Tag Archives: etfs

Beating The Market With Profit And Beta: An Exercise

Summary Having established that low-beta stocks outperform, I posited that stocks with returns on invested capital much greater than their cost of capital would also outperform. I further posited that a portfolio comprised of the lowest-beta of these stocks would produce further risk-adjusted outperformance. Using the S&P 1500 as my pool of stocks to choose from, I simulated these strategies over the past 5 years. Here’s what I found. Having recently established in a separate article that low-beta stocks can strongly outperform the market, I wanted to see whether other approaches might outperform the market in an independent fashion, or else add to the alpha of a low-beta approach. I decided to look at whether or not companies with “economic moats” might outperform the broader market as well. The idea is certainly appealing. A company capable of sustaining an economic profit over time would probably benefit from what Morningstar typically contends are moat sources : Network effect, Intangible assets, Efficient scale, Cost advantage, and Switching costs. Certainly, a company imbued with these qualities would be expected to outperform the broader market over a full market cycle, and any discount on such a high-quality firm would be expected to dissipate relatively quickly as the market reestablished a premium reflective of these characteristics. This is the rationale behind certain exchange-traded funds like the Market Vectors Wide Moat ETF (NYSEARCA: MOAT ), and to some degree behind value-based methodologies practiced by Warren Buffett and others of his ilk. The problem, unfortunately, is that moatish qualities are difficult to quantify and may fade over time. A rough guess for the presence of an economic moat for a given firm has been posited by some as the firm being able to post a return on invested capital greater than its weighted average cost of capital, though certainly any given firm in a cyclical industry might be able to do so unreliably. What is probably more predictive is a demonstrated, sustained ability of a firm to generate an economic profit. These might be more readily found in stable industries with predictable dynamics. I posited that a strategy focused on firms with demonstrated sustained economic profits with business models suggestive of stable dynamics would outperform the broader market, and that this strategy would be also prove superior to a low-beta strategy alone. Experimental Method: I gathered 10-year financial data from Morningstar on each of the 1,500 components of the S&P 1500, as well as 10-year price data. I calculated yearly returns on invested capital for each company, and, starting with 2009, calculated a rolling 5-year average ROIC for each company between 2009 to the present. Beta was calculated in rolling 5-year increments using the S&P 500 (NYSEARCA: SPY ) as a benchmark, and a 5-year rolling cost of equity was calculated with the risk-free rate being a rolling average of 10-year treasury interest rates. Weighted average cost of capital was calculated using the normal method, with the cost of debt informally assumed to be either the yearly interest payment over the sum of short and long-term debt versus the interest rate suggested by the company’s interest coverage, whichever was higher. Economic profit was calculated as EVA = ROIC – WACC. From these metrics, the following strategies were simulated: A low-beta strategy, with monthly rebalancing into an equal-weighted portfolio of 12 stocks. On a monthly basis, the entire portfolio would be redistributed into the 12 stocks with the lowest rolling beta values, regardless of valuation. An economic-profit strategy, with monthly rebalancing into an equal-weighted portfolio of 12 stocks. Pre-screens for yearly profitability (e.g., positive yearly EPS) in addition to a positive 5-year rolling EVA were applied. On a monthly basis, the entire portfolio would be redistributed into the 12 stocks with the lowest price to economic-profit ratio (hereafter, “PEVA”). A combined strategy, wherein the top 50 stocks with the lowest PEVA ratios were selected (using the aforementioned pre-screens), and, from these, the 12 with the lowest beta scores would be selected and equal-weighted on a monthly basis; this strategy was repeated using a quarterly rebalancing rule. These 3 strategies were then compared to the S&P 500 and S&P 1500, looking prospectively over the past 5 years. Results: (click to enlarge) As noted previously, a low-beta strategy generated significantly higher annualized returns than the broader market, by a significant amount (26.6% CAGR over the past 5 years versus 15.4% for the SPY and 18.4% for the S&P 1500): (click to enlarge) In comparison, a strategy focused purely on PEVA generated significantly higher returns than even the beta strategy, with a CAGR of 32.76%. (click to enlarge) Returns using a monthly rebalancing rule using a combination of PEVA and beta outperformed a lone beta strategy by nearly 1000 basis points, with a CAGR of 35.3% yearly. (click to enlarge) On a risk-adjusted basis, using a long-term risk-free rate assumption of 4.5%, the PEVA-beta strategy outperformed all other strategies, with a Sharpe ratio of 1.77 (versus 1.64 for low-beta alone). (click to enlarge) Overall, a combined PEVA-low beta strategy offered the strongest risk-adjusted returns over the past five years, and produced the strongest absolute annualized returns over the past 5 years with reasonable compensation for overall risk. Discussion: The results of this exercise suggest that a low-beta strategy may be enhanced by pre-selecting only those firms demonstrating the ability to generate sustained economic profits over time. The success of the PEVA strategy also suggests an underlying valuation component as well, as the strategy focused only on those stocks which had the highest economic profit yield relative to the price. It is worth noting that this strategy did not focus on a single year’s worth of data but rolling 5-year averages; additional study might consider looking at longer rolling averages of ROIC to see if this would affect returns. The astute reader will undoubtedly point out a significant limitation of this study is the relatively low volatility of the overall market during this timeframe, during which time there was virtually no period in which a yearly loss might be recorded. This obviously affects the relative performance of the low-beta or PEVA-beta strategies, though one would probably expect that, if anything, these strategies would be expected to outperform in bear markets. Finally, despite the encouraging results, the PEVA-beta strategy clearly has limitations. Changing the rebalancing period to quarterly shaves off nearly 1000 basis points worth of outperformance and puts the PEVA-beta strategy about on par with the beta strategy alone, reducing the Sharpe ratio to a pedestrian 1.17. Given that an ostensible goal of a focus on sustained economic profits would be to focus on companies capable of outperforming over years at a time, why quarterly rebalancing would diminish returns relative to monthly rebalancing remains a bit unclear. Conclusion: Though generating strong economic profits over time is not necessarily indicative of a stable, high-quality firm, doing so certainly can be suggestive. The success of the PEVA-Beta strategy in this study suggests that focusing on such firms may produce significant outperformance. Though monthly rebalancing costs might be substantial (and capital gains tax burdensome), such a strategy may be worth considering in sideways or downward markets where uncertainty reigns and volatility is high. Current stocks suggested by the PEVA-beta strategy include Coca-Cola (NYSE: KO ), Monster Beverage Corporation (NASDAQ: MNST ), the Brown-Forman Corporation (NYSE: BF.B ) and The Hershey Company (NYSE: HSY ). Other consumer defensive firms make the list, like Altria (NYSE: MO ); trucking firms Knight Transportation (NYSE: KNX ) and Landstar (NASDAQ: LSTR ) are also included.

This ETF Will Tell You A Lot About Inflation Expectations

Summary Inflation is a scary word, as it generally presages effects like rising interest rates, higher costs of living, and climbing commodity prices. Based on widely accepted measures such as the Consumer Price Index (CPI), inflation has been kept in check or steadily trending downward over the last several years. Another way to gauge inflation expectation is by taking the temperature of the fixed-income markets. Inflation is a scary word, as it generally presages effects like rising interest rates, higher costs of living, and climbing commodity prices. This has been one of the expected outcomes from the Fed’s implementation of quantitative easing during the course of the last half decade. Yet, despite their best efforts, inflation has been a non-event in the economic recovery from the 2009 lows. Based on widely accepted measures such as the Consumer Price Index ((NYSEARCA: CPI )), inflation has been kept in check or steadily trending downward over the last several years. Obviously the decline in traditional commodity and agriculture prices has helped keep input costs in check, which have in turn carried forward to products and services we consume. Another way to gauge inflation expectation is by taking the temperature of the fixed-income markets. One of my preferred methods for this task is monitoring the price trend of the iShares TIPS ETF (NYSEARCA: TIP ). This ETF has $13.5 billion dedicated to a portfolio of 39 Treasury Inflation Protected Securities. TIP has an expense ratio of 0.20% and an average duration of 7.71 years. Most investors incorrectly assume that something with “inflation protection” in the name must mean it works well in a rising interest rate environment. However, TIPs function by readjusting their coupon payments based on the movement in CPI. Essentially they offer an insurance component that makes them attractive to own when inflation measures are on the move higher. A look at the chart of TIP below shows how fixed-income investors perceive the likelihood of true inflationary pressures creeping up. Not only is the price of TIP trending lower, but the short and long-term moving averages are also sloping down as well. Of course, it’s important to consider the price trend of TIP in context of the wider bond market as well. When you compare this index against a basket of traditional intermediate-term Treasury bonds, it makes the divergence even more pronounced. Below is a 1-year performance comparison between TIP and the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ). The spread between these two indexes shows a big separation since mid-July, when the talk about the Fed raising interest rates really started to gain some traction. So what does this mean for your portfolio? The primary reason for owning TIPs is to gain a hedge against inflationary pressures. Right now there isn’t any evidence to support this thesis. One day that will probably change, but for the time being I am avoiding any significant ownership of this sector. It makes more sense to stay focused on areas of the bond market that offer higher yields, solid trends, or a compelling advantage for your specific portfolio . One such fund that I own for clients in my Strategic Income Portfolio is the SPDR DoubleLine Total Return Tactical ETF (NYSEARCA: TOTL ). This actively managed ETF owns a variety of quality and credit securities across multiple attractive sectors of the bond market. TOTL eschews any TIPs exposure for greater focus on mortgage backed securities, emerging market bonds, and a mix of corporates. This ETF has a 30-day SEC yield of 3.18%, average duration of 4.25 years, and charges an expense ratio of 0.55%. The Bottom Line TIP is a solid index to monitor for a sense of where the market perceives inflation to be headed over the short and intermediate-term time frames. However, I would prefer to own this ETF in the midst of a strong price trend and more supportive fundamentals for inflationary statistics.

Does The Rebalanced Barron 400 ETF Look Smarter?

The smart beta Barron’s 400 ETF (NYSEARCA: BFOR ) has made strategic shifts in its portfolio as part of the most recent semi-annual index rebalancing. The fund now seems to have superior fundamental attributes and be less susceptible to the current market turmoil due to increased weighting to the small cap stocks. Background of BFOR The ETF seeks to track the performance of the rules-based and fundamentals-driven Barron’s 400 Index. The benchmark uses the MarketGrader’s equity rating system to select America’s highest-performing stocks based on the strength of their financial statements and the attractiveness of their share prices. Notably, MarketGrader’s methodology assigns grades on a scale of 0-100 based on a proprietary combination of 24 fundamental indicators across growth, value, profitability and cash flow while it screens for size and sector diversification and liquidity. This approach has made BFOR superior to many other ETFs in the space with attractive fundamentals and growth prospects. The fund has been consistently crushing the ultra-popular broad market funds – the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) – by wide margins. The fund gained nearly 23.3% since its June 2013 debut compared to gains of 20% for SPY and 8.9% for DIA. From the year-to-date look, the ETF is down 3.8%, which is better than the decline of 5.8% for SPY and 8.6% for DIA. Despite the strong performance, the product has not been able to garner enough investor interest as depicted by its AUM of $196.1 million. One of the main reasons for the unpopularity might be its expense ratio of 0.65%, which is one of the highest in the multi-cap ETF space. Further, it has a hidden cost in the form of wide bid/ask spread that increases the total cost of trading as it trades in a light volume of about 18,000 shares a day on average. Index Change and New Holdings During rebalancing of the index, sector allocation to the most beaten down energy sector was trimmed by more than half from 9.25% to 4%. Now, financials and industrials remain the top two sectors at 20% each. They are closely followed by consumer discretionary (19.25%), technology (13.75%) and health care (10.25%). In terms of security, 58 companies have found their way to the index and the ETF for the first time ever with the most notable names being GrubHub (NYSE: GRUB ), LendingTree (NASDAQ: TREE ), Blue Nile (NASDAQ: NILE ) and the recently merged Walgreens Boots Alliance (NASDAQ: WBA ). Some other big names that have been added to the holdings list are JPMorgan Chase (NYSE: JPM ), Verizon Communications (NYSE: VZ ), Altria Group (NYSE: MO ) and United Parcel Service (NYSE: UPS ). However, some marquee names such as Microsoft (NASDAQ: MSFT ), Facebook (NASDAQ: FB ), Wal-Mart (NYSE: WMT ), Celgene (NASDAQ: CELG ) and 3M (NYSE: MMM ) were booted from the portfolio. With these changes, the index currently has a total market capitalization of $18.28 billion post-rebalance versus $19.07 billion in March. The drop came on the heels of increased focus toward small cap stocks from 16% to 22%. Exposure to large cap stocks decreased from 27.25% to 25.5% while mid cap stocks saw a decline from 56.25% share to 52.5%. The fund currently holds 401 securities in its basket that are widely spread with nearly 0.25% share each. Bottom Line Though the new holdings suggest a modest change in the fund’s sector exposure, the reallocation to securities saw significant fluctuations in terms of market cap level. This is especially true as the tilt toward small caps suggests that BFOR will now be less exposed to the international markets, currently ruffled by China worries, a strong dollar and global slowdown concerns. As a result, the new portfolio now reflects increasing fundamental attractiveness of companies that earn the lion’s share of their profits in the U.S. The objective of the fund remains the same — offering quality exposure to investors seeking to stay invested in the broad market. The high quality stocks seek safety and protection against volatility in turbulent times and thus, outperform in a crumbling market. Overall, the Barron’s 400 Index and ETF seeks to take advantage of the improving U.S. economy with a heavy tilt toward the cyclical sectors and increased focus on small cap stocks. Link to the original post on Zacks.com