EMLC and BKLN to Reduce Cash

[bigoilboomer]

I have a client account (IRA at Interactive Brokers) that's currently:

15.6% IVV
6.1% IWM
14.9% IEFA
6.0% IEMG
11.4% TLT
12.9% GLDM

66.9% total
33.1% remaining in T-bills

I feel like I can do something better with cash than stick it in T-bills. I considered—

44.6% IEI instead of 11.4% TLT

100% total
0% remaining in T-bills

Duration stays the same. But I kind of prefer long-term Treasuries over intermediate-term.

The only other way I could think of to reduce the cash position is—

10.7% EMLC instead of 6.0% IEMG
18.0% BKLN instead of 6.1% IWM

83.5% total
16.5% remaining in T-bills

Is this a bad idea?

[bigoilboomer]

I plugged EMLC (emerging market local currency bonds) and BKLN (senior loans) into my investment model to replace IEMG (emerging market stocks) and IWM (Russell 2000). The Sharpe ratio, utility score, and alpha improve a little bit. But skew gets more negative and kurtosis goes up a bit too.

Losses are bigger in a liquidity crisis—e.g. March 2020. But if you don’t panic and run for the exits, it looks like you can capture a little more long-term alpha from credit securities.

Alpha would be higher if not for the expense ratios—0.30% for EMLC and 0.65% for BKLN. Even though they’re index funds, I’m not sure you’d get any money back from securities lending.

[nisiprius]

EMLC = VanEck JP Morgan EM Local Currency Bond ETF (emerging markets bonds)
IEMG = iShares Core MSCI Emerging Markets ETF (emerging markets stocks)

BKLN = Invesco Senior Loan ETF (bank loans)
IWM = iShares Russell 2000 ETF (small-cap stocks)

...I feel like I can do something better with cash than stick it in T-bills...

It's usually hard to do much better, and it can even be dangerous when people are not seeing risk, rather than seeing and accepting risk.

You'd expect "the going rate" for a risk-free investment to be well-defined and hard to beat. If two investments have virtually no risk, then the only difference is return, and you'd expect in a competitive market that everyone would quickly migrate to the highest-paying option and that nobody could pay much less than "the going rate" or they would not find any buyers.

Of course there are always exceptions. Banks may pay less than "the going rate" when they don't need buyers, i.e. they have enough deposits. Series I savings bonds may be more than "the going rate" because they are not marketable bonds and are not competing in a market, and are provided as a public service.

But usually, if something is paying meaningfully more than T-bills or money market mutual funds or competitive bank accounts, there is risk and you need to be sure you know what it is and why you are willing to take it. The worst case is that there is risk there and that you are not seeing it. Examples would be auction rate securities in 2006-2007, the Schwab YieldPlus fund and the Fidelity Ultrashort Bond Fund in that same time period.

Source



The big question I have is that at the quickest glance EMLC and BKLN obviously have had far more risk than cash. They are not cash-like at all! So the obvious question: if you are happy to take that much risk, why haven't you been holding them all along?

With regard to EMLC, please forgive me if you already know all about this, but the one historical fact that everyone needs to know about emerging markets debt is: "1998."



That's the Fidelity New Markets Income Fund, one of the few EM bond funds that existed at that time, but e.g. the Morningstar category average for emerging markets debt does exactly the same thing. It is unfortunate that this even is outside the 10-year view shown in mutual fund and ETF data, and that many emerging market products don't go back that far and thus 1998 can escape notice.

Is this a bad idea?

That depends entirely on your reasons for holding cash before, and your reasons for holding something far riskier now.

I'm risk-averse and invest in simple ways, and I have a strong personal preference for reducing risk by holding things that are intrinsically low-risk--like series I savings bonds--as opposed to 1) looking for (allegedly) lower-risk things in a higher risk category (e.g. low volatility stocks), or 2) constructing financially-engineered machinery that combines high-risk things whose risk pulls in (allegedly) counteracting directions (e.g. stocks and long-term bonds).

[bigoilboomer]

The big question I have is that at the quickest glance EMLC and BKLN obviously have had far more risk than cash. They are not cash-like at all! So the obvious question: if you are happy to take that much risk, why haven't you been holding them all along?

Forgive me for the confusion. So the current cash position is 33.1% of the portfolio. I could eliminate it completely by replacing my 11.4% TLT (long-term Treasuries) position with 44.6% IEI (intermediate-term Treasuries). Duration, risk, and return for the entire portfolio would be nearly the same.

Or I could try to reduce some cash by investing in 10.7% EMLC instead of 6.0% IEMG. The idea is that EMLC is less risky than IEMG, so I use up some cash to buy a lot of EMLC that replaces the IEMG position in my portfolio. Bigger EMLC position replaces smaller IEMG position (delta weighting). EMLC isn't replacing my cash position.

Same for 18.0% BKLN instead of 6.1% IWM.

10.7% - 6.0% = 4.7%
18.0% - 6.1% = 11.9%
4.7% + 11.9% = 16.6%

Thus my 33.1% cash position is reduced by 16.6% and becomes 16.5% of the total portfolio. This difference is because I'm now using credit bonds instead of emerging market and small-cap stocks.

Total portfolio volatility is very roughly similar. The difference is in the big tail events, as you pointed out.

[bigoilboomer]

With regard to EMLC, please forgive me if you already know all about this, but the one historical fact that everyone needs to know about emerging markets debt is: "1998."



That's the Fidelity New Markets Income Fund, one of the few EM bond funds that existed at that time, but e.g. the Morningstar category average for emerging markets debt does exactly the same thing. It is unfortunate that this even is outside the 10-year view shown in mutual fund and ETF data, and that many emerging market products don't go back that far and thus 1998 can escape notice.

The EMF fund (emerging market stocks) also had a 65% drawdown during that time. The graphic above looks like a 41% drawdown in emerging market bonds.

So if I use the previously mentioned weights—

IEMG: 6.0% of portfolio × 65% drawdown = 3.9% drawdown

EMLC: 10.7% of portfolio × 41% drawdown = 4.4% drawdown

There's some difference there, as there should be in liquidity events. Hopefully that 0.5% difference is made up for in additional return for credit bonds over the long term.