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Small-Cap Value ETFs: The Right Play Now?

The ominous clouds that have been hanging over the U.S. small-cap ETFs space since the start of the year seem to be dispersing now. The space came under pressure at the beginning of 2016 due to a raft of downbeat U.S. economic readings, weaker greenback and risk-off trade sentiments in the market (owing to global growth worries as well as oil price turmoil) and threw U.S. small-cap ETFs out of investors’ favor. However, things are turning around lately with a volley of improving U.S. economic data, be it labor market, retail and manufacturing. Though the Fed reduced its forecasts for rate hikes in 2016 from four to just two hikes, a few hawkish comments from some Fed officials revived the rate hike talks. As per these officials, the reduced rate hike projection mainly reflected the tantrums thrown by the global financial market, which are now showing signs of cooling off. The two important indicators to measure the timing of another rate hike – labor market and inflation – are both stabilizing. San Francisco Fed president even said that he would promote a hike as early as April. Meanwhile, Q4 2015 U.S. GDP was adjusted higher, from the advanced estimate of 0.7% to 1.0% in the second estimate and then finally to 1.4% in the third reading. This is the reason that small-cap stocks could arguably be better plays in today’s economy. Small caps perform better when the domestic economy is marching higher as these pint-sized stocks generate most of their revenues from the domestic market, turning out to be safer bets than their large and mid-cap cousins. As these are less exposed to foreign markets, these stocks remain less scathed by the stronger greenback. Having said this, we would like to note that uncertainties in the economy still persist. The latest data which showed that the U.S. consumer spending grew slightly in February and overall inflation moved back gave us some reasons to doubt the possibility of an April rate hike. Also, small caps normally experience higher levels of volatility. That is why investors intending to bet on small-cap ETFs may also need some amount of safety or value quotient in their portfolio. This strategy may prove fruitful for investors as the chances of the market going wild are higher next month. Analysts noted that, “during the periods when the Fed was raising interest rates, the value stocks had an average return of 1.2% a month, or 14.4% a year, versus the growth index’s 0.7% a month, or 8.3% a year.” Below we highlight three such ETFs which could be in focus in the coming days. SmallCap Dividend Fund (NYSEARCA: DES ) DES looks to track the performance of the WisdomTree SmallCap Dividend Index. The fund is one of the popular choices in the small-cap value space with about $1.17 billion in AUM. It charges 38 bps in fees. Holding more than 700 stocks in its basket, the product puts about 10% of its total assets in the top 10 holdings, suggesting low concentration risk. Sector wise, this ETF is heavy on financials (24.6%) followed by consumer discretionary (18.3%), industrials (16.5%) and utilities (10.0%). The fund has a yield of 2.94% per annum. The fund carries a Medium risk outlook along with a Zacks ETF Rank #3 (Hold). Vanguard Small-Cap Value ETF (NYSEARCA: VBR ) This fund provides exposure to the value segment of the U.S. small cap market by tracking the CRSP US Small Cap Value Index. It holds a large basket of 856 stocks, which is widely spread across individual securities as none of these has more than 0.6% of assets. In terms of sector exposure, financials dominates the portfolio at 30.4%, followed by industrials (20.2%) and consumer services (12.2%). The ETF is quite popular with AUM of more than $6.01 billion. It charges 9 bps in fees per year from investors. The fund has a dividend yield of 2.30% (as of March 28, 2016). VBR has a Zacks ETF Rank #3 with a Medium risk outlook. S&P Small Cap 600 Value Index Fund (NYSEARCA: IJS ) The fund looks to provide exposure to U.S. small-cap value stocks by tracking the S&P SmallCap 600 Value Index. The $3.23-billion fund holds a total of 453 small cap stocks. The fund appears diversified as no stock accounts for more than 1.07% of the basket. Among the different sectors, Financials, Industrials, Consumer Discretionary and IT occupy the top four positions with 21.7%, 18.9%, 16.4% and 16% of weight, respectively. The fund charges a premium of 25 basis points annually. This Zacks Rank #3 ETF yields 1.52% annually (as of March 28, 2016). Original Post

Tax Efficiency: A Decisive Advantage For Some Index Stock Funds

Key highlights “Tax cost”-the difference between the before-tax return of a fund and its preliquidation after-tax return-is a way to gauge a fund’s tax efficiency. Vanguard analysis found that, for the 15 years ended November 30, 2015, the median tax cost of domestic actively managed stock funds was 27 basis points higher than that of domestic index stock funds. Some index stock funds can be tax-inefficient as well, especially those that seek to track more narrowly focused benchmarks, such as those in the mid- and small-capitalization markets. Broad-market index stock funds and ETFs may be more tax-efficient than actively managed stock funds and ETFs. Just as some ways of managing investments are more tax-efficient than others, certain types of investments are, by their nature, more tax-efficient as well. What makes one mutual fund more tax-efficient than another? Some relevant factors include a portfolio’s management strategy, the turnover or trading strategy, the accounting methodology used, and the activity of the fund’s investors. “One way that a fund’s tax efficiency can be measured is with its ‘tax cost,’ ” said Scott Donaldson of Vanguard Investment Strategy Group. “Tax cost refers to the before-tax return of a fund minus its preliquidation after-tax return. It represents a very high hurdle for active fund managers to overcome, in addition to their ongoing fund management expenses.” The illustration below shows a decisive tax advantage for index stock funds: The median tax cost for index stock funds (left side, green) was 71 basis points, whereas the median tax cost for actively managed stock funds (right side, green) was 98 basis points. Thus, for the funds in the data set, the median tax cost of domestic actively managed stock funds was 27 basis points higher than that of domestic index stock funds. The gap can be even larger: Note the 295 basis-point difference between the worst tax costs (shown in blue) of domestic actively managed and index stock funds. Moreover, the chart shows a much narrower range in tax cost in the index category. Why index stock funds may have the upper hand Because active managers make decisions based on a security’s potential to outperform, they can be more inclined to make specific, concentrated purchases in fewer stocks and to liquidate entire holdings more often than managers of broad-market index stock funds would. In making wholesale liquidations, active managers can be much more likely to realize capital gains, since an entire position’s gain could be realized at once. The tax efficiency of actively managed stock funds could, therefore, be much less stable, and the lack of depth and breadth of share lots in actively managed stock funds could negatively affect their future tax efficiency. Actively managed stock funds also have the potential for manager changes, resulting in new managers completely restructuring the portfolio, which could cause realization of gains from past investment success. Granted, some index stock funds can be tax-inefficient as well (see chart above). For example, stock funds that seek to track more narrowly focused benchmarks, such as those in the mid- and small-capitalization markets, fall into the bottom quartile in Vanguard’s tax-cost analysis. “Much more broadly based index stock funds will typically be more tax-efficient because they change their holdings less often,” Donaldson said. “Moreover, not all ETFs or conventional index stock funds are the same. Even stock funds that seek to track the same index can have different performance. The bottom line is, while Vanguard believes it’s much more important to manage the overall allocation of assets in your portfolio than it is to manage exclusively for taxes, your portfolio’s tax efficiency is important to take into account.” Aside from choosing stock funds that are more tax-efficient, investors can also engage in other best practices to minimize their taxes: Use tax-advantaged accounts. Maximize the use of tax-advantaged accounts, such as 401(k) plans and IRAs (both traditional and Roth) and 529 college savings plans. Be a tax-efficient investor. Use tax-advantaged accounts to rebalance an asset allocation or to sell appreciated positions that may provide better after-tax returns than completing similar transactions in a taxable account. Pay attention to asset location. Purchase tax-efficient investments in taxable accounts and tax-inefficient investments in tax-advantaged accounts, which can help you keep additional returns. Those incremental differences can have a powerful compounding effect over the long run. Notes: All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. We recommend you consult an independent tax advisor for specific advice about your individual situation. Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Floating Rate ETFs In Flux

This article originally appeared in the April issue of WealthManagement Magazine and online at Floating Rate ETFs in Flux . With fed rate hikes likely coming at a slower pace, investors flee some floating-rate notes. Nearly a year ago, as part of our survey of alternative income funds (” Alternative Alternative Income “), we picked through a number of floating-rate note (FRN) portfolios to find the potential best-of-class performance should interest rates rise. Well, since then rates have risen by 34 basis points in the three-month Libor and 26 basis points in the three-month T-bill yield. Curiosity compels us to revisit the floater funds to see how the asset class has fared. Not all these portfolios are alike, so one shouldn’t expect uniform results. The vast majority of the $9.8 billion held by exchange traded fund (ETF) versions are invested in corporate securities. And, among these, there’s further differentiation by credit ratings. Most investors are attracted to funds holding high-yield securities, though significant assets are committed to investment-grade paper. The junk/quality split is 54/40 with the remaining 6 percent in municipal and Treasury notes as well as a fund devoted to variable-rate preferred stock and hybrid securities. Money Flows Overall money has flowed out of the 12 ETFs plying the floater trade over the last 12 months. Net redemptions of $417 million reduced the category’s asset base by 4 percent. This wasn’t a wholesale dumping; it was more tactical. Some segments lost assets, some gained. And that’s a story in itself. Junk note funds lost nearly 16 percent, or $986 million, while ETFs invested in higher-grade corporate notes saw inflows of nearly 5 percent, or $183 million. At the same time, there was a $5 million, or 45 percent, boost in the newer (and smaller) Treasury segment. The single fund devoted to municipal notes bled assets, losing $27 million, or 28 percent, of its base while the other singleton, the variable preferred stock ETF, tripled in size with $408 million in net creations. Two trends are at work here. Some of the high-yield assets migrated to safer havens, namely bank-grade and Treasury paper. Mainly, that’s been an escape from duration risk. Money’s also being drawn to the equity side in response to more encouraging economic data. The second trend is a mercenary search for yield. Consider the inflow to the preferred stock ETF. Dividend yields for variable preferreds indexed in the Wells Fargo Hybrid and Preferred Securities Floating and Variable Rate Index exceed 5 percent, significantly higher than the rates earned by junk notes. Investors believe that stocks, common or preferred, are okay to buy again. Especially if they produce lip-smackin’ income. The insulation from duration risk is a boon. So, let’s take a closer look at the cash thrown off by these ETFs, along with their return characteristics. High-Yield Corporate Floaters The 600-lb. gorilla among high-yield floater ETFs is the $3.7 billion PowerShares Senior Loan Portfolio ETF (NYSEARCA: BKLN ) , which owns more than 70 percent of the segment. As BKLN goes, so goes the segment. Buoyed by a market-weighted 4.22 percent dividend yield, high-yield ETFs collectively earned a total return of -2.54 percent over the past 12 months. The segment’s discernible duration is 2.27 percent, making it the most rate-sensitive in the asset class. When benchmarked against the i Shares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ) , a broad market bond index tracker with a duration of 5.53 percent, you can see the bargain made by FRN investors: Aiming for higher dividends and less rate sensitivity, they settled for lower overall returns. Despite its middling dividend yield, assets have flowed to the First Trust Senior Loan ETF (NASDAQ: FTSL ) in the past year. FTSL is actively managed with a mandate that allows the portfolio to be invested in non-U.S. paper and equities. Net creations have boosted the fund’s asset base by 87 percent. Investment-Grade Corporate Floaters Dividends are a lot lower in the bank-grade segment. With a collective “A” credit rating, the segment’s market-weighted yield is just 0.58 percent. Modified duration, at 0.12 percent, is very low as well. Like high-yield corporates, total returns have been negative, though at -0.40 percent, less so. The $3.5 billion iShares Floating Rate Bond ETF (NYSEARCA: FLOT ) sets the segment’s pace, though the fund to beat has been the SPDR Barclays Investment Grade Floating Rate ETF (NYSEARCA: FLRN ) . FLRN is the only corporate floater that produced a positive total return over the past year. Treasury Floaters Floating-rate Treasury paper, with its low yield and virtually nonexistent duration is really a cash substitute. Investors, wary of potential Fed rate hikes, have goosed up the segment’s small asset base in the last 12 months. It’s the only segment, too, that’s produced a positive, albeit small, total return. Nearly all the segment’s assets are held in the iShares Treasury Floating Rate Bond ETF ( TFLO) . Other Floaters There are a couple of ETFs at the corners of the floating-rate market. The PowerShares Variable Rate Preferred Portfolio ETF (NYSEARCA: VRP ) , claiming the highest dividend yield in the class, earns the variable moniker in more than one way. It’s been one of the category’s more volatile issues, and ended up losing money overall in the past 12 months. A stablemate, the PowerShares VRDO Tax-Free Weekly Portfolio ETF (NYSEARCA: PVI ) , owns municipal bonds, rated AA- on average, that can be redeemed weekly. Duration is negligible, which make the fund a cash substitute. With no dividend stream, however, the total return pretty much reflects its holding costs. No wonder the fund lost assets. An Overview The side-by-side comparison in Chart 1 shows how the category’s biggest funds behaved over the past 12 months. Three ETFs-FLOT, PVI and TFLO-varied little from their starting values, but BKLN and VRP wobbled significantly. Such volatility speaks to inherent risk. Floating-rate funds limit duration risk so they’re obliged to take on more credit risk to generate attractive returns. We seem to have reached a risk inflection point, though. By and large, investors are fleeing the risk in the high-yield corporate market. That exodus, in great part, reflects investor perceptions that Fed rate hikes may be coming at a slower pace than originally expected. The advantage of holding variable-rate securities, then, has diminished, making other assets more appealing.