Tag Archives: etfs

Addressing Long-Term Goals During Short-Term Volatility

Assumptions about future returns are made every day by a wide variety of investors. These assumptions are often based on annualized returns that can mask tremendous amounts of performance variation. For instance, a simple blended portfolio consisting of 55% U.S. large-cap stocks and 45% intermediate U.S. Treasury bonds delivered an annualized return of 8.5% since 1926. However, since the start of that year, in 20% of rolling 10-year windows, a 55/45 blended portfolio failed to achieve a return of even 6%. We believe that the next 10 years may be a period where returns to a passive buy-and-hold balanced strategy are likely to come up short. Investors facing this likely reality have three options: 1. Lower their long-term return assumptions Return assumptions should represent good faith estimates of the likely long-term return on investment. While a lower-return assumption may be necessary for those with unrealistic expectations, others should carefully evaluate their investment approach to determine if there is a way to increase the odds of successfully meeting their objectives. 2. Raise their target allocation to equities However, the greater expected return from stocks versus bonds is also accompanied by greater expected volatility. Greater volatility can result in greater drawdowns that can adversely impact the ability of some investors to meet more near-term objectives. 3. Embrace a flexible, active asset allocation strategy This may be the most realistic of the three alternatives. At any point in time, equity market returns are driven by one or more of the following factors: fundamentals, valuation, and sentiment. As active managers, we prefer a framework that seeks to identify regimes where the risk of sustained capital loss (i.e., a bear market) is high, or conversely market environments that strongly favor owning stocks. Such a framework also acknowledges that the market is likely to go through periods where neither regime is overwhelmingly likely. That last environment is where we find the U.S. stock market at the outset of 2016. While valuations are somewhat elevated, the U.S. economy remains far from overheating, and sentiment is anything but speculative today. In an environment such as this, investors can be rewarded by taking advantage of market volatility to increase their exposure to attractively valued and well-positioned markets/sectors/companies. Nevertheless, successful asset allocation is not just about what an investor owns, it also is about what one chooses not to own. Investors in passive strategies must own whatever allocations make up the index, regardless of the merit of those investments. This can prove disastrous when an index becomes heavily-skewed toward overvalued segments of a market. Valuations suggest that over the next 10 years, a static asset allocation approach is likely to fail to meet the long-term return targets of many investors. The reason is simple – starting valuations both in equity and fixed income are not priced to deliver the returns that history has led investors to expect. In a low-return world, investors can ill-afford to operate without what we believe is the most effective tool for increasing the likelihood of achieving their long-term return objectives: an active approach to asset allocation. History suggests that the volatility of the opening trading days of 2016 is hardly unprecedented. Active asset allocation provides investors the opportunity to respond to these developments and shift the odds of long-term success more in their favor.

Highly Overvalued Market? Consider Employing These Strategies

It is one of the hardest things for investors to do. What am I referring to? It’s this: Breaking away from the tendency, in making investment decisions, to be highly influenced by how things have been going lately , and then assuming such observations suggest that the same general type of results will carry forward for at least the next several years, if not indefinitely. While it may often be true that investments that have been doing well lately will continue to do well over the relatively shorter term, investors, in my opinion, should be much more cautious when ETFs/ stock funds appear to be showing signs of moderate to gross overvaluation. Those happenstances may not occur that often: they most likely will occur mainly late in extended bull markets. Investors mindfully, but perhaps just sub-consciously, have much greater tendency to invest more in stocks during a long bull market, and with greater confidence, than when stocks aren’t in one, and instead are either a) just chugging along moderately well but not some downside, b) essentially going nowhere over a considerable period, or c) are in, or near, a bear market. For many, it seems hard to not to invest more during a prolonged bull market, and also not to invest in the prior best performing types of funds under what appear to be highly favorable conditions. People seem naturally inclined to extrapolate past to future. They tend to assume that what has been working well will continue to do so, which in the case of a bull market, is typically stocks in general. Additionally, they also tend to believe those specific categories of stocks which have been performing particularly well, and the best performing market sectors, will continue along the same path. A Re-think Is Often Necessary Under such circumstances, investors, rather than investing as they might have before the overvaluation began, need to think even more than otherwise, about what their returns might be as far as three years ahead, as opposed to, say, merely over the next six months, or even the next year or more. Why? Here are some data showing what might otherwise happen: About a year and a half ago (July 2014), stocks from around the developed world were on a tear. Prior one year returns were at least 20% pretty much no matter where one looked, and even more caution-inducing from my point of view, 5-year annualized returns were generally in the high teens, such as the S&P 500 index, up 18.8%. Virtually all stock fund categories were overvalued, as repeatedly emphasized over many months before that date in articles I authored on my website and elsewhere, including on Seeking Alpha. Which types of stock funds were looking the strongest, and therefore, to the unwary, deemed most likely to continue their sizzling performance? Some sector fund returns were showing near 30% one-year returns or better, including health care, natural resources, and technology. Over the prior 5 years, small- and mid-caps, as well as health care and real estate sector funds were approximately averaging at least 20% annualized returns. So, it is not surprising that back then, aside from investing heavily in the broad market and international stocks, investors had also gravitated toward relatively large positions in small caps, mid caps, and the above sectors through funds and ETFs. By one year later, that is, by July 2015, the returns on these investments presented a mixed picture. While the S&P 500, mid-caps and small-caps were still holding on to moderate one year gains in the 6 to 7% range, international stocks had generally tanked into moderately negative territory. Only health care sector funds continued to sizzle; while technology and real estate funds were still positive, they slowed considerably from their prior performances. Now here we are a little more than another 6 months later. So where do these year and a half ago choices stand today? Most of the above gains have been wiped out, or nearly so, although small health care gains still remain intact. The following table shows prices for some representative Vanguard stock ETFs from the start of the period compared with now (all data in this article thru Jan. 25). The percentage change in price gives one a close approximation as to how each ETF has performed over the period. Such ETF performance can be taken as a close proxy for other identical category funds, both unmanaged and managed: ETF (Symbol) 6-30-14 Price 1-25-16 Price Percent Change Over 1.5+ Years (not annualized) S&P 500 ETF (NYSEARCA: VOO ) 179.46 172.07 -4% Mid-Cap ETF (NYSEARCA: VO ) 118.66 107.64 -9 Small-Cap ETF (NYSEARCA: VB ) 117.12 98.34 -16 Total International Stock ETF (NASDAQ: VXUS ) 54.15 40.96 -24 Health Care ETF (NYSEARCA: VHT ) 111.58 122.31 +10 Materials ETF (NYSEARCA: VAW ) (Natural Resources) 111.77 80.97 -28 Information Technology ETF (NYSEARCA: VGT ) 96.75 98.82 +2 REIT ETF (NYSEARCA: VNQ ) 74.87 75.93 +1 Note: An ETF’s total return, including dividends and capital gains if any, is not reflected when just looking at the above prices alone. So, for example, if a given ETF pays a 2% yearly dividend, you will not see how that dividend affected the fund’s year and a half return. To get a better estimate of actual performance, you would need to add the approximately 3% in dividends for the 1 1/2 year period to the percent change shown above. This also applies to all the percent change figures below. Implications for Stock/Bond/Cash Allocations Are there any other types of investments investors might have considered investing more in back in July 2014? Unfortunately, most other categories of stock ETFs/funds have not performed any better, and some have done even worse. On the other hand, in some cases, where returns for many the above types of stock funds have been negative, at least for the period under consideration, investors would have been better off by just being in cash or money market funds. While such funds hardly returned much more than zero, at least they did not show negative returns. How about bond funds ? The following chart shows prices for some representative ETFs and funds from Vanguard then and now. ETF/Fund (Symbol) 6-30-14 Price 1-25-16 Price Percent Change Over 1.5+ Years (not annualized) Total Bond Market ETF (NYSEARCA: BND ) 82.15 81.31 -1% Total Intl Bd Idx (MUTF: VTIBX ) 10.25 10.62 +4 Interm-Term Tax-Exempt (MUTF: VWITX ) 14.14 14.37 +2 Note: Returns from tax-exempt bond funds should be regarded as higher than they appear because, unlike with taxable bonds, one typically gets the full return rather than the after-tax lowered return that will result from ordinary bonds held in a taxable account. But Short-Term Returns Often Fail to Show the Whole Picture Of course, the above data presents only a snapshot taken at the current point in time. Therefore, one cannot say conclusively that investors will continue to have been better off in non-stock investments because, if held further, the stock investments could well rebound and eventually outpace holding the non-stock investments. Obviously, though, there is no guarantee that stock prices will quickly return to their winning ways. And because it is a fact that many investors do wind up switching out of losing positions and thus missing out on eventual recoveries, it may therefore turn out that many investors would have been better off by not having invested as much as they might have in mid-2014’s overvalued stock funds, and instead, by having reallocated some of these investments to cash or bonds. Thus, while we still don’t know how well stocks will do in the next few years, it is highly possible that there would have been some better options looking forward from mid-2014 than the well-performing, but overvalued, funds/ETFs mentioned above. Instead of investing based on current data which often just suggests, at best, a possible relatively short-term investment direction, it is often better to invest with at least a three year horizon which looks beyond the “here and now” and tries to anticipate where things are more likely to go if and when there is a change in underlying economic data and/or investor sentiment. And over such a lengthier span, it makes sense to consider the downside of sticking with highly “overvalued” fund categories, and the potential upside of any possibly less overvalued categories that may not have performed as well but are still likely to do considerably better in the future. Another possibility is just to become more defensive, increasing one’s allocation to cash, and possibly, bonds. A Flashback to the Past Is there a recent comparable period of time in which investors turned out to have likely mistakenly gravitated toward high-flying stocks? The last time this happened was in the fall of 2007 when, as above, virtually all stock fund categories had become overvalued. The average US stock fund had returned 17.6% over the prior year and 16.1% over the prior 5 years annualized. International stock funds had done even better, showing 26.3% and 22.6% gains over the same periods. Among the standout categories were mid and small caps, technology, communication, utilities, natural resources, and emerging markets. On the other hand, at that time, bond funds weren’t doing terribly, but not particularly well over the prior 5 years with the benchmark (NYSEARCA: AGG ) returning 4.1% annualized. But things turned around sharply over the following three years. Most of the above mentioned stock fund/ETF categories showed deeply negative 3-year returns by the fall of 2010. The AGG bond benchmark, on the other hand, returned better than 21%, or 7% annualized. The following table shows how some of the high-flying stock performers in the fall of 2007 fared over the following three years: ETF (Symbol) 9-28-07 Price 9-30-10 Price Percent Change Over 3 Years (not annualized) S&P 500 ETF 140.61 105.06 -25% Mid-Cap ETF 79.64 66.30 -17 Small-Cap ETF 72.63 63.51 -13 Total International Stock ETF 20.67 14.95 -28 Information Technology ETF 60.68 55.59 -8 Telecommun Serv ETF (NYSEARCA: VOX ) 83.09 62.72 -25 Utilities ETF (NYSEARCA: VPU ) 83.02 66.36 -20 Materials ETF (Natural Resources) 88.05 70.92 -19 FTSE Emerging Markets ETF (NYSEARCA: VWO ) 103.80 45.35 -56 Now, here’s how two Vanguard bond funds and its main money market fund did over the same 3 year period: ETF/Fund (Symbol) 9-28-07 Price 9-30-10 Price Percent Change Over 3 Years (not annualized) Total Bond Market ETF 75.44 82.56 +9% Interm-Term Tax-Exempt 13.19 13.89 +5 Prime Money Market Fund (MUTF: VMMXX ) 1.00 1.00 +5 Note: Return for the money market fund was 1.5% annualized, or approximately 5% non-annualized over the period. Final Thoughts While history unlikely ever exactly repeats itself, and 2007 through 2010 was undoubtedly different than 2014 through 2016 and beyond will be, investors should be on guard against certain similarities. Evidence suggests that once stocks get “ahead of themselves” for too long, returns tend to be subdued, if not outright negative, for a number of years going forward. Research I have conducted suggests that making “contrary-to-the-prevailing-sentiment” decisions based on extreme overvalued (or, for that matter, undervalued) conditions may appear wrong-headed and wrong-footed over the short term. However, over periods of at least three years, these decisions likely will come out ahead of sticking with what the majority of investors opt for as their current favorite choices which are often based heavily on current conditions, relatively devoid of overvaluation considerations.

Smart Beta Strategy: Aces Australian Scrutiny

Paul Docherty, a senior lecturer at Newcastle Business School, University of Newcastle, in Australia, has studied the performance of the factors that underlie smart beta portfolios within the equity markets of that country. On the basis of a long time-series of data, Docherty has concluded that four such factors “all generate positive abnormal returns” in those markets: value, momentum, low vol, and quality. Diversifying across these four factors is the smart way to make use of smart beta , he thinks. The other factor in the usual list of five is size . Since Rolf W. Banz’ work in 1981 , there has been speculation that small firms generate greater return than do larger firms, after controlling for risk. But Docherty can’t find evidence for this in Australia. After accounting for illiquidity and transaction costs, the remaining “size effect” is insignificant. “Not an investable anomaly,” he says. This is in accord with recent international findings. But with the other four smart-beta factors? Value refers to the book-to-market ratio. This is also known as the HML ratio, from the phrase “high minus low”, given the Fama-French argument that companies with high book-to-market ratios (value stocks) outperform those with low ratios (growth stocks). Docherty mentions that there are several other ways to measure “value” aside from book-to-market. One might use the P/E ratio, for example, or compare cash flow to price. But book-to-market “is the superior proxy for value in the Australian equity market.” The HML ratio has had a good run over most of the sample period Docherty employs, beginning in 1990, and its cumulative returns across time are impressive, but it’s important to observe that “there is an evident reduction in the gradient of the cumulative returns in recent years.” Performance of the WML factor in Australia Mean St. Dev. T-Strat Sharpe Ratio Hit Rate Max Drawdown 1991-2015 1.29% 5.19% 4.27 0.25 63% -19.96% 1991-1995 0.31% 3.53% 0.68 0.09 53.3% -7.98% 1996-2000 1.15% 5.28% 1.68 0.22 65% -19.96% 2001-2005 2.61% 5.12% 3.95 0.51 71.7% -8.51% 2006-2010 0.89% 6.53% 1.06 0.14 61.7% -13.68% 2011-2015 1.37% 4.80% 2.15 0.28 64.9% -13.41% (Source: Docherty, “How smart is smart beta investing?” Table 3.) Moving on… the momentum factor (or “winner-minus-loser”, that is, WML) is the best-documented anomaly of the traditional five. Docherty cites a recent study by Vanstone and Hahn that reports that “the capacity of momentum investing in Australia is sufficiently large in dollar terms to support its practical implementation as an investment strategy.” Low vol has been under discussion as a factor in above-normal returns since a seminal paper by Black, Jensen, and Scholes in 1972. The notion of a low vol premium by definition implies that the actual security market line is much flatter than the one predicted by the Capital Asset Pricing Model. Significant Drawdowns Docherty’s data indicates that the mean monthly return on the vol factor in Australian markets is 1.45%, the highest monthly return of any of the five factors he looked at. Both the vol factor and WML share one drawback – both have seen significant drawdowns. The max drawdown for the vol factor in Australia over the covered period in 25.56%. Then, there is quality , or quality-minus-junk (QMJ). As in all fields, “quality” in the realm of capital assets is a tricky thing to define. As Docherty understands it, the term refers to asset growth and accruals (negatively) as well as to corporate governance and profitability (on the positive side). Quality, as so understood, has “relatively modest returns compared with other smart beta factors,” he finds, but it does provide a hedge against downturns in broad market movements. What is most intriguing about Docherty’s numbers is that the correlations among the factors he discusses “are quite low and, in many cases, negative.” Given this situation , the real question is not whether smart beta is smart (it is) or which factor is smartest (that depends on where one is in the business cycle, and other matters), but what mix of the four (or, if one wants to continue including size, what mix of the five) factors is optimal.