Tag Archives: etfs

Low Blow – Why Low-Volatility ETFs Could Prove Anything But When You Really Need Them To Be

By Ian Kelly Just as nobody buys a parachute primarily for its colour – well, certainly not twice – presumably the main reason investors choose to buy low-volatility exchange-traded funds (ETFs) is safety-related. If they really were looking for a smoother ride from the share prices of their underlying holdings, though, events in global markets over the last few days may well have come as a considerable shock. Low-volatility stocks have enjoyed a good run in recent years, and as is often the way with investment, the better an asset or sector performs, the more people want a piece of the action. The low-volatility ETF market is now considerable – to pick out one example, the PowerShares offering that tracks the S&P 500 Low Volatility Index (NYSEARCA: SPLV ) has attracted almost £3bn from investors since its launch in May 2011. If pushed on why low-volatility stocks have done so well, here on The Value Perspective, we would raise the possibility they were priced very cheaply at the start of their run. In a previous article, ” Lost and pounds “, for example, we reminded you how lowly valued tobacco stocks used to be as the market fretted over, among other things, huge threats of litigation. Then, as those fears largely receded, the shares re-rated. Once a group of stocks reach “fair value”, however, the only way they can continue to outperform the rest of the market is if they grow their earnings more quickly. Where we would take some convincing then is that there is any reason why a business would be able to grow its earnings faster over the longer term just because its share price happens to bounce around a little less than the wider market does. In other words, while a low-volatility strategy has worked in the past, we have our doubts as to whether it will to continue to do so. Where we have few doubts, however, is that many people will have been shocked over the last few days by just how volatile their low-volatility ETFs have proved since the global markets went into free fall over concerns about China. The following chart shows how the aforementioned S&P 500 Low Volatility ETF traded versus the whole S&P 500 on Friday, August 21. While we would not normally focus on intra-day pricing on The Value Perspective, when a low-volatility ETF at one point plummets 46% as its wider benchmark drops just 7% – while trading real volumes on those numbers – we are prepared to make an exception. (click to enlarge) (Source: Bloomberg, August 2015) (click to enlarge) (Source: Bloomberg, August 2015) A good lesson to take from this is the importance of, as it were, looking under the bonnet of any collective investment so you are comfortable with the sort of businesses you own through it. Anyone “popping the hood” of the S&P 500 Low Volatility Index, for example, would find an allocation of almost 15% to insurance companies and a further 13% to real estate investment trusts. Is there any great reason why the valuations of these stocks should not be volatile over time, or in the case of insurance, the businesses themselves should not be volatile? If you accept that the valuations of these businesses and their earnings are likely to be volatile, you might ask what are they doing making up more than a quarter of a low-volatility benchmark? The answer lies in the fact that these kinds of indices, and the funds that track them, are mechanistic in nature. Thus, the S&P 500 Low Volatility Index is set up to measure the performance of the 100 least volatile stocks of the S&P 500, with volatility defined as “the standard deviation of the security computed using the daily price returns over 252 trading days”. It may seem odd for the index to have a 15% allocation to insurance companies today, but over time, ideas such as low volatility can become self-fulfilling. There will be times when this sort of strategy works and times when it does not. But you only ever get what the market is willing to pay, and at one point on August 21, for low volatility, that was half what it was the day before. To our minds, owning a low-volatility investment that fails to provide it when it is really needed is akin to a pretty-coloured parachute which doesn’t open when you pull the cord.

Have The Robots Broken The Stock Market?

As more and more economic data comes out, it is becoming clear that China really isn’t having much of an impact on the US economy. Today’s initial jobless claims is about as real-time as it gets, and they’re near all-time lows. So now, Monday’s flash crash is becoming an even hotter topic. Here’s my experience, and why more human involvement might not be such a bad thing. The markets were sloppy last week, and we went out on a bad note. Sentiment was very negative. And when Chinese stocks continued to crash on Sunday, it looked like we might be on the verge of something nasty. Uncertainty was everywhere. And then the robots took control. I watched the futures market almost all night on Sunday, and we were seeing 100-point moves in the Dow Futures contract within a few minutes. This was not human controlled. And it was not rational. I reached out to a friend of mine who has some experience in High Frequency Trading, and here’s what he said to me: ” I am beginning to wonder if certain algorithms don’t get confused during these liquidity events. This week’s trading looked like momo [momentum] algos chasing price which turned into a positive feedback loop on itself until the system just crashed. ” That statement resonated with me. After all, I’ve traded through the rise of the robots, and I used to specialize specifically in illiquid markets, but I don’t recall anything quite like this other than the Flash Crash of 2010. When I woke up on Monday morning and watched the market open, I’d never seen so many broken positions. There were dozens of ETFs trading at 25-50% discounts to their NAV. I was buying the Schwab U.S. Mid-Cap ETF (NYSEARCA: SCHM ) at a 25% discount. (click to enlarge) That is, I was playing market maker with my small asset management business in a broken market, because I looked at the prices and I knew for a fact, without seeing the Intraday Indicative Value of the ETF, that we were trading at irrational discounts. The robots failed to do that. Humans like myself, who have traded in these kinds of markets before, are like first responders. We run into the fire when everyone else is running away from it. Had there been more human market-making involvement that morning, I doubt this price discrepancy would have even occurred. I am certainly not against the rise of the robots and the technological progress we’re making, but some of the developments of the last few years do make me wonder if we’re relying a bit too much on the robots at times… Disclosure: My firm is net long SCHM (and has been for a long time) in many accounts. P.S. – I should add that this does not add credence to some of the commentary that ETFs are illiquid or inefficient products. In fact, ETFs traded precisely how we should have expected them to. And when some underlying positions didn’t open, many irrational sellers sold into the panic. This was not a product error. This was a human error. I wasn’t the only one who recognized this error in real-time.

Fidelity Equity Dividend Income: I’d Rather Own A CEF

FEQTX changed managers in 2011 looking to spruce up performance. Although there has been improvement, the results have been middling. If you are looking for income, you might be better off with a CEF. Mutual funds are generally the top-of-mind way for investors to quickly gain access to professional management. However, the Fidelity Equity Dividend Income (MUTF: FEQTX ) shows why you need to be cautious when you go down this route. In the end, if you are looking for dividend income, there are better options out there. Turning to a new leader FEQTX changed managers in late 2011 with the goal of shaking things up at a fund that had been lagging and, generally, not living up to its name. That means that 2011 and part of 2012 were really a transition period as new manager Scott Offen put his mark on the fund. So he’s got about three years of performance under his belt with a portfolio he created. The fund’s objective is reasonable income and capital appreciation. Reasonable income is defined as a yield above that of the S&P 500 Index. FEQTX’s trailing yield is roughly 2%. For comparison, the SPDR S&P 500 ETF Trust’s (NYSEARCA: SPY ) yield is about 1.9%. So I guess it lives up to its definition of reasonable yield, but that may not be your definition. Searching for stocks, Offen looks for , “…companies that deliver attractive, above-market dividend income and provide exposure to conservative earnings-growth potential with relatively low volatility.” He likes companies with, “…high or improving returns on capital and companies with strong balance sheets, including cash on hand…” As a shareholder, these are the types of things you’d like a manager to look for. The fund tilts toward value stocks, which isn’t surprising since Offen’s last gig was at a value fund. The interesting thing here is that the manager cautions that focusing too much on yield is dangerous. He highlights the banking sector during the 2007 to 2009 recession as a cautionary tale. And while that’s a worthy warning, 2% isn’t a material yield and it certainly isn’t much more than an index is offering, so income investors looking at, or in, this fund have a right to wonder if they are getting their money’s worth. Performance is so-so The problem is that performance relative to the S&P isn’t all that great. Over the trailing three years through July, FEQTX’s annualized return, which includes reinvested distributions, is around 14.7%. The SPY’s annualized return over that span is nearly 17.6%. Both have roughly similar standard deviations and FEQTX’s Beta is nearly 0.95, meaning it moves roughly in line with the S&P. (SPY, as you might expect, moves in lock step with the S&P.) So there’s little yield advantage, no performance advantage, and the same amount of risk. Although the expense ratio of around 0.60% is low for a mutual fund, the extra expense isn’t worth it when you could by SPY, get better performance and a similar yield, and pay just 10 basis points or so in expenses. A better alternative? This is why you shouldn’t get sucked in by a fund name. I’m not suggesting that FEQTX is a bad fund, per se, just that it isn’t compelling enough compared to other options. That said, I don’t believe it lives up to the words “dividend income,” which are found in its name. If you own the fund or are looking at it, you’ll basically be getting something on an index clone at greater cost. Why not shift gears and look at a completely different space? For example, you might consider the Nuveen S&P 500 Buy-Write Income Fund (NYSE: BXMX ). This fund was created through the merger of two older Nuveen closed-end funds late last year and now has the goal of tracking the S&P while writing index options to generate current income. It doesn’t have a long track record, to be sure, but it has put up decent results so far. First off, the distribution is around 7.6%, well above that offered by the index and FEQTX. And year to date through July, BXMX’s return is nearly 6.2% while SPY is about 3.4% and FEQTX is just 1.3%. A big difference, however, is in the expense ratio, which is just under 1%. But based on performance so far under the new investment strategy, you are being rewarded for that. The biggest risk, of course, is that the new strategy is untested. Which is a legitimate concern. That said, writing options should mute downside risk since in a falling market option income will offset capital losses. At least that’s the theory, anyway. Time will be the true test of this, meaning that you’ll need a little faith if you choose to own BXMX. But with a discount of nearly 7%, you are getting a little protection built in by buying below the actual value of the portfolio. Looking at that a little closer at recent performance, since the last few months have been pretty rough, BXMX’s trailing daily return over the last three months through August 26th was a loss of almost 4.2%. The S&P over that same span fell just under 7.3%. Over the trailing month through August 26th, BXMX was down about 5.1% and the index was down nearly 6.5%. So, through the current turmoil anyway, BXMX seems to be holding its own. Note, too, that upside performance should be muted in a roaring bull market because of the use of options. This year’s sideways market is really a good space for option writing. So the strong out of the gate performance really shouldn’t be taken as an indication of future performance. But income should always be notable. Not the only option That said, BXMX is just one option. It seems like a compelling one compared to FEQTX, but there are other closed-end funds with compelling yields and performance histories. That said, the real point here is to make sure you understand what you own. That’s particularly true of mutual funds where a fund may not be living up to its name. If you find you are an income-oriented investor stuck in such a fund, consider shifting to closed-end funds. You might find you are willing to pay a little more for a higher level of income-that’s especially true when the fund you own is simply tracking a broader index. 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.