Tag Archives: asset

Stocks Look Expensive… And Still Attractive

By Ilya Figelman Developed-market equity valuations seem a bit expensive today – but we still think they’re worth an overweight in multi-asset strategies. A wider view shows that stocks remain attractive globally. Let’s start with valuations. To get a comprehensive assessment, we integrate traditional measures such as the price/earnings ratio with other key corporate metrics. These include sales, cash flows and dividends; sales, for example, are currently on the low side relative to earnings. Based on our more robust valuation measure, global developed-market equities are unattractive. US Federal Reserve Chair Janet Yellen, commenting recently on the US equity market, echoed that assessment: “Equity market valuations at this point generally are quite high.” Good Quality Mostly Offsets High Valuations But valuations are only part of the equation when we’re gauging the intrinsic value of stocks. Investors need to incorporate aspects of quality, too. And globally, corporations are pretty healthy. Net equity issuance is low by historical standards. This means there’s a high volume of stock buybacks, which increase shareholder value, compared with new stock issuance, which dilutes value. When we roll all of this together, the positive impact of strong quality offsets almost all the negative impact of poor valuations. But even that still leaves the assessment for developed-market equities in roughly neutral ground. What’s missing? Macro Factors Argue in Favor of Equities The answer is the impact of the macro environment on equity attractiveness. It’s not enough to simply look at the intrinsic aspects of valuations and quality. We need to incorporate how macro aspects stack up for or against equities. And in short, unattractive valuations are mostly offset by strong quality, with the macro impact of falling inflation pressures and strong economic stimulus tilting the balance in favor of an equity overweight (Display) . What’s the best way to capture the effect economic conditions such as inflation and stimulus have on the equity decision? We think you need to come at the question from both quantitative and fundamental angles. We prefer to start with market-based metrics instead of economic releases; they’re timelier and, in our experience, more accurate in predicting equity market returns. Oil Rebounds, But is Still Well Below its Peak To determine the impact of inflation, we mainly look at changes in commodity prices and breakeven inflation rates. Inflation pressures have been declining largely because of falling commodity prices since mid-2014, and they’re a strong positive factor making equities attractive. Even though per-barrel oil prices have rebounded somewhat from the upper $40s to near $60, they’re still well below last summer’s near-$100 high. This quantitative signal is supported by AB’s fundamental research, which asserts that lower oil prices have been driven predominantly by supply rather than demand. This dynamic should generally be a positive for equity prices. Also, our economic research views the decline in energy prices as a boost for consumers, and therefore, good for equities. Recent Uptick in Bond Yields, but Plenty of Stimulus Remains What about economic stimulus? To gauge that impact, we use the level of – and changes in – government bond yields. Despite the US Federal Reserve tapering and contemplating official rate increases this year, officials are still likely to withdraw stimulus very cautiously – and slower than economic conditions warrant. Other central banks are providing more stimulus: the European Central Bank and Bank of Japan are at the beginning of easing cycles. From the market’s perspective, the pronounced global stimulus is reflected in low and declining bond yields, and that’s very favorable for equities. We’ve seen rates turn upward recently – 10-year German bund yields, for instance, rose from about 8 basis points in mid-April to about half a percent today. But rates still remain relatively low. We were more favorable on equities before oil prices and interest rates rose recently, and the equity markets have indeed performed well. We’ll be watching these two macro factors carefully, along with other variables that impact overall equity assessment. There’s a lot more to investing in equities beyond the high-level decision of how much to allocate to the asset class. Investors need to make regional, country, sector and security decisions, too. But the asset allocation decision is vital, and we still think the current balance of valuations, quality measures and the macro environment favors an overweighting to equities versus strategic portfolio allocations. Ilya Figelman is Portfolio Manager – Dynamic Asset Allocation at AB (NYSE: AB ).

An ETF Leveraged Pairs Strategy That ‘Works’ (But Would Still Be A Terrible Investment)

Summary In general, shorting pairs of leveraged ETFs does not generate favourable returns. An exception to this is shorting the volatility future TVIX, XIV pair, with this giving seemingly excellent returns. But this strategy is not advised, with the investor effectively selling financial catastrophe insurance. The theory The core equation describing the expected return of a leveraged ETF is as follows: Here ‘underlying return’ is simply the return on the asset the ETF leverages, anything from SPY, industry-specific equity funds, VIX futures and various commodities. λ specifies the ETF’s leverage; typically this is -1 (i.e. inverse), 2 or sometimes 3. Finally, σ is the standard deviation of the underlying return. The equation can be split into two, showing the key drivers of the return: The return on the underlying, leveraged λ times: The decay from volatility: It is the second – volatility decay – term that generates much of the criticism of leveraged ETFs. It reduces the return unless the ETF is unlevered i.e. λ = 1 or has no volatility i.e. σ = 0. Its adverse impact increases with leverage and the volatility of the underlying. The practical reason for volatility decay is the ETF’s daily rebalancing: a, say, 10% fall in the underlying, followed by a 10% rise will leave the underlying unchanged but see a leveraged ETF lose money. A leveraged ETF’s return is, however, not necessarily negative. It depends on the balance between the underlying’s return and the volatility decay factor. For example, SPY – representing the S&P 500 – has a (conservative) expected return of, say, 6% p.a. and a standard deviation of, say, 20% p.a. Plugging these numbers into the above formula gives a long-run expected return of ~8% for a 2x leveraged SPY ETF. This is well below the naïve 2 x 6% = 12% expectation, but is an improvement on the unlevered 6%. It is nevertheless at the cost of more than proportionally increased volatility. The theory applied to shorting leveraged ETF pairs Moving on to this article’s main subject, shorting pairs of leveraged ETFs. Applying the equation to shorting a pair of ETFs with leverage λ and -λ: The next step needs some algebra. Take the above equation and expand out (using Taylor’s series), neglecting any term higher than order 2 (these terms will be small in comparison). Then with λ = 2: Examining this equation shows the return will be positive for realistic pairs of leveraged ETFs: an asset’s return standard deviation (σ) will be bigger than its expected return (U). By shorting a pair of ETFs with opposite leverage and the same underlying, the return of the underlying cancels out and does not impact the strategy’s result. The strategy instead collects the (on average) losses generated by the interaction of the asset’s volatility and the daily rebalancing. In practice: Shorting UPRO and SPXU These two ETFs are designed to give 3x and -3x the compounded daily return on the S&P 500. Shorting $100k of both gives the following return chart: …equating to a stable before cost return of ~2% p.a. Unfortunately, the after cost return is ~-5%! These costs are principally the cost of borrowing the shares to short. I have UPRO costing ~5% p.a. to borrow and SPXU ~3.5% p.a. Notwithstanding the theory above, the market is efficient and has reached such by increasing borrow costs to unusually high levels. Similar results occur for all – bar one – pairs of leveraged ETFs that I have examined. In practice: Shorting TVIX and XIV The exception are a couple of volatility ETFs, TVIX and XIV. TVIX is designed to return 2x the VIX futures short term index. XIV is designed to return -1x the same index. Because the fund’s leverages are not equal and opposite, this strategy involves shorting $2 of XIV for every $1 of TVIX. It results in the following return chart, for a $100k notional investment: After costs, it yields a return of ~10% p.a. with a Sharpe ratio of ~ 2 (compared to the S&P 500’s ~ 0.5). It is also possible to leverage this strategy further; as shown it starts at -$33k TVIX and -$67k XIV, but (if you have portfolio margin) your broker may allow multiples of these amounts. The strategy works because of the exceptionally high volatility of the underlying VIX futures, together with the ETF’s relatively large tracking errors. The large drawdown in early 2012 was caused by a short squeeze on TVIX. Its price rose well above its net asset value. The short squeeze occurred because the issuing bank reached its internal risk limits in respect of VIX futures. It hence stopped creating new TVIX units, removing the normal mechanism for keeping the ETF’s price near its net asset value. Holders of this strategy may well have had their TVIX shares called at the worst possible time – the minimum of the black curve – missing out on the subsequent recovery. The key problem with this strategy is, however, its tail risk. Gains from shorting a stock are limited to 100% of its value. Losses are unlimited. A large enough single-day increase in the value of VIX could see the strategy lose more than 100% of the notional investment. In particular, if a day sees the VIX short term futures index double or more, XIV – if it functions as designed – will go to zero. But TVIX can continue to rise, generating unhedged, potentially unlimited losses for the strategy. I suspect this is the main reason that the market allows this apparent inefficiency. Executing the strategy is equivalent to selling financial catastrophe insurance. Additional disclosure: I am sometimes long / short XIV, but do not execute this strategy.