Tag Archives: management

The Case For Local Currency Denominated ETFs

Summary Few investors in the U.S. explore ETFs listed abroad. There may well be a larger and cheaper fund available to gain the desired exposure. Local currency denominated ETFs offer important benefits from the risk management standpoint. Investors are frequently advised to allocate at least a portion of their portfolios to international securities in order to benefit from the only ‘free lunch’ in the markets – diversification. Developed economies, emerging markets, frontier countries and a range of other definitions are commonly used in day to day conversations. However, with the ETF universe constantly expanding both in the U.S. and overseas, there are so many different options to give you the desired exposure that it has become a challenge to choose the most suitable fund. Investments in international markets come with an important element of complexity – currency risk. From a U.S. investor’s perspective, this means that even if the selected market performs well, the ultimate result can be affected by the local currency’s movement against the U.S. dollar. I have already discussed currency risk management in one of my previous articles , thus this time I would like to draw your attention to the differences between U.S. and internationally listed ETFs. Hopefully this will give you an alternative perspective about investing abroad. Finding an international equivalent As a practical example, I am going to use a case where a U.S. investor wants to invest in blue chip stocks in the United Kingdom. Checking the ETFdb.com , there appear to be 7 U.S. listed ETFs that invest solely in the U.K. Although 3 out 7 funds offer currency hedged exposure, by far the largest and most popular ETF in the U.K. category is the iShares MSCI United Kingdom ETF (NYSEARCA: EWU ), which leaves the pound-dollar FX risk unhedged. In fact, EWU with has 9 times more assets under management ($2.7 billion) than all other funds combined. This suggests to me that either U.S. investors are willing to accept the FX risk or they prefer to manage it on their own. If either is true, it then makes sense to explore local currency denominated ETFs that invest in U.K. stocks. To explore the European ETF space, one of my favorite tools is justETF.com . The screening tool on this website finds 11 ETFs investing in FTSE 100 constituents. The largest fund on the list is the iShares Core FTSE 100 UCITS ETF (LON:ISF), which is primarily listed on the London Stock Exchange. Compared with EWU, this fund has a couple of obvious advantages. First, its expense ratio of a mere 0.07% is well below 0.48% charged by EWU. Second, with $5.8 billion in AUM, ISF is twice as large and a more frequently traded fund. Returns In terms of portfolio holdings, both EWU and ISF have almost identical composition. Both ETFs hold just over 100 U.K. blue chip stocks weighted by market cap, thus the differences are so marginal that they can be neglected. However, does that mean that their impact on the portfolio is the same? The chart below illustrates performance of both ETFs as well as GBPUSD exchange rate over the last 12 months: (click to enlarge) Source: Google Finance Given that the operating model of EWU is to gather funds from investors in USD, convert them into GBP and then invest in U.K. stocks, its theoretical return should be very close to the combined result of ISF and GBPUSD. In reality, EWU underperformed by more than 1% (EWU: -6.78% vs. ISF: -1.01% and GBPUSD: -4.38%). There could be several factors accountable for the discrepancy, including tracking errors, expense ratios and the difference in trading hours. Separating the FTSE 100 index performance and GBPUSD impact gives an investor a much clearer picture of return drivers. In this particular instance, it is the FX component that accounted for the bigger part of EWU loss in the last year. Risk management Another important reason to consider local currency denominated ETF is the possibility to purify exposures. Looking at risk parameters of EWU calculated on a freely available investor resource utilizing 12 months historical data, it appears that the fund’s annualized volatility was 18.4%, whilst its beta against the SPDR S&P 500 ETF (NYSEARCA: SPY ) almost equal to 1. However, if we look at ISF.L in isolation, it turns out that the underlying index actually has a bit lower volatility and is substantially less dependent on S&P 500. I have included the Guggenheim CurrencyShares British Pound Sterling Trust (NYSEARCA: FXB ) in the table below as a proxy for GBPUSD. Source: InvestSpy The fact that relationship between FTSE 100 and S&P 500 is not so close is further confirmed by correlations, which show that ISF had a coefficient of only 0.58 as opposed to 0.80 of EWU. Source: InvestSpy This means that an investment in FTSE 100 has more potential to offer diversification benefits to a U.S. investors than it may appear at the first sight. Not surprisingly, the well-known and documented home country bias among investors only gets aggravated when market participants look at distorted statistics. Not only investing in local currency denominated ETFs gives a clearer picture of the underlying index, but it also forces an investor to make a conscious decision about the FX risk. In contrast, using a U.S. listed ETF for international exposure leaves the investor with a convenient alternative of not doing anything. As documented by behavioral economists and Nobel Prize winners Kahneman and Tversky, “opt in” vs “opt out” questions can lead to completely different outcomes. Systematic models Finally, for investors that rely on quantitative or technical analysis, it is important to distinguish whether their models are suitable for stocks, FX, or both. A moving average on SPY is not the same thing as a moving average on EWU because the latter is effectively a wrapper for both equities and FX components. If your model has been tailored for equities, ILS would be a more appropriate choice with the FX decision left as a standalone issue. Conclusion The aim of the article was to offer a different perspective into international investing via ETFs. Using the case of the U.K., I have illustrated that in some cases a local currency denominated ETF listed outside the U.S. can be a better way to achieve the desired exposure. One reason for this is that some foreign ETFs are cheaper and larger than their U.S. counterparts. Another important point is that using a local currency denominated fund purifies exposures arising from the underlying index and foreign currency. One point of caution though is the tax treatment of investments in funds domiciled abroad. Every investor should assess their individual circumstances as part of the decision making process. But if your tax situation does not preclude you from investing in ETFs listed abroad, such an approach may bring more transparency to your portfolio. It is a rare feat in the world of finance nowadays.

Guard Against Rising Rates With These ETFs

The latest Fed meeting saw mixed reactions from investors. As expected, the Fed remained dovish on rate issues citing a slowing job market, moderating U.S. economic growth, subdued inflation and most importantly, a shaky global market. All these issues were discussed in the September meeting itself and the investing world had pushed back the timeline of the lift-off to early next year, presuming a delayed U.S. economic rebound. But to their utter surprise, the Fed kept the December timeline on the table. A keen watch on employment and inflation data is now crucial for the U.S. monetary policy in the December meeting. After all, the global market turmoil has eased now with the Chinese economy resorting to fresh rate cuts and the ECB hinting at a stepped-up QE measure. The dual dose was sturdy enough to bring the global economy back on the growth path and encourage the Fed to mull over a December hike. Investors rapidly shifted their bets with futures contracts entailing a 43% December hike possibility compared with 34% preceding the statement. In anticipation of a faster lift-off, the 10-year Treasury bond yields jumped 14 bps to 2.19% in the two days (as of October 29, 2015). Given this, investors might seek to safeguard themselves from higher rates. For them, we highlight a few investing strategies and the related ETFs: Say Yes to Zero or Negative Duration Bonds Rising rates result in increasing losses for bonds since bond price and yields are inversely related to each other. As a result, zero or negative duration bonds are less vulnerable and better hedges to rising rates. Negative duration bond ETFs offer exposure to traditional bonds while at the same time short Treasury bonds using derivatives such as interest-rate swaps, interest-rate options and Treasury futures. The short position will diminish the fund’s actual long duration, resulting in a negative duration. As a result, these bonds could act as a powerful hedge and a money enhancer in a rising rate environment. The zero duration funds include the WisdomTree Barclays U.S. Aggregate Bond Zero Duration ETF (NASDAQ: AGZD ) and the WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration ETF (NASDAQ: HYZD ) while negative duration funds include the WisdomTree Barclays U.S. Aggregate Bond Negative Duration ETF (NASDAQ: AGND ) and the WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration ETF (NASDAQ: HYND ) (read: Negative Duration Bond ETFs: Right Time to Bet? ). Stick to Floating Rate Bond ETFs A floating rate note is a bond with a coupon that is indexed to a benchmark interest rate. Some of the popular benchmarks include LIBOR and Treasury rates. Since the coupon is adjusted to reflect market interest rates, at a regular interval, these bonds are less sensitive to increases in rates compared with traditional bonds with fixed rate coupons, which lose value as the rates go up. The i Shares Floating Rate Bond ETF (NYSEARCA: FLOT ) and the SPDR Barclays Capital Investment Grade Floating Rate ETF (NYSEARCA: FLRN ) are some of the floating rate bond ETFs to watch. Cycle into Cyclical Sectors Investors should note that rising rates are synonymous with economic improvement. Cyclical sectors like technology and consumer discretionary should perform better ahead. The Market Vectors Retail ETF (NYSEARCA: RTH ) and the PowerShares Dynamic Leisure & Entertainment Portfolio ETF (NYSEARCA: PEJ ) are a couple of consumer discretionary ETFs to watch. The SPDR S&P Semiconductor ETF (NYSEARCA: XSD ) and the PowerShares Nasdaq Internet Portfolio ETF (NASDAQ: PNQI ) are technology ETFs that investors can try out. Most importantly, a rising rate scenario is a great backdrop for financial ETFs as this corner of the market should soar on improving interest rate margins. This is because banks borrow money at short-term rates and lend the capital at long-term rates thereby benefitting from a widening spread between long- and short-term rates. Financials ETFs like the Financial Select Sector SPDR ETF (NYSEARCA: XLF ) and the SPDR S&P Bank ETF (NYSEARCA: KBE ) are some of the financial ETFs to be considered for gains (read: Guide to the 7 Most Popular Financial ETFs ). Withdraw Rate-Sensitive Sectors There are a few sectors that are highly associated with the Fed’s interest rate policy. Sectors like utilities and real estate are known for their high dividend payout and require huge infrastructure, leading to an immense debt burden and the consequent interest obligation. As a result, these sectors underperform in a rising rate environment. So, investors need to turn aside these sector ETFs or rather bet on inverse utility or real estate ETF to cash in on rising rates. The ProShares UltraShort Utilities ETF (NYSEARCA: SDP ) and the ProShares Short Real Estate ETF (NYSEARCA: REK ) are some of the opportunities in this field. Satiate Income Need with High Yield ETFs In this backdrop, yield-loving investors might be looking for ways to beat the benchmark Treasury yield and yet enjoy decent capital gains. Senior loan, preferred stock and business development ETFs could fit the bill for high-yield seekers. Senior loans are issued by companies with below investment grade credit ratings. In order to make up for this high risk, senior loans normally have higher yields. Since these securities are senior to other forms of debt or equity, senior loans give protection to investors in any event of liquidation. The PowerShares Senior Loan Portfolio ETF (NYSEARCA: BKLN ) and the Highland/iBoxx Senior Loan ETF (NYSEARCA: SNLN ) are examples of two senior loan ETFs yielding 3.97% and 4.23% as of October 29, 2015. Preferred stocks are hybrid securities having characteristics of both debt and equity. The preferred stocks pay the holders a fixed dividend, like bonds. These types of shares normally get priority over equity shares both in case of dividend payments as well as at the time of liquidation if the company fails. Preferred stocks are thus relatively stable and usually exhibit a low correlation with other income-generating assets. The iShares S&P U.S. Preferred Stock ETF (NYSEARCA: PFF ) yields about 6.02% as of October 29, 2015. Business Development Companies (BDCs) are firms that loan out to small- and mid-sized companies at relatively higher rates and often grab debt or equity stakes in those companies. BDCs dole out high cash payments together with capturing the equity performance of the borrower. The U.S. law obliges BDCs to hand out more than 90% of their annual taxable income to shareholders. The Market Vectors BDC Income ETF (NYSEARCA: BIZD ) yields 9.03% as of October 29. 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Investors Favor Equity ETFs In 2015

By Patrick Keon Positive net flows into equity exchange-traded funds (ETFs) (+$55.5 billion) have far outweighed those into equity mutual funds (+$6.9 billion) for the year to date. Investors putting more net new money into equity ETFs as opposed to equity mutual funds has been true for every year except one (2013) since the global financial crisis. What jumps out about this year’s fund flows activity for equity ETFs is that nondomestic equity ETFs have dominated equity ETFs. Nondomestic equity ETFs have grown their coffers by almost $64 billion so far for 2015, while domestic equity ETFs have seen over $8 billion leave. If this trend holds through year-end, 2015 will be the first year since 2010 that nondomestic equity funds have had more net inflows than domestic ones. Nondomestic barely nudged out domestic for most net inflows for 2010 (+$34.0 billion versus +$33.7 billion), while the roughly $70-billion spread for this year would be by far the highest annual difference between the two groups for the 20 years Lipper has been tracking the data. It stands to reason then that nine of the ten largest net inflows among equity ETFs this year have been for nondomestic products. These nine ETFs are split up between MSCI EAFE (4), Europe (3), and Japan (2) products. The MSCI EAFE ETFs have taken in the most net new money (+$24.3 billion) of the three groups, followed closely by Europe ETFs (+$21.6 billion), with the Japan products recording more-modest gains (+$8.5 billion). The single largest positive net inflows belong to Deutsche X-trackers MSCI EAFE Hedged Equity ETF ( DBEF , +$12.9 billion). Conversely, the largest equity ETFs are two S&P 500 Index products: SPDR S&P 500 ETF Trust ( SPY , $168.0 billion of assets under management) and iShares Core S&P 500 ETF ( IVV , $63.8 billion of assets under management); each has seen money leave this year. SPY has had net outflows of almost $36 billion for YTD 2015, while IVV is down $1.1 billion.