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An ETF Primer

Via Robert Sinche at Amherst Pierpont Securities: Every once in a while a topic, usually the media coverage of a topic, creates a burr in my saddle, as they say. While that has taken place less frequently as I age, the coverage of the ETF market, and particularly the High Yield ETF market, has now reached that level. To be sure, the detailed operation of the ETF market is complicated and I have benefitted significantly from a dialogue with my former colleague and BlackRock Chief FI Investment Strategist Jeff Rosenberg. What I present below, however, are my views and may or may not represent his views. So, there seems to be the view that the creation of ETFs have brought capital into various market segments and, somehow, have added to risk and volatility in those markets. High yield bond ETFs currently are the target of many. But to argue that somehow the money that flowed into ETFs is now creating forced selling and excessive volatility reflects what I think is a lack of understanding on how ETF construction takes place . To be sure, the process IS very complicated and I can understand the misconceptions, and hopefully this note may add some information to the discussion. Jeff forwarded a 2012 paper (pdf attached) by Downing and Lyuee, and for those who want to go through the detailed analysis feel free to do so. What I am more interested in is their excellent discussion of the ETF creation process on pages 3-4. The key quote from the paper is below. As I understand the issue, the selling of ETFs generally only leads to the selling of the underlying assets when there is an arbitrage opportunity for the APs (see below) to buy the ETF and sell the underlying if the price of the ETF falls too far below the NAV of the underlying securities. But it also can work the opposite way – if the underlying securities get too cheap relative to the ETF price, the APs can buy the underlying securities and sell the ETF in the market. It is in this context that ETFs could trade huge volumes at prices set in the open market between buyers and sellers without having to transact ANY underlying securities. In other words, transactions in the underlying securities will take place because of arbitrage opportunities, not simply because investors are selling the ETF . In this context, it does seem to me that ETFs can increase market liquidity and price discovery, not exacerbate the situation in illiquid underlying markets. This is actually different than the open-end MF market – if investors sell their positions in open-end funds the fund company must liquidate underlying securities (unless they already were holding cash positions,), a much bigger problem for the underlying market. Comments/feedback/correction appreciated. Exchange-traded funds (ETFs) are investment vehicles that combine the key features of traditional mutual funds and individual stocks. The typical ETF structure is much like a mutual fund in that shares in the fund represent claims on a portfolio of securities. Typically the ETF portfolio is constructed to track a publicly available index such as the S&P 500. Like stocks, shares in an ETF can be bought or sold (long or short) on an exchange throughout the trading day. This is in contrast to mutual funds, where transactions in shares of the fund occur directly with the fund company at the close of each business day. The pricing mechanism of ETFs relies on the so-called “creation/redemption” process. If an ETF is trading at a price that is higher than the sum of its constituents’ prices, i.e. trading at a premium, the Authorized Participants (APs), which are usually market makers, can purchase the underlying securities and exchange them for shares in the ETF with the ETF manager, and immediately sell the ETF shares on the exchange for a quick profit. This creation mechanism ensures that any premium in ETF pricing is arbitraged away by the APs. The redemption process, which eliminates discounts in ETF pricing, works in the reverse direction. The composition of the basket of securities eligible for creation/redemption is published daily by the ETF manager. In practice, ETF managers may not require that the basket of securities to be exchanged for ETF shares perfectly match the published holdings given the liquidity constraints imposed by the underlying market (i.e., not every bond is trading everyday). The manager may decide to accept a basket where some securities are substituted by similar securities if the substitution would not increase tracking error. One common misconception is that ETFs are “forced sellers” of bonds when markets decline. The rationale behind this view is that, as markets fall and investors sell ETF shares, the ETF portfolio manager will be required to sell securities to fund redemptions. This dynamic does in fact occur with traditional open end mutual funds. While open end mutual funds typically carry a cash reserve to help facilitate redemptions, this reserve may be quickly exhausted during periods of larger outflows, resulting in a sale of securities by the mutual fund portfolio manager. In contrast, ETF investors sell shares of their ETFs on exchange. Whether or not an ETF share redemption ultimately occurs will be driven by the relationship between the exchange market price of the ETF and the actionable value of the underlying redemption basket. If it is economically attractive to exchange shares for bonds, APs will likely seek to do so. At the extreme, if bond markets are impaired, ETF investors may still be able to liquidate their shares on exchange, albeit at a market price that could differ appreciably from the NAV and the ETF’s index (both of which may lag given the limited trading activity in the OTC bond market). In this sense, ETFs do have an additional liquidity venue the exchange which may actually serve to reduce the amount of trading activity in the OTC bond market relative to a traditional open end bond mutual fund. Critics often cite the appearance of anomalous premiums or discounts during periods of market volatility as evidence of dysfunctional behavior in the ETF. However, such behavior often reflects elements of price discovery given the gap in liquidity between the ETF and the underlying bond market [Tucker and Laipply (2012)].

Your 2016 Investment Strategy Guide: 10 Best ETF Buys

Summary Emerging markets are cheap, trading at 42% below their median P/E. Developed market financials, particularly in the U.S. and U.K., having de-levered since 2009, are better positioned to participate in a growth upturn in their economies. Valuations in Europe are cheaper and dividends higher than in the U.S. (click to enlarge) How should you invest your money in 2016? I asked a group of investment strategists to weigh with their top recommendations and their outlook on the stock market. Some of the issues I asked them to address were: Do you think we’re headed for a bear market? Why? or Why not? What do you make of the stock market’s valuations? What impact will a Federal Reserve Rate hike have on the stock market? What are the best investing opportunities now given the state of the stock market? 1. iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ) by Zachary Abrams, manager of wealth management and portfolio analysis at Capital Advisors, Ltd . in Cleveland, Ohio with about $600 million under management. The sentiment is so poor that emerging markets are oversold. In the short-term it’s hard to find the positives other than a possible a reversal in the dollar, which tends to depreciate after the first rate hike and could reverse capital flight. From a trend standpoint, assets that move down tend to keep moving down until they don’t and assets that outperform now are likely to outperform moving forward until they don’t. Emerging markets stocks are currently moving down and their relative performance versus U.S. Stocks is poor. It’s hard to say when this will stop. My longer-term view is constructive given the forward return projections over the next decade versus U.S. large, U.S. small, and developed market stocks. For example, we project U.S. large at 2% real returns over the next 10 years. We then use Research Affiliates (NYSE: RA ) for other asset classes, which project 0% for U.S. small, 5% for developed markets, and 8% for emerging markets. For the longer-term projections Research Affiliates uses Shiller P/E (price divided by the average of 10 years of earnings (moving average), adjusted for inflation). Here is the table: Asset Class Current P/E Median P/E % +/- Valued 10 Year Real Return Projections U.S. Large 25 16 56% 1% U.S. Small 47 40 18% 0% Developed Markets 14 22 -36% 5% Emerging Markets 11 19 -42% 8% Emerging markets are cheap, trading at 42% below their median P/E. Further, this is also true relative to U.S. large where U.S. large has a P/E of 25 and emerging markets is at 11. The caveat to this, and what I alluded to in the first bullet, is that what is cheap now can continue to get cheaper (i.e. emerging markets could fall in value more). I could make this same argument over the last few years and yet emerging markets continue to fall. Further, the sample size is small I believe relative to U.S. large and thus perhaps the median is actually inflated and thus the current valuation isn’t as undervalued as indicated. I should also note that U.S. large average valuations have been trending up and thus perhaps are not as overvalued as indicated. This would mean that emerging markets are not as relatively undervalued to U.S. Large. Additionally, I believe the projections are based on growth constants and could thus be off if growth is higher or lower than the mean. In spite of all those caveats, the probability still favors Emerging Markets outperformance over the next decade. As you can see, when emerging markets have outperformed it tends to be for a prolonged period of time. The same on the flip side. Thus, from a relative performance standpoint even if you don’t time the bottom of emerging markets you can still have a good probability of generating higher returns by waiting for them to turn around. From a fundamental standpoint I would look for the following: 1) clear route to Fed tightening, 2) reversal in U.S. dollar or at least the expectation it will stop rising, and faster and growing growth than the developed markets. I got these from Mark Dow and they seem to fit the narrative. None of these appear to be on the horizon at this point, which is why it’s hard to be bullish currently as noted in the first bullet. This is a gross domestic product growth table from the IMF: Projections 2013 2014 2015 2016 Emerging 5.0% 4.6% 4.2% 4.7% Advanced 1.4% 1.8% 2.1% 2.4% Difference 3.6% 2.8% 2.1% 2.3% As you can see, emerging growth has decreased and it’s growth differential from the advanced world has also decreased. This would be evident even more so going back before 2013. Further, while the projections show improvement, they are just that – projections. The growth trend is still against them and this was from July 2015. I suspect that would be weaker right now. The only major risks investors face in my view is not meeting their long-term financial goals and/or permanent catastrophic loss of capital. This happens by not having a financial blueprint and subsequent investment plan. Without those, investors are more prone to panic and thus facing those risks. If we are only talking emerging markets, the big risk is obvious: they continue to fall in value and you’re trying to catch a falling knife. The cheap asset gets cheaper. Further, emerging markets are very volatile. 2. SPDR S&P International Financial Sector ETF (NYSEARCA: IPF ) by Daniel Waldman, Themos Fiotakis and Yianos Kontopoulos, strategists at UBS Securities We think of emerging market financials as entering the late stage of the credit cycle, while developed market financials, particularly in the U.S. and U.K., having de-levered since 2009, are better positioned to participate in a growth upturn in their economies. Emerging markets, having levered up steadily since the crisis, is likely to face a weak growth profile, negative credit impulse, and more severe asset quality problems moving forward. So far there has been no major increase in local currency money and bond market rates despite currencies having sold off for the last four years, but with credit spreads also slowly losing their mooring, the risk of rising cost of equity becomes much more real. Our analysts believe implied cost of equity for emerging market banks has already increased from about 11.7% to 13.8% during the last six months. Credit growth is slowing, and nominal gross domestic growth is slowing even faster, implying leverage is still rising. This compromises both the ability to accumulate incremental assets, and also suppresses return on current assets. Some 56% of UBS analysts covering emerging market financials now expect downside risks to net interest margins, compared to 40% in the previous quarter. The equivalent number for developed market is 31%, unchanged from third quarter. Although emerging market financials trade below developed market financials on a price-to-book basis, we believe that trends in return on equity are worse in emerging market as well. emerging market financials’ return on equity has dropped from 19% in 2012 to 15.6% today, and is likely to slip further. Also, if nominal gross domestic product continues to fall at a faster pace than credit, we would expect emerging market financials to de-rate further. Already, valuations in emerging market financials seem high in this context. We see developed market financials not so much as a cheap play poised for a serious re-rating, as a defensive play that happens to be much better positioned than emerging market financials. We take the view that a slowdown in the emerging world is unlikely to substantially impact growth in the developed world. This is because a) developed market economies are much less open than emerging market economies, so a hit from developed market to emerging market cuts much deeper into emerging market than vice versa, and b) global liabilities are written in developed market currencies, not emerging market currencies, so a tightening of liquidity in the latter owing to local banking or credit problems will not have nearly the same impact on global growth as a banking crisis in developed market (as we saw in 2009). The risks: emerging market growth (particularly China/Asia) surprises to the upside, alleviating asset quality concerns and supporting credit demand. 3, 4, 5. Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ), Deutsche X-trackers MSCI Europe Hedged Equity ETF (NYSEARCA: DBEU ) and First Trust Global Tactical Commodity Strategy ETF (NASDAQ: FTGC ) by Herb Morgan, founder, CEO and chief investment officer of Efficient Market Advisors, LLC (NYSEMKT: EMA ) in San Diego, Calif. with $692 million assets under management. We’re not headed for a bear market. But I do think a correction is a possibility. If we define a bear market as a decline in equity prices as measured by the S&P 500 of 20% or more, than no. To be sure stocks aren’t cheap, nor are they particularly expensive. At 18.5 times current earnings the S&P 500 is only slightly above its 15-year average price-to-earnings multiple. Considering the earnings yield of the S&P is 5.4% and the risk free yield of the 10 year U.S. Treasury 2.23% there is a large premium to be earned by owning stocks. Further, U.S. companies can be expected to have earnings growth in excess of the mediocre GDP growth due to the operational leverage granted them by the low cost debt issued during this era of ultra-low interest rates. In order to see a bear market, we’d first have to expect and envision a major recession. This is not in the cards due to massive monetary stimulus taking place globally. Even though the Fed is likely to raise short-term interest rates on Dec. 16, investors should not equate this with tightening. This is simply less-loose monetary policy and move towards normalization. The risk to my scenario would be a surprise uptick in inflation, which would have to be met with aggressive Fed tightening. There is a large gap between the earnings yield of the S&P 500 and the risk-free yield of the 10-year U.S. Treasuries rendering either stocks cheap, or bonds expensive. It’s a little of both. While the returns on bonds over the last 30 years have been coupon plus appreciation, we see coupon minus appreciation going forward. So the valuations on bonds are expensive. Valuation is always and everywhere a “relative” metric. So, while stocks aren’t cheap by historical P/E, they are cheap relative to bonds. Barring any major developments between now and Dec. 16 the Fed will raise its target for the Federal Funds rate. (The rate banks borrow at from each other). This rate will still be extremely low. The Fed is still being very loose. The question for investors is really how many more hikes to expect and over what period of time. We believe the plan is for a slow return to normalization. In the old days of the past 60 years a normal Fed Funds rate was 5%. Today, I think a more normal rate will be 2.5%. Further, I don’t see us getting to 2.5% for at least a couple of years. Investors will have lower returns on fixed income for a very long time. Fixed income will remain an important part of a portfolio. But the interest earned will stay paltry. Income oriented investors need to identify managers who can be creative (without adding too much complexity or risk) in creating total return so investors can increase their portfolio income with inflation. It means income oriented investors need to carefully include non-bond sources of income in their portfolios. Such non-bond sources could include master limited partnerships (MLPS), real estate investment trusts (REITs), common stocks and alternative investments. Given the state of the stock market, we see good opportunity in stocks. The strength of the U.S. dollar has left many foreign investments cheap for U.S. investors. International developed markets as measured by the MSCI EAFA index are flat for the year. But the valuations are below that of the U.S. This is not without reason, as the big players Japan and Europe have lagged significantly behind the U.S. in the recovery cycle. Also, emerging markets as measured by the MSCI Emerging Markets Index have been decimated by the strong dollar, plummeting commodity prices and concern over the Chinese economy. We think all the concerns are justified but have been fully priced into the market, so we have begun to accumulate shares in the Vanguard Emerging Markets ETF. We also like Europe. Europe is about five years behind the U.S. in recovery but has been expanding for all of 2015. European unemployment while high is declining and the European Central Bank, led by Mario Draghi, is committed to doing whatever it takes to return to growth. We favor the Deutsche MSCI Hedged European ETF. Valuations in Europe are cheaper and dividends higher than in the U.S., plus hedging out the likely rise in the dollar are taken care of within the ETF. Finally we like commodities. Many commodities are trading below their marginal production costs. We see demand coming back in 2016 and the impact of the rising U.S. dollar fading somewhat. We have been buying First Trust Global Tactical Commodity Fund . We like it because its active and doesn’t have as much oil exposure as other commodity ETFs, and its unique structure cause it to issue a 1099 at tax time rather than a burdensome K-1. 6, 7. iShares MSCI Global Metals & Mining Producers ETF (NYSEARCA: PICK ) and SPDR S&P Metals and Mining ETF (NYSEARCA: XME ) by Mike Chadwick, CEO of Chadwick Financial Advisors in Unionville, Conn. with $150 million under management. The stock market is very dangerous at this time. Prices are inflated across the board pushed higher by seven years of zero interest rates and unconventional monetary policy across the globe. People are searching for yield, and in doing so have pushed asset prices to insane levels in many asset classes, completely unaware of the risks they’re taking. This could be a who’s who of horrible times to invest. We are going to have a bear market and I believe it’s close, very close to happening. We’re actually likely in the topping process right now, markets are high but participation is dwindling, fewer and fewer stocks are driving prices higher in the major indices. I think the likelihood of a rate increase is only 50/50, the underlying economy isn’t supportive of record high asset prices it’s simply a product of chasing returns and monetary policy. Never before has so much been dependent upon what central bankers and politicians promise. Valuations make little economic sense in many categories such as biotech, some technology and many ordinary businesses, people are chasing momentum and technical indicators without regard to fundamental economic principles. Not only are stocks in a bubble, but so are many categories of bonds, real estate and other typically uncorrelated asset classes. The market isn’t currently linked to the economy at all, it is being held hostage by central banks and political promises, neither of which are reliable for the preservation or creation of wealth. At some point the faith of market participants in these antics will cease, and then we’ll see a shift in the tide and behavior will require earnings and relative valuations, not just a better alternative than 0% in the bank. Simple metrics such as corporate earnings as a percentage of Gross Domestic Product is at record levels. The Schiller P/E is pushing levels we’ve only seen before in 1999 and 1929. Many companies are trading at 100, 200+ times estimated earnings, some have no earnings and trade at 10 or 20 times sales. There are many similarities in todays markets and the market in 1999. This is a debt fueled bubble that when pops, will be painful for the majority. The best investment opportunities I see today are in the miners and the energy complex. This isn’t likely an all-in now opportunity but rather an easing in overtime strategy. Valuation is the thesis plain and simple, the miners especially are grossly undervalued, many trading at 20% of book, never mind any other metric. Miners remind me of the banks in 2009, when everyone thought a lot of them were going under. Some did so one needs to be careful but most will rebound and those who survive will take market share from those who fail. Miners also act as a leveraged play on metals, which will at some point do well when people lose faith in central bank policies and wake up to the reality of the over indebted world with no easy way out. We cannot fix our debt problem with more debt. Oil not as good of a value, but relative to the rest of the market my second choice. Both industries are under pressure, companies are cutting dividends, laying off workers and getting lean. This is when to really buy companies safely and make serious gains. The concept of buying what is hot doesn’t work for value investors and this has been a go go growth market for seven years now. These categories can certainly go lower from here. But at these levels the majority of the downside risk has been taken off the table. 8. First Trust Preferred Securities and Income ETF (NYSEARCA: FPE ) by Brock Moseley, managing partner of Miracle Mile Advisors in Los Angeles with $500 million under management 2015 has been a lost year for U.S. equity markets and current valuations point to a similar result in 2016 as the current average price-earnings ratio of the S&P 500 is 18.5, higher than its historical average of 17.1. While valuations may be stretched, the macroeconomic indicators still suggest that the U.S. economy is growing at a solid rate so a bear market remains unlikely. Compared to the U.S., valuations overseas remain attractive (current price-warnings of MSCI EAFE is 15.4) paving the way for 2016 to be the first time since 2012 that international developed markets will outpace those of the United States. This divergence is already occurring in Japan as the MSCI Japan Index is up 6.2% over the past trailing year whereas the S&P 500 is only up 2.2%. Continued stimulus by the European Central Bank and the Bank of Japan will provide a boost to the regions’ exporters who will be the drivers of double digit growth in the international developed markets in 2016. Converse to the accommodative stances of central banks abroad, November’s solid job report increased the probability that in December the Fed will initiate an interest rate hike for the first time in seven years. If the Fed embarks on a series of hikes in 2016, traditional fixed income investments will face continued downward pressure from rising interest rates. For yield seeking investors looking to reduce their interest rate sensitivity, one ETF to consider is the First Trust Preferred Securities and Income ETF. FPE has muted interest rate sensitivity because 65% of its holdings are fixed to floating rate preferred securities. Furthermore, FPE is up over 6% year-to-date and offers a healthy yield of 6.2%. After years of record low volatility, the average VIX reading increased to 16.5 in 2015. The uptick in volatility was driven by uncertainty regarding the Fed’s first hike, sluggish demand in the global economy, and plummeting energy prices. These factors as well as heightened geopolitical tensions in the Middle East are still grabbing headlines meaning that 2016 could be an even more volatile year than 2015. 9. Consumer Discretionary Select Sector SPDR ETF (NYSEARCA: XLY ) by Ryder Taff, CFA, portfolio Manager at New Perspectives in Ridgeland, Miss. with roughly $85 million. We are looking at a very interesting time in the market. On the whole, valuations are very high as interest rates are low. There is a lot of anticipation of the valuations declining, which would mean that stock prices have to decline unless earnings rose dramatically. Two large expenses of companies, interest and labor cost, are almost certain to start rising next year. This will limit earnings growth. I anticipate little earnings growth and some decline in valuation ratios across the board. The American consumer is benefiting greatly from the rising economy and rising wages. All sorts of things can benefit here but I am very interested in consumer discretionary stocks. The SPDR Consumer Discretionary ETF will likely benefit from people having extra money to work: On home projects: Home Depot (NYSE: HD ) and Lowes (NYSE: LOW ) Shop online: Amazon (NASDAQ: AMZN ) Keep or upgrade cable packages: Comcast (NASDAQ: CMCSA ), Disney (NYSE: DIS ) and Time Warner (NYSE: TWC ) Buy a cup of coffee on the way to work: Starbucks (NASDAQ: SBUX ) The sales of these companies should rise faster than the average which will benefit them even as some expenses increase. 10. SPDR EURO STOXX 50 ETF (NYSEARCA: FEZ ) by Daniel Waldman, Themos Fiotakis and Yianos Kontopoulos, strategists at UBS Securities European equity valuations are favorable, and markets should benefit from a combination of improving credit growth, monetary stimulus, low energy prices, and a slightly positive fiscal impulse in 2016. After remaining stalled for years, credit growth has begun to recover in the Eurozone. Our leading credit indicator for Europe, constructed from components of the European Central Bank lending survey, has historically led both credit and gross domestic product growth, as well as equity performance ( see link ). This leading indicator is pointing to a further acceleration in credit growth, yet markets are significantly underpricing the possibility (Figure 6). (click to enlarge) The improvement in credit growth, combined with supportive monetary and fiscal policy, and lower energy prices, should lead to an acceleration in 2016 growth. Our European Economics team forecasts growth rising from 1.5% in 2015 to 1.8% next year. In particular, they see a pickup in nominal gross domestic product growth as inflation turns – a key support for corporates’ revenue growth. Policy in Europe is supportive, with both fiscal and monetary policy set to ease, and the ongoing easing in credit conditions is pointing to acceleration in private sector demand. Against a backdrop of accelerating growth, continuing low inflation should allow accommodative policy to remain in place and enable credit reflation. This should be particularly positive for equities, and our European strategists have a 13% earnings growth forecast for 2016. This would be the first earnings growth in five years, driven by improving nominal GDP, rising margins, and high operational leverage as wage and material costs remain low. They also stress that actual lending to corporates by banks, which is the principal source of funding for European corporates, has turned positive for the first time in over three years. Finally, it is worth noting that on a cyclically-adjusted basis, the European valuation gap to the U.S. is at recessionary levels (Figure 7). (click to enlarge) The risks: Some degree of European recovery is likely priced. Earnings disappointment due to European growth weakness or a rise in fears regarding the emerging market backdrop would be negative. Euro-to-U.S. dollar strength would be a drag on earnings, though we are likely far from levels where it would be an issue, and would expect the ECB to lean against euro/U.S. dollar strength above 1.15 in the near term.

Why U.S. Investing Differs A Lot From Europe Investing…

Summary US is definitely not a market for traditional stock pickers, as this market is a flow-driven market. In Europe, the economic knowledge of the population is very low. Stock pickers should focus on Europe, and systematic or factor-based investors on the US. Smart risk management is as important as finding equity ideas to generate alpha. The whole study with all the statistics and charts may be found on SSRN , or just ask the author. We compare European Indices (DJ STOXX 600, EURO STOXX 50, FTSE 100) to US Indices (Russell 2000, S&P 500, NASDAQ Composite, NASDAQ 100) and Japanese Indices (TOPIX, Nikkei 225). First, from 2014 December 31st to 2015 November 11th. Using a longer period could lead to wrong conclusions given the important turnover of the components within each index (roughly 5% per year), and the death-survivorship bias. Therefore, in a second attempt, we compare the behavior of the large indices such as the TOPIX, NASDAQ Composite and Russell 2000 year after year, from 1999 to 2015. We do the same analysis for DJ STOXX 600, even if the sample seems tight. Why year after year and not the 16 years in a row? Because turnover is huge on US indices, and the Russell 2000 or NASDAQ Composite composition as of 2015 is very different from the one as of 1999. Russell 2000 Beta per couple (capitalization; volatility) (click to enlarge) First of all, turnover is huge. Therefore, it is important to stress again that a study over a long period of this index versus its components is not relevant. Second, looking at the performance vs. (capitalization; volatilities), we can notice that although over the period, the performance of the index is largely positive (+249% total return between Dec. 31st 1998 and Nov. 11th 2015) – meaning it was a bull market with on average 7.7% per year – the red cells are much more represented on the right column of the table. This happens when the index performance is negative of course (2002, 2008), but it happens as well when the index performance is flat or mildly positive (2000, 2001, 2004, 2011, 2012, 2014, 2015). On the other hand, these high-volatility stocks strongly outperform the universe in two periods out of 17: 1999 and 2003, with respective total return performance of the Russell 2000 of +21%, +47%. This means that the outperformance of volatile small caps is very hard to capture, because over the long run, it may be easy to experience huge drawdowns with difficulties to recover. Keep in mind that when a stock drops by 50%, it needs to increase by 100% to come back to the initial level. Regarding capitalization effect, things seem to be more difficult to explain. As a summary for this part, should you want a smooth pattern, focusing on the low-volatility stocks in N-1 is worth in order to succeed in such a challenge, whereas dealing with historically high-volatility stocks may suffer from huge drawdowns (2002, 2008), and only rare astonishing performances, which may struggle in erasing the previous underperformance. The issue is always the same: what is your investment time frame? And it has to deal with the way performance fees are calculated and rewarded. If the latter depend on High-Water Mark (HWM), then low volatility should be chosen. If it does not, then the performance fees may be perceived as a yearly call on performance… And when you are long a call, it depends positively on volatility, and do not suffer if the market is negative end of year, as its value is null. Therefore, the asset manager is likely to choose the riskier stocks as he may – even if it is only two years among 17 – sharply outperform the index punctually and underperform most of the time. HWM is strongly needed in order to protect investors from these types of greedy and unconscious asset managers. This phenomenon is likely to persist and be amplified by the emergence of smart-beta, risk premia, through the ETF market which is huge in the US and tends to offset the traditional Mutual and Hedge Funds: flows focus on ETF, and the latter focus on low-volatility stocks creating and feeding the famous “low-volatility puzzle”, challenging the well-known Markowitz theory. In this puzzle, the lower the volatility, the higher the expected return, whereas Markowitz used to state the opposite… Regarding the persistence of the winners and losers, this relationship is quite volatile. According to the numerous papers by Bouchaud (“Two centuries of trend following”), most of the time the market is trend followers, but when the regime changes, it hurts a lot (examining the performance of CTAs may help to understand – CTAs being by construction trend followers). 2009 is a very good example (with the red circle): the losers of 2008 were the winners of 2009, within a strong rebound of the market. It looks as if after a huge drop, the rule is to buy the worst performers. Looking at the beta per volatility quartile, the higher the historical volatility, the higher the beta, whereas there is no clear pattern with respect to capitalization. This can be explained by the fact that small capitalizations are perceived to be more volatile than large, but in practice, this is not the case. Do not forget that beta is the ratio of covariance over the product of standard deviations, therefore the surprising “in-range” beta is much more explained by the low numerator (covariance): small caps are volatile but not correlated with the benchmark, whereas large caps are less volatile but much more correlated with the benchmark. Regarding stock picking, stock pickers are likely to pick their stocks in the upper right hand side of the table: low capitalization, high volatility. Low capitalization, because they aim at being anti-benchmark, and high volatility because their way of choosing relies on fundamental analysis and upsides – the higher the volatility, the higher the upside. The Russell 2000 is definitely not a territory for stock pickers, with 2% of the stocks exhibiting more than 100% YtD performance in 2015, and more than 55% doing worse than the index. Should you want to post performance by picking up small caps and high-volatility stocks within the Russell 2000 universe, then you have to be very sharp in terms of choosing the right ones, and avoiding all the underperformers (which are numerous – “Many are called, but few are chosen”), and be very sharp in terms of market timing, given the number of years small caps largely underperform. NASDAQ Composite Beta per couple (capitalization; volatility) (click to enlarge) Turnover is huge with less than 5% of the components remaining after 16 years. The “capitalization effect” is more important on the NASDAQ Composite than it is on Russell 2000. Russell 2000 only refers to small capitalization (less than 10BlnUSD), whereas the NASDAQ Composite gathers stocks whose capitalization lays between 2MlnUSD and 700BlnUSD in 2015. The beta is decreasing with respect to capitalization, and is increasing with respect to historical volatility, with a beta close to 2 for the couple (1st capitalization; 4th historical volatility). As for Russell 2000, the red part of the table is concentrated on the right hand side, with scarce very high outperformances. Same explanation about the smoothness profile required, and the performance fees policy needed. Regarding the persistence of the winners and losers, this relationship is quite volatile, as for Russell 2000. Most of the time (and easy to see in 2002 and 2015), the winners of N-1 remain the winners of N (momentum effect), whereas in a year such 2009, the breach is very sudden and the relationship no longer holds. Looking again at the couple (1st capitalization; 4th historical volatility), which we use as a proxy for stock picking here the ranking of this couple among the other couple per year. The ranking goes from 1 to 16. We could say that the higher the index performance, the higher the ranking of this “stock-picking couple proxy” (“SP”). Before 2012, it works. But since 2012, we can notice that in spite of the huge performance of the index (respectively +17.8% and +40.2% in 2012 and 2013), this stock-picking proxy lags a lot. We compare the stock-picking proxy to its opposite, the “benchmark proxy” which is the couple (4th capitalization; 1st historical volatility) (“B”). In 2012 and 2013, the respective median performance (in absolute value) of “SP” and “B” were: The impact of ETF and “low-volatility” Smart Beta (“Minimum Variance” products, “Equal Risk Contribution” products) dramatically changed the market, developing, thanks to the high risk-aversion of customers (still traumatized by the 2008 drop in equities). The flows are huge and totally offset any fundamental reasoning since 2010. At this date, two years after the big krach, investors are eager to take some equity risk again, but with strong risk management. This is the promise of these ETFs. On the other hand, one can notice the difference of magnitude between the performance boundaries over the years: It is interesting to look at this table as of logarithmic return, as this type of returns keeps the symmetry. Therefore, we can notice that “B” suffers less from asymmetry than “SP”. The same reasoning we already made on Russell 2000 holds here again about huge drawdowns for “SP”, and the smooth pattern for “B”, with less difficulty to recover. Once again, the performance fees policy is the key to secure the shareholder, and prevent him from any rogue asset manager. As for the Russell 2000, the NASDAQ Composite is definitely not a territory for stock pickers, with 2.5% of the stocks exhibiting more than 100% YtD performance in 2015, almost 2/3 doing worse than the index, and a random stock picking underperforming the index by almost 10%. The market evolution and the emergence of ETF do not allow any stock picker to outperform the index. DJ STOXX 600 Beta per couple (capitalization; volatility) (click to enlarge) Turnover is pretty low compared to the US indices. Beta depends as on capitalization (negative relationship), and historical volatility (positive relationship). The difference between stock pickers (“SP”) as explained for the NASDAQ Composite and benchmark investors (“B”) is pretty clear on the table, with a beta of 0.66 for “B” in the lower left, and a beta of 1.57 in the upper right. Red and green colors seem a lot more balanced than in the US, either among columns or among rows. No pattern with respect to the capitalization or to the historical volatility may be exhibited. The ETF did not significantly modify the European equity market (yet?). We can notice that during years with very positive return (2005, 2006, 2009, 2013), high historical volatility stocks tend to outperform significantly, so do small caps. But the difference between “SP” and “B” performances remains very low compared to the US extremes. Regarding the “momentum effect” and the persistence of winners and losers, we find the same pattern as in the US, meaning a quite strong trend-following process, except during big breaches such as what happened in 2008-2009. Therefore, we can suggest to separate the ETF impact and the “low-volatility” puzzle their flows create in the US, and the trend-following process of the market. The latter does not rely on ETF flows, but on the behavioral and cognitive biases of investors. Europe’s equity market remains a territory for stock pickers. Definitely. The ETF impact remains very contained. The only major pattern that can be exhibited is a trend-following aspect of the returns over the years, but nothing relative to capitalization or historical volatility. TOPIX First of all, looking at the beta per couple, we can notice that the higher the capitalization, the higher the beta. This means that lower capitalizations post very dispersed returns with very low correlated returns among a given class, whereas the big caps exhibit very close behaviors among themselves. Performances are well balanced between columns (volatilities) and rows (capitalizations). Using our former notations (“SP”) and (“B”), let’s have a look at the rankings over the years. On the table, we can notice a change of pattern since 2014 (included), with a more European look-alike pattern before and a US look-alike pattern since then. If we add the latter characteristic to the fact that beta depends positively on the capitalization, TOPIX seems to be at the middle of the road between US and Europe in terms of investment philosophy, US being the “new-way” of investing, flow driven, and Europe being the “old-way” of investing, fundamental driven. “Momentum-wise”, except in 2009, where the worst performers of 2008 posted the best performance of years, it is difficult to sort the Japanese market either on the “trend-following” side or on the “mean-reverting”. The TOPIX remains quite difficult to understand, as it is a mix between European patterns and US ones. We can notice that there is no clear “trend-following” or “mean-reverting” process. Large capitalizations seems to be riskier, due to their high-intra correlated pattern, posting a higher beta than small caps, which suffer from highly dispersed returns. Global Conclusion First of all, we noticed over the past 15 years that US stock returns are much more dispersed than Europe or Japanese. We have much more positive and negative extreme outliers in the US. US is definitely not a market for traditional stock pickers, as this market is a flow-driven market. This relies on a structural fact: US people are all interested in stock exchange performances as their retirement relies on the latter. Therefore, the level of knowledge in the US is by far higher than the one in Europe, meaning that all the Americans are stock-exchange investors, providing huge flows, and expecting the same commitment from their financial advisors in term of risk exposure. People are still scared by the 2008 crisis and their come-back in the equity markets relies on a strict risk-management rule. Today, smart-beta ETFs provide the solution, mainly known as “Minimum Variance” or “Equal Risk Contribution”. This is the reason why last year’s rally in US equities is often described as a “defensive” rally. Therefore, flows concentrate on these products encouraging the pattern to pursue. In Europe, the economic knowledge of the population is very low. In addition to that, financial practitioners and financial-related topics are hated. There is no pension funds in Continental Europe. Therefore, the equity market does not depend on huge flows as in the US, and remains the stronghold of some “happy-fews” whose way of thinking relies on fundamentals. Thus, European equity market still reacts on fundamental data and news, as flows are almost insignificant. The question is: until when these patterns may last? Why they may be threatened? In the US, we have been waiting for six years on an “aggressive” rally. It will happen when the couple (“small caps”, “high vol”) will dramatically outperform the couple (“large caps”, “low vol”). It happened in 2009, after the 2008 krach, but this can be analyzed as a kind of “mean-reverting” process on very low levels of valuation. But, today in the US, valuation standards do not exist anymore. An investor just have to think as follows: Where do the flows go? What are the main drivers of the market with metrics such as capitalizations and historical volatilities? We could challenge this vision: how can a low volatility stock perform a high volatility stock? Because low volatility stocks exhibit positive volatility (volatility on upside moves) and a smooth pattern, whereas high volatility stocks exhibit negative volatility (volatility on downside moves) and jumpy charts. Thus, the question is: given such matter of fact, is the stock exchange the best place for a start-up to raise money? Isn’t Private Equity a better shelter, and just wait to get a decent size or a decent brand-famousness (as Alibaba (NYSE: BABA ) or Uber (Pending: UBER )) to go listed? In Europe, while the money is still in the hands of the 50+ old generations, we will keep this fundamental-driven market. Recently, we noticed the emergence of Fintech actors in Europe, with 40 founders. This 40 generation is interested in stock exchange and portfolio management. When these guys will take the money of the elders, and given the difficulty of savings system in Europe, pension funds are likely to develop dramatically. Therefore, we can assume that today’s US pattern will cross the Atlantic. Thus, when this happens, it will be time to focus on large caps, low volatility names such as the Swiss. Japan is very difficult to understand. It seems to be a merge of Europe and US, but the trend tends towards a more US look-alike market, with stock-picking that is likely to become more and more difficult. In addition to these areas, type of investors – related pattern – there is a “momentum effect” that tends to be persistent. “Winners remains the winners, losers the losers”, same as for good and bad pupils. This stresses the “trend-following” pattern of the equity market, whatever be US, European or Japanese, with a kind of performance clustering over the years, as we can notice about volatility: period of good performance tends to be followed by good performance again. Stock pickers should focus on Europe, and systematic or factor-based investors on the US. Should you want to pick up stocks in the US, first select quantitatively a universe with capitalization and historical volatility factors. It is likely to enhance significantly the performance of this “conditional” stock-picking, and avoid large losses. Moreover, keep in mind that today, fund holders have access to financial information instantaneously, so do the asset managers. There is no more information asymmetry. Information is now the same for everybody, professional and not professional. This means that finance has changed a lot: 30 years ago, the fund holder used to receive information about his funds two times per year. Now, it happens everyday. Therefore, his psychological risk-budget – which has not increased – is filled by far more quickly. The consequence? Implicitly, unconsciously, this phenomenon has dramatically reduced the holding period of the fund by the fund holder. Therefore, risk-management has – now more than ever – to be taken into account ex ante in the asset management process – and not ex post, as it can be seen too often in the French AM industry. Smart risk management is as important as finding equity ideas to generate alpha. It is a way to avoid negative alpha and then create added value for the fund holder. The other requirement is to know and understand the market you invest in. This is the aim of this article: it is not the same to know the companies you invest in (analyst), and to know the market you invest in (asset manager).