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Over-Rated: Do Fund Asset Classifications Tell The Whole Liquidity Story?

By Hamlin Lovell, CFA Suspensions of dealing by the credit mutual funds Third Avenue and Stone Lion have prompted various knee-jerk requests for a simple rule of thumb to help avoid recurrence: Beware Level 3 assets. It is reported that Third Avenue owned 18% in Level 3 assets. Many credit funds have zero or less than 1% of their assets in this category. Behavioral finance teaches us that we are susceptible to messages that simplify the complex. Unfortunately, financial market liquidity may not be amenable to such simple rules. Level 3 assets are assets for which a fair value can’t be determined by observable measures such as models or market prices. Though they are commonly dubbed mark-to-model, any unobservable input applied to modify a market price can also lead assets to be classified as Level 3 despite their valuation not being entirely model driven. Furthermore, relying on the Level 1/2/3 breakdown as a proxy for liquidity can result in both false positives and false negatives. Let’s start with the false negatives. Absent or insufficient market prices or dealer quotes can be reasons for Level 3 classifications, but they are not the only reasons. For instance, derivatives with non-standard maturities may be valued by interpolating between broker quotes on those derivatives with standard maturities. So a six-week currency option might be valued roughly halfway between a one-month and a two-month quote, but if the fund in question offers quarterly dealing, there need not be grounds for concern about asset/liability mismatches. But Level 3 is a broad range. At the other end of the spectrum, Level 3 could include private equity that might never be monetized, leading to an immortal “zombie” fund. Many assets might fall between these negative extremes; structured credit, for example, can be self-liquidating if cash flows from underlying assets accrue to various tranches according to the predetermined schedule. Some short-dated structured credit assets could generate cash flows faster than, say, zero coupon or payment-in-kind (PIK) bonds, where there may be indicative broker quotes – but you’d only find out if the borrower could repay (or refinance) at the maturity date! So using Level 3 categorizations to avoid illiquids is a crude tool. Of course, for those investors not worried about missing some adequately liquid assets falling under the Level 3 umbrella, a “Level 3 is bad” rule should still avoid many of the least liquid and completely illiquid assets. Less discussed and of greater concern are the false positives that can arise from assuming Level 1 and Level 2 must be liquid. That assets have an exchange price or some form of counterparty quote does not mean they can be traded in unlimited amounts, as the price or quote may only be good up to certain volume levels. Indeed, Third Avenue claimed it cannot liquidate “at rational prices,” which may imply they could sell at discounted prices. Any asset’s liquidity needs to be seen in the context of the fund’s position size, and I have seen funds take months or years to exit some Level 1 or Level 2 securities when they are holding a substantial multiple of volumes. The bottom line is that valuation methods should not be used to draw inferences about liquidity. Credit Ratings Third Avenue owned significant amounts of assets with a CCC credit rating, which may be deemed extremely speculative. The impulsive response here is to suggest that funds with higher credit ratings are more liquid, or less risky, or both, than those with lower (or no) credit ratings. Let us remind ourselves that some asset-backed security vehicles stamped AAA and backed by subprime mortgages ended up worthless and illiquid during and after the 2008 crisis, to the chagrin of institutional investors ranging from Norwegian pension funds to German municipal banks. Some money market funds that were perceived as super-safe cash substitutes also had to suspend dealing in 2008, and they were, broadly speaking, required by Rule 2a-7 to hold assets bearing the highest two short-term credit ratings. Since September 2015, money market funds are no longer bound by this constraint , as Dodd-Frank requires them to ensure assets meet a range of appropriate criteria. “Unrated” Assets When an asset is unrated, it generally means that the issuer has declined to pay for a credit rating rather than that the ratings agency has declined to provide one. The amount of C-rated issuance seen in the United States and Europe over the past two years shows that agencies are perfectly willing to provide some of the lowest credit ratings to companies that may be stressed or distressed. Convertible debt is often not rated, but this does not necessarily mean it is less liquid. I recall convertible bond funds largely comprising unrated names in 2008 paying out plenty of redemptions on time. In any case, credit ratings are not necessarily a reliable proxy for liquidity. Some credit assets reportedly see higher volumes after they get downgraded or default, partly because some holders become forced sellers and specialist distressed investors then become interested in the higher potential returns on offer. So, neither valuation hierarchies nor credit ratings can necessarily guarantee fund liquidity. Nor can regulation – both US mutual funds and US money market funds are now allowed to suspend dealing, and the SEC has approved Third Avenue’s suspension. Investors and advisers need to broaden and deepen their levels of analysis to get a better handle on liquidity risks. Quantifying fund liquidity is not only nuanced but also fluid, particularly as there can be seasonal variations, with calendar year-end reportedly a less liquid time. Investors and asset management companies may be drawn to the apparent certainty of putting funds into a small number of boxes, buckets, or categories, but this may prove to be a false comfort. Exact estimates of fund liquidity could prove to be spuriously precise, so the concept needs to be presented in broad brush terms that allow plenty of margin for error. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Japan ETFs To Tap On Renewed Stimulus Hopes

After logging in the biggest weekly drop of 11% in more than seven years on a rising yen, fears of a global slowdown and the sell-off in banks, the Japanese stocks bounced back strongly at the start of this week. Notably, the Nikkei 225 index jumped 7.2% in Monday’s trading session, representing the biggest daily gain since September, and extended gains of nearly 0.2% in today’s trading session. With this gain, the index has reversed the bearish trend it saw last week. Impressive two-day gains came on the back of bargain hunting and hopes for further stimulus from the central banks in Europe and Japan. In particular, renewed contraction in the Japanese economy brought back the need for more easing measures to stimulate the economy. Additionally, the yen has weakened from the highest level of ¥110.98 reached last week against the greenback that will benefit exporters and the manufacturing industry. This is because Japan is primarily an export-oriented economy, and a weaker currency makes its exports more competitive. More Stimulus in the Cards The economy contracted 1.4% year over year in the final quarter of 2016, worse than the Wall Street expectation of a 1.2% contraction. A drop in consumer spending, weak exports and lower private consumption continued to weigh on the growth of the world’s third-largest economy. The persistent slump in Japan’s biggest trading partner – China – added to the woes. The slowdown is the major setback for Prime Minister Shinzo Abe and his reform policy, Abenomics, which is aimed at pulling the country out of deflationary pressure and putting it back on the growth trajectory. Sluggish growth has raised speculation over additional fiscal stimulus by the central bank. Earlier this month, Bank of Japan (BoJ) adopted measures similar to the European Central Bank (ECB) by pushing interest rates to the negative territory. Additionally, the central bank maintained its bond buying program of 80 trillion yen ($675 billion) per year and invested in exchange-traded funds and real estate investment trusts. Now, an analyst at J.P. Morgan expects BoJ to cut interest rates further to minus 0.5% from the current minus 0.1% anytime soon, plus increase its Japanese government-bond purchases. Further, many economists expect Japanese growth to rebound in the coming months. As per the survey by the Japan Center for Economic Research, 38 analysts project that the economy would expand by an average of 1.4% in the first quarter, which would mark the best growth in five quarters. Given this, Japanese ETFs are poised for a rebound, especially in the session right after the Presidents’ Day holiday in the U.S. As a result, investors could tap the current opportune moment by investing in Japan ETFs. ETFs in Focus Currently, there are several Japanese equity ETFs trading on the U.S. market. While there are a handful that are relatively specialized, either tracking small-cap benchmarks or dividend-focused indexes, the most encouraging funds right now are the ones that are not confined to one segment, but provide exposure to the broad Japanese equity market. Below, we have highlighted some of them that could fetch substantial returns in the coming days on the expectation of additional stimulus. Of these, the ultra-popular fund is the iShares MSCI Japan ETF (NYSEARCA: EWJ ), with a total asset base of $17.7 billion. This fund tracks the MSCI Japan Index and holds 318 stocks in its basket. Though it is slightly skewed toward the top firm – Toyota Motor (NYSE: TM ) – at 5.8%, other firms do not account for more than 2.12% of assets. It trades in heavy volume of 50.3 million shares per day and charges 47 bps in annual fees. Another fund that provides a similar broad exposure to the Japanese stock market is the Precidian MAXIS Nikkei 225 Index ETF (NYSEARCA: NKY ). This fund does not have the same level of AUM or volume as EWJ, having nearly $41.6 million in assets and exchanging 40,000 shares a day. But it follows a much more widely known index – the Nikkei 225. Here, Fast Retailing ( OTCPK:FRCOF , OTCPK:FRCOY ) makes the top firm with 8.4% share, while other securities hold less than 4.3% share in the portfolio. The ETF has a slightly higher annual fee of 50 bps. Investors should note that both EWJ and NKY are large-cap centric funds with minor allocations to mid and small caps, and having consumer discretionary and industrials as the top two sectors. The products also have a Zacks Rank of 3 or “Hold” rating. Apart from these, Japan hedged funds – the WisdomTree Japan Hedged Equity ETF (NYSEARCA: DXJ ), the Deutsche X-trackers MSCI Japan Hedged Equity ETF (NYSEARCA: DBJP ) and the iShares Currency Hedged MSCI Japan ETF (NYSEARCA: HEWJ ) – seem excellent picks. These ETFs offer exposure to the broad Japanese stock market, while at the same time provide a hedge against any fall in the Japanese yen. The trio has a Zacks ETF Rank of 2 or “Buy” rating, suggesting that they will outperform the markets in the coming months. Risk-aggressive investors seeking to make big profits from the bullish sentiments in a very short period could go long on either of the three leveraged products, namely the ProShares Ultra MSCI Japan ETF (NYSEARCA: EZJ ), the Direxion Daily MSCI Japan Currency Hedged Bull 2x Shares ETF (NYSEARCA: HEGJ ) and the Direxion Daily Japan Bull 3X Shares ETF (NYSEARCA: JPNL ) – available in the space. EZJ provides two times (2x, or 200%) leveraged exposure to the daily performance of the MSCI Japan Index, while JPNL creates a triple (3x, or 300%) leveraged long position in the same index. Meanwhile, HEGJ seeks two times leveraged exposure to the MSCI Japan US Dollar Hedged Index. Original Post

To Be (The Market) Or Not To Be?

Key highlights After significant losses by large-capitalization and growth stocks during the 2000-2002 bear market, investors have become increasingly interested in non-market-cap index-weighting strategies that intentionally divorce a security’s index weighting from its price. Such rules-based alternatives to market-cap-weighted indexes include strategies labeled alternative indexing, fundamental indexing or, more commonly used, smart beta. Vanguard believes strongly that, by definition, smart beta indexes should be considered rules-based active strategies because their methodologies tend to generate meaningful security-level deviations, or tracking error, compared with a broad market-cap index. Our research shows that such strategies’ “excess return” can be partly (and in some cases largely) explained by time-varying exposures to various risk factors, such as size and style. Place “the market” in front of a mirror and what would you see? A perfect reflection of that market-same size and shape, nothing added, nothing taken away. If you wanted the reflection to show something different from the market-something better?-you’d need to place something different in front of the mirror. That’s the puzzle of smart beta, whose providers often suggest that they’re “like the market,” only better. If you’re looking to get different returns from, for example, the U.K. stock market, “you have to look different in some way, shape, or form,” said Don Bennyhoff, senior investment analyst in Vanguard Investment Strategy Group. “The first thing smart beta providers do is modify what the market looks like, based on their own active choices and biases.” Recent research by Bennyhoff and his colleagues Christopher Philips, Fran Kinniry, Todd Schlanger, and Paul Chin found that the rules-based methodologies employed by alternatives to market-cap-weighted indexes tend to generate meaningful tracking error compared with broad market-cap indexes. The methodologies may weight securities differently from their market-cap weighting. Or they may exclude securities that feature in a benchmark and include securities that aren’t part of the benchmark. “In our opinion,” Bennyhoff said, “these rules-based strategies are active, which means they’re not asset-class beta or ‘the market’ in the traditional sense.” The sources of outperformance “These strategies tend to result in portfolios that emphasize smaller-cap or value stocks, which have performed very well since the early 2000s,” Bennyhoff said. “So the question is, ‘Are these higher returns the result of higher risks?’ There is rigorous debate about that topic. But when we look at risk-adjusted returns, the excess return tends to go away, and maybe that’s a meaningful finding.” Moreover, as the figure below shows, smart beta strategies’ exposures to risk factors change over time. Non-market-cap-weighted strategies’ exposures to risk factors are time-varying 60-month rolling style and size exposure of alternative index versus broad developed-equity market, 1999-2014 Source: Illustration by Vanguard, based on data from MSCI, FTSE, S&P Dow Jones Indices, and Thomson Reuters Datastream. Figure displays 60-month rolling inferred benchmark weights resulting from tracking error minimization for each index across size and style indexes. Factors are represented by the following benchmarks: fundamental-weighted-FTSE RAFI Developed 1000 Index; equal-weighted-MSCI World Equal Weighted Index; GDP-weighted-MSCI World GDP Weighted Index; minimum volatility-MSCI World Minimum Volatility Index; risk-weighted-MSCI World Risk Weighted Index; dividend-weighted-STOXX Global Select Dividend 100 Index. “We’re not saying that paying attention to factors or tilting on value or small-cap is necessarily a bad thing,” Bennyhoff said. “Whether they pay off in the future as they’ve paid off in the past remains to be seen. But instead of putting together a strategy where the factor exposure is a by-product of the weighting scheme or the security-selection scheme, maybe it should be the primary focus .” And if you’re looking to capture the risk and reward of an asset class, Bennyhoff says, “the only way you can reflect that aggregate capital invested in the asset class is through market-cap weighting.” Interested in an overview of smart beta and other rules-based active strategies? Read our research brief . Notes: All investing is subject to risk, including possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. 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. 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.