The dynamics of investor behavior over the past 11 months have done a complete reversal. Formerly risk-averse investors have been re-converted into risk takers.
ETF asset flows for most of 2009 illustrate this phenomenon. The largest categories for new investment were global international stocks ($29.34 billion), commodities ($28.79 billion) and real estate stocks ($2.51 billion). These are the very areas that investors wanted nothing to do with in early 2009 but now they can't seem to get enough.
As one might expect from the herd mentality, much of these investor asset flows occurred after these investment categories had already rallied. While investors may have changed their mood from risk aversion into risk taking, they haven't changed their predictable pattern of being late to the party and chasing returns.
Let's analyze risky asset classes that have led one of the largest stock and bond market reversals of our lifetime. Instead of being cause for celebration, this should heighten the awareness of financial advisors. Have your clients jumped back onto to the risk bandwagon?
Commodities
The plunge back into commodities is evidence that risk taking has increased. In 2009, broadly diversified commodity ETFs like the PowerShares DB Commodity Index Tracking Fund (DBC) and the GreenHaven Continuous Commodity Fund (GCC) increased between 14 to 19 percent in value. Both funds include exposure to key commodities like corn, oil, metals, natural gas and wheat.
Speaking of metals, if he were still alive, Solomon R. Guggenheim would be proud. While precious metals like gold and silver routinely get all the attention, it's the late magnate's beloved copper that has outperformed. Through late December, the iPath Dow Jones-AIG Copper Total Return Sub-Index ETN (JJC) had a startling year-to-date gain of 123.41 percent. Over the same time period gold (GLD) was ahead by just 23.15 percent and silver (SLV) by 50.09 percent.
Copper prices have risen sharply because of demand from emerging market countries, labor problems at two South American mines and fears of supply shortages.
JJC is not an ETF but an ETN, and so it carries not just market risk but credit default risk of its issuer Barclays Bank. The note's underlying index tracks the Copper High Grade Futures contract traded on the COMEX. The index is reweighted and rebalanced each year in January on a price-percentage basis. JJC matures on October 22, 2037 and its annual fee is 0.75 percent.
High-Yield Bonds
Although the credit market is still recovering from its panic bout, high-yield bonds are once again back in vogue. During the height of the 2008 credit crisis, investors wanted nothing to do with high-yield bonds. The iShares iBoxx $ High Yield Corporate Bond Fund (HYG) declined by 23.86 percent and was seemingly left for dead. Since then, HYG has regained around 29 percent in value.
As of December 24, 2009, HYG carried a 30-day SEC yield of 8.54 percent. While that may seem good in today's low rate environment, it's not as good as last year's double-digit bond yields. Surging bond prices have resulted in lower yields.
HYG's average weighted maturity for bonds within the fund is just 5.48 years and the fund's annual expenses are 0.50 percent.
Emerging Markets
In 2009 emerging market stocks (VWO) jumped by around 72 percent but more upside may be in store. According to Alec Young, S&P International Equity Strategist, VWO's underlying benchmark, the MSCI Emerging Markets Index, trades at a P/E ratio of just 13 based upon consensus earnings expectations for 2010.
"This is a reasonable valuation because it leaves room for further multiple expansion, of course assuming the global economic recovery remains on track," states Young. "We think emerging markets will continue to outperform developed markets but we think their performance will moderate relative to 2009."
Young adds that S&P's favorite emerging market country is Brazil (EWZ). The valuations of Brazilian equities compared to other emerging markets are average but the fundamentals are above average. Also, a boost in currency should help stock returns as the Brazilian real rises relative to the U.S. dollar.
Industry Sectors
The global trend towards clean energy production hasn't put a damper on the environmentally unfriendly coal market. The Market Vectors Coal ETF (KOL) shot ahead around 140 percent last year. KOL is linked to the Stowe Coal Index, which contains 42 stocks that derive at least 50 percent of their revenues from the coal industry. The fund has $402 million under management and it charges annual expenses of 0.62 percent.
To the chagrin of naysayers, KOL's dynamite performance may not yet be over.
A fundamental factor driving coal stocks has been demand. China, the world's largest steel manufacturer, faces a severe shortage of coking coal, which is a necessary ingredient for producing steel. Coal is heated in large ovens and after its impurities have been burned off, it leaves behind a very hard foam-like material called "coke." It's this coke that provides furnaces the consistent and very high temperatures required to convert iron ore into metal.
According to Macquarie Securities Group, JPMorgan Chase and Morgan Stanley, coal prices may surge between 23 to 38 percent in 2010.
Other risky sectors connected to commodities have surged too.
The SPDR S&P Metals & Mining (XME) gained around 94 percent in 2009. XME's performance is closely tied to companies that mine and produce industrial metals like aluminum, copper and zinc.
Along similar lines, the tiniest industry sector within the S&P 500 has been among its best performers. The Materials Select Sector SPDRs (XLB) shot ahead by roughly 53 percent.
Conclusion
Last year was a honeymoon for investors. After touching market lows not seen since the mid-1990s, global financial markets rocketed ahead. In what's usually a marketplace of diverse and contrasting performance returns, asset classes ranging from commodities to emerging markets, high yield bonds and frontier markets were all up big. Is the convergence in global asset returns cause for celebration or cause for caution?
Advisors should be quick to help their clients rebalance and strategically reposition the investments inside their portfolios to reduce risk.
The Volatility Index (VIX) is close to 52-week lows, which is a warning sign of investor complacency. The fear of losing money has become a distant memory for too many investors. VIX readings are sounding alarm, but is anyone paying attention?
Help your clients to lighten up on the risky assets and to diversify into areas that have less volatility. Once winds begin to kick up again, they'll be thanking you.
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