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ALFA Underwhelms As Hedge Fund Darlings Crater Plus An Untimely Hedge

Summary ALFA’s hedge was triggered for the first time at the start of last September. Unfortunately, ALFA’s recent performance has been uninspiring. This analysis reveals two likely reasons for ALFA’s underperformance since the hedge was activated. In my Aug. 31, 2015 article entitled ” ALFA: A Market-Beating ETF About To Go Market-Neutral ” I reported that the AlphaClone Alternative Alpha ETF (NYSEARCA: ALFA ) was about to go market-neutral for the first time since its inception due to the S&P 500 closing below its 200-day moving average at month-end. I also commented on the fact that ALFA has had significant wire-to-wire outperformance vis-a-vis the SPDR S&P 500 Trust ETF ( SPY) since inception (see chart below), suggesting that investors in ALFA benefited from being able to “invest with the best.” Recall that ALFA uses a proprietary “Clone Score” methodology in order to aggregate the ideas of hedge funds which have strong historical performance. Alas, ALFA can no longer lay claim to this achievement. Its total return performance since inception now trails SPY by some 15% (55% vs. 70%). ALFA Total Return Price data by YCharts Zooming up to the time frame since the hedge was triggered at the start of September (it was actually activated at the market close on Sep. 2nd) reveals that most of the relative underperformance occurred over the last month. ALFA Total Return Price data by YCharts Reconstructing ALFA’s return without the hedge Recall that when the hedge is triggered (caused by the S&P 500 closing below its 200-day moving average at month-end), ALFA shorts the S&P 500 in an amount equal to the notional value of its long holdings. In other words, ALFA becomes market-neutral. Obviously, given that SPY has (as of last week) reclaimed its 200-day moving average in a brief span of two months, the hedge appears to be ill-timed. Nevertheless, investors in ALFA must be prepared to accept the fact that this hedging strategy will likely underperform in whipsaw situations, such as what was observed over the past two months, as part of the cost of protecting oneself from the worst of bear markets. I wanted to see whether the severe underperformance of ALFA was due to the hedge being triggered, or something else. Therefore, I reconstructed the total return of ALFA since the start of September to visualize what the return profile of ALFA would have been if the hedge had not been activated. We can see from the chart above that had the hedge not been activated, the hypothetical 100% long ALFA (denoted ALFA-L in the graph above) would have returned -1.95% since Sep. 1st, compared to -8.14% for the actual ALFA. While this alleviates the underperformance a bit, it is still far below that of SPY at 8.69%. So what can the rest of ALFA’s underperformance be attributed to? Hedge fund darlings crater In my previous article, I compared the top 10 holdings of ALFA and SPY. ALFA SPY Stock Ticker % Assets Stock Ticker % Assets Apple Inc. (NASDAQ: AAPL ) 7.25 Apple Inc. AAPL 3.75 Valeant Pharmaceuticals (NYSE: VRX ) 7.19 Microsoft Corporation (NASDAQ: MSFT ) 2.03 Celgene Corporation (NASDAQ: CELG ) 2.55 Exxon Mobil Corporation Common (NYSE: XOM ) 1.78 Horizon Pharma plc (NASDAQ: HZNP ) 2.53 Johnson & Johnson Common Stock (NYSE: JNJ ) 1.49 Allergan PLC (NYSE: AGN ) 2.41 Wells Fargo & Company Common St (NYSE: WFC ) 1.46 The Priceline Group Inc. (NASDAQ: PCLN ) 2.36 General Electric Company Common (NYSE: GE ) 1.41 Transdigm Group Incorporated Tr (NYSE: TDG ) 2.22 Berkshire Hathaway Inc. Class B (NYSE: BRK.B ) 1.4 Oracle Corporation Common Stock (NYSE: ORCL ) 2.05 JPMorgan Chase & Co. Common St (NYSE: JPM ) 1.37 Biogen Idec Inc. (NASDAQ: BIIB ) 1.79 Pfizer, Inc. Common Stock (NYSE: PFE ) 1.19 Skechers U.S.A., Inc. Common St (NYSE: SKX ) 1.5 AT&T Inc. (NYSE: T ) 1.15 How have the top 10 stocks of ALFA fared over the past two months? Answer: not pretty. AAPL Total Return Price data by YCharts As can be seen from the graph above, only 2 of ALFA’s top 10 holdings at the start of September, PCLN (+12.44%) and AAPL (+10.55%), have outperformed SPY. There are three massive losers: SKX (-30.5%), HZNP (-41.2%) and VRX (-48.2%). Assuming that the weightings of those three stocks did not change over this time period, they would have contributed a total of -6.24% to the total return of ALFA over this time period. That actually accounts for over half the entire difference between the hypothetical unhedged ALFA-L (-1.95%) and SPY (8.69%) during this time! Now, I am aware that ALFA’s holdings are not static, and hence the above calculation is merely an estimate. Nevertheless, it is clear that ALFA has been hit by a “doubly-whammy” of an untimely hedge, plus the underperformance of hedge fund darlings such as Valeant Pharmaceuticals (see this comically-timed Forbes article ” Hedge Fund Superstars Stocking Up On Valeant Pharmaceuticals ” that was published the day before VRX’s price came crashing down). This illustrates an important fact: even the best and brightest in the industry can sometimes get it (very) wrong. Due to ALFA’s heavy concentration in tech and biotech, one might say that SPY is not an appropriate benchmark for ALFA. The following chart therefore also shows the total return of the PowerShares QQQ Trust ETF (NASDAQ: QQQ ) and the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ) since the start of September, as well that of another hedge fund-following ETF, the Global X Guru Index ETF (NYSEARCA: GURU ). Unfortunately, ALFA still lags the other four ETFs, although the hypothetical ALFA-L (-1.95%) would have outperformed IBB (-5.12%) and closely trail GURU (-0.37%). ALFA Total Return Price data by YCharts Summary The last two months has not been kind to ALFA holders. Not only was the timing of the hedge unfortunate, but a number of the fund’s largest holdings have suffered tremendously, particularly VRX and HZNP, whose pricing practices have come under intense scrutiny. Will ALFA rebound in the future? I don’t know. As of today, VRX and HZNP are still two of ALFA’s top 10 holdings, at 3.30% and 2.00% weights, respectively, suggesting that ALFA’s future performance may still be somewhat tethered to the fates of those two specialty pharmaceutical companies. Moreover, note that while ALFA is currently in market-neutral mode, this will change if the S&P 500 manages to remain above its 200-day moving average for one more week, as the end of the month is near.

Q4 Outlook For REIT ETFs

After a strong performance last year, the real estate investment trust (REIT) space has lost ground this year, largely reflecting Fed-centric anxieties. The total return from the FTSE NAREIT All REITs Index decreased 4.52% for the year through September 30 against a 27.15% positive return in 2014. The group’s recent weak performance notwithstanding, the outlook for REITs remains favorable. The Fed uncertainty no doubt remains a dominant theme for the industry, but the central bank appears in no hurry to start the monetary policy normalization process, particularly following the recent bout of soft economic data. The “bad data”, ranging from weaker job additions in September, the decline in counts in the two ISM surveys, the dip in the Consumer Price Index (CPI) and weak manufacturing activity have raised doubts about reaching the Fed’s inflation rate target for a rate hike. Now, October seems to be almost off the table, and chances of a December hike are trending low, adding further cheer to the REIT space. No doubt, REITs’ dependence on debt for acquisitions, development and redevelopment activities make them gainers when rate remains low. Also, their dividend yield grabs investors’ attention more than yields on fixed income and money market accounts in times like this. But a low rate environment cannot be a perpetual one. While REITs (those having shorter leasing periods) with the power to adjust their rent quickly to a rate hike look quite bankable, the individual market dynamics of different asset types owned and managed by the REITs would be needed the most for the stocks to excel. After all, everything is not possible virtually, and one will eventually need “real space” for economic activities. For this special hybrid class, this is their most fundamental strength, and their ability to boost shareholders’ value through steady dividend payouts makes them all the more attractive. Dividends Still Standing Tall U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends. And as of September 30, the dividend yield of the FTSE NAREIT All REITs Index was 4.44%, while the yield of the FTSE NAREIT All Equity REITs Index was 3.97%. Clearly, the REITs continue to offer decent yields and outpaced the 2.28% dividend yield offered by the S&P 500 as of that date. Capital Access Moreover, REITs have been proactive in the capital market in recent years, leveraging the low rate environment to improve their financials. As of September 30, REITs raised over $49.0 billion in initial, debt and equity capital offerings (IPOs – $1.4 billion, Secondary Common – $20.3 billion, Secondary Preferred – $2.1 billion and Secondary Debt – $25.3 billion). This indicates the rise in investors’ confidence in this sector and their willingness to pour money into it. Exploring the Sector Through ETFs In this backdrop, we believe this is the right time to explore the sector through ETFs, so as to reap the benefits in a safer way. Considering the return prospects from dividend income and capital appreciation, we have tracked the following REIT ETFs, which could be worth considering: Vanguard REIT Index ETF (NYSEARCA: VNQ ) The fund, launched in 2004, seeks investment results by tracking the performance of the benchmark MSCI US REIT Index, which is used to gauge real estate stocks. The fund consists of 145 stocks of companies which acquire office buildings, hotels, and other real property. The top three holdings are Simon Property Group Inc. (NYSE: SPG ), Public Storage (NYSE: PSA ) and Equity Residential (NYSE: EQR ). It charges 12 basis points (bps) in fees (as of May 28, 2015). VNQ managed to attract $26.2 billion in assets under management till October 16, 2015. iShares U.S. Real Estate ETF (NYSEARCA: IYR ) Launched in 2000, IYR follows the Dow Jones U.S. Real Estate Index that measures the performance of the real estate industry of the U.S. equity market. The fund comprises 118 stocks, with its top holdings including Simon Property Group Inc., American Tower Corporation (NYSE: AMT ) and Public Storage. The fund’s expense ratio is 0.43% (as of August 31, 2015) and the 12-month trailing yield is 3.94% (as of September 30, 2015). It has around $4.4 billion in assets under management as of October 16, 2015. SPDR Dow Jones REIT ETF (NYSEARCA: RWR ) Functioning since 2001, RWR seeks investment results of the Dow Jones U.S. Select REIT Index. The fund consists of 97 stocks that have equity ownership and operate commercial real estate, with the top holdings being Simon Property Group Inc., Public Storage and Equity Residential. The fund’s expense ratio is 0.25% (as of October 19, 2015), and the dividend yield is 3.21% (as of October 15, 2015). RWR has over $3.1 billion in assets under management (as of October 16, 2015). Schwab U.S. REIT ETF (NYSEARCA: SCHH ) This fund debuted in 2011 and tracks the total return of the Dow Jones U.S. Select REIT Index. It consists of 97 stocks that own and operate commercial real estates. The top three holdings are Simon Property Group Inc., Public Storage and Equity Residential. It charges 7 bps in fees (as of October 9, 2015), while the trailing 12-month distribution yield is 2.39%. SCHH boasts $1.7 billion in assets under management (as of October 16, 2015). First Trust S&P REIT Index ETF (NYSEARCA: FRI ) Launched in May 2007, FRI is an ETF that seeks investment results of the S&P United States REIT Index, which gauges the U.S. REIT market and retains consistency, depicting the overall market composition. The fund comprises 157 stocks, with the top holdings being Simon Property Group Inc., Public Storage and Equity Residential. The fund’s net expense ratio is 0.50% (as of May 1, 2015) and the 12-month distribution rate is 2.73% (as of September 30, 2015). FRI has about $206.5 million in net assets under management (as of October 16, 2015). Original Post