Tag Archives: economy

Hedging Via Index Funds: 5 Winning Funds And 5 Surprising Losers

Summary I looked at a large collection of index ETFs, calculating their correlations with the S&P 500. I found five winning hedges and five losing hedges. Two ETFs in particular showed almost zero correlation to the US stock market: EEM and TAN. During the 2008 bear market, I lived in both Taiwan and China – at separate times, of course. While in Taiwan, I often heard complaints from the Taiwanese regarding poor American business practices: “Your banks went and screwed everything up for everyone.” Yet, while in China, I heard no such complaints. The people there seemed happy with their economy. The difference? Correlation. Market connection. While today, the US stock market is strongly correlated to that of China’s, a number of years ago it wasn’t. Perhaps China’s economy just recently became big enough to sync to the US economy. In that case, perhaps some other countries out there have stock markets uncorrelated to ours. If so, index funds on those markets would provide good hedging opportunities for bear markets, market corrections, and market crashes. My last study on investments uncorrelated to the US market unveiled some surprising results – you can read it here . Now, I intend to tackle a request from one of the readers of that last article: (click to enlarge) The request was to find CEFs, index ETFs, and sector ETFs uncorrelated to the S&P 500. In fact, these are actually three requests. I’m going to be tackling the question of index ETFs in this article, perhaps moving onto the former in the next article; and the sector ETF request is easily tackled – no sector ETFs are uncorrelated to the market. So, the main question is, “What index ETFs are uncorrelated with the S&P 500.” Immediately, my mind turns to indexes in certain countries. Later, I will show my findings on which countries have stock markets uncorrelated with the US market. But I will also look at other indexes unrelated to geography. Correlation First, we must define correlated. In a previous article, I spent some time talking about the theory behind correlation determinations. I direct you to that article if you wish to learn more. For now, let me just explain how I determined whether an investment was correlated to the S&P 500. I imported index data, ^GSPC, via Yahoo Finance using R, statistical software. Then, I imported various index ETFs that I thought might have low correlations. I ran correlation calculations on the index ETFs vs. ^GSPC, using a 5-year time frame. Any investment with a correlation between -0.3 and 0.3 was considered uncorrelated. In this way, the index ETFs chosen as Winners (those suitable for hedging) change a maximum of 20% per significant market move. The Close Calls, in contrast, change in the range of 20-40% when the market moves. The idea is to compose a portfolio of index ETFs that can act as a hedging portion of your portfolio. The end result was four ETFs uncorrelated with the market, with one index ETF in particular having two near-zero correlation funds. Some of the Winners and Close Calls may surprise you. Winners iShares MSCI BRIC ETF (NYSEARCA: BKF ) and iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ) . Money has been flowing out of emerging markets, yet emerging markets might just offer a strong hedging opportunity. Of particular interest is the slight, but significant, difference between BKF and EEM. While these two ETFs are strongly correlated, EEM has a near-zero correlation with the S&P 500, while BKF has a -0.25 correlation. Overall, I don’t think this difference is very important for most investors. Their yields are approximately the same: 2.4% for EEM and 3% for BKF. Either investment would be a good hedging tool, allowing exposure to emerging markets and providing dividends. However, the holdings of these funds differ to some extent. BKF heavily weights the its major holdings, with 40% of its holdings in China and 30% being financial services. Its biggest holdings are Chinese financial services, such as banks and insurance companies. In contrast, EEM more evenly disperses its holdings. In addition, because it is not forced to invest in BRIC countries, the fund’s two biggest holdings are Korean and Taiwanese companies: Samsung ( OTC:SSNLF ) and Taiwan Semiconductor Manufacturing (NYSE: TSM ). Also, in stark contrast to BKF, which only hold stock in developed countries, EEM dedicates 30% of its portfolio to developed markets, which equates to more exposure to technology stocks in this case. iShares MSCI South Korea Capped ETF (NYSEARCA: EWY ) : Surprisingly, this Korean ETF is uncorrelated to the US market. As you would expect, 40% of this fund’s holdings is dedicated to tech stocks, which can promise decent growth. The yield here is rather low, at 1.22%. Samsung, which makes up 30% of this ETF, has been underperformer in EWY’s portfolio for the past few years. If this were an ex-Samsung ETF, I could see it easily outperforming the fund as it is currently composed. Nevertheless, EWY is a good opportunity for both hedging and profiting from South Korea’s economy, which is set for a comeback. iShares MSCI Malaysia ETF (NYSEARCA: EWM ) : Malaysia was another country I checked, and I found this particular fund to be both uncorrelated to the S&P 500 and quite similar to the emerging market funds in terms of its portfolio allocation. EWM is 30% financial services, with Malaysian banks as its main holdings. This fund also gives you significant exposure to Malaysia’s utilities and consumer industries, and has a sweet yield of 3.76% Guggenheim Solar ETF (NYSEARCA: TAN ) : This ETF tracks the MAC Global Solar Energy Index. The holdings are about half US-based. Unlike the above funds, this ETF’s portfolio consists mainly of small and mid-cap stocks. TAN has a near-zero correlation with the S&P 500 – 0.04, to be exact – which is likely a product of it being cut both across a sector and across geography. The main countries involved in this portfolio are, unsurprisingly, the US and China. With a 2.15% yield, this is a great hedging opportunity, and is a suitable choice if you’re bullish on solar energy, which seems poised for a rebound since its fall in 2011. Close Calls In this section, we look at investments that made 20-40% movements in response to market moves. These are “Close Calls” – ETFs that you’d think would be uncorrelated to the general market, but which actually show a small or moderate correlation. They might still be good investments, but are not appropriate for hedging. iShares MSCI Mexico Capped ETF (NYSEARCA: EWW ) : With its disgusting ticker name, EWW is one of those geography-based index ETFs that I thought might be uncorrelated to the US market. Of course, that was wishful thinking, as Mexico and the US have a strong trade connection. However, the correlation is quite low, at 0.34. With Mexico becoming stronger in the world economy, EWW is a decent emerging market investment vehicle, but should not be used for hedging. iPath MSCI India Index ETN (NYSEARCA: INP ) : Listed as an ETN, INP tracks the MSCI India Total Return Index. India still shows a correlation with the US market, making this ETN a poor choice for hedging. However, depending on your outlook of the country, this might be a good choice. Personally, I’d choose BKF over this, as you’d still have exposure to India, be more diversified across geography and gain dividend payments. Guggenheim China Small Cap ETF (NYSEARCA: HAO ) : While all the China ETFs I checked were strongly correlated to the US market, this fund consisting of small-cap Chinese stocks shows a much lower correlation than the rest. If you want to invest in China, but fear a drop in the US market could damage your portfolio, HAO is a bit safer than other Chinese ETFs. Strange that a small-cap ETF would be safer, but for Americans, that seems to be the case. Fidelity MSCI Energy Index ETF (NYSEARCA: FENY ) : The energy market seems to be doing its own thing, regardless of the market. However, the market is generally moving upward while energy prices drop. Thus, checking the correlation between the two might be enlightening. The correlation between FENY and the market is small, but it’s there. A general market decline, then, should predict a slight increase in the energy market. FENY might be a good choice if you’re expecting a market correction or crash, and if you’re speculating that the energy market has hit its true bottom. Global Commodity Equity ETF (NYSEARCA: CRBQ ) : Much like the energy market, the commodity market has been moving opposite to the S&P 500, but appears rather uncorrelated. In fact, the correlation here is -0.44. The dollar, which is correlated to the market, is inversely correlated to the commodity market, which explains this moderate correlation. With its low liquidity, you should only buy this if you have no better way of investing in commodities and want to hold this ETF for the long term. I Want Your Input Obviously, I simply don’t have the time to cover every industry. While reading this article, you probably thought of at least one investment that should have gone in my “Winners” section. Let me know about it in the comments section below. Request a Statistical Study If you would like for me to run a statistical study on a specific aspect of a specific stock, commodity, or market, just request so in the comments section below. Alternatively, send me a message or email.

The European Local Recovery: Introducing A New Index

By Jeremy Schwartz Earlier, we discussed how positive trends in the European economy showing domestic growth are leading the eurozone , while global trade has been one of the weak points. 1 We also discussed how our favorite leading indicators of the economy-both M1 growth and the European Commission’s Economic Sentiment Indicator-were showing positive signs that bode well for future trends in the local economy. 2 What could be a good way to position toward this local economic recovery? Creating an Index to Respond Strongly as Economic Conditions Improve At WisdomTree, we build innovative equity Indexes that offer the opportunity to express certain characteristics or have greater potential to respond to different economic trends. If an economic recovery in Europe is truly taking hold, we wanted to create an Index that best reflects these local economic conditions. WisdomTree thus created the WisdomTree Europe Local Recovery Index to reflect attributes of an improving domestic economy that is less reliant on the global export markets. Especially over the past five years, certain more defensive sectors of the MSCI EMU Index have exhibited lower correlation to changes in the economy and the leading indicator of activity, the European Commission’s Economic Sentiment Indicator. These defensive sectors thus may not offer the most representative exposures to improving economic conditions within the eurozone. Over the past five years, those same defensive sectors have exhibited lower betas when measured against the returns of the MSCI EMU Index. In times of turmoil or uncertainty, this could be a potentially positive attribute, but if an investor truly believes in the prospects for a eurozone economic recovery, these lower-beta defensive sectors are likely to be least responsive to a more positive growth environment. Defensive Sectors Less Correlated to Changes in Economic Activity and Sentiment (click to enlarge) Positioning in Cyclicals: No Defensives In positioning for local economy recovery, these data points lead us toward a preference for cyclical sectors over defensive sectors. Within the WisdomTree Europe Local Recovery Index, the Consumer Staples, Health Care, Telecommunication Services and Utilities sectors are not eligible for inclusion. Two important factors are driving allocations in the WisdomTree Europe Local Recovery Index: Stock Selection: In addition to the aforementioned sector screens, there is also a geographic revenue requirement to ensure a domestic European focus: constituents must derive more than 50% of their revenue from inside Europe, giving focus to what is happening within Europe and less sensitivity to the global growth outlook. Weighting: We also employ a weighting methodology to maximize sensitivity to improving economic conditions. This process tilts the weight toward stocks whose returns have been most correlated to changes in economic conditions, defined by the European Commission’s Economic Sentiment Indicator discussed above. This unique weighting methodology ranks stocks by their correlation to the Economic Sentiment Indicator and, using a smoothed weighting process, tilts weight from the traditional benchmark market capitalization weights toward stocks that are more responsive to changes in economic sentiment and activity. Formally, the weights are set by two factors: 25% according to their market capitalization percentages, and 75% according to how correlated each stock is to economic activity over the last five years (based on each stock’s returns and its relationship to the European Commission’s Economic Sentiment Indicator). Bottom Line 3 : Local Focus: WisdomTree Europe Local Recovery Index has nearly 70% of its weighted average revenue coming from within Europe. Opposite of WisdomTree Europe Hedged Equity Index: This is a distinctly complementary approach to that employed by the WisdomTree Europe Hedged Equity Index, which requires constituents to derive more than 50% of their revenue from outside Europe. The weighted average revenue exposure from Europe in that Index is only 30%. Unhedged Local Exposure Complements Hedged Exporters: There has been a huge amount of interest in currency-hedged eurozone exporters in 2015. The unhedged local recovery basket provides a nice complement both from its unhedged nature and the distinctly different profile of stocks represented in the local recovery Index. Based on the macroeconomic trends discussed in our blog post ” A Recovering Eurozone Economy: Where Should You Position? ,” this local recovery index should also be a focal point for traditional unhedged replacements, as the local economy is showing relative strength within the European economy. Sources Bloomberg, Eurostat and WisdomTree, with data as of 6/30/15. Bloomberg, European Commission, European Central Bank and WisdomTree, with data as of 9/30/15. Bloomberg, FactSet, with data as of 9/30/15. Important Risks Related to this Article Investments focused in Europe increase the impact of events and developments associated with the region, which can adversely affect performance. Jeremy Schwartz, Director of Research As WisdomTree’s Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel’s head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper “What Happened to the Original Stocks in the S&P 500?” and the Wall Street Journal article “The Great American Bond Bubble.”

DON: A Typical Mid-Cap ETF Presented As A Dividend ETF

Summary DON offers a dividend yield of 2.45%. It just isn’t high enough to make me think of this as a compelling dividend investment. The individual company allocations are reasonable for preventing diversifiable risk. The expense ratio is simply too high for my tastes. The sector allocation strikes me as being too volatile. Looking at historical performance confirms the higher volatility of the fund. It delivered great performance, but it was compensation for risk. The WisdomTree MidCap Dividend ETF (NYSEARCA: DON ) is a weird fund that doesn’t quite seem to go together for me. I’ve seen quite a few good dividend ETFs lately and started to wonder if my standards were simply slipping. It seems I was just due for finding one that didn’t work for me. Expenses The expense ratio is a .38%. This is quite a bit too high for my tastes. Dividend Yield The dividend yield is currently running 2.45%. Is that really a dividend ETF? I’m not convinced so far. Am I just having a grumpy night? Who knows, but I’m expecting dividend yields to exceed 2.5% even in this low interest rate environment. Some of my ETF holdings have yields over 2.5% without any emphasis on the dividend yield. Holdings I put grabbed the following chart to demonstrate the weight of the top 10 holdings: (click to enlarge) The thing I do love about these allocations are that the diversification across individual companies is excellent. There are very few companies with a weight higher than 1%, so any scandal event would be unlikely to cost an investor a substantial portion of their portfolio. I do like seeing Coach (NYSE: COH ) as a top holding and I certainly don’t mind their dividend yield being greater than 4%. The question may be how many low dividend holdings are included in the fund to drive the fund yield below 2.5%? Mattel, Inc. (NASDAQ: MAT ) has a dividend yield greater than 6%. I’ll have to admit that when the dividend yield gets that high I have to start questioning the sustainability of the dividend. I prefer dividend growth to always be positive. Negative growth just doesn’t offer the same appeal. Darden Restaurants (NYSE: DRI ) is another solid yielding stock at 3.55% and they recently delivered a solid earnings beat from their “OG TO GO” program which allows customers to pick up food from Olive Garden to go. The program is excellent because it allows the company to expand the volume of sales without requiring substantial capital expenditures in new seating areas. Lately quite a few of the restaurants I cover have been trying to figure out how to deal with increased traffic because they just don’t have enough seating room. Of course, it is possible to handle that problem by raising prices but the competitive nature of the casual restaurant industry is incredibly fierce to companies that opt to give customers less value for their money. Sectors (click to enlarge) I don’t like it. That’s got to be one of the most frank assessments you’ve heard on sector allocations and it is precisely accurate. I really don’t like this sector allocation whatsoever for a dividend ETF. There is a very heavy emphasis on financials and consumer discretionary. The allocation to utilities is nice at 13%, and I don’t mind industrials at 14.04%, but I’d rather see financials and consumer discretionary at the bottom of the list. I’d like to see consumer staples and health care with heavy allocations. Neither of them got the nod. There is nothing wrong with this sector allocation for a typical mid-cap ETF , but I’d rather see it named along those lines. Generally speaking I find the mid-cap space to be more volatile than the large cap space and I’d rather feel that the holdings within that part of the market were going to be safer holdings. That makes me double down on the importance of using heavy allocations to consumer staples. This portfolio is designed in such a manner that makes it simply feel too risky for investors that are focused on dividends and growing their portfolio. I wouldn’t mind it as a simple “mid-cap” ETF, but it doesn’t work as a dividend ETF for me. When I ran a regression on the returns for DON with the returns for the S&P 500 as measured by the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), with a sample period going back to June 2006, the results were great for returns but bad for risk. DON returned a very impressive 119% in that period while SPY returned 101%. Clearly that strong performance is great, but the max drawdown was almost 62% compared to 55% for SPY and the annualized volatility for DON was higher. Simply put, I believe the excess returns here are strongly correlated to the excess risk. There is nothing wrong with a higher risk portfolio, but it doesn’t match the typical expectation of an investor hoping to drop their cash in and get a fairly safe and growing stream of dividend income. Conclusion This is a fine mid-cap ETF but it doesn’t make sense as a dividend ETF. The yield, the sector allocations, and the risk level demonstrated over the last 9 years or so are indicative of a more typical mid-cap ETF that is appropriate for aggressive investors with very bullish expectations about the future path of the economy. This is the kind of allocation I would be interested in buying when the market had crashed and already lost 40% of the total market value. If shares get that depressed, then this allocation would be much more acceptable for trying to catch the ride back up in equity prices. In my opinion, our market would have to fall quite a ways before I would want to start grabbing up those highly aggressive allocations. I can’t argue with the past returns, but the risk just doesn’t match up with my desires.