Tag Archives: management

The Real Cost Of Hedging With Leveraged ETFs

Summary Scaled hedging has some advantages over usual market-timing. Leveraged ETFs are convenient hedging tools, but they suffer from a decay. This article calculates the additional cost of hedging a stock portfolio with leveraged ETFs. A timed, scalable hedging tactic has at least 3 advantages over usual market-timing consisting in going out of the market: adaptability to the risk level, lower transaction costs, and cashing all dividends. This previous article shows how to use a systemic risk indicator to scale a hedging position and protect my premium portfolio with SPXU . ETFs are not necessarily the best hedging tools, but they are available and understandable for all investors. SPXU has the advantage to allow hedging in an account where only long positions in stocks and ETFs are possible, and without margin. Like all leveraged ETFs, it has the drawback of suffering from a decay called beta-slippage. This article calculates the real additional hedging cost incurred by this decay in 2015 for SPXU, and for another leveraged inverse S&P 500 ETF: SDS . It also shows the decay of long leveraged ETFs. What is beta-slippage? If a volatile asset goes up 25% one day and down 20% the day after, a perfect double leveraged ETF goes up 50% the first day and down 40% the second day. On the close of the second day, the underlying asset is back to its initial price. At the same time, the perfect leveraged ETF has lost 10%: (1 + 0.5) x (1 – 0.4) = 0.9 This decay is called beta-slippage. It is a mathematical property of a leveraged and frequently rebalanced portfolio (leveraged ETFs may hold futures, options and/or swap contracts). In a trending market, beta-slippage can be positive. If an asset goes up 10% two days in a row, on the second day, the asset has gone up 21%. The perfect 2x leveraged ETF is up 44%: (1 + 0.2) x (1 + 0.2) = 1.44 It is 2% better than holding the underlying leveraged 2x on margin. Beta-slippage is path-dependent. If the underlying gains 50% on day 1 and loses 33.33% on day 2, it is back to its initial value, exactly like in the first example. This time, the perfect leveraged ETF loses one third of its value, which is much worse than the 10% of the first case: (1 + 1) x (1 – 0.6667) = 0.6667 Without a formal demonstration, it shows that the higher the volatility, the higher the decay. Hence the name of beta-slippage: “beta” is the best known statistical parameter of volatility. Of course, it is uncommon to have such price variations on an ETF’s underlying asset. These numbers are here to give an amplified vision of what happens with more realistic daily returns, day after day and month after month. (click to enlarge) SPXU in red, SPY in blue. Chart and data: portfolio123 Decay of S&P 500 ETFs in 2015 The next table gives the decay of leveraged ETFs on the S&P 500 index from 1/1/2015 to 10/15/2015 (9.5 months). It was a sideways and quite volatile market, with a worse than usual beta-slippage. The decay includes beta-slippage, and also tracking errors and management fees. Ticker Return Return of SPY x leveraging factor Decay (difference) Drag on portfolio SPY -0.52% SH (1xshort) -1.84% 0.52% -2.36% -1.18% SSO (2xlong) -3.92% -1.04% -2.88% -0.96% UPRO (3xlong) -8.69% -1.56% -7.13% -1.78% SDS(2xshort) -4.84% 1.04% -5.88% -1.96% SPXU(2xshort) -9.45% 1.56% -11.01% -2.75% When using SDS or SPXU for hedging, the hedging position represents 1/3 of the total portfolio (stocks + hedge) in the first case, and 1/4 in the second one. So the real drag on the portfolio was respectively 1.96% and 2.75% compared with shorting SPY. This is the additional cost of hedging the whole portfolio during the whole period (setting it in market neutral mode), which is not the best tactic proposed in my previous article (and service ). The cost of using leveraged ETFs with any of the proposed variable hedging tactics was much lower. Rebalancing the hedge weekly also lowers the decay due to beta-slippage (but not tracking errors). Finally, the cost is lower than losing all dividends when going out of the market in a classic market-timing approach, and it is likely to provide a better long-term risk-adjusted performance. SSO and UPRO also look like decent alternatives: SSO had the lowest portfolio drag. But short selling always incurs additional risks and borrowing costs. SDS and SPXU allow to hedge without borrowing cost and with less or no margin cost. These costs depend on the broker, so the best choice for hedging with an ETF may depend on your broker. If you have the skills and possibility to manage other instruments like futures, options, CFDs, they may be more cost-effective. Keep also in mind that the hedge and the stock portfolio can be in different accounts. If you like this article, you might be interested in the next ones. Click the “Follow” tab at the top if you want to stay informed of my free-access publications on Seeking Alpha. You can even choose the “real-time” option if you want to be instantly notified.

Multi-Factor Investing

Multi-factor investing that combines value, momentum, quality (profitability), or low volatility factors is today’s hot new investment approach. There has been an explosion of multi-factor ETFs recently with nine of the fourteen existing U.S. multi-factor funds coming to market this year, and five of them showing up within the past 60 days. Multi-factor funds may be a good thing, since single factor funds can have some serious drawbacks. However, multi-factor funds can also have their own quirks and issues. If the large variety of factors is thought of as the “factor zoo,” then multi-factor approaches may be the “factor circus” with its own collection of silly clowns, dangerous acrobats, and amusing jugglers. Factor Investing Issues With factor investing in general there are three potential problem areas: tractability, scalability, and volatility. With respect to tractability, it is well-known that value investing can have long periods of serious under performance. This happened in the late 1990s and also somewhat during the past two years. Not all value investors may be willing to watch this happen without losing patience and giving up on their factor portfolios. To a lesser degree, momentum and other factors are also subject to sustained tracking error. Scalability has to do with too much money chasing after too few stocks. Factors perform best when you can focus on those stocks having the strongest factor characteristics. For example, Van Oord (2015) showed that from 1926 through 2014, only the top decile of U.S. momentum stocks outperformed the market. Stocks below the top decile added nothing to strategy results. Yet just two out of the twelve large-cap U.S. equities single factor ETFs only include stocks that are within the top decile of their factor rankings. For example, the oldest and largest single factor value ETFs are iShares S&P 500 Value (NYSEARCA: IVE ), iShares Russell 1000 Value (NYSEARCA: IWD ), and Vanguard Value (NYSEARCA: VTV ). They hold 72%, 69%, and 50% respectively of the stocks that are in their investable universes. This makes them, to a great extent, closet broad index funds with higher fees. Their large sizes ($8.3 billion, $23.5 billion, and $34.6 billion, respectively) may impede them from focusing on just fifty (the top decile of S&P 500 stocks) or one-hundred (the top decile of Russell 1000) value stocks. The same is true with respect to momentum. The largest momentum fund, with over $1 billion in assets, is the AQR Large Cap Momentum Style mutual fund with an expense ratio of 0.45. It holds 532 out of an investable universe of 1000 stocks. This is a far cry from the top decile of momentum stocks. Large amounts of investment capital may make it difficult for single factor funds of all types to focus exclusively on the relatively small number of stocks that appear in their top factor deciles. The third problem for single factor portfolios is increased volatility and high bear market drawdowns that accompany value, momentum, and small cap factors. Trend following filters, such as absolute momentum, can help reduce downside exposure with respect to long-term bear markets, but it does little to alleviate uncomfortable short-term volatility. Trend following is also less effective when applied to value factors than when applied to other factors like momentum. Multi-Factor Solutions All three of these problem areas for single factor investing – tractability, scalability, and volatility – can be significantly reduced by using intelligently constructed multi-factor portfolios. Multiple factors can obviously reduce tracking error, since it is unlikely that several factors will substantially under perform at the same time. As for scalability, if a fund uses four factors instead of just one, it can handle four times the investment capital without eroding its ability to enter and exit the markets. Finally, the volatility and large bear market drawdown associated with value and momentum factors can be reduced by combining these factors with less volatile ones, such as quality and low volatility. However, I intentionally included the words “intelligently constructed” when I referred to the potential benefits of multi-factor portfolios. It surprises me that six out of the fourteen U.S. multi-factor funds include small size as a factor. Sponsors of these funds must have been asleep during the past 25 years when abundant academic research showed that small cap stocks, while giving higher returns, add nothing positive on a risk-adjusted basis because of their high volatility. When combined with value or with value and momentum, which is what all six funds of these funds do, small cap can be particularly undesirable, since it can aggravate already high portfolio volatility and bear market drawdown exposure. It is also surprising that the “premier anomaly,” price momentum, is included in only eight of the fourteen U.S. multi-factor funds. Abundant research has shown that momentum is the most powerful factor for generating positive returns. More sleepy time among fund sponsors? The final issue associated with multi-factor funds is their average annual expense ratio of 42 basis points for what are enhanced index funds. This is higher than the Morningstar US ETF Large Blend Strategic Beta expense ratio of 38 basis points and the Morningstar US ETF Large Blend Index expense ratio of 36 basis points. Until just recently, an investor who wanted multi-factor exposure would have been better off creating it herself by combining the single factor iShares MSCI USA Value Factor, USA Momentum Factor, USA Quality Factor, and USA Minimum Volatility ETFs, since these all have expense ratios of only 15 basis points. New Solution This situation changed dramatically last month when Goldman Sachs entered the ETF business with an offering called Goldman Sachs Active Beta U.S. Large Cap Equity (NYSEARCA: GSLC ). GSLC is the only multi-factor fund having what I consider an optimal mix of factors: value, momentum, quality, and low volatility. Here is a description of how they determine these factors: • Value: The value measurement is a composite of three valuation measures, which consist of book value-to-price, sales-to-price and free cash flow-to-price (earnings-to-price ratios are used for financial stocks or where free cash flow data are not available). • Momentum: The momentum measurement is based on beta- and volatility-adjusted daily returns over an 11-month period ending one month prior to the rebalance date. • Quality: The quality measurement is gross profit divided by total assets or return on equity (ROE) for financial stocks or when gross profit is not available. • Low Volatility: The volatility measurement is defined as the inverse of the standard deviation of past 12-month daily total stock returns. Even though the fund holds 432 stocks out of an investable universe of 500, it uses a weighting scheme (most multi-factor funds with a large number of holdings do the same) that allocates substantially more of its capital to stocks with high factor ratings. GSLC rebalances positions quarterly and uses a turnover minimization technique (especially useful for momentum stocks) of buffer zones to reduce the number of portfolio transactions. I use a similar buffer zone technique myself with some of my more active momentum models. What is especially appealing about GSLC is its low cost structure. The fund came into existence because some of Goldman’s largest clients wanted to invest this way using an ETF wrapper to minimize their tax consequences. Because of this sponsorship, the fund was set up with an annual expense ratio of only 9 basis points. This is the same expense ratio as the biggest and most popular ETF in the world, the SPDR S&P 500 ETF Trust (NYSEARCA: SPY ). GSLC already has $78 million invested in it since coming to market one month ago. GSLC is not an ideal investment from our point of view, since it doesn’t have a trend following filter like absolute momentum to help it avoid severe bear market drawdown. GSLC is also unable to benefit from international diversification during those times when international stocks show greater relative strength than U.S. stocks. However, because of its low cost structure, GSLC might be a good asset to consider along with the S&P 500. If GSLC continues to attract considerable assets so that it has good liquidity and if it performs well relative to the S&P 500 over the next year, I may add GSLC to my dual momentum models. Multi Factor Funds Symbol Factors Assets Stocks Exp Ratio 4 Factor Goldman Sachs Active Beta U.S. Large Cap GSLC Value, Mom, Quality, LoVolty $78 m 432 0.09 ETFS Diversified Factor U.S. Large Cap SBUS Value, Mom, Size, LowVolty $17 m 492 0.40 iShares Factor Select MSCI USA LRGF Value, Mom, Size, LowVolty $5 m 135 0.35 3 Factor SPDR MSCI USA Quality Mix QUS Quality, Value, LowVolty $6 m 624 0.15 JP Morgan Diversified Return U.S. Equity JPUS Value, Mom, Quality $11 m 561 0.29 John Hancock Multifactor Large Cap JHML Size, Value, Profit $79 m 772 0.35 AQR Large Cap Multi-Style (non-ETF) QCELX Value, Mom, Profit $1.2 b 338 0.45 iShares Enhanced U.S. Large Cap IELG Value, Quality, Size $71 m 109 0.18 PowerShares Dynamic Large Cap Value PWV Value, Quality, Mom $927 m 50 0.58 FlexShares U.S. Quality Large Cap Index QLC Quality, Value, Mom $3 m 120 0.32 Gerstein Fisher Multi-Factor Growth Equity (non-ETF) GFMGX Size, Value, Mom $227 m 298 1.03 2 Factor ValueShares Quantitative Value QVAL Value, Quality $47 m 41 0.79 FlexShares Morningstar U.S. Market Factor Tilt TILT Value, Size $740 m 2249 0.27 Cambria Value and Momentum VAMO Value, Mom $3 m 100 0.59 Nothing contained herein should be interpreted as personalized investment advice. Under no circumstances does this information represent a recommendation to buy, sell or hold any security. Users should be aware that all investments carry risk and may lose value. Users of these sites are urged to consult their own independent financial advisors with respect to any investment.

Take Your PIIC – Philippines, Indonesia, India Or China

Summary Consider to invest in Asia. Within Asia I believe the best countries to invest in are the Philippines, Indonesia, India, China and Vietnam. All have high growth driven by domestic consumption. All except China have incredibly low household debt to GDP compared to their Asian peers, which will allow them to easily borrow more and build more. The “Asian Century” has arrived and if you fail to invest in it you are missing an enormous long-term opportunity to grow your wealth. In this article, I discuss what I believe to be the top five Asian destinations for investment and why. But first, why invest in Asia? The answer is simply because it is growing more rapidly than any other continent on the planet. By 2030, Asia Pacific is estimated to contribute a staggering 59% of global consumption , up from 23% in 2009. Some key points from DBS on where Asia is heading in the next 25 years: · Asia adds a Germany (in economic terms) every 3.5 years, and will add three Europe’s in 25 years (by 2040), or if Asian currencies appreciate one to two percent pa (as is the norm for developing economies), Asia will add 5 or 6 Euro zones by 2040. · The Asian middle class is set to triple (to 1.8b) in size between 2015 and 2020, and to have increased 615% (6.15 fold) between 2009 (525m) and 2030 (3,228m). · China (59%) and India (16%) will dominate the Asian middle class. · For every addition to the US population, Asia’s headcount will rise by seven. · China’s growth is moving inland, and also towards Central Asia. · Capital will flow to Asia like never before. Why? Businesses want to be where the growth is. Ever hear one say different? In 2039, when Asia has added three Euro zones, it will be creating a Germany every seven months. That’s a pretty big attraction. Inflows mean currency appreciation. Asian currencies will rise against the dollar, euro and yen. · China’s per-capita energy consumption is one-eighth what it is in the US, India’s is one-twentieth. Rising incomes mean Asia’s energy demand will continue to soar. Asian, not G3 demand, will drive the price of energy. Source The World’s largest economies in 2010 and 2050 Source You can read more about the rising Asian middle class in my previous article here . Why Philippines, Indonesia, India and China? I choose these as my top 4 Asian countries to invest because they have high growth (domestic driven), low household debts (see chart below), and a rising middle class (with jobs and wage growth). The best time to buy is ideally when valuations are good (PEs below 15), or dollar cost averaging. Source No1- Philippines The Philippines’ main advantage is their cheap, young and skilled labour force with excellent English skills. The BPO industry is growing around 20% pa (it grew 18.7% in 2014). The Philippines is currently growing around 5.6% pa (with a long term growth rate estimated at 7.3% pa), with the main growth drivers being overseas foreign worker’s remittances, and the BPO (call centre, back office administration) industry. Tourism, manufacturing (electronics, ship building), mining and farming also contribute. This money is being channeled into the property sector, combined with increased lending (household debt is a mere 6% of GDP). Demographics are excellent with around half the population below 25, and salaries are rising at least 6.5% pa, or higher in the BPO industry where staff are paid sign on bonuses. The property boom can run for many years as pent up demand for housing is huge and prices are still low at just USD 3,156 psqm or less in Manila. The banks are making good net interest margins around 3.02 %, and growing their loan books 20% pa, with non-performing loans at a very low 1.8% and double digit profits. Investors can buy iShares MSCI Philippines ETF (NYSEARCA: EPHE ), currently on a PE of 21.17 as of 30 September 2015. No 2 – Indonesia Indonesia has a huge population with strong demographics, a rising middle class, and improving Government. Indonesia GDP was 5.0% in 2014, however it is expected to average 6.8% pa in the long term (see table below). Along with Philippines and India, it has very low household debt, and rising employment and wages. The new Government seems focused to reduce debt and build infrastructure. In October 2015, they announced a USD 5 billion high speed railway from Jakarta to Bandung in a JV with China Railway Group (00390:xhkg) (PE 10.1). Property prices are low at just USD 2,766 psqm, and rising . Investors can buy iShares MSCI Indonesia ETF (NYSEARCA: EIDO ), currently on a PE of 18.19 as of 30 September 2015. No 3 – China China is off course the booming manufacturing hub of the World, but is changing to be a more consumer led economy. This is causing a slowdown in fixed asset investment, and the so called “China slowdown” and “commodities rout”. Their GDP is currently 7.0% and slowing. Demographics and household debt levels are not so good; however, the rising middle class is still huge. The best way to play China is to buy into the consumer sector via a fund or individual stocks. A suitable fund would be db x-trackers CSI300 Consumer Discretionary 1D ETF. Chinese (Shanghai, Beijing) property is not as expensive as India (Mumbai), and is priced at USD 6,392 psqm. Investors can buy iShares MSCI China ETF (NYSEARCA: MCHI ), currently on a PE of 14.56 as of 30 September 2015. Another good choice is db X-trackers Harvest CSI 300 CHINA A-Sh ETF (NYSEARCA: ASHR ). No 4 – India India has perhaps the best growth potential but is expensive on current valuations (PE around 30), so best to wait for opportunity to buy in or average into the market over time. Current GDP is around 7.3% pa, and the long term average is expected to be around 8.0% pa. Indian labour is cheap with strong English and IT skills. Property is growing but expensive in the major cities such as Mumbai at USD 11,455 psqm, which may be a drag on the short term growth (as in China). By 2050, India is expected to be the World’s largest economy (see earlier table). Investors can buy iShares MSCI India ETF (BATS: INDA ), currently on a PE of 30.75 as of 30 September 2015. No 5 – Vietnam Vietnam is my preferred short-term pick as PEs are around 13, so great value now. Long term its prospects are also good, as it is a cheaper manufacturing hub to China and jobs are booming as a result. Household debt is low at around 20% to GDP. Investors can buy db x-trackers FTSE Vietnam ETF (GR). I would avoid Malaysia (household debt to income of 146% ) and Thailand (debt 121% ), based on high personal debts and economies that are heavily dependent on exports. Many frontier markets will also offer good returns for investors but perhaps at greater risk, so invest accordingly. Other high growth countries (listed below) to consider are Nigeria, Iraq, Bangladesh, Vietnam, Mongolia, Sri Lanka and Egypt. Source : Finally, for those that want something different, then consider to invest in either Pakistan (PE 9.2) via db x-trackers Pakistan (03106:xhkg), or Central Asia and Kazakhstan via Global X Central Asia & Mongolia Index ETF (NYSEARCA: AZIA ) (PE of 16.7), as China is pushing infrastructure and growth in that direction.