Tag Archives: etfs

Morningstar Ratings Of Target Date Funds Are Obsolete

Asset allocation is the primary determinant of investment performance and risk. Many say asset allocation explains more than 90% of investment results, but the fact is that it explains more than 100% . Because of this importance, we provide a detailed examination of target date fund glide paths in order to differentiate the good from the bad. Our focus is on fiduciary responsibility and the characteristics of a glide path that make it Prudent. Prudent glide paths are good. Imprudent glide paths are not good for both beneficiaries and fiduciaries. Fiduciaries face possible legal action for imprudent TDF selections. A glide path does not have to produce high returns to be Prudent. In fact, high returns can be an indication of imprudent risk taking. We use the PIMCO Glide Path Analyzer in the following to examine TDF Prudence and to develop Prudence Ratings that differ from Morningstar Ratings. Morningstar Ratings tend to penalize Prudence. Click to enlarge Defining Prudence The three great benefits of target date funds are diversification and risk control provided at a reasonable cost. All three of these benefits vary widely across target date fund providers, as shown on the right of the above graph. Looking to the left of the graph at long terms to target date, we see consensus in high equity allocation – the lines cluster. The differentiator at long dates is diversification. Theory states, and evidence confirms, that diversification improves the risk-reward profile of a portfolio. Greater diversification leads to higher returns per unit of risk, and is a benefit of TDFs. Looking to the right of the graph, near the target date, we see wide disagreement, with equity allocations at target date ranging from a high of 70% to a low of 20%. The prudent choice is safety at the target date, the other benefit of TDFs. These two key benefits, plus fees, are discussed in the following in the order of their importance. The most important benefit is safety at the target date Safety at the target date is the most important benefit for the following reasons: There is no fiduciary upside to taking risk at the target date. Only downside. The next 2008 will bring class action lawsuits. There is a “risk zone” spanning the 5 years preceding and following retirement during which lifestyles are at stake. Account balances are at their highest and a participant’s ability to work longer and/or save more is limited. You only get to do this once; no do-overs. Most participants withdraw their accounts at the target date, so “target death” (i.e., “Through”) funds are absurd, and built for profit. All TDFs are de facto “To” funds. Save and protect. The best individual course of action is to save enough and avoid capital losses. Employers should educate employees about the importance of saving, and report on saving adequacy. Prior to the Pension Protection Act of 2006, default investments were cash. Has the Act changed the risk appetite of those nearing retirement? Surveys say no. Click to enlarge As you can see in the following graph from PIMCO’s Glide Path Analyzer, only a handful of TDFs provide true safety at the target date. The second most important benefit is reasonable cost Fees undermine investment performance and are the basis for several successful lawsuits. You can be the judge of what is reasonable, keeping in mind that you want to get what you pay for. The challenge for plan providers is achieving good diversification for a reasonable cost. Assets that diversify, like commodities and real estate, are expensive. As shown in the following graph, only a handful of TDFs are low cost, similar to the scarcity of TDFs that provide safety at the target date. You need to ask yourself what you get for a high fee that you can’t get for a much lower fee. Fees Click to enlarge Diversification is the third most important benefit ” A picture is worth a thousand words.” Diversification is readily visualized as the number of distinct asset classes in the glide path, especially at long dates. The following are examples of well diversified TDFs, as seen through the lens of PIMCO’s Glide Path Analyzer. Keep these images in mind when you view the other glide paths shown in the next section. Think “A rainbow of colors is diversified.” Click to enlarge Common Practices Most assets in target date funds are invested with the Big 3 bundled service providers and with funds that have high Morningstar ratings. Here are the glide paths for these common practices. Click to enlarge Fidelity is the most diversified of this group, as indicated by the color spectrum at long dates (40 years). All three end at the target date with more than 50% in risky assets, which is not safe. As shown in the risk graph above, the Big 3 are low on the list of safety at the target date. Click to enlarge High Morningstar ratings go to funds with a high concentration in US stocks because US stocks have performed very well in the past 5 years. High Performance is not the same as Prudence. In fact, it’s currently an indication of imprudent risk concentrated in US stocks. Putting it all together: Prudence scores To summarize, some TDFs provide good safety, while others provide broad diversification, and still others provide low fees. To integrate these three benefits we’ve created a composite Prudence Score, detailed in the Appendix. The graph on the right shows the Top 20 Prudence Scores and compares them to Morningstar Ratings. The tendency is for the 8 highest prudence scores to get low Morningstar ratings. Four of the Top 8 have Morningstar ratings below 3. Prudence scores below the top 8 tend to get Morningstar ratings above 3.5 stars. The difference of course is performance, especially recent performance that has benefited from high US equity exposures. This “Group of 8” deserves your attention. Conclusion Fiduciaries now have a choice between TDF rating systems that are quite different. You can choose between Prudence and Performance. The cost of Prudence in rising markets is sacrificed Performance, but this sacrifice pays off in declining markets and can easily compensate for sacrifices. We hope you find this glide path report and Prudence Score helpful. We also hope that plan fiduciaries will vet their TDF selection. The fact that more than 60% of TDF assets are with the Big 3 bundled service providers suggests that fiduciaries are not considering alternative TDFs, so participants might not be getting the best; they’re simply getting the biggest. See our Infographic for more detail. Endnote Many thanks to PIMCO for letting me use their Glide Path Analyzer. It’s great. That said, the views expressed in this report are strictly my own. Disclosure : I sub-advise the SMART Target Date Fund Index that is included in this report. It’s treated exactly the same as all the other funds. Appendix: Constructing Prudence Scores The Prudence Score is not very quantitative, & much simpler than Morningstar ratings. It uses only 3 pieces of information: Fees: obtained from Morningstar # of diversifying risky assets at long dates: I counted these, & excluded allocations that are less than 1%. Some funds have meaningless allocations to commodities for example. Safety at target date: % allocation to cash & other safe assets, like short term bonds & TIPS. Here’s the table I filled out by hand: Company Fee (bps) # Risky % Safe SMART Index – Hand B&T 34 6 90 PIMCO RealPath Blend 28 6 30 Allianz 90 6 40 John Hancock Ret Choice 69 5 40 PIMCO RealPath 65 6 30 JP Morgan 82 6 30 Harbor 71 4 35 Blackrock Living Thru 98 5 35 Wells Fargo 53 5 25 Invesco 111 4 40 Putnam 105 3 40 MFS 102 6 25 Schwab 73 3 30 Guidestone 121 5 30 DWS 100 5 25 USAA 80 4 25 BMO 68 3 25 Franklin LifeSmart 110 5 25 TIAA-CREF 21 3 15 Vanguard 17 4 10 Hartford 117 5 25 Voya 113 6 20 Nationwide 89 6 15 American Century 96 4 20 Principal 86 6 10 Russell 92 5 15 Alliance Bernstein 101 4 20 Mass Mutual 97 5 15 T Rowe Price 79 4 15 Fidelity Index 16 3 5 Great West L1 99 4 15 Blackrock 98 5 10 John Hancock Ret Living 91 5 5 Great West L2 102 4 10 Manning & Napier 105 4 10 Fidelity 63 3 5 Mainstay 92 3 10 American Funds 93 3 10 Legg Mason 139 5 10 Franklin Templeton 110 4 8 Great West L3 95 4 5 State Farm 119 4 5 The next step is a little quantitative. I made up some rules for the importance of each factor: Safety got the highest importance. I adjusted the “% safe” allocations so the safest got a score of 25 Fees are 2nd in importance. I weighted them at 15. Diversification gets a max score of 10 Then I add the 3 scores for each & divide this sum by 10, so the highest composite score is 5: (25 + 15 +10)/10 The 1st table is totally verifiable. We can discuss the weighting scheme in the following 2nd table: Prudence Scores Company Fee (15) Divers(10) Protect(25) Prudence Mstar SMART Index – Hand B&T 12.8 10 25.0 4.8 1.5 PIMCO RealPath Blend 13.5 10 25.0 4.2 4 Allianz 6.0 10 25.0 4.1 1 John Hancock Ret Choice 8.5 7.5 25.0 4.1 2.9 PIMCO RealPath 9.0 10 18.8 3.8 4 JP Morgan 7.0 10 18.8 3.6 4 Harbor 8.3 5 21.9 3.5 3.4 Blackrock Living Thru 5.0 7.5 21.9 3.4 3.2 Wells Fargo 10.5 7.5 15.6 3.4 1 Invesco 3.4 5 25.0 3.3 4 Putnam 4.1 2.5 25.0 3.2 3.1 MFS 4.5 10 15.6 3.0 3.6 Schwab 8.1 2.5 18.8 2.9 3.6 Guidestone 2.2 7.5 18.8 2.8 3.3 DWS 4.8 7.5 15.6 2.8 3.3 USAA 7.2 5 15.6 2.8 3.5 BMO 8.7 2.5 15.6 2.7 4 Franklin LifeSmart 3.5 7.5 15.6 2.7 4 TIAA-CREF 14.4 2.5 9.4 2.6 3.5 Vanguard 14.9 5 6.3 2.6 3.5 Hartford 2.7 7.5 15.6 2.6 3.8 Voya 3.2 10 12.5 2.6 2.8 Nationwide 6.1 10 9.4 2.5 3.5 American Century 5.2 5 12.5 2.3 2.8 Principal 6.5 10 6.3 2.3 3.3 Russell 5.7 7.5 9.4 2.3 3.3 Alliance Bernstein 4.6 5 12.5 2.2 3.6 Mass Mutual 5.1 7.5 9.4 2.2 3.7 T Rowe Price 7.3 5 9.4 2.2 3.7 Fidelity Index 15.0 2.5 3.1 2.1 3.1 Great West L1 4.9 5 9.4 1.9 3.3 Blackrock 5.0 7.5 6.3 1.9 3.3 John Hancock Ret Living 5.9 7.5 3.1 1.6 3.2 Great West L2 4.5 5 6.3 1.6 3.4 Manning & Napier 4.1 5 6.25 1.5 4.2 Fidelity 9.3 2.5 3.1 1.5 3.3 Mainstay 5.7 2.5 6.3 1.4 3.6 American Funds 5.6 2.5 6.3 1.4 4.1 Legg Mason 0.0 7.5 6.3 1.4 3.3 Franklin Templeton 3.5 5 5.0 1.4 4 Great West L3 5.4 5 3.1 1.3 3.5 State Farm 2.4 5 3.1 1.1 3.2 PAGE * MERGEFORMAT 10 Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

How XIV Earns Value (Hint: It’s Not Through Contango)

From 2012 through mid-2014, the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ), an inverse VIX-futures ETN was a very profitable investment. It rose over 900% during that time. Since the end of that period, however, it’s shed over 60% of those gains, returning to 2013 levels. Any trading vehicle that dynamic is risky. Trading it profitably…and even just avoiding large losses…requires a solid understanding of what drives its movements. Unfortunately, however, many retail investors trade XIV and other VIX-futures ETNs like the ProShares Short VIX Short-Term Futures (NYSEARCA: SVXY ), the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ) and the ProShares Ultra VIX Short-Term Futures (NYSEARCA: UVXY ), based on an explanation of their value changes that’s inaccurate. The prevailing ( but incorrect! ) wisdom goes like this: ” The inverse volatility products (including XIV and SVXY) profit during contango by buying the cheaper front month, selling the more expensive second month and keeping the difference as profit. Since the term structure is in contango most of the time, this ongoing positive roll yield generates profits for the inverse volatility ETNs and drains value from the forward volatility ETNs VXX and UVXY.” You can find this explanation offered many places, including articles on Seeking Alpha: Before diving into what’s wrong with this explanation, I’d like to establish some background with a quick overview of futures and a description of how the VIX-futures ETNs are structured. I’ll then describe the real reason these ETNs’ value changes and look at why XIV was such a profitable investment from 2012 through mid-2014. I’ll discuss the association between contango/backwardation and profitability in the VIX-futures ETNs, then end with some observations on XIV’s dramatic rise and fall that may provide insight for trading these vehicles. The terms contango and backwardation are used throughout, so let’s explain those right away. When the futures term structure is in contango, the price of the front month future, M1, is lower than the second month, M2. In backwardation, the reverse is true. Figures 1 and 2 below illustrate this. Click to enlarge Figure 1. Contango. Click to enlarge Figure 2. Backwardation. Futures Overview Quick disclaimer here: I’m not a futures trader. What I know about the mechanics of this market comes from reading and from analyzing and trading VIX-futures ETNs. A long position on a future is a contract to buy a commodity, a bale of cotton for example, on a certain future date at a certain price — the purchase (i.e., contract) price at which the future was obtained. If market price for that commodity remains low until that contract’s delivery date, the purchaser pays for the benefit of having locked down the price ahead of time. The contract’s seller, on the other side, has the short position and collects a holding fee for storing the commodity and for guaranteeing its price in advance. Using futures, both buyer and seller can establish pricing guarantees for their respective businesses. At first, it may seem the benefit is all on the side of the seller, however, things can go wrong for the seller. Suppose the seller’s warehouse is destroyed in a fire or hurricane, or workers go on strike. If the contract to deliver is for a time far in the future, the seller may not obtain the commodity until after having agreed to its selling price. In all cases, the seller is essentially placing a bet on being able to obtain and/or store the commodity at a low enough price prior to the delivery date to generate a profit. In other words, the buyer is paying the seller to assume a risk on the future price and availability of a commodity. Since both short (seller) and long (buyer) positions can be bought and sold on a futures exchange, these contracts create opportunity for speculators to buy and sell futures without ever getting involved in the physical delivery of the commodity. The VIX futures have a slight twist in that the VIX itself plays the role of physical commodity and the value of the VIX is its spot price. Delivery is purely electronic. Instead of a bale of cotton appearing on the delivery date, the buyer receives (or pays) the difference between the VIX and the final settlement price of the future; the short position’s account pays (or receives) the negative of that amount. In other words, to fulfill the contract at expiry, the seller “buys” a purely numeric value (the VIX) at its spot “price” and delivers that difference to the account that holds the long position. This is equivalent to what would happen in a physical delivery contract if, instead of delivering the physical commodity from a warehouse, the buyer and seller settled in cash for the difference between the contract price and the current spot price. One last point: futures are settled daily. At the end of each trading day, the exchange establishes a settlement price — usually based on the last few trades. All contract positions — short and long — are settled daily by crediting or debiting the difference between the prior contract price and that day’s settlement price. This is equivalent to starting each trading day with a new contract that has the prior day’s settle as its contract price. Design of the VIX-Futures ETNs The VIX-futures ETNs XIV, SVXY, VXX and UVXY, represent a mixture of M1 and M2 contracts. This mixture is rebalanced daily to maintain the equivalent of synthetic future contracts with an expiration date that’s always one month in the future. This rebalancing progressively weights M2 higher and M1 lower until, when M1 expires, all contracts have been moved (rolled) to what was M2 on the day it becomes the new M1 (since the old one has just expired). This daily roll from M1 to M2 to maintain a constant one month expiration date appears to be the source of much confusion. It should be clear from the previous section that profit and loss occurs via the nightly settlement. The daily roll occurs after that profit or loss has already accrued and does not, in itself, change the ETN’s value any more than trading two fives for a ten changes one’s cash total. Sources of Profit and Loss in the VIX-Futures ETNs The daily change in ETN value that occurs via the nightly settlement is the one-day change in contract price of M1 multiplied by the number of M1 contracts plus the one-day change in contract price of M2 multiplied by the number of M2 contracts on that day. To see what might influence these price changes, consider what the VIX futures prices represent. For volatility futures, there’s no storage cost, because the commodity is virtual. It’s a measurement produced, published and maintained by the CBOE. That means the difference between these futures and spot VIX represent the current risk premium to hedge against a rise in VIX prior to the future’s expiry. Buyers are transferring that risk to sellers and sellers charge that premium for carrying that risk. This difference in value, which is constantly being readjusted as market conditions change, represents the current premium longs need to pay to induce short positions — it’s the going market cost of volatility insurance. If the VIX subsequently spikes up above the contract price and remains high, the risk premium may have been an inadequate compensation and the inverse ETN’s value declines to reflect that loss. Conversely, for buyers, their hedge paid off, sheltering them from at least some market downside. If the VIX remains low, however, sellers pocket the risk premium as profit. Contango, Backwardation and the Mythical “Roll Yield” One reason the conventional (but incorrect) wisdom summarized at the start of this article seems so plausible is that it appears to be supported by evidence. XIV and SVXY do indeed tend to go up during periods of contango and down during periods of backwardation, while VXX and UVXY move inversely. Let’s look more closely at that association. When the term structure is in contango, a positive risk premium is in effect. This is the normal state of affairs because without that premium, sellers would have no inducement to de-risk the chance of volatility spikes for the buyers of these contracts. If contango were not the normal state of affairs, there would be no market. Contango is the result , not the cause, of the ongoing risk premium that’s required to make the market in volatility futures. When the VIX spikes above the values of both M1 and M2, the term structure shifts into backwardation. M1 (and usually M2) contracts rise in price to reflect the higher estimate of future VIX based on this spike, but typically remain below spot, since prior VIX (which was lower before the spike), is also factored into the market’s estimate of future VIX. The inverse-VIX ETNs lose value when this happens, while volatility hedges represented by the long side of these contracts pay off. Backwardation is not the cause of these valuation changes; it’s only their visible manifestation. Contango and backwardation are thus lagging indicators. They show what’s already happened, not what’s about to happen. The “roll yield” that’s so commonly described as a profit-loss mechanism in the volatility ETNs simply doesn’t exist. As described previously, profit and loss happen during settlement and are due to changes in the prices of both M1 and M2 as the forward estimate of future VIX adjusts to changing market conditions. The rebalancing, or roll, happens after this valuation change. Where did the misconception regarding a roll-yield profit/loss come from? The confusion may have arisen because the term “roll yield” is commonly used in futures trading — but with a different meaning. It’s used in the context of buying (or selling) a future, letting it expire, then buying (rolling into) a new future with the same duration. That’s different from how VIX-futures ETNs work. And even in the strategy of rolling an expiring future, the term roll yield is just a bookkeeping convenience. The past profit or loss from an expired contract is not changed by subsequently opening a new contract. Each new contract is an independent bet (or hedge) on the future value of VIX. Its net profit or loss still comes from paying or receiving a risk premium and from the difference between past-estimated and future-realized values of the VIX. The Spectacular Rise and Fall of XIV If it’s not due to contango and it’s not due to roll yield, why did XIV rise so vigorously from 2012 through mid 2014? Take a look at the chart in Figure 3, where this period of steady rise on plots of both the VIX and XIV is highlighted. The period of steadily rising XIV is notable for exactly corresponding to the period in which the VIX declined steadily and relatively smoothly to its lowest point since the 2009 crisis. After mid 2014, the VIX began ratcheting back up — slowly at first, then more aggressively, in an upward trend that started in the latter half of 2015. After spiking in August 2015, the VIX failed to return to its earlier lows. This is the point at which XIV finally breaks down. In between mid 2014 and mid 2015, both XIV and the VIX became much more volatile than before. Although XIV put in a new high during that time, once the upward trend in the VIX took hold, XIV began its precipitous fall. Figure 3. XIV and the VIX (aligned). Closing Remarks In summary: There is no yield from rolling VIX futures and contango does not determine profitability for the VIX-futures ETNs. It seems almost too obvious, yet the bottom line here is that changes in the market’s expectation for the future value of the VIX are what matter for the VIX-futures ETNs. Those expectations can be altered by changes in the trend and behavior of the VIX itself. This was a long discussion. I hope it shed light on how these volatility products work and their drivers for profit and loss. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XIV, VXX, OR UVXY over the next 72 hours. 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.

Survival Skill: Distancing Yourself From Counterparty Risks

In a recent article entitled, Whatever You Do, Avoid Major Mistakes , I suggested that investors study-up on the subject of counterparty risk. Under a constructionist definition , the term equates to default risk as defined by the inability of a party to live up to its contractual obligations. The failure of a debtor to meet its obligations under a credit arrangement is a counterparty risk as is failure to perform under a swap or option agreement. A Broader Definition Needed However, for investors, a broader definition of the term is more appropriate to reflect that: a) counterparty risk arises when a major player(s) in a firm’s value-chain fails to perform whether contractually or not, b) the mere thought or mention of default gives rise to counterparty risk, and c) counterparty risk reverberates out from the source of the problem such that it can involve not just two, but multiple parties serially / simultaneously. This more encompassing definition explains a lot of what is going today: China’s faltering economy has seriously disrupted supply chain relationships beginning, notably, with miners as close as Australia and as far away as South America. For example, questions have been raised about Rio Tinto (NYSE: RIO ), Glencore ( OTCPK:GLCNF ) and Freeport-McMoRan (NYSE: FCX ) three of the largest mining companies in the world. The collapse in oil prices has now reverberated well away from drillers to servicing, pipeline, storage and tanker companies, landlords and hoteliers housing field personnel, banks, municipalities, states, and even countries. Take, for example, Kinder Morgan (NYSE: KMP ), the Royal Bank of Canada (NYSE: RY ), or Statoil (NYSE: STO ) / Norway. The gadget business that is over-saturated with products amid slackening demand has created problems along the value-chain including between the likes of Samsung ( OTC:SSNLF ) and Qualcomm (NASDAQ: QCOM ). Bricks retailers such as The Gap (NYSE: GPS ) and Aeropostale (NYSE: ARO ) are beating their brains out over fashion style and space utilization resulting in downstream impact to shopping center REIT’s as in the case of CBL & Associates (NYSE: CBL ). Distancing Yourself from Counterparty Risks It’s therefore understandable that some investors are scared. Stocks and bonds that they thought were fairly valued and perfectly safe are tanking. Moreover, fears are being whipped up by the likes of hedge fund managers who actually have lost their a$$ and are looking down the barrel at significant redemptions. Some would have us believe that the world is going to hell. It’s not. I personally see no reason to sell everything and to blow up an income stream in order to protect principle in these extremely volatile markets. BUT, if you haven’t already, the time is rapidly passing to put more distance between your portfolio and counterparty risks. This begins in one of two ways: a) By stepping back to consider macro changes that are developing / underway and how they may affect your holdings, or b) By taking a micro perspective and ‘looking back through’ your portfolio to ‘see’ what negative consequences may be coming at you from interrelated sectors. The idea is to get away, as quickly as possible, from ground zero. On my end, earlier this year, I took three actions to put more distance between our portfolio and counterparty risks: 1) I sold Corning (NYSE: GLW ) not because I don’t like the company – I really do – but because of concerns about the weakening gadget business, 2) I divested our positions in Chevron (NYSE: CVX ) and Royal Dutch Shell (NYSE: RDS.B ) even though as integrated companies they have fared a lot better than ‘pure plays’ in the oil production business, and 3) I bailed on JPMorgan Chase (NYSE: JPM ) believing that they have not been completely forthright about their exposures to oil and related sectors. In other words, I have concerns that, like other financial institutions, JPM may not have a handle on their counterparty risks. At the same time, I am sitting tight with positions in industries / companies that are more insulated from counterparty risks and whose demand for their products and services is relatively inelastic – military defense contractors, water management firms, and pharmaceutical companies. Also, I continue to make investments in what I feel will be growth areas such as in the fight against migrating tropical diseases. Two Directions to Alpha Like everyone else, I have suffered losses so far this year. However, by moving away from counterparty risks, my losses have been 3 to 4% less than comparable indices. Remember, just as alpha-level performance is doing better than the market when it is up, it is also doing less bad when the market is down. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.