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Which Low Volatility ETFs Will Protect Your Portfolio?

Stock markets world-wide have been in turmoil over the past few weeks. While panic selling was initially triggered by currency devaluation in China, anemic global growth and uncertainty related to rate hike by the Fed, have added to investors’ concerns. Low-volatility ETFs are designed for investors who want exposure to stocks but do not want to take on too much risk. These products have become extremely popular over the past few years since historical performance revealed that low-risk stocks have rewarded investors with higher return than high-risk stocks as well as the broader markets over long-term, in all the markets studied. This outperformance suggested that that investors actually misprice risk. Did these low-volatility ETFs deliver on their promises during the past month, which by some measures, has been the one of the most volatile on record. Now may be a good time to revisit these products and see whether they deserve a place in investors’ portfolios. And, while a number of products are available to investors, there are significant differences in their strategies and investors should understand them properly before investing. There are more than 30 low- and minimum-volatility ETFs available to investors, focused on different styles (large/mid/small cap), geographical regions (U.S./Developed/Emerging/Europe/Japan) and strategies (low/minimum volatility/volatility weighted/risk weighted etc.). In this article, we focus on the two ultra-popular U.S. large cap low volatility ETFs – the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) and the PowerShares S&P 500 Low Volatility Portfolio ETF (NYSEARCA: SPLV ) . Here’s a snap shot of these two ETFs and the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Yield Expense Ratio Beta Standard Deviation (Annualized)* 1 Month Return 1 Year Return Upside Capture Ratio (3 Y)** Downside Capture Ratio (3 Y)** USMV 1.96% 0.15% 0.78 10.44% -5.99% 6.27% 84.38 71.72 SPLV 2.50% 0.25% 0.80 11.55% -6.45% 4.71% 80.25 72.81 SPY 2.10% 0.09% 1.00 12.37% -6.93% -0.10% 99.75 100.76 *Calculated from daily price returns for the past 3 years **Source: Morningstar Approach to Managing Volatility SPLV holds 100 stocks from the S&P 500 Index with lowest realized volatility over the past 12 months, which means SPLV takes into account volatility of individual stocks to arrive at the low- volatility portfolio. The index is rebalanced quarterly. USMV holds 163 stocks that, in the aggregate, have lower volatility than the broader U.S. stock market. The underlying index uses Barra Optimizer to build a portfolio with the lowest absolute volatility, taking into account, variances of individual stocks as well as covariance of all stocks, with a certain set of constraints. In simple words, this ETF uses correlations between stocks in addition to volatility of individual stocks in arriving at the portfolio. The index is rebalanced semi-annually. Performance Did low volatility ETFs provide some comfort to the portfolio during wild market swings? It seems that they did deliver on their promises. During the one month period ended September 11, when the market was very unstable in the wake of China growth concerns, low volatility ETFs fell less than the broader market. And over the past one year, when the broader market returns were almost flat, both these ETFs had much better performance. Further, both the ETFs had lower volatility compared to the broader market. Looking at risk and returns, USMV had better performance compared with SPLV. One of the reasons is USMV’s significantly higher allocation to Healthcare-which has been the best performing sector among all S&P sectors over the past few years. Over the past three years, USMV and SPLV had upside capture ratios of 84.38% and 80.25% and downside capture ratios of 71.72% and 72.81% respectively. These ratios show how much these ETFs gained and lost compared to the S&P 500 index, during periods of market strength and weakness. So, when the market was rallying, USMV was able to capture 84.38% of the upside but when the market went downhill, its losses were limited to 71.72% of the broader market’s decline. In simpler words, with low volatility strategies investors sacrifice some upside but protect themselves from a lot of downside. Preparing for Higher Rates While the Fed has been priming the markets for its first rate hike in almost a decade, it now appears that they may keep the monetary policy unchanged this week, in view of ongoing turmoil in global markets. Investors, however, should be prepared for higher rates now since with improving labor markets, the Fed may not hold off a rate hike for a long time. They should keep an eye on their allocations to rate sensitive sectors. Locking at the interest rate sensitivity of the two products, both are currently largely focused on sectors that tend to perform well in rising rates environments and have rather low exposure to Utilities and Telecom sectors that are quite rate sensitive. SPLV has 35% of assets invested in Financials, 15% in Industrials and 11% in Healthcare. However, SPLV’s 22% allocation to Consumer Staples may hurt its performance when rates rise. USMV has invested 20% of its asset base in Healthcare, 18% in Financials and 15% in Information Technology sectors. For investors concerned about rising rates, PowerShares recently launched the PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (NYSEARCA: XRLV ) , which is worth a look. This ETF holds 100 stocks from the S&P 500 index with low volatility characteristics, and removes stocks that historically have performed poorly in rising interest rate environments. The Bottom-Line Looking at the two ultra popular ETFs in the space, it appears that USMV has beaten SPLV, with higher returns and lower volatility. Further, USMV is cheaper than SPLV. Overall, both ETFs are effective tools for reducing overall portfolio risk and improving risk-adjusted performance over longer term. At the same time, investors should remember that these strategies underperform in strong bull markets. Link to the original post on Zacks.com

Royce Micro Cap Trust: A Tough Year, But Sticking To What It Knows

RMT is a value-focused micro-cap CEF. A while back, I compared the fund to its open-ended sibling, RYOTX. Although it’s been a bad year for RMT, that’s not surprising and may actually open up a buying opportunity. The Royce family of open- and closed-end funds is managed with a bottom-up value approach. Historically, that’s been a great niche, but more recently, it’s been a performance drag. But if you are looking for a closed-end fund, or CEF, that has a value focus and invests in micro-cap stocks, I still think Royce Micro Cap Trust (NYSE: RMT ) should be on your short list. What does Royce do? The goal for every Royce fund is to find companies with strong balance sheets and the potential for above-average returns. Some of the attributes Royce looks at when examining a company include operating leverage, returns on capital, return on assets, operating dynamics, and the sustainability of its business model. Another key factor, however, makes it more difficult to find stocks to buy when the market has been heading higher for several years: Royce also wants market prices that are 30-50% below what it believes a company is worth. So it is, then, that RMT’s annualized trailing five-year net asset value, or NAV, return through August was roughly 12.8%, while the return of the Russell 2000 was a more robust 15.6% or so. By design, the Russell 2000 will have a blend of growth and value names. However, looking further back, the annualized trailing 15-year NAV return for RMT was 8.1% through August, compared to the Russell 2000’s gain of only 6.7%. (All number include reinvested distributions.) That should bring to mind the saying that the market is a voting machine over short periods, but a weighing machine over long periods. Which is exactly what RMT is all about, trying to find the stocks that have been voted “off the island” in the near term, but that still have long-term appeal. And sticking to that focus can lead the fund to underperform in bull markets. Did something just change? So far this year, it’s been no different. Year to date through August, RMT’s NAV is down 10.5% while the Russell 2000 is down only 3% or so. That’s not surprising, since, as noted, Royce sticks to its approach no matter what’s going on in the broader market. That’s exactly what a long-term investor in RMT and other Royce funds should want. But it can be hard to sit back and watch your fund underperform in the near term even though historical numbers suggest, though of course don’t guarantee, it will all turn out okay in the long term. Which helps explain why RMT’s market price declined around 14.5% through August, as investors got scared off by the laggard showing. In fact, the fund’s discount to its NAV currently sits around 15%, compared to a three-year average of around 12%. That’s a fairly deep discount for what is really a well-run fund, but shows pretty clearly that investors are worried about its performance numbers. And what about that market sell-off last month? It made things worse. At least on an absolute basis… which is worth looking at. RMT’s NAV fell 4.3% or so in August. But that marked a reversal from the trend, because the Russell 2000 fell 6.3% in the month. That’s only two percentage points, but it’s a big difference from what’s been happening recently. And once again, I’d attribute that to the fund’s value focus. Since it buys undervalued stocks, the steepening market downturn has had less of an impact. Indeed, the early-year performance of many of its holdings suggest that the portfolio had already felt the sting of the market shifting gears. In the final days of a bull market, investors tend to refocus around high-flyers, leaving other names behind. But eventually, those loved stocks also succumb when the market turns en masse. In fact, the most loved names on the upside often turn into the least loved on the downside. Value stocks, meanwhile, are usually always kind of unloved until their fundamentals shine through. But at the end of the day, RMT is trading at a wider discount than normal and has been doing better, at least on a relative basis, than the broader market as volatility has kicked up. Exactly what I’d expect from a value-focused micro-cap fund. Will it continue to hold up better? Hard to tell. But I know management will remain true to its investment focus. If we are entering a market downturn, that should serve investors well. The problem spots? So, stepping back from the last month or so of relative outperformance, what’s been going on at the fund? Looking back at the first six months of the year, lead manager Charles Royce noted that the fund’s consumer discretionary, healthcare and information technology holdings were laggards relative to the same sectors within its benchmark indexes. And that was pretty much all stock selection. For example, the fund has little exposure to biotechnology stocks, which have been on a tear in recent years. But, as Royce notes , “Most biotech companies, however, lack the fundamental attributes we seek in our holdings.” It’s the perfect example of the fund sticking to what it does, even if the market is favoring other investments. And while the next update won’t come out until after the end of the third quarter, I wouldn’t expect the theme here to change. In the end, it’s been a rough stretch for RMT. But if you have a long-term focus, don’t get too discouraged. Value investing goes in and out of favor over time, and the recent bull market, which has at least taken a breather if it hasn’t turned into a bear, has been tough for value investors like Royce. That doesn’t change the fact that RMT is a well-run fund. In fact, if you are in the market for a micro-cap value fund, now might even be a good time to start picking up some shares. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

IBB: Trees Don’t Grow To The Sky

Summary The collective market capitalization of the biotech index is disconnected from actual sales. Given the huge U.S. Federal deficit (now $18 trillion) and skyrocketing healthcare costs, the costs of biotechnology drugs are unsustainable. The U.S. spends far more than other developed nations for healthcare as a percentage of GDP and on a per capita GDP basis. Unless you are reading the children’s story, Jack and the Beanstalk, the last time I checked, trees don’t grow to the sky. Evidently, the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ) didn’t get the memo. Let me be clear, I don’t have a science background. So my angle and perspective aren’t derived from actual industry experience or academically grounded. However, as an investor, I don’t need to be able to build the watch, I simply need to tell what time it is. Through a series of charts, common sense, and a general awareness of the world around me, I will lead the reader towards the notion that IBB is priced for perfection. That said, I am not discounting or doubting the remarkable innovation and scientific breakthroughs that are occurring in this gilded age of biotechnological. Rather, I’m simply suggesting the collective valuation is a disconnected sanity. Here are some high level statistics on U.S. healthcare spending. In 2013, U.S. healthcare spending was 17.4% of GDP, or $2.9 trillion. (click to enlarge) Here is a chart comparing per capital spending versus other major industrialized nations: (click to enlarge) Here is another chart depicting spending as a percentage of GDP. As you can clearly see, U.S. spending is off the charts: Source Here are the top holdings within IBB. I also added the rounded market caps. of each top holding (as of September 11, 2015). (click to enlarge) Source: IBB website Although I am much more concerned about IBB than big pharma, I included some of the major pharma names for perspective. The names below cumulatively have $1.7 trillion, that’s with a “T”, in market caps. This doesn’t include their debt as big pharma has been known to issue a lot of low interest rate debt to finance share buybacks and pay sporty dividends. (click to enlarge) Source: Google Finance Over the past five years, IBB has climbed 319% or $270 per share. Wow! (click to enlarge) Source: Google Finance Here is a detailed version of the U.S. healthcare spending: (click to enlarge) Here are the top global drug sales by specific drug and then ranked by the type of therapy area: Source: American Chemical Society Here is why IBB is overvalued and vulnerable to a sharp pullback. Essentially, there is a recognition and ground swell by members of the medical community that drug costs are unsustainable. Given that the government and private health insurers negotiate the prices for these drugs, I’m arguing there will be cost controls and regulatory risks. It is when not if in my mind. Lower-cost generic drugs are on the horizon due to the excessive costs charged by biotechnology companies. These companies have let their greed get the better of them and they may have killed the golden goose. (click to enlarge) Source: WSJ Remember, since 2000, U.S. public debt has grown from $6 trillion to $18 trillion in fifteen years. We have been running deficits every year since the dot-com bubble. Our healthcare costs are at least 600 bps points higher than other industrialized nations and higher on a per capita GDP basis. With the exception of the super-wealthy, the vast majority of people simply can’t afford to buy these expensive medications. (click to enlarge) Andrew Pollack’s NYT article “Drug Prices Soar, Prompting Calls for Justification” published on July 23, 2015, captures this theme poignantly. Here is a direct quote from the article: Pressure is mounting from elsewhere as well. The top Republican and Democrat on the United States Senate Finance Committee last year demanded detailed cost data from Gilead Sciences, whose hepatitis C drugs, which cost $1,000 a pill or more, have strained the budgets of state and federal health programs. The U.A.W. Retiree Medical Benefits Trust tried to make Gilead (NASDAQ: GILD ), Vertex Pharmaceuticals (NASDAQ: VRTX ), Celgene (NASDAQ: CELG ) and other companies report to their shareholders more about how they set prices and the risks to their businesses from resistance to high drug prices. The trust cited the more than $300,000 per year price of Vertex’s cystic fibrosis drug Kalydeco and roughly $150,000 for Celgene’s cancer drug Revlimid. Here is an NPR article with the same theme, “Doctors Press For Action To Lower “Unsustainable” Prices For Cancer Drug.” Here are two direct quotes: “A lot of my patients cry – they’re frustrated,” says Dr. Ayalew Tefferi , a hematologist at the Mayo Clinic. “Many of them spend their life savings on cancer drugs and end up being bankrupt.” The average U.S. family makes $52,000 annually. Cancer drugs can easily cost a $120,000 a year. Out-of-pocket expenses for the insured can run $25,000 to $30,000 – more than half of a typical family’s income. Lastly, written by Robert Pear , here is another NYT article “Health Insurance Companies Seek Big Rate Increases for 2015.” This was published on July 3, 2015. Here is a direct quote from the article: “Health insurance companies around the country are seeking rate increases of 20 percent to 40 percent or more, saying their new customers under the Affordable Care Act turned out to be sicker than expected. Federal officials say they are determined to see that the requests are scaled back.” Conclusion Yes, I understand that 2014 was a great year for purveyors of prescription drugs , with sales climbing 12% at their fastest percentage growth rate since 2002. However, as a society, the political pendulum is tipping towards increased awareness and anger. Given the skyrocketing costs of healthcare, the federal deficits, and the nosebleed market capitalization of biotech stocks relative to sales, it would be prudent to take profits in shares of IBB. The risk greatly outweighs the benefits given the valuations. Remember, trees don’t grow to the sky and $300K drug therapies are unsustainable. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.