with yields climbing past 4 percent on short- and long-term government bonds.

Most bonds pay fixed coupons, the same amount and usually twice a year. When interest rates rise, the price of an existing bond will fall because investors can buy new bonds with higher yields. When interest rates fall, the bonds go up in price because new bonds offer less income. Investors holding bonds to maturity don’t worry as much about changes in interest rates, but those investing in bond funds will see the fund value rise and fall in the opposite direction of interest rates.

There are two main risks with bonds: interest rate risk and credit risk. U.S. Treasurys have no risk of default because the government can print money to pay principal and interest. The price of Treasury bonds moves entirely based on the interest rates. If the market pushes rates up, Treasurys sell off. If the market pushes rates down, Treasurys rally. Corporate bonds also move based on interest rates, but their price change isn’t solely determined by changes in interest rates.

Investors can quickly access the interest rate risk of a bond by looking at the duration, a statistic found on nearly all financial websites. The rule of thumb is that for every 1 percent change in the relevant interest rate, the price of the bond or fund will move by the duration. If a fund has a duration of 5 and interest rates rise/fall one percentage point, the fund will decrease/increase about 5 percent.

Credit risk also factors into bonds of companies and countries that don’t issue debt in their own currency. The higher the credit risk, the more the price of the bond will be driven by credit risk rather than interest rate risk. In the past decade, the only way to obtain significant income from a bond portfolio was through higher-yielding bonds. For the first time since before the 2008 financial crisis, these bonds finally have some competition.

Conservative Short-Term Bonds

It has been more than a decade since investors could expect a nice return in a money market fund, but those times are back. Fidelity Government Money Market (SPAXX) has a 7-day SEC yield of 3.96 percent. Since the Federal Reserve isn’t done hiking, it’s almost guaranteed to rise to around 4.25 percent in the next month and then possibly toward 5 percent or more later this year if the Fed keeps hiking. This income is “risk free” since it comes from U.S. government securities.

Investors can achieve slightly higher yields with short-term bond funds such as Fidelity Short-Term Treasury Bond Index (FUMBX), which yields 4.10 percent.

The risk with these funds isn’t loss of principal; instead, it is the potential loss of income if bond yields fall. Investors will not receive much “compensation” via capital gains as yields fall.

These funds are best suited for two environments. First, when interest rates are stable, they can produce reliable income over long periods of time. Second, when interest rates are rising, they mitigate losses. In 2022, SPAXX gained 1.31 percent. Even though it has a low duration, the rapid rise in rates sank FUMBX by nearly 7 percent.

Investors who do not expect any rate cuts and want to capture rising rates with no risk can stick with a money market fund such as SPAXX. Investors who think rates might peak later this year and who might hold the position into 2024 when the possibility of rate cuts will increase, have more potential upside from FUMBX while collecting a similar level of income today.

Diversified Bond Funds

As long as interest rates are in a normal range, investors can profit from bond diversification. Exposure to Treasurys, corporate and high-yield bonds of varying maturities can produce good income and solid long-term returns. Diversified bond funds such as Fidelity Total Bond (FBND, FTBFX) currently yield 3.13 percent.

Total bond funds were down about 17 percent at their lows last year. Adjusted for dividends, these funds lost all their gains going back to 2015. It’s worth noting the bulk of the gains came in between 2019 and 2022 when the Federal Reserve was slashing interest rates to zero. If we remove dividends, the losses on the bond portfolios exceeded those of 2008. Stripped of dividends, the low for FTBFX in 2022 came within a few percentage points of the 2008 low.

One of the axioms of investing is “buy low, sell high.” While the process of making a low can be complex and take time, the price of commodities such as crude oil, wheat and natural gas all point to falling inflation later this year. The capital losses experienced by bonds in 2022 won’t be repeated this year or next. If the Federal Reserve stops raising rates later this year, the risk of capital losses will decline and be replaced by potential gains from falling rates.

Investors who want a little more income with less credit risk can opt for the far more narrowly invested Fidelity Intermediate Treasury Bond Index (FUAMX). It has a 30-day SEC yield of 3.57 percent and a duration of 6 years. The fund gained about 3 percent from October to February when the 10-year yield fell about one percentage point. This gives investors similar income without any of the credit risk contained in FTBFX.

Within the bond universe, broadly diversified funds will always deliver a return somewhere in the middle of the bond market. These funds are best for investors with very long holding periods who want to minimize the number of funds in their portfolio.

Long-Term Government Bonds Are an Aggressive Option

In prior years, investors referred to long-term government bonds as “return free risk.” Income was a pittance and did not compensate for the risk because bond yields couldn’t get much lower with the Federal Reserve at zero percent. Getting the lower bond yields seen in Japan and Europe would require the Federal Reserve to cut going into negative territory with interest rates. The risk in long-term bonds manifested itself in 2022. Long-term Treasury bond funds tracked the Nasdaq, with both asset classes losing more than 30 percent of their value.

With bond yields rising since then, long-term government bonds offer potential capital gains in the event of a recession and interest rate cuts. From the October low to the December high, the Fidelity Long-Term Treasury Bond Index (FNBGX) gained 16 percent. In February though, the fund gave back close to half those gains. This level of volatility is unsuitable for most investors. Additionally, the 3.75 percent yield offers no income advantage on money market and short-term bond funds but still contains substantial downside risk if inflation and interest rates do not peak this year or eventually go much higher.

That said, unlike in 2021 and 2022, long-term government bonds can potentially hedge a portfolio against recession and bear market risk if yields drop. If and when signs of recession appear, aggressive active investors may consider using long-term government bond funds as a hedge against that risk.

High-Yield Bonds Remain Attractive

High-yield bond funds are least attractive in a recession and most attractive in growing economies when credit risk is low. Talk of recession has picked up because the yield curve is inverted and inversions of this size have been followed by recessions in the past, but the timing of such a recession is unknown. At the moment, the Atlanta Federal Reserve’s GDPNow model has been hiking its growth forecast for the first quarter, hitting 2.8 percent as of February 27. The market has been reducing its assessment of credit risk since July. Spreads between higher-yield bonds and similar Treasurys have been falling since then.

Fidelity Floating Rate High Income (FFRHX) has a duration that approaches zero because the bonds in its portfolio reset as interest rates rise. FFRHX has a positive return since the end of 2021 because most of the bond market risk last year was centered on interest rate risk, not credit risk. It has an 8.55 percent 30-day yield, and that can go higher with Federal Reserve rate hikes.

Credit risk is the main worry for investors in this fund. The low in FFRHX came in July 2022 (the fund was down about 5 percent from its high at that point) because that is when credit risk peaked.

Floating-rate funds such as FFRHX only suffer if interest rates start falling, in which case the yield on these bonds will also.

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Small-cap value stocks outperform in the long run. They are riskier, turning off some investors. They are too small for many large institutional investors. The entire U.S. stock market is valued at around $44 trillion, and the value of all the companies in DFSV’s portfolio come to less than $4 trillion. Not only is it hard to invest but it is even harder to get out. Therefore, this space is avoided by most institutions and large investors or only gets a proportionate value of their assets, less than 10 percent of an equity allocation.

In addition to being passed over by large investors, small-cap value stocks are also avoided by financial analysts since there isn’t a great deal of interest. This means investors have to do their own research, which the vast majority do not. These stocks are also more volatile, which turns off conservative investors. Paradoxically, all these negatives probably explain small-cap value’s outperformance. Most of the time, this asset class is trading at a discount.

Dimensional Fund Advisors is a fund provider based on the academic research of Eugene Fama and Kenneth French. Many of the funds using factor-based methods base their models directly on the work of Fama and French or derived models that use their research as a starting point. Dimensional goes straight to the source — Fama sits on Dimensional’s board of directors.

In a nutshell, they created a new asset pricing model after finding that small-cap stocks with low price-to-book ratios outperformed the market. This shouldn’t be the case if variations in stock returns were mostly random, something that earlier academic research showed. This was sometimes described as the “random walk” theory. Investors who believe in this theory would do best buying a passive fund covering the entire market, such as the S&P 500 Index. In contrast, Fama and French’s work suggested asset allocation among market segments, such as market capitalization and traditional growth and value, or international and so on, had an impact on returns. Later, they discovered that other factors such as momentum could explain returns and thus be used as the basis for investment selection.

The market segment that showed the best performance was small-cap value, as shown in the earlier work of Fama and French. In 2022, Dimensional Advisors launched an ETF based on their work: Dimensional U.S. Small Cap Value (DFSV). Since the launch of DFSV in February, it has consistently outperformed iShares Russell 2000 (IWM) as well as small-cap value competitors such as Vanguard Small-Cap Value (VBR) and SPDR S&P Small-Cap Value (SLYV).

Investment Strategy

DFSV starts its universe with the cheapest 10 percent of the U.S. stock market as measured by market capitalization. It then narrows this universe by hunting for stocks with lower price-to-book ratios, cutting off at the bottom third. It looks for companies with higher profitability that haven’t been aggressively expanding. Short-term signals such as price momentum can also be a criterion for investment. Liquidity screens and the need to keep turnover low also impact which stocks make it into the portfolio. Holdings are weighted by market capitalization as a way of keeping turnover down.

Costs are kept low, but at 0.31 percent, it’s relatively pricey compared with passive alternatives such as VBR and its 0.07 percent cost.

DFSV has already earned a Morningstar Silver rating.

Portfolio

DFSV currently holds 957 stocks. The weighted average market capitalization is $3.4 billion. The portfolio of stocks has an aggregate price-to-book ratio of 1.27, which compares with 1.99 for the Russell 2000 Index and 1.33 for the Russell 2000 Value Index.

Financials dominate the portfolio with a 27 percent allocation, but this isn’t far above the benchmark’s 24 percent. Industrials are also slightly overweight at 20 percent of assets. Consumer cyclicals are in line with the benchmark at 14 percent of assets. Energy at 9 percent is overweight by three percentage points. Technology rounds out the top five at 8 percent of assets, underweight by 1 percent. Utilities, healthcare and real estate are the sectors with the largest underweighting.

The top 10 holdings have a small percentage of assets, as expected in a diversified fund with nearly 1,000 holdings. Allocations in the top holdings range from 0.76 percent of assets down to 0.54 percent. At the top is Transocean (RIG), followed by Commercial Metals (CMC), TechnipFMC (FTI), IPG Photonics (IPGP), Bank OZL (OZK), Foot Locker (FL), New York Community Bank (NYCB), FNB Corp. (FNB), Jackson Financial (JXN) and Genworth Financial (GNW).

DFSV doesn’t have enough history for beta and standard deviation, but a sister mutual fund trades under the symbol DSFVX. It has a beta of 1.18 and a standard deviation of 29.26, making it more volatile than the Small-Cap Value category on both scores, albeit only slightly.

Performance

DFSV has gained 12.80 percent in 2023, beating both the category and the benchmark index. It has similarly beaten both since its inception a little less than one year ago.

Its sister fund DFSVX has a long history of performance. Over the past 20 years, it has gained 800 percent, well ahead of iShares Russell 2000 Value’s (IWN) 547 percent. Over the past 15 years, it gained 278 percent to IWN’s 209 percent. DFSVX ranks in at least the top 27 percent of small-cap value funds over the past 5-, 10- and 15-year periods.

Notably, DFSVX performed much better in the past year. It gained 6.50 percent, while the category and index rose less than 2 percent. This landed it in the top 13 percent of funds. Both DFSVX and DFSV made new all-time highs in February of this year. This shows the fund can also outperform in down markets.

Caution is warranted though. In 2008, DFSVX lost 67 percent from high to low. While there are some signs the current market resembles the early 2000s (DFSV’s performance this past year reinforces this comparison) and DFSVX did end up gaining over the entirety of that bear market, it would be unwise for investors to assume a repeat should markets turn lower.

Outlook

DFSV is one of the top options for investors seeking small-cap value exposure. Although DFSV is a little more expensive than the competition, if it can do as well as its mutual fund counterpart DFSVX, it can more than make up for the higher expense ratio. For example, DFSV is outperforming VBR by several percentage points in 2023, with about six weeks of trading done. That dwarfs the difference in their expense ratios.

DFSV can serve as a core holding for younger and more aggressive investors with longer time horizons. More conservative investors should stick to smaller satellite positions, although investors can be more aggressive in bear markets and major corrections when adding the fund offers a much stronger risk/reward proposition.

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