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Momentum, Quality And Low Volatility: Continuing The Quest For Smarter Beta

Summary In November I introduced a smart beta portfolio based on MSCI’s indexes for quality, momentum and low volatility. The semi-annual rebalancing of those indexes is complete. I review the previous six-month performance and determine the components of the rebalanced MQLV portfolio. In early November I proposed the idea of using the iShares smart beta ETF portfolios as a filter for building one’s own risk-premia portfolio ( A Quest for the Smartest Beta ). I started from three ETFs, each indexed to a single factor: Low Volatility, Momentum and Quality. iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) iShares MSCI USA Momentum Factor ETF (NYSEARCA: MTUM ) iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ) Taken together, these three ETFs make a solid holding as seen in this table showing results of an equal weighted portfolio of the three ETFs vs. the S&P 500 since the inception of QUAL, the youngest of the three, in August 2013. (click to enlarge) Starting from the premise that each of the ETFs is selecting for a single “smart-beta” factor I wanted to look at the intersection of the three funds. I asked if there were overlapping positions in all three ETFs. I compared their full sets of holdings looking for that overlap. There were 14 funds shared by all three. I reasoned that since each of the 14 passed the MSCI filters for low-volatility, momentum and quality, it could be worth looking at a portfolio comprising all 14, in effect, a portfolio located at the intersection of Quality, Momentum and Low Volatility. June through November Results The 14 stocks from the end of May rebalance are: Arch Capital Group Ltd (NASDAQ: ACGL ) Accenture PLC (NYSE: ACN ) Axis Capital Holdings Ltd (NYSE: AXS ) Chubb Corp (NYSE: CB ) Chipotle Mexican Grill Inc. (NYSE: CMG ) Home Depot Inc. (NYSE: HD ) Eli Lilly (NYSE: LLY ) Nike Inc. Class B (NYSE: NKE ) O’Reilly Automotive Inc. (NASDAQ: ORLY ) Reynolds American Inc. (NYSE: RAI ) Starbucks Corp (NASDAQ: SBUX ) Sigma Aldrich Corp (NASDAQ: SIAL ) Visa Inc. Class A (NYSE: V ) W.R. Berkley Corp (NYSE: WRB ) Each of the ETFs is rebalanced to a revised index twice annually, on the last business days of May and November. So, when I looked at the portfolio, let’s call it MQLV , it had a five-month record from its “inception” on the last business day of May. It had performed well. For the five months from June 1 to Nov 1, it turned in a CAGR of 41.0% vs SPY’s -1.30%. Now that the full cycle is complete we can update performance at the close of the six-month holding period. It performed thusly: (click to enlarge) That is a quite impressive performance record. In a market environment where the S&P 500 index could only muster a 1.74% total return, MQLV chalked up nearly 19%. Sharpe (2.21) and Sortino (7.29) ratios are at rarely seen levels. Pretty good evidence that there may well be something to this idea. Not in any way definitive, of course; it is, after all, a single cycle. But those results are surely saying “Hey, look over here.” Rebalancing for December through May Now that MSCI has rebalanced the indexes, I let’s have a look at the changes. The current overlap for the three funds has moved from 14 to 18 stocks. Eleven remain from the previous list. There are seven new entries, and three have dropped off. The additions are: Costco Wholesale Corp (NASDAQ: COST ) Henry Schein Inc (NASDAQ: HSIC ) Lockheed Martin Corp (NYSE: LMT ) Mcdonalds Corp (NYSE: MCD ) Public Storage REIT (NYSE: PSA ) Travelers Companies Inc (NYSE: TRV ) Ulta Salon Cosmetics & Fragrance I (NASDAQ: ULTA ) And the deletions: Chipotle Mexican Grill Inc. Reynolds American Inc. Sigma Aldrich Corp CMG is no longer included in MTUM’s holdings but remains in USMV and QUAL. RAI was dropped from QUAL; it remains in USMV and MTUM. SIAL was acquired. The sector mix is dominated by Consumer Discretionary and Financials which account for 12 of the 18 positions. (click to enlarge) If we combine these 18 positions into an equal-weighted portfolio, the portfolio metrics are as follows: (click to enlarge) (from investspy.com based on one-year’s data) One-year performance for these 18 is outstanding, having beaten SPY 27.7% to 3.5% for the year. This is, of course, no indication of what the portfolio will do over the next six months between now and the next rebalance, but it does auger well for success. And, let’s not forget, 11 of these holdings were included in the previous iteration which trounced SPY handily. Here is a correlation matrix for the holdings. (click to enlarge) Running the portfolio through Portfolio Visualizer’s four-factor analysis produces the following regressions. Once again, it’s based on one-year’s data. (click to enlarge) As commenters pointed out in discussing the November article, there is little exposure here to size, all but three of the size exposures are negative. Several suggested that I should include the value factor. I argued that value was inherent in some of the selection criteria used by USMV and QUAL, so adding an ETF like the iShares MSCI USA Value Factor ETF (NYSEARCA: VLUE ) would be redundant. That point of view was confirmed to a large extent by including the VLUE and the iShares MSCI USA Size Factor ETF (NYSEARCA: SIZE ) portfolios in the analysis as a follow-up ( Expanding the Smart Beta Filter: Does It Help? ). Now, from the results of this regression analysis of the Fama-French factors, we can see that value exposure is, in fact, fairly high. This result confirms my sense that value was being addressed at least partially, even though it is not a specific factor for any of the three source ETFs. HSIC, LLY, LMT, SBUX are negative for value, but the rest are positive or neutral. Unsurprisingly, momentum exposure–the only factor specifically selected for by a source ETF–is high; only LLY is negative here. Given the extraordinary success of the June through November record I am excited to see how the rebalanced portfolio performs. At 18 positions this is a fairly large commitment for an outright investment, but it could well be worth some serious thought. To me, the concept appears sound and the track record, limited though it may be, is supportive. Is it actionable? I’d like to think so, but the hard evidence, however impressive, is sketchy. So any action taken would be largely based on an appreciation for the conceptual basis of the strategy. I’ll be keeping this updated as we move forward.

10 Questions And Answers On ETFs And Other Topics

I was asked to participate with 57 other bloggers in a post that was entitled 101 ETF Investing Tips . It’s a pretty good article, and I felt the tips numbered 2, 15, 18, 23, 29, 35, 44, 48, 53, 68, 85, 96, and 98 were particularly good, while 10, 39, 40, 45, 65, 67, 74, 77, 80, and 88 should have been omitted. The rest were okay. One consensus finding was that Abnormal Returns was a “go to” site on the internet for finance. I think so too. Below were the answers that I gave to the questions. I hope you enjoy them. 1) What is the one piece of advice you’d give to an investor just starting to build a long-term portfolio? You need to have reasonable goals. You also have to have enough investing knowledge to know whether advice that you receive is reasonable. Finally, when you have a reasonable overall plan, you need to stick with it. 2) What is one mistake you see investors make over and over? They think investment markets are magic. They don’t save/invest anywhere near enough, and they think that somehow magically the markets will bail out their woeful lack of planning. They also panic and get greedy at the wrong times. 3) In 20 years, _____. (this can be a prediction about anything – investing-related or otherwise) In 20 years, most long-term public entitlement and private employee benefit schemes that promised fixed payments/reimbursement will be scaled back dramatically, and most retirees will be very disappointed. The investment math doesn’t work here – if anything, the politicians were more prone to magical thinking than naïve investors. 4) Buy-and-hold investing is _____. Buy-and-hold investing is the second-best strategy that average people can apply to markets, if done with sufficient diversification. It is a simple strategy, available to everyone, and it generally beats the performance of average investors who buy and sell out of greed and panic. 5) One book I wish every investor would read is _____. (note that non-investing books are OK!) One book I wish every investor would read is the Bible. The Bible eliminates magical thinking, commends hard work and saving, and tells people that their treasure should be in Heaven, and not on Earth. If you are placing your future hope in a worry-free, well-off retirement, the odds are high that you will be disappointed. But if you trust in Jesus, He will never leave you nor forsake you. 6) The one site / Twitter account / newsletter that I can’t do without is _____. Abnormal Returns provides the best summary of the top writing on finance and investing every day. There is no better place to get your information each day, and it comes from a wide array of sources that you could not find on your own. Credit Tadas Viskanta for his excellent work. 7) The biggest misconception about investing via ETFs is_____. The biggest misconception about investing via ETFs is that they are all created equal. They have different expenses and structures, some of which harm their investors. Simplicity is best – read my article, ” The Good ETF ” for more. 8 ) Over a 20-year time horizon, I’m bullish on _____. (this can be an asset class, fund, technology, person – anything really!) Over 20 years, I am bullish on stocks, America, and emerging markets. Of the developed nations, America has the best combination of attributes to thrive. The emerging markets offer the best possibility of significant growth. Stocks may have a rough time in the next five years, but in an environment where demographic and technological change is favoring corporate profits, stocks will do better than other asset classes over 20 years. 9) The one site / Twitter account / newsletter that I can’t do without is _____. Since you asked twice, the Aleph Blog is one of the best investing blogs on the internet, together with its Twitter feed. It has written about most of the hard questions on investing in a relatively simple way, and is not generally marketing services to readers. For the simple stuff, go to the personal finance category at the blog. 10) Any other ETF-related investing tips or advice? For a fuller view of my ETF-related advice, go to Aleph Blog, and read here . Briefly, be careful with any ETF that is esoteric, or that you can’t draw a simple diagram to explain how it works. Also realize that traders of ETFs tend to do worse than those that buy and hold.

Spinoffs: Looking For Value

Investing in and around spinoffs has been an extremely lucrative endeavor over the past decade, according to the Nov. 30 issue of Value Investor Insight. Indeed, since the end of 2002, Bloomberg has maintained a U.S. Spin-Off Index, which tracks the share prices of newly spun-off companies with market capitalizations of more than $1 billion for three years after they begin trading. Over the near 13-year period tracked, Bloomberg’s U.S. Spin-Off Index has risen 557%, compared to a return of 137% for the S&P 500. Moreover, spinoff activity is close to an all-time high as companies, spurred on by activists, try to unlock value for shareholders by splitting up their businesses. This year’s total number of spinoffs is expected to be 49, the fourth-highest level on record. However, more often than not, due to a number of factors, spinoffs are mispriced by the market, which can lead to some very attractive opportunities for value investors. In this month’s issue of Value Investor Insight , four spinoff experts – Murray Stahl of Horizon Kinetics, Joe Cornell of Spin-Off Advisors, The London Company’s Jeff Markunas and Jim Roumell of Roumell Asset Management – discuss the key factors that lead to spinoff mispricing and where they’re looking for opportunity today. (click to enlarge) Spinoffs: Four key factors There are four key structural factors that can lead to spinoffs being mispriced : Limited information – The documentation filed with the SEC when companies split can be quite complex, and the pro-forma financials can be difficult to analyze. Moreover, analyst coverage tends to be limited, and investors, rather than do the legwork themselves, would rather look elsewhere. Forced selling – A spinoff may see a parent company force a SpinCo onto a shareholder that doesn’t want, or legally can’t hold the shares, which will lead to selling. An S&P 500 Index fund can’t own a spinoff company outside the index, for example. Sandbagging – SpinCo managements usually receive significant financial incentives to underperform and over-deliver. Top managers’ incentive stock plans are typically based on average share prices of the spinoff company for the first 20 or so days of trading after the spinoff, which can lead to sandbagging of the highest order before those prices are locked in. ” Capitalism works ” – According to Value Investors Insight , when a SpinCo leaves its parent, “pent-up entrepreneurial forces are unleashed” as “the combination of accountability, responsibility, and more direct incentives take their natural course.” In other words, without the parent, the newly independent company can take advantage of capitalist forces to improve performance. Spinoffs: Looking for value So what do the experts look for in a good spinoff? According to Murray Stahl of Horizon Kinetics, there are four key characteristics to look for when a company spins off an unwanted subsidiary or division. First, a higher-margin business is spinning off a lower-margin business. Second, CEO movements. If the CEO of the larger company decides the best place to be is with the spinoff it’s, “a message to heed.” There’s also the capital structure of the SpinCo to consider. Too much debt dumped on the SpinCo from the parent can be a burden that haunts the company and strangles growth. That said, if figures show that the debt can be paid down over time, this creates an opportunity, like a publicly-traded leveraged buyout, according to Murray Stahl. And the last spinoff situation that creates an opportunity for profit is the very small spinoff that those engaged in industrial-scale money management are unable or unwilling to own (market cap