Tag Archives: etfs

Short IWM, SLY Or VB And Long GWX? U.S. Small Caps Likely Overpriced

Summary U.S. small caps seem overvalued relative to international small caps. The dominate way to exploit this fact would likely be short VB and long GWX with a Sharpe ratio of 1.93. Given uncertainty about the underlying valuations of the ETFs, expected returns are between 22-42%. On Saturday, I stumbled across what I believe to be irregularity in the pricing of small-cap stocks, which I thought was worth exploring for a trade during my daily commutes. Since I generally operate under the assumption that I am wrong and the market is right and I am not much of a trader, I thought it was worth publishing the idea for critique before I put any real Helvetic francs to work. As we all know the major averages have taken a beating and the small-cap stocks have been hit harder than the large caps as one might expect. The international small-caps now seem undervalued relative to the United States where foreign capital continues to pour into small-cap companies to take advantage of the rising dollar, while at the same time be insulated against large-cap foreign earnings currency translation. Are (U.S.) Small-Caps Fundamentally Overpriced? Pitching my thesis, someone asked whether U.S. small-caps fundamentally overpriced. There are a number of ways of answering that question, in terms of growth, historical terms, GDP expectations, or using a model of international financial integration. In terms of growth the U.S. stocks now have a FW PEG ratio of about 1.25x, which is fundamentally overpriced, whereas the international stocks are about fair value with a FW PEG of about 1. In historical terms, stocks are pricey in general, but the international stocks are more in line with history. But in general, since stock prices often have little tether to their underlying claim on future profits, so we often look to analogous assets for guidance. Since I am a macro-economist, this article answers that question of fundamental valuation from an international capital mobility perspective, and the answer is, “Yes, U.S. small-caps are dear.” Under complete capital mobility, efficient exchange rate discovery, then U.S. small-caps are fundamentally misvalued . The U.S. has nigh perfect capital mobility, and we shall see below the exchange rate discovery is efficient. International investors prefer a cheaper claim on future profits for similar asset classes, ceteris paribus . The expected change in the dollar that drove international investors into small caps is likely overdone, meaning U.S. stocks are likely overpriced. Figure 1: Recent trend of the SPDR S&P International Small Cap ETF ( GWX) ((blue)) vs. the iShares Russell 2000 ETF ( IWM) (red). Source: Yahoo! Finance (click to enlarge) As one piece of evidence of this thesis, there seems to be a large discrepancy in the valuation levels between the Russell 2000, and the other major U.S. small-cap ETF holdings, and State Street’s GWX. The other international small-cap indices, the iShares MSCI EAFE Small-Cap ETF ( SCZ) and the Vanguard FTSE All-World ex-U.S. Small-Cap ETF ( VSS), are also a bit cheaper than IWM / the SPDR Russell 2000 ETF ( TWOK), but GWX seems to be the cheapest, and thus is the focus of this arbitrage. The ETF’s undervaluation is a bit surprising because GWX’s index, the S&P® Developed Ex-U.S. Under USD 2 Billion, does not seem terribly underpriced vis-à-vis the Russell 2000. Further evidence is exhibited in Table 1, which shows the standard valuation metrics of the major U.S. small-cap ETFs against GWX. Table 1: Fund and Index Characteristics ETF: Vanguard Small Cap ETF (NYSEARCA: VB ) SPDR S&P 600 Small Cap ETF (NYSEARCA: SLY ) SPDR Russell 2000 ETF ( TWOK)/IWM GWX Earnings Growth 3-5 Year Growth 14.87%* 14.61% 15% 16.67% Weighted Average Market Cap 2018 1714 1908 1248 Number of Holdings 1494 600 1963 2303 Price/Cash Flow 10.6 10.74 10.46 3.12** Price/Earnings 29.5 21.6 17.94 15.62 Price/Earnings ratio FY1 19.19 19.6 18.78 16.52 Return on equity 11.8% 11% 6.84% 9.40% Price/Book Ratio 2.5 2.03 2.07 1.37 Dividend Yield 1.43% 1.31% 1.62% 1.66% Price/Sales*** 1.17 1.16 1.15 0.74 * Average of SLY & IWM. Not all fund information is available. Some of the values are taken from the underlying index. **Still listed on their website as of this writing, but SSGA responded in an email stating the fund’s current P/CF is 8.55x. ***Source: macroaxis.com. Data as of Saturday, 15th August 2015. Based the fund information, most of the key metrics indicate that GWX is cheaper than its U.S. counterparts. That discount for an analogous asset class opens up the possibility of a pair trade by going long GWX and short one of the small-cap U.S. ETFs. ETFs have been a great financial innovation allowing retail and institutional investors to cheaply invest. Yet, I do think they have a few weaknesses that became more apparent in this exercise. The first is that all the characteristics needed to rationally evaluate the ETF holdings are not entirely reported, nor are they comparably reported across providers. Moreover, the entire holdings lists are often not reported in a way that allows one to match with external data to fill that gap. A glaring example is that State Street reports a 3.12x cash flow for its benchmark index on its website for GWX, but the index provider reports 14.12. It is hard to know whether this is typo (doubtful because attributes are reported daily and hence are likely automated), or some value-factor “optimized sampling” (a term of art in the ETF industry), which the State Street uses to juice returns when selecting the 2303 stocks from the 3571 stocks from the benchmark index, or how negative cash flows are accounted for. All these small differences make a pure arbitrage play more difficult because the margin of error is slim already given the relative efficiency of the market. The other thing that became clear is that the funds often trade at a premium to NAV and their holdings seem to be slightly bid up vis-à-vis their benchmark (i.e. NAV premium drag on top of ETF drag on top of indexing drag). Both likely have some drag on returns; depending how you leg into the long and short side you might already be down 100 bps before commissions. Not a trade breaker, but an additional complication. As an additional caution for our investors outside the U.S., please be aware that this arbitrage strategy poses additional risks because foreign versions of these ETFs exist in highly fragmented regulatory environments, which are essentially legalized scalping operations with mile-wide bid-ask spreads, implied local currency premia, higher expense ratios, and stronger departures from NAV. Étude d’Arbitrage Now that we have a trading thesis in hand, the question is how to best operationalize it. While the spark of a trading idea came from the price of the Russell 2000, alternate ways to implement the strategy might be to short Vanguard’s VB or State Street’s IWM, two widely held small-cap ETFs. We thus need to ascertain the concomitant risk-return profiles for each possible implementation (a tedious feat, and why most arbitrage is done with computers). Since we are dealing with percentages, there are a few ways to calculate the returns depending on whether you think the trade will lean to one side. The assumption here is both legs will eventually regress toward their mean netting profit on both sides. Rather than rely on a single indicator like price to book, I calculate the average of them all in order to estimate the expected arbitrage for a leg. Table 2 shows the expected gains for each leg, which are calculated off the center point values of the legs. Table 2: Arbitrage ALTERNATE SHORT LEGS LONG LEG GWX AGAINST: VB SLY TWOK/IWM VB SLY TWOK/IWM Price/Cash flow* 12.5% 11.1% 12.7% -9% -9% -10% Price/Earnings -36.9% -13.8% -6.5% 19% 19% 7% Price/Earnings ratio FY1 -5.9% -7.9% -6.0% 9% 9% 7% Return on equity 18% 6% -16% -6% -6% 16% Price/Book ratio -32.0% -16.3% -16.9% 24% 24% 26% Dividend yield convergence -3.5% -11.8% -1.2% 11% 11% 1.2% Price/Sales -23.2% -22.1% -21.7% 28% 28% 28% 5-Year growth convergence -3.5% -4.7% -3.5% 4% 4% 3% Ex{Center point arbitrage on leg} 9.3% 7.4% 7.4% 10.1% 10.1% 9.7% Ex{Total gain} (3.12x CF) 19% (42%) 17.5% (39.7%) 17.1% (39%) *Assumed to be 13.12x not 3.12x. See text. Since, the expected gains may be sensitive to the cash/flow outlier, I conservatively assume the cash flow to be 13.12x rather than 3.12. Being short the U.S. small-caps and long foreign small-caps implies being short dollars and long foreign currency, which means currency is a concern. A fair assumption might that the spot rate is the correct rate, but currency translation has been a major headache for me this year (thank you SNB…), so I am especially cautious. In order to estimate FX effects, I use the standard economist’s model that domestic net interest and inflation rates equal net inflation interest and inflation rates abroad, where “abroad” I define as Japan and the Eurozone. Currency Risk USD (EUR+JPY) /2 Spread Inflation (IMF 2016 forecast) 1.49% 1.10% 0.39% Interest (forward 6-month LIBOR) 0.56% 0.24% -0.32% Net spread: 0.07% Estimated USD appreciation needed to eliminate spread: 0.29% What amount of currency appreciation would U.S. rates into line? About 0.3%, assuming an inflation/currency elasticity of -0.24 (Kim 1998, pg. 617). Bond and currency traders seem to be doing their job extremely well, so we probably should not worry about currency. Since the strategy is equally long and short, it should be market-neutral. Yet, despite the proposed trade having an expected beta of zero, it entails risk. Therefore, I estimate the portfolio standard deviation using 2 years of adjusted price return data from Yahoo! Finance as a proxy for the portfolio risk. Strategy Profiles Table 3 shows the strategy implemented either using 2 or 3 ETFs. Using more than one short leg held out the possibility of reducing risk. Table 3: Strategy Implementation Profiles Three Asset Two Asset -VB/+GWX -SLY/+GWX -IWM/+GWX -SLY/+GWX -VB/ +GWX -IWM/ +GWX -TWOK/ +GWX -SLY/ +GWX Ex{Sharpe}* (3.12x CF) [+ lending] 1.54 (3.57) [4.15] 1.40 (3.39) [3.61] 1.93 (4.31) [4.99] 1.43 (3.44) [4.01] 0.68 (2.54) [3.07] 0.82 (2.00) [2.34] Ex{Equity Arbitrage} 23.51% 22.15% 25.05% 22.32% 22.32% 21.97% Ex{Currency Delta} -0.29% -0.29% -0.29% -0.29% -0.29% -0.29% Ex{Borrow Costs} -1.24% -1.48% -1.00% -1.48% -9.11% -1.47% Ex{Lending Income} 6.29% 6.29% 6.29% 6.29% 6.29% 6.29% Ex{SD Portfolio} 10.9% 11.1% 9.4% 11.0% 11.9% 18.6% *Returns calculated without lending income and 13.12xCF. See text. I present 3 different Sharpe values. The most conservative version assumes a price to cash flow of 13.12x. The second uses the provider’s index information. And the third includes the market rate security lending income. If you are able to collect the market rate for lending GWX, the trade becomes almost a pure arbitrage play. With an expected Sharpe of 1.93, the dominant operationalization would appear to be short VB and long GWX. Conclusion It would therefore seem, even based on conservative calculations, the proposed long-short strategy dominates a long position in the S&P500, which has an expected Sharpe of about 0.47. All of the trades seem to meet the first test of rationality, and thus a decent risk-adjusted trading opportunity. For this reason, I like to know what you think. Is the data wrong? Have I made an error in calculation? Is there a problem with my deduction and/or conclusion? If not, how would you implement the trade and when? Based on your feedback I shall make a determination to open a small position. 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.

Response To: Structured Note Read The Fine Print

Response to a biased article by AllianceBernstein on Structured Notes. Structured Notes may be helpful in introducing, reducing or modifying risk. The referenced Structured Note is not given credit in the referenced article for the downside protection it provides. Furthermore, to compare to a balanced portfolio which wins in all markets is unrealistic. I recently came upon a Seeking Alpha article by Alliance Bernstein titled Structured Notes: Read the Fine Print . The article expressed a fairly negative and, in my opinion, inaccurate view of structured investing based on an analysis of one structured note in particular. As an experienced structurer and trader prior to founding Exceed Investments, I’d like to help set the record straight. The article analyzes a 5-year 28% buffered note on the S&P 500 as an example. While they do not share a link to the terms, the note is similar to, if not exactly the same, as this note . First, let’s briefly consider what a structured note is and discuss its purpose. Structured notes are an example of what I call “defined outcome” investments, which are options-based strategies that allow investors to shape a risk/ reward exposure to fit their personal objectives. In these strategies, market participation levels are preset. Therefore, the targeted downside participation is known in advance, as is the upside potential. A defined outcome investment can be built to introduce risk, reduce risk, or modify it – in this case, the 28% buffered note offers S&P exposure with a material level of downside protection, which I will refer to as downside “insurance” in this article. Performance at maturity, assuming no default of the issuer, looks like this (X axis is Adjusted S&P 500 return; Y axis is the Note return): An investor may be interested in this product if they are risk-averse but still want to participate in equity markets (e.g., an executive who is retiring in 5 years from now and can’t take a big hit over the next 5 years). The “insurance policy” of this note will cover up to 28% of downside “damage” 5 years from now – e.g., market down 28%, investor loses 0, market down 40%, investor loses 12%. As in all insurance policies, a premium needs to be paid – in this case, the investor loses all dividends of the S&P 500. Over 5 years, those lost dividends amount to about 12% in a reasonable model scenario (2% annual dividend rate, assumed reinvestment at a compounded 8%). Is 28% of potential downside insurance worth giving up 12% of dividend upside, while still participating in the price appreciation of the S&P 500? There’s no right answer to that question as it depends on an individual’s needs and perspectives. As mentioned, I found a number of inaccuracies and misrepresentations (e.g., expense levels, liquidity) in the article but will focus on the main items which I found to be flawed. To summarize: The article directly compares the expected performance of the S&P 500 with the Note, without fairly pointing out the insurance benefit provided by the Note The article then compares the performance of a balanced portfolio with the Note, which I find two issues with – Why compare a product vs. a balanced portfolio? It’s an unfair comparison – no sane investor would invest all their funds in a single note The balanced portfolio described is somehow expected to gain during equity declines as well as fairly closely match bull returns, which is just impossible Greater detail follows: “Our analysis suggests that this structured note has an 80% chance of underperforming the S&P 500 over the next five years…” On one hand, while I can’t attest to the accuracy of their model, it seems reasonable. The note will underperform the S&P if the S&P finishes > -12% after 5 years. That’s because the cost of the insurance purchased, (i.e., 12% of lost dividends), will be greater than the insurance “payout” if the market isn’t down by more than 12%. Given historical performance, odds are the S&P does better than a cumulative -12% over the next 5 years. On the other hand, this isn’t a fair statement. If an investor buys any type of insurance, (e.g., earthquake insurance, fire insurance, theft insurance) and there is no major catastrophe in the next 5 years, which is usually the case, the investor will lag the performance of people who didn’t buy insurance. The same is true of buying 28% worth of portfolio insurance – if the market isn’t down by at least your premium spent, you will lag. That obviously doesn’t mean ipso facto that no one should buy insurance. “Projecting thousands of plausible outcomes across all types of market environments, we found that the median outcome for the structured note is more than 6% below what we’d expect from a fully diversified balanced portfolio, as the next Display ” For starters, no reasonable investor would take all their assets and purchase this single structured note vs. choosing a balanced portfolio. A more reasonable approach to this comparison may be to replace a relevant component of the balanced portfolio, for instance large cap value, with the structured note and then stress test outcomes between the two varying portfolios. Now let’s talk about the finding that a balanced portfolio over 5 years results in a median 4.5% return when the stock market finishes down, and a median 38% return when the market finishes up (which is apparently just about equal to the S&P price return). While I am sure their model is well designed, this simply doesn’t pass the smell test. How did individuals with balanced portfolios do in 2008? Hint: not very well. I am not aware of any product or portfolio design that had positive returns in 2008 and then proceeded to equal the price return of the S&P 500 over the following five years. If someone else is, please share it with me so I can invest. In conclusion, while I acknowledge that Structured Notes have issues (I cover them in detail at the end of this white paper ), which is what drove me to found Exceed Investments in the first place, this article does not treat them fairly. Ultimately, the referenced note provides a very defined risk / reward exposure to the S&P 500, providing a level of downside protection that may be deemed appropriate and/or may resonate for a subset of investors. 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. I have no business relationship with any company whose stock is mentioned in this article.

Trounce The Market With Less Risk

Over a lifetime, stocks trounce bonds more than 800-fold. Contrary to conventional thinking, LESS risk taking can lead to HIGHER returns. Active investing can significantly outperform balanced, buy-and-hold strategies. Most of us tend to think of investing in terms of the experiences of our lifetime, and in fact, of that limited span during which we were vaguely aware of economic events in the world at all. (Nope, you can’t count those teenage years…) But it is important to view things in a greater historical perspective. The chart below does that. (click to enlarge) Source: Stocks, Bonds, Treasury Bills and Inflation 1926-2010 If you zoom in on the graph, you’ll quickly grasp one salient fact: over the long run, if you can stand a bit of risk, you’ll certainly be richly rewarded for that risk. From 1926 to today, an investment in the lowest risk strategy, short term government bonds, grew your money 19-fold, but barely outpaced inflation which eroded the value of the dollar 12-fold over that same period. In stark contrast, investing in small caps grew your money 16000-fold. Yes, you read that right! Put another way, a $1000 investment grew to just over $16 million. Here are a couple of other important observations: If time is on your side, you are seriously shortchanging yourself by not investing in the stock market. A small increment in your yearly return makes a huge difference over time. Look at how a 4 percent difference between large cap stocks and long term bonds increases returns by more than 40 times over that period. Thanks to the incredible magic of compounding, the earlier you start the better off you’ll be. The more you depend on your investments for income today, the less you can (safely) earn, ironically enough. (The corresponding corollary to that in the banking sector is that the more you need a loan, the less likely you will get one. Oh well…) It may take you 20 years to recover from a market break! If you invested in the market in late 1928, you were not back to square one until 1946 !!! (If you think we have that problem solved, just talk to some Japanese investors. Or view this article on my blog.) Even government treasuries can be a poor investment. See the period from 1965 to 1970, when treasuries dropped, yet inflation was raging. Faced with the complexities of investing, sticking your head in the sand and your money under your pillow just ain’t the way to go! Just look at that inflation line. It means your $1.00 invested in 1928 buys you about 8 cents in 2015 prices. So you cannot afford to be on the sidelines. In fact, if you are not investing, you have almost a complete certainty of seeing your assets shrink. So given all of these conclusions, how should you invest your hard-earned money for the best results? Or if you’re among the fortunate few born with a silver spoon in your mouth, how should you protect your leisurely-inherited millions? The short answer is: it depends… For those of you not quite happy with that decidedly hedged answer (Ever wonder what the word hedge funds really means?), please read on. I promise to give you a more concrete response. A traditional approach would be to spread your assets widely among several groups of investments. Take a look at the following graph showing how several different categories of exchange traded funds performed in the last big stock market crash in 2008. (click to enlarge) As the graph makes clear, while the stock market was plunging, other market sectors (mortgage-backed securities, short and long term treasuries, corporate bonds and government backed securities) were rising. So by mixing your asset classes, you can significantly smooth out the volatility of your portfolio. This is particularly important for retirees, since you can choose to withdraw only from areas that have risen in value, as opposed to selling at the worst possible moment, when asset values are at all time lows. A number of mutual funds and ETF’s already subscribe to this strategy. The chart below shows the performance of the Janus Balanced Fund, plotted against the SPDR S&P 500 ETF Trust ETF (NYSEARCA: SPY ), which is a proxy for the S&P 500 index. This has averaged a 9.85% return over 20 years, with fewer big drawdowns than the S&P itself. (click to enlarge) (click to enlarge) If you pay close attention to the percentage comparison, you will note that the balanced approach actually beat the S&P 500 in overall return with less volatility along the way! Some people mistakenly assume that this “spread your marbles out evenly” strategy argues against an actively managed approach. Nothing can be further from the truth. The next two graphs show an active approach that picks the best stocks in the US stocks universe (according to our proprietary formula), times the buys according to certain technical criteria related to momentum, and rebalances the portfolio on a weekly basis. Here is a relatively low-beta (low volatility) approach, that still wallops the results of the JANUS fund shown above, as well as the S&P. (click to enlarge) And for those of you willing to sit tight through a little more volatility, how does a 16 fold return on your money over a 12 year period grab you? But don’t complain about the 50% drawdown… (click to enlarge) Source: quantopian.com Strategy back-testing based on universe of 8000 plus US stocks from 1993-2015. Graphed results are NOT based on historical performance. Real results may differ significantly from back-tested results. 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. Additional disclosure: The author currently holds positions using some of these strategies. We do not currently hold position in the Janus fund. The active strategies mentioned require margin accounts and the ability to short stocks at certain times.