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Are You Ready For CEFL’s Year-End Rebalancing?

Summary The index for CEFL/YYY was last rebalanced in December 2014, and changes to the index were made public a few days before the event. Last year, heavy buying or selling pressure in particular index components forced CEFL/YYY to buy-high and sell-low, causing significant losses to CEFL/YYY unitholders. How will CEFL’s rebalancing be handled this year? Introduction The ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ) is a 2x leveraged ETN that tracks twice the monthly performance of the ISE High Income Index [symbol YLDA]. The YieldShares High Income ETF (NYSEARCA: YYY ) is an unleveraged version of CEFL. CEFL is popular among retail investors for its high income, which is paid out monthly. (Source: Pro Spring Team ) YLDA holds 30 closed-end funds [CEFs], and is rebalanced at the end of every calendar year. The changes were publicly announced on the ISE website on Dec. 24, 2014, or about five days prior to the rebalancing event. According to YYY’s prospectus (emphasis mine): Index constituents are reviewed for eligibility and the Index is reconstituted and rebalanced on an annual basis. The review is conducted in December of each year and constituent changes are made after the close of the last trading day in December and effective at the opening of the next trading day . As CEFL is an ETN, it is not forced to buy or sell the constituent ETFs, but one would imagine that the note issuer, UBS (NYSE: UBS ), would be inclined to do so to hedge its exposure of the note. Rebalancing shenanigans Unfortunately, CEFL/YYY unitholders were hurt by the rebalancing mechanism last year. I first noticed that something was wrong when CEFL fell -2.96% (and YYY -1.25%) on Jan. 2nd, 2015, a day where both stocks and bonds held relatively steady, and where the comparable PowerShares CEF Income Composite Portfolio ETF (NYSEARCA: PCEF ), an ETF-of-CEFs that tracks a different index, rose +0.21%. A bit of detective work on my part revealed that the CEFs that were to be added to the index received heavy buying pressure in the days between the index change announcement and rebalancing day, while the CEFs that were to be removed came under tremendous selling pressure. This caused the prices of the added CEFs to rise significantly during that period, which was topped off by an upwards price spike on rebalancing day, while the prices of the CEFs to be removed declined markedly in price, culminating in a downwards spike on rebalancing day. As a consequence, the index and hence YYY were forced to “buy high and sell low” on rebalancing day, causing about 1.3% of the net asset value [NAV] of YYY to be vaporized in an instant. This findings were presented in my Jan. 4th article ” Frontrunning Yield Shares High Income ETF YYY And ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN CEFL: Could You Have Profited ?” However, the pain was not over for CEFL/YYY holders. The upwards price spike of the CEFs to be added on rebalancing day occurred on top of the artificially-inflated prices caused by the buying pressure days before the actual event. After rebalancing, the added CEFs possessed premium/discount values dangerously above their historical averages, as I warned in ” Beware Reversion In YieldShares High Income ETF And ETRACS 2x Closed-End Fund ETN ,” leading to further losses as the premium/discount of those CEFs reverted back to their original levels. How much were CEFL/YYY investors hurt? How much were CEFL/YYY holders hurt by last year’s rebalancing mechanism? It is impossible to provide an exact number, but here is my estimate. The 10 added CEFs with the largest increases in allocation rose by 2.96% in one week, while the 10 with the largest decreases in allocation declined by -3.38% in one week (as presented in my Jan. 4th article). Assuming that CEFL is equally-weighted*, these events would have caused an overall 2.11% decline in asset value. Up to a further 1.25% was lost on rebalancing day due to price spikes. Moreover, the 10 CEFs that were added to the index declined by 1.26% two weeks after rebalancing as mean reversion possibly took place (as discussed in ” 2 Weeks Later: Did Mean Reversion Of CEFs Take Place? “), contributing a further 0.42% decline of the index, again assuming equal-weight. This sums to a 3.8% loss for YYY holders, or about a 7.6% loss for CEFL holders, not an insignificant amount. Note that this number is likely to be an underestimate because only the top 10 CEFs undergoing the highest increases and decreases in allocation were considered. In actuality, 19 funds were added, and 17 were removed. *(CEFL is actually not equal-weighted, but it is not entirely top-heavy either. See my Jan. 4th article linked above for details to the index weighting methodology). An alternative methodology for calculating the underperformance of CEFL/YYY is to simply compare the performance of YYY to PCEF, as both are ETFs-of-CEFs, but track different indexes. As analyzed in ” Has CEFL Done As Badly As It Looks? ” YYY underperformed PCEF by a total of 5.3% in the months of December and January, i.e. the months surrounding the rebalancing date. Although this approach is only approximate (as the exact composition of the two funds differ), it does produce a number that is on a similar order of magntitude as the 3.8% loss calculated with the first approach. Either way you cut it, a 4% or higher loss for the index/YYY (double that for CEFL, due to leverage) because of factors outside of “normal” market behavior hurts. Moreover, the fact that the index was forced to buy high and sell low necessarily results in a lower income for the fund going forward, as the fund would not have been able to purchase as many shares of the new CEFs than it “should” have been entitled to. Indeed, each share of CEFL paid out a total of only $4.03 in 2015, down from $4.40 in 2014, representing a 8.5% decrease in income paid for the year. I lost…so who won? So if CEFL/YYY unitholders were hurt during rebalancing, who profited? Most likely, it was the savvy investors who purchased the CEFs to be added to the index and shorted the CEFs to be removed as soon as the index changes became public. This could, in fact, include UBS themselves, who are free to adjust their hedges for CEFL anytime they like (because CEFL is an ETN rather than an ETF), and not only on rebalancing day. This creates an ironic situation in which the act of UBS adjusting their hedges at more favorable prices before rebalancing could have actually and directly hurt investors in their very fund. Why is this a problem for CEFL and not other funds? The main problem appears to be the lack of liquidity for CEFs, as well as the fact that arbitraging price differences for CEFs can be risky as they often trade at premium or discount values around their intrinsic NAV, meaning that it would be difficult for arbitrageurs to determine the “true” value of a CEF. An insightful comment from a reader in my previous article reveal that this has happened to other funds as well, and also illustrates a possible solution to this problem: [We] also had a FTSE 100 tracking fund run externally by a well known global indexing house. I recall at one index rebalance, said fund had a MOC order to buy one of the new index constituents, and ended up paying about 25% MORE than the prevailing market price was 1 minute before. All index tracking funds got completely shafted as guess what, the next day the stock was back down to the price it was before its index inclusion. … Some index managers get friendly brokers to ‘warehouse’ stocks (take them onto their own book) for a few days, buying them up ahead of inclusion in a particular index, the fund then takes an average price, and doesn’t get the shaft with a MOC order. It can lead to a bit of ‘tracking error’ mind you. This time it’s…different? As a CEFL unitholder and with the end of the year rolling around, I thought I would refresh myself on the rebalancing mechanism of the index YLDA to confirm exactly when the CEF changes would be announced, so that I could…uh…you know…get in on the frontrunning action and profit at the expense of fellow CEFL/YYY holders. Just kidding, I would have definitely shared this information with all my loyal readers! (Please do click the “follow” button next to my name if you haven’t done so already if you enjoy my ETF analysis.) So I fired up the YLDA methodology guide and looked for the rebalancing date… and looked, and looked…only it wasn’t there! I then checked the date of issue of the methodology guide: December 4th, 2015. So this couldn’t have been the guide I was reading when I was writing my earlier CEFL articles this year. Luckily, I had a version of the guide stashed in my downloads folder, and the relevant section (4.3) is dutifully reproduced below (emphasis mine): 4.3. Scheduled component changes and review ( OLD v1.2 ) The ISE High IncomeTM Index has an annual review in December of each year conducted by the index provider. Component changes are made after the close on the last trading day in December , and become effective at the opening on the next trading day. Changes are announced on ISE’s publicly available website at least five trading days prior to the effective date . How does this compare with the current version of the methodology (emphasis mine)? 4.3. Scheduled component changes and review ( NEW v1.3 ) The ISE High IncomeTM Index has an annual review in December of each year conducted by the index provider. The index employs a “rolling” rebalance schedule in that one third of component changes are implemented at the close of trading on each of the first, second and third trading days in January of the following year and each change becomes effective at the opening on the second, third and fourth trading day of the new year, respectively. No prizes for spotting the difference! Not only has the statement about the announcement of changes been removed, the rebalancing is now not performed all at once at the close of the last trading day in December, but is now equally spread through the first, second and third trading days of the following year. I then used the free PDF comparison tool ( DiffPDF ) to scan for any additional changes to the methodology between last and this year’s. Besides being nearly foiled by the addition of two blank pages in this year’s edition, the software showed that, besides the aforementioned change in Section 4.3, a similar statement to the above had been removed from the index description in Chapter 2: Chapter 2. Index Description ( bold sentence in OLD guide only ) Companies are added or removed by the ISE based on the methodology described herein. Whenever possible, ISE will publicly announce changes to the index on its website at least five trading days in advance of the actual change . No changes were made to the constitution or weighting mechanisms of the fund. Appendix B of the current document lists the entirety of the changes as “Rebalance revision (4.3).” What does this mean for investors? Analysis of the old and new methodology guide reveals two major changes: The changes to the index will not be public beforehand. Instead of rebalancing the components all at once, the rebalancing will be conducted in three equal parts spread across three days. What does this mean for investors? I believe that the first change is well-intended, but may ultimately prove fruitless. The methodology for index inclusion and weighting is relatively complex, but is publicly available (it’s found in the methodology document), and I have no doubt that professional investors will be able to determine the changes even before they happen. In fact they may be doing this right now as I am writing this, and also later, when you are reading this. The second change is, I believe, a positive one, but only if it means one of two possible ways that one could construe “one-third.” The guide states that ” one-third of component changes are implemented… on each of the first, second and third trading days in January .” So if 10 CEFs have to be added to the index, does it mean that 33.3% of the total dollar value of the 10 CEFs will be purchased on each of the three days? In this case, the liquidity situation will be improved because each CEF will be purchased over three days. This would decrease the likelihood of a price spike occurring upon rebalancing (presumably by YYY, the ETF), which ameliorates the buy-high sell-low situation faced by the index last year. If instead, it means that 4 CEFs will be 100% purchased on the first day, 3 on the second, and 3 on the third, then unfortunately I don’t think that the liquidity situation will improve, as the trading in each CEF is still going to be concentrated in a single day, despite the fact that different CEFs may be spread out on different days. What do readers think about how this sentence should be interpreted? So, it appears that this time may actually be different. However, personally, I’m not waiting around to find out. I’ve recently sold all but a single share of CEFL to keep my interest in the fund, and replaced it with several better-performing CEFs (such as the PIMCO Dynamic Income Fund (NYSE: PDI )), as recommended in Left Banker’s article here .

Proposed Allocation

Two weeks ago I wrote an article on Seeking Alpha discussing the ETFs that will comprise the core of our future portfolio . My goal, in all aspects of my life, is to always be learning and growing. Part of that process is to challenge myself and my ideas. My wife and I have run a bifurcated portfolio , comprised almost exclusively of individual stocks, for the past several years. While I thoroughly enjoy researching and valuing companies currently, I can see that the day is coming when I’ll want to be a much more passive investor. I anticipate achieving semi-retirement a couple years out, and at that time I’d like to transition to a portfolio which is maybe 30% individual stocks… with the rest being index ETFs and cash. Recently, I have begun to think it’s arrogant to think that our portfolio of (mostly) individual stocks can provide the diversification we require… while ‘not’ also requiring a great deal of time to manage. I also received a few comments and emails last week asking me why I wasn’t just proposing a portfolio of strictly ETF and index funds. I want to retain 20% to 30% of the portfolio in individual funds, because there are some truly amazing companies available to the investing public. I expect these companies to compound our capital for decades to come! So why not just invest in these amazing individual companies?! Two reasons: 1) I may be wrong, and it’s pure arrogance to think otherwise; and 2) I don’t believe there are enough of these truly amazing companies, that I could build a diversified portfolio out of them… even if I had the time to manage it. Simply put, I am looking to strike the right risk/reward balance. With that background expressed, below is my desired portfolio allocation. Please note that this includes my wife’s and my capital, as well as the trust fund we set up for our children. 25% Individual Stocks 20% Cash (or cash equivalents)* 15% Vanguard Total Stock Market ETF (NYSEARCA: VTI ) 15% Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) 15% Vanguard FTSE All-World ex-U.S. ETF (NYSEARCA: VEU ) 10% Vanguard REIT ETF (NYSEARCA: VNQ ) *Reduced by 10% when bonds re-enter our portfolio Individual Stocks First, let’s talk about what these categories mean. Within Individual Stocks, I mean both the amazing companies I want to hold for the long term (like Union Pacific (NYSE: UNP ), Visa (NYSE: V ), Coca-Cola (NYSE: KO ), etc.) and the “Deep Value” opportunities that present themselves from time to time. While these “Deep Value” opportunities usually manifest themselves as small and under-reported companies, they can also take the form of commodities or alternatives. Agricultural commodities are looking interesting to me today and gold will likely be appealing in a few months. My intention with this group is that the vast majority of this group be long term holdings… and the remainder be allocated toward alternatives and deep-value trades. Bonds You may have noticed, correctly may I add, that our portfolio will not have a bond allocation for the foreseeable future. Given our young age, mid-thirties, and the ultra-low interest rates… we have chosen to shift any bond allocation to other areas of our portfolio. If rates were to suddenly jump a tremendous amount, it’s possible bonds could join our portfolio… but it’s not likely for the foreseeable future. U.S. Stocks The next question I am likely to receive surrounds how we could only allocate 15% to U.S. Stocks (in the form of Vanguard’s Total Stock Market ETF ( VTI )). I will be quick to point out that the ‘vast’ majority of the individual stocks we invest in, are in fact US stocks. Therefore, it’s reasonable to assume that nearly 40% (25% individual stocks and 15% VTI) will be invested in U.S. stocks. Given that I am paid in U.S. dollars and the property we own is in the U.S., I don’t feel like we are short-changing our homeland. Around 40% of the world’s global equity capitalization is sold on U.S.-based markets. Therefore, I feel my U.S. stock allocation is right where I want it to be, especially when you back cash out of the equation. Emerging Markets I frequently receive email questions concerning why I think Emerging Markets are so well-represented in our portfolio. The simple fact is that the majority of global growth will come from countries which are now called “emerging”. Around most of the developed world, populations are barely growing… if they are growing at all. However, the populations of “emerging” markets are growing much more rapidly. There is some elevated risk that those local governments won’t enforce the rule of law, or more likely that those governments will nationalize your investment, but I think that is a risk in developed countries as well… just a little bit smaller risk. Foreign Stocks There are a ton of companies in this world, with plenty of market capitalization to go with them. To gain exposure to these markets, we will utilize Vanguard’s FTSE All World ex-U.S. ETF ( VEU ). It is important to note that nearly one-fifth (18%) of this ETF is comprised of companies from emerging market economies, so there is this overlap. The rest of the ETF is comprised of companies from developed counties (like Germany, the U.K., Japan, etc.). Real Estate Cash-flowing real estate can be a great investment. Unfortunately, our investable capital is not enough to purchase a diversified real estate portfolio in our part of Florida. We can, however, invest in real estate through Vanguard’s REIT ETF ( VNQ ), with the added benefit of instant diversification and much-improved liquidity. If I had the time and inclination to be a full-time landlord, I would prefer to go that route… but it seems unlikely on any large scale. So, with the funds listed above, we intend to transition to a simpler… and less time consuming… investment approach. Last week, I sent an email out to our subscribers discussing which current investments I was looking to rotate out of in the coming months. I also identified a few of the investments I shouldn’t have made, as I think it’s important to learn from our mistakes. If you would like to receive emails like these in the future, sign up for our email list by completing the box on the right side of our homepage. I hope this holy week is fully of good times and great memories for you all. Take care. What do you think of our allocations, and how do they compare to your own? Disclosure: Long VWO, KO, UNP, V. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. The information above can be found at Vanguard.com.

Valuation Dashboard: Energy And Materials – Update

Summary 4 key fundamental factors are reported across industries in Energy and Basic Materials. They give valuation status of an industry relative to its historical average. They give a reference for picking stocks in each industry. This is part of a monthly series of articles giving a valuation dashboard in sectors and industries. The idea is to follow up a certain number of fundamental factors for every sector, to compare them to historical averages. This article covers Energy and Basic Materials. The choice of the fundamental ratios used in this study has been justified here and here . You can find in this article numbers that may be useful in a top-down approach. There is no analysis of individual stocks. You can refine your research reading articles by industry experts here . A link to a list of stocks to consider is provided in the conclusion. Methodology Four industry factors calculated by portfolio123 are extracted from the database: Price/Earnings (P/E), Price to sales (P/S), Price to free cash flow (P/FCF), Return on Equity (ROE). They are compared with their own historical averages “Avg”. The difference is measured in percentage for valuation ratios and in absolute for ROE, and named “D-xxx” if xxx is the factor’s name. For example, D-P/E = (AvgP/E – P/E)/AvgP/E. It can be interpreted as a percentage in under-pricing relative to a historical baseline: the higher, the better. It points to over-pricing when negative. ROE is already a percentage. A relative variation makes little sense. That’s why we take the simple difference: D-ROE = ROE – AvgROE. The industry factors are proprietary data from the platform. The calculation aims at eliminating extreme values and limiting the influence of the largest companies. These factors are not representative of capital-weighted indices. They are useful as reference values for picking stocks in an industry, not for ETF investors. Industry valuation table on 12/21/2015 The next table reports the 4 industry factors. For each factor, the next “Avg” column gives its average between January 1999 and October 2015, taken as an arbitrary reference of fair valuation. The next “D-xxx” column is the difference between the historical average and the current value, in percentage. So there are 3 columns relative to P/E, and also 3 for each ratio. P/E Avg D- P/E P/S Avg D- P/S P/FCF Avg D- P/FCF ROE Avg D-ROE Energy Equipment&Services 20 24.2 17.36% 0.72 1.73 58.38% 8.65 35.34 75.52% -10.91 7.34 -18.25 Oil/Gas/Fuel 14.93 18.53 19.43% 1.65 3.35 50.75% 15.48 29.03 46.68% -15.55 4.47 -20.02 Chemicals 18.3 18.48 0.97% 1.31 1.21 -8.26% 35.82 25.37 -41.19% 8.71 6.74 1.97 Construction Materials 51.27 21.44 -139.13% 1.36 1.16 -17.24% 58.56 40.5 -44.59% 9.34 5.77 3.57 Packaging 21.58 17.96 -20.16% 0.91 0.61 -49.18% 23.15 20.09 -15.23% 18.23 8.34 9.89 Metals&Mining 19 19.83 4.19% 1.2 2.65 54.72% 13.94 25.53 45.40% -19.39 -8.6 -10.79 Paper&Wood 30.98 21.27 -45.65% 0.92 0.72 -27.78% 21.8 22.81 4.43% 8.35 4.99 3.36 The following charts give an idea of the current valuation status of Energy and Materials industries relative to their historical average. In all cases, the higher the better. Price/Earnings : Price/Sales : Price/Free Cash Flow : Quality (ROE) Relative Momentum The next chart compares the price action of the SPDR Select Sector ETF in Materials (NYSEARCA: XLB ) and energy (NYSEARCA: XLE ) with SPY (chart from freestockcharts.com). (click to enlarge) Conclusion In one month, XLE has fallen by 11.3% and XLB by 6.3%, both underperforming SPY by a wide margin. The reason is obvious looking at WTI oil price: it hit last week a level not seen since the second half of 2003. In this meltdown, the five more resilient S&P 500 stocks in Energy and Materials on a 3-month period are Airgas Inc (NYSE: ARG ), Chevron Corp (NYSE: CVX ), E. I. du Pont de Nemours (NYSE: DD ), Tesoro Corp (NYSE: TSO ), Valero Energy Corp (NYSE: VLO ). The two latter are refiners. Oil price is not a major driver of their profitability, and concerns about a possible end of the crude oil export ban seem to disappear. The improvement in valuation ratios for all industries of these sectors since my last update is just a consequence of lower stock prices. The harder the fall, the better the “improvement”. It is not a signal that things are really improving for oil and gas companies. It is even the opposite: the quality measured by the ROE industry factor went down. As a group, energy and metal/mining are looking like a nest of value traps: the 3 valuation ratios point to underpricing, whereas the quality factor (D-ROE) is deep in the red and worsening. This is not true for all the oil industry: we have seen that refiners are doing quite well and several of them have hit an all-time high in November. Some of them are also in the very best of the S&P 500 in my value and quality-based screens. No industry in these two sectors looks globally very attractive. However, comparing individual fundamental factors to the industry factors provided in the table may help find quality stocks at a reasonable price. The next table shows a list of stocks in the Energy and Basics Materials sectors. They are all cheaper than their respective industry for 3 valuation factors simultaneously: Price/Earnings, Price/Sales, Price/Free Cash Flow. Then they are selected for their higher Return on Equity. This screen updated and rebalanced monthly has an annualized return about 17% and a drawdown about -65% for a 17-year backtest. The corresponding sector ETFs XLE and XLB have an annualized return of respectively 8.32% and 6.79% on the same period. Past performance, real or simulated, is not a guarantee of future return. This list may be considered an entry point for further due diligence, or as a portfolio after adding a few trading rules and market timing. This is not investment advice. Do your own research before buying. ATW Atwood Oceanics Inc. ENERGYEQUIP DOW Dow Chemical Co (The) CHEM EMN Eastman Chemical Co CHEM IOSP Innospec Inc CHEM KS KapStone Paper & Packaging Corp FORESTRY LYB LyondellBasell Industries NV CHEM REX Rex American Resources Corp OILGASFUEL TSO Tesoro Corp OILGASFUEL VLO Valero Energy Corp OILGASFUEL WNR Western Refining Inc OILGASFUEL If you want to stay informed of my updates on this topic and other articles, click the “Follow” tab at the top of this article.