Book Review: Invest with the Fed
Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy. 2015. Robert R. Johnson, CFA, Gerald R. Jensen, CFA, and Luis Garcia-Feijóo, CFA, CIPM.
Readers may be “fed up” with the thought of another “Fed watch” book. Many have appeared over the decades, and the good ones are rare. Standouts include two by David M. Jones — Fed Watching and Interest Rate Projections: A Practical Guide (New York Institute of Finance, 1989) and Unlocking the Secrets of the Fed (Wiley, 2002). Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy differs from some of its predecessors in that it is written for serious investors by a fine team of CFA charterholders and goes far beyond the projection of interest rates. Each of its authors has extensive experience as a professional investor or financial academic, much like Professor Jones. Additionally, each has long-standing ties with CFA Institute and exhibits a commitment to its educational efforts and outreach. This book is a tribute to serious, well-tempered investing and opens doors to many new ideas that should appeal even to the most seasoned practitioner who has “seen it all.”
The authors acknowledge that all one needs to implement the book’s recommended strategies is a cursory knowledge of the security markets. The more readers know, however, the better they will succeed in capitalizing on the strategies, which are introduced at a steadily increasing pace throughout the book.
Invest with the Fed provides overwhelming evidence that heeding the Fed’s signals can enhance portfolio performance. Yet many financial professionals misinterpret or incorrectly apply the signals by responding too early or too late or by selecting the wrong asset classes or strategies. The authors explain that in 1977, Congress formally recognized the Fed’s monetary objectives by giving it a dual mandate of promoting maximum employment and maintaining price stability. In this context, monetary conditions can be described as expansive, restrictive, or indeterminate. Each of these conditions has been in place about a third of the time since 1966. Under the successive leadership of Alan Greenspan, Ben Bernanke, and Janet Yellen, the Fed has made it easier for investors — provided they know what to look for — to understand the reasons behind adjustments in monetary policy in pursuit of the dual mandate.
Johnson, Jensen, and Garcia-Feijóo analyze the impact of Fed policy and monetary conditions by security type and by strategic component within the portfolio and then, in the last chapter, present an overall investment strategy. They begin with a long-term analysis of the performance of stocks (the S&P 500 Index), bonds (10-year Treasury notes), and one-month Treasury bills (representing money market securities) under a variety of monetary conditions and in terms of annualized total return. The charts accompanying the analysis follow a consistent format throughout the book, training the reader’s eye regarding what to look for. Risk for all asset classes is tracked through standard deviation. These presentations represent infographics at their best for practicing security analysts, strategists, portfolio managers, and hedge fund managers.
The authors provide backtested proof of success in investing in equities side by side with the Fed. Discussions of style investing and equal weighting versus value weighting prove to be natural expansions of the initial discussion of stocks. The authors address such style extensions as the “Dogs of the Dow” and international stock investing in innovative ways, uncovering unexpected results through their backtests. For example, they show that Scandinavian stocks outperform stocks of other regions, with similar risk, under both expansive and restrictive monetary conditions.
Many investors are familiar with sector rotation strategies, but they will be startled to see the magnitude of the advantage over a buy-and-hold strategy that simple rotation strategies produce — and how performance can be enhanced even further with the addition of commodities. This analysis creates the potential for achieving high returns accompanied by low correlations with stocks.
The chapter dealing with fixed-income analysis under various monetary conditions will leave many readers wishing for more. Although all risk classifications across the maturity spectrum are addressed, neither international bonds nor credit upgrade and downgrade candidates are introduced. Still, the fixed-income chapter is a critical component of the book’s mission to explain how to invest successfully with the Fed. It documents performance that runs contrary to the general pattern of equities (except for high-yield bonds) and that includes a high percentage of positive months, even in a restrictive monetary environment.
Johnson, Jensen, and Garcia-Feijóo address hedge fund investing in a unique yet simple way. They investigate several hedged positions:
A long position in small-cap stocks and a short position in large-cap stocks (the small-minus-big [SMB] portfolio)
The value premium portfolio (constructed like the SMB portfolio)
The small-value-minus-big-growth (SVMBG) portfolio
The investment horizon for these hedging strategies is not determined beforehand. Instead, the trade is unwound when the monetary environment changes. The authors supply appropriate exchange-traded funds and exchange-traded notes to help readers create their own hedges.
Readers will be delighted to see how all the analysis and backtesting draw the book to its conclusion, with the laying out of investment strategies for each type of monetary environment. Equity rotation is the foundation, enhanced by style investing, foreign equities, and alternative assets. By intention, none of the strategies include fixed income. The authors believe that the returns of fixed-income securities are relatively invariant to the monetary environment. After finishing this chapter, readers will be inspired to begin implementing the strategies because at that point, they will have all the analytical guidance they need to make a huge, positive difference in portfolio performance over long periods, across economic cycles, and under a variety of monetary conditions.
The book’s crown jewel is the appendix, “Why Interest Rates Matter.” Given the Fed’s major impact on investor sentiment, readers should start with the appendix, not with Chapter 1 (“Fed Monetary Policy and the Performance of Traditional Asset Classes”). Interest rates affect the value of all assets, influence business profits, and determine the appeal of borrowing on margin.
Rates also affect the attractiveness of newly issued securities, especially fixed-income securities, compared with seasoned securities available in the secondary market. The current phenomenon of newly issued long-term investment-grade bonds yielding next to nothing — and actually delivering negative returns — in a low-interest-rate environment brings home the point. In such a scenario, stocks appear to offer better value, based primarily on earnings yield. As investors emerge from a low-interest-rate world — as anticipated by the minutes of the Federal Open Market Committee — the valuation exercise becomes much more difficult because no one knows precisely when the ascent of interest rates will begin, what will trigger it, and at what pace it will occur.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.