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Forget REITs, Invest In Utility ETFs Instead?

The global investing world across asset classes was caught off guard recently by the Chinese market rout. The world’s second largest economy has completely derailed the market in August after China devalued its currency, the yuan, by 2%, to presumably maintain export competitiveness and revealed a six and a half-year low manufacturing data for the month. The tumult in global equities, currencies and commodities suddenly perked up the safe haven appeal of the market. While this risk-off trade sentiment among investors went against most asset classes, a downtrodden defensive sector – utility – cashed in on (slightly) this debacle. Investors should note that the U.S. economy is primed for a rate hike sometime later in 2015 after nine long years. Several U.S. economic data released lately were upbeat, supporting the case for an imminent rate hike. Quite expectedly, this phenomenon should weigh on rate sensitive sectors like utilities and REITs. These sectors need a high level of debt for operations and approach the capital markets for raising funds. As a result, a rising rate environment is a downright negative for these areas. While the utility sector suffered from the looming rate hike worries in the last few months, REITs seem less ruffled by this threat. Broader utility ETF Utilities Select Sector SPDR (NYSEARCA: XLU ) is down over 13% in the year-to-date frame while the Vanguard REIT ETF (NYSEARCA: VNQ ) has lost about 11%. This was probably because a healthy economy and busy activities helped the REIT space weather the rate hike worries to a large extent. However, investors should note that the retreat in VNQ was steeper in the last one-month time frame compared to XLU. In the said period, XLU was down about 6% while VNQ shed 7.9% (as of September 4, 2015). Let’s take a look at what’s giving utilities a slight edge over REITs? Safe Haven & Cheaper Valuation Win, Rate Sensitivity Loses The downward drift in utilities decelerated in recent times as these can be attractive in a choppy market like this. This sector is less volatile in nature and relatively immune to the market peaks and troughs. If this was not enough, the space is less exposed to a stronger dollar due to the lack of foreign coverage. Rather lower commodity prices amid the strengthening greenback will help lower the input costs of the utility companies. Investors should also note that long-term interest rates have been on a downhill ride post the China currency episode. Yield on the 10-year Treasury note fell to 2.13% (as of September 4, 2015) from 2.24% on August 10. If this was not enough, U.S. job numbers in August grew at the most sluggish pace in 5 months and fell short of analysts’ expectations. As per several market participants, the China issues and the latest setback on the job front have silenced the growing buzz about the likely Fed rate hike as early as this month to some extent. This played yet a big role in bringing down the Treasury yields. Since utilities usually have strong yields, investors can embrace this segment amid falling Treasury bond yields. Notably, the yield of XLU was 3.71% as of September 4, 2015. Though REITs too offer bumper yields as evident by the 4.14% offered by VNQ, REITs score lesser than utilities on safety. To add to this, after being crushed for the last few months, utility ETFs now offer a compelling valuation, which acts as another driver for its northbound ride. XLU is presently trading at a P/E (ttm) of 16 times while VNQ trades at 37 times of P/E (ttm). This clearly explains why it might be better to look away from REITs, and tilt toward utility ETFs. Even research house MKM Partners is of the same opinion. As a result, utility stocks and the related ETFs might ricochet in the coming days to reflect the flight to safety. Bottom Line We no doubt believe that the utility sector will have several deterrents over the longer term among which the Environment Protection Agency’s Clean Power Plan seems to be a big one. The norm looks to lower carbon emission from power plants and utilities have long been dependent on coal. But as of now, the sector looks solid. Investors, who normally eye cheaper plays, can thus try out a few utility ETFs to reduce the beta in the portfolio, especially until this China-induced anxiety is over and the Fed shapes up a well-defined solution over policy tightening. These funds include XLU, the First Trust Utilities AlphaDEX Fund (NYSEARCA: FXU ) , the Guggenheim S&P Equal Weight Utilities ETF (NYSEARCA: RYU ) and the Vanguard World Fund – Vanguard Utilities ETF (NYSEARCA: VPU ) . Original Post

Oil Refiner ETF CRAK: A Better Buy Amid Weak Energy

Thanks to an ever-increasing production, a large supply glut and sluggish demand, oil price skidded to half over the past one year, making the commodity the worst nightmare. In fact, trading in oil became wilder last month after China devalued its currency and weaker economic data raised worries over the health of the world’s second largest economy, suggesting lower demand for crude. Currently, U.S. crude is hovering around $45 per barrel while Brent crude is trading above $48 per barrel. Market participants are bearish on oil prices for at least the short term as global developments are expected to add to the supply glut. This is because the U.S. is still producing oil at near record levels, the Organization of Petroleum Exporting Countries (OPEC) is pumping out maximum oil in more than three years, Iran is looking to boost its production once the Tehran sanctions are lifted and inventories continue being built up. On the other hand, demand seems muted at present given the persistent slowdown in China as well as sluggishness in Europe, Japan and other key emerging markets. The International Energy Agency (IEA) in its recent monthly report stated that the global oil market would remain oversupplied throughout 2016 though lower oil prices and a strengthening economy will boost oil demand at the fastest pace in five years. Oil Refining Thriving Amid Oil Prices Given the unfavorable fundamentals and a bleak oil outlook, almost every corner of the energy segment is suffering except oil refining, which is negatively correlated with the price of oil. This is because the players in this industry use oil as an input for processing refined petroleum products like gasoline. Hence, lower oil prices are boosting margins for refiners, leading to healthy stock prices. This trend is likely to continue if crude prices (input costs) remains lower or continue to fall further, leading to higher spreads. Spread is the difference in price between a barrel of oil and a barrel of refined product like gasoline, diesel, or jet fuel. As a result, the higher the spread, the more the profits will be for the oil refiners. That being said, as long as the spread remains stable at the current levels, refiners are expected to outperform the rest of the energy sector. Further, continued outperformance in the oil refining and marketing industry is well justified by its solid Industry Rank in the top 15% . Investors could tap the rising opportunity in this niche segment with the new Market Vectors Oil Refiners ETF (Pending: CRAK ) recently launched by Market Vectors. It is a one-stop shop for investors to play the oil refining market. CRAK in Focus CRAK looks to follow the Market Vectors Global Oil Refiners Index. The benchmark measures the performance of the largest and most liquid companies in the global oil refining segment. Companies eligible for inclusion in the index should generate at least 50% of their revenues from crude oil refining including gasoline, diesel, jet fuel, fuel oil, naphtha, and other petrochemicals, or have at least half of their assets devoted to the refining of crude oil. The product is getting the first-mover advantage as it has accumulated $1.8 million in its asset base within three weeks of its inception. It currently trades in a lower volume of about 14,000 shares a day on average. Any Downside Risk? The fund is heavily concentrated on the top 10 firms with huge allocations to Phillips 66 (NYSE: PSX ) , Marathon Petroleum (NYSE: MPC ) and Valero Energy (NYSE: VLO ) that collectively make up for one-fourth of the portfolio. This increases company-specific risk and suggests that the top firms dominate the fund’s returns. While VLO was recently upgraded to a Zacks Rank #2 (Buy), PSX and MPC were downgraded to a Zacks Rank #3 (Hold) each. Further, the fund is not a pure American play and is hence exposed to currency risk. More than half the portfolio offers international exposure, namely Japan, India, South Korea, Poland, Taiwan, Portugal, Finland, Turkey, Australia, Thailand and Greece. Investors should note that it is a relatively high cost choice in the energy space. It charges a bit higher fee of 59 bps compared with the expense ratio of 0.15% for the broad sector fund – Energy Select Sector SPDR (NYSEARCA: XLE ) . Bottom Line Given the encouraging outlook for the oil refiners, CRAK could prove to be the lone star in the energy space in a plunging oil price environment. Original Post

An Introduction To Merger Arbitrage And Available ETF Options

Summary Everyone is fascinated by Merger Arbitrage. This is an introduction. You have a few options ETF wise. Find out why I don’t like them. I recently discussed gaining exposure to spinoffs through an ETF. If gaining exposure to such deals passively is a good idea, one might ask whether other “Hedge fund strategies” can be attained through ETFs. We’ve all heard of famous billionaire arbs such as John Paulson (although he didn’t make his billions with merger arbitrage), and we might be tempted to have a go at such strategies. In this article I will: Go over the basics of merger arbitrage for readers who are not familiar with the practice. (If that’s not you, skip below.) Highlight the main risks linked to the strategy. Take a look at two Merger ETFs and the construction of their underlying indexes. Explain why I don’t think such ETFs make a good addition to your portfolio. THE BASICS Merger arbitrage attempts to profit from merger activity through spreads between offer price and trading price. Here is a simple example which expresses the strategy. Company A is trading at $10 a share. Company B is trading at $20 a share. Company B offers to buy company A, offering owners one share of Company B for each share of Company A. Following the announcement company A’s stock surges to $15. If the deal goes through, owners of Company A will have a security which is worth $20 today. To lock in the $5 spread between current price and offer, investors can go long A, and Short B; simultaneously buying the same asset for $15 and selling it for $20. Why would a security trade for $15 if someone is going to pay you $20 for it, and how do we interpret this? For a number of reasons, which we will discuss further, the deal might not go through. In such a case, the target’s (Company A) stock will usually fall back to pre-merger announcement prices ($10 in our example). Therefore the price at which a security a security trades between the acquisition’s announcement and its completion reflects the odds the market assigns to a deals completion. The basic math is: [(Current Price)-(Price before deal announcement)] / [(Offer Price)-(Price before deal announcement)] In the case of our example: (15-10)/(20-10)=50% As a deal gets closer to going through, you can expect the spread between security A and B to diminish. Whether A goes up, B goes down, or they meet somewhere in the middle, going long A and short B would net a profit as both prices converge. Since deals can go south for a number of reasons, investors must determine when the odds the market gives any given deal don’t match their own estimation of the odds. If an investor believes our deal has a 70% chance of being completed, the trade would seem attractively priced today (70%> 50%) and he could take a long position in A and a short position in B. Likewise if an investor believes our deal has only a 30% chance of being completed, he might view today’s price as expensive, and decide to go short A and long B, on the basis that the spread could get wider. Since large initial increases in shares of the target firm occur after the announcement, the downside if the deal doesn’t go through is usually larger than the possible gain (the spread). So there you have it. This traditional strategy is mostly used in the case of a stock for stock offer. In the case of a cash only offer, shorting the acquirer will be of no use in capturing the spread. THE RISKS While being a risk arbitrageur seems like an interesting strategy since your simultaneous long and short positions reduces your systematic exposure, many things can go wrong. The returns are mostly deal driven, so risks come primarily from regulation and financing issues. Even if most mergers are allowed by regulators, it is imperative to assess antitrust concerns before regulators rule. In deals where antitrust issues are a primary concern it is likely the spread will narrow shortly after the deal has been approved by regulators. There is no free lunch here, investors must do their own research and due diligence to assess how these issues can impact the deal’s timing and viability. Regulators being fun as always, might also cancel the deal for many other reasons, such as nationalistic concerns. Also if part of the deal involves a cash transaction, financing issues must be taken into account. Which Banks are working with both companies? Is financing secured, or likely to be? Merger Arbitrage returns are negatively skewed. If deals go through, small consistent gains are made, but investors are exposed to large losses when they run in to problems. In other words, large upswings occur a lot less than large downswings, distributing the returns somewhat as such. So as I mentioned above, the real opportunity lies in detecting deals where the probabilities of a deal going through are significantly different than what the market price implies. On Seeking Alpha, Chris Demuth does a great job at getting all the M&A info and ideas you need. But we do both agree on one point, Merger Arbitrage is research intensive. MERGER ETFS Given the extensive research required, you might be tempted to gain exposure to merger arbitrage plays through ETFs. Here is a brief overview of two of them, the IQ ARB Merger Arbitrage ETF (NYSEARCA: MNA ) and the Proshares Merger ETF (BATS: MRGR ). The IQ Merger Arbitrage ETF tracks the IQ Merger Arbitrage index which is a rule based index which seeks to gain exposure to companies all over the world in which a merger or acquisition announcement has been made. The index is rebalanced monthly, and excludes deals which have an offer price inferior to the price of the stock prior to the announcement. If the implied probability of completion is less than zero or greater than 100%, the positions will be held until the deal completes or 180 days pass after the announcement. When an implied probability is between 0 and 100, existing positions will be held for up to 360 days. Here are a few key points to keep in mind: Long positions in the target only Equity Hedge achieved through shorting sector or regional ETFs Cash exposure is kept in short term treasuries. No qualitative assessment of individual deals. No stock can be above 10% of the index. MNA data by YCharts The Proshares Merger ETF tracks the S&P Merger Arbitrage index. A maximum of 40 long positions and 40 short positions are included in the index at any given time. Deals are subject to liquidity and sizing constraints (Must be bigger than $500 mi). Everyday, if a new merger is announced, the position is added to the index. If there are already 40 positions, the position with the weakest performance since inclusion in the index is removed and is replaced with the new one. A few things to remember: Long and short positions in individual stocks are taken, unlike MNA. When included into the index, positions are sized at 3%. Like MNA this is a rule based index with no qualitative analysis. SPY data by YCharts MY TAKE ON THESE. MNA data by YCharts Let’s start with what is to be liked. Both ETFs are diversified and give exposure to a bunch of deals worldwide. Over the last 3 years, we can say that MNA has achieved its objective of attaining consistent absolute returns with little correlation to traditional equity markets. On the other hand MRGR has produced negative returns overall. And I believe this underperformance -as in less than 0%- is due to a structural problem in the Index’s construction. If 40 positions already exist when a new deal arrives, the deal with the worst performance is excluded. This defies the underlying logic if capturing the spread in the current price and offer price: To capture it, you hold until completion or until completion is totally priced in! As such MRGR might be discarding the most lucrative deals because of a structural flaw. MNA has its own flaws. By using ETFs as a hedge, you are partially removing market risk, but not locking in a spread between a target and an acquirer. In the case of an all stock offer, if the acquirers price was to converge towards the targets price rather than the other way round, you wouldn’t profit. But my main problem re$mains the ignorance of risks. Successful M&A investing revolves around finding mispriced deals to go long or short. In both of these indexes you don’t account for the annualised return which is possible, and you don’t stack it up against the risks. CONCLUSION As such I chose to not invest in either of these ETFs. If I had to chose, I would pick MNA, although I am not a fan of its structure, it is less harsh than that of MRGR. Target companies tend to depend on event risk more than market risk, so shorting out market exposure does allow for exposure to M&A deals, even though it doesn’t do so in an ideal manner. 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.