Tag Archives: management

FXZ And RTM: Material Evidence

Summary An opportunity for long term investors to be pre-positioned in the materials sector. One fund is equally weighted, conservatively invested; the other more diversified and alpha weighted. Either fund challenges the investor to take advantage of the business cycle. There’s an old Wall Street adage to ‘buy low, sell high’ and based on the basic principles of investment, this statement is axiomatic. However, it does beg the questions, ‘how low is low?’ and ‘how high is high?’ So to apply this axiom, the idea would be to find an investment that is low. Anyone who has paid attention to global financial news over the past few months is well aware that the supply of strategic materials, as well as production, has run far, far ahead of demand. But just what is the ‘materials sector’? According to Investopedia : … A category of stocks that accounts for companies involved with the discovery, development and processing of raw materials. The basic materials sector includes the mining and refining of metals, chemical producers and forestry products. .. So apparently, this is a starting point: supply is high, demand is low therefore prices decline, thus profits, thus stock prices of ‘basic materials’ producers. (click to enlarge) Unless one has the time, effort, patience and knowledge to analyze and filter through the hundreds, if not thousands of global basic materials manufactures, it best to select a basic materials ETF and then a ‘plain vanilla’ one at that. Lastly, the individual would be wise to select the best fund in the class. By filter U.S.Equities => Basic Materials=> All, then excluding ‘Leveraged’, ‘Inverse’ and ‘ETN’, the very handy Seeking Alpha’s ETF Hub tool identifies nine suitable results. There are two candidates with a “least bad” one year performance and the best three year performance. First is the Guggenheim’s S&P Equal Weight Materials ETF (NYSEARCA: RTM ) and second is the First Trust Materials AlphaDEX ETF (NYSEARCA: FXZ ) . According to Guggenheim , the investment’s objective is to: … replicate as closely as possible, before fees and expenses, the performance of the S&P 500 Equal Weight Index Materials[S15] … Clearly, the 28 component holdings of the Guggenheim Materials fund are then equally weighted and readjusted quarterly according to the index it tracks. The underlying S&P tracking index: …imposes equal weights on the index constituents included in the S&P 500 that are classified in the GICS® materials sector… (Note that ” GICS ® ” is an abbreviation for G lobal I ndustry C lassification S tandard , developed by S&P and M organ S tanley C apital I nternational ). (click to enlarge) The First Trust fund’s investment objective: … is to seek investment results that correspond generally to the price and yield, before fees and expenses, of an equity index called the StrataQuant® Materials Index [STRQMT]. .. This is an: … enhanced index developed, maintained and sponsored by the NYSE Euronext or its affiliates which employs the AlphaDEX stock selection methodology to select materials stocks from the Russell 1000 Index .. The AlphaDEX methodology , as the name suggests will identify index components with the greatest potential for capital appreciation. In plain speak, the fund will weight companies in the sector which are performing better than the average company in the sector. So instead of just trying to just replicate the index, it weights its holdings more towards the best performing stocks. (click to enlarge) Observe though that both funds have performed similarly in both good and bad market cycles, but interestingly, the Guggenheim fund conservatively equally weights its holding whereas the First Trust Funds weights slightly more towards risk. The Guggenheim Fund has a far more simple subsector allocation construction, five in all and then most heavily weighted in Chemicals at 57% of the fund’s total holdings. The First Trust fund allocates among ten subsectors, also most heavily weighted in Chemicals, 34%, but also includes an allocation for Aerospace and Defense, 5%, normally part of the Industrial Sector. (click to enlarge) (data from First Trust and Guggenheim) Both companies, as might be expected, have holdings in common; 21 in all. These are listed by First Trust’s weightings; (since Guggenheim equally weights): Holdings in Common Name and Symbol FXZ Weighting SEALED AIR (NYSE: SEE ) 3.47% MARTIN MARIETTA (NYSE: MLM ) 3.12% VULCAN MATERIALS (NYSE: VMC ) 3.03% NEWMONT MINING (NYSE: NEM ) 2.70% The MOSAIC (NYSE: MOS ) 2.61% NUCOR (NYSE: NUE ) 2.42% LYONDELLBASELL (NYSE: LYB ) 2.26% ALOCA (NYSE: AA ) 2.25% DOW CHEMICAL (NYSE: DOW ) 1.89% SHERWIN-WILLIAMS (NYSE: SHW ) 1.89% EASTMAN CHEMICAL (NYSE: EMN ) 1.86% CF INDUSTRIES (NYSE: CF ) 1.65% BALL CORP (NYSE: BLL ) 1.24% AIRGAS (NYSE: ARG ) 1.18% E.I. du PONT de NEMOURS (NYSE: DD ) 1.11% WESTROCK (NYSE: WRK ) 0.76% ECOLAB (NYSE: ECL ) 0.68% AIR PRODUCTS & CHEMICAL (NYSE: APD ) 0.65% PRAXAIR (NYSE: PX ) 0.58% INTL PAPER (NYSE: IP ) 0.56% PPG INDUSTRIES (NYSE: PPG ) 0.53% Data From First Trust and Guggenheim As a general rule, the investor should take the time and trouble to compare the holdings of any ETFs in the same asset class for a reason exemplified here. Of the 28 holdings of the Guggenheim Fund, only 7 are not in common with the First Trust fund. Of those 7, four are in the Chemical subsector, 2 in Containers & Packaging and one in Metals and Mining. Further, as mentioned above, the Guggenheim fund seems rather heavily weighted in Chemicals compared to the First Trust fund; 57.06% vs. 34.09%. In Containers & Packaging the Guggenheim fund is slightly more weighted than Firsts Trust; 18.17% vs. 13.25%. First Trust is a little more weighted in Metals and Mining; 14.23% vs. 20.10%. Lastly, by applying some simple arithmetic, the average weighting of the First Trust’s holding which are not in the Guggenheim fund is just over 2%. The equally weighted unadjusted Guggenheim holding averages 3.57%. The point being that Guggenheim fund is mostly contained in the First Trust fund in terms of holdings, similar in allocation and reasonably close in average weighting. Also as noted above, the First Trust fund has two Aerospace & Defense holdings, 4.69%; a subsector more properly defined as an Industrial subsector. One is Hexcel Corporation (NYSE: HXL ) and the other is Precision Cast Parts (NYSE: PCP ) . In the case of these two companies, the sector to which it belongs just might be a matter of perspective since both companies manufacture specialized materials . Hexcel manufactures: … everything from carbon fiber and reinforcement fabrics to pre-impregnated materials… …and honeycomb core, tooling materials and finished aircraft structures … Precision Cast Parts, as the name implies, manufactures precision and complex casting using high performance nickel and titanium alloys. Hence, although classified as Aerospace and Defense companies, they do produce materials used in industry so are appropriate holdings for a materials fund. Fund and Inception Expense Ratio 1 Year Return 3 Year Return 5 Year Return TTM Yield P/E 3 Month Average Volume Beta Guggenheim [RTM] 11/1/2006 0.40% -7.48% 11.67% 10.78% 1.54% 17 12020 1.09 First Trust [FXZ] 5/8/2007 0.70% -11.43% 9.36% 10.65% 1.57% 17 85131 1.08 (Data from YaHoo!, Guggenheim and First Trust) So what it boils down to is this. RTM is investing conservatively in this volatile sector. FXZ may be viewed as an extension of RTM, with the opportunity for capital appreciation. However, in doing so its accepting a little more risk in this volatile sector. Both are good choices, but the decision of which to choose depends on the risk tolerance of the investor. Having described both funds, the original point must be reiterated: Is this the time to buy into the Material Sector? By referring to the included price divided charts, it is evident that both funds are well off their lows, both lows having occurred in the recession year of 2008. Hence both funds appreciated during the recovery years, in particular those years for which emerging market nations created a seemingly insatiable demand for materials. If those emerging market nations are correcting towards a more sustainable growth rate, then the Materials sector correction may not yet be over. However, this is precisely what is meant by the ‘business cycle’. Eventually, excess supply will be worked down and production capacity will adjust accordingly so that supply and demand will again come into balance. Hence, for a risk tolerant individual investor, a gradual accumulation in the materials sectors, in particular, by patiently dollar cost average in over a long period of time will put the investor in an advantageous position to be able to take advantage of the next, inevitable, up cycle and put to the test the old adage, buy low, sell high.

Short-Selling: What Are You Optimizing?

Summary What separates investing from gambling? Positive expected value. Short-selling has a negative expected value – more negative than some casino games. What are you optimizing? In theory investing is about optimizing return, but many investors’ behavior suggests they are optimizing/minimizing something else. For some heavy short-sellers, it’s intellectual stimulation. I don’t think short selling is right for me or most investors, but this is just my still-evolving opinion. Full disclosure: I’ve never shorted a stock in my life. As such, I’m probably terribly biased and not credible. Short selling is betting that a stock or security will go down. Instead of buying low and selling high, you first sell high and then buy low. You do so by borrowing someone else’s shares when you initially sell and then replacing those shares later on by buying them. For reasons I will explain in this article, I don’t think most investors, including myself, should engage in short selling. Some should, but even for those for whom short selling (“shorting”) is appropriate, it probably should not be used as a primary strategy. This argument has been hashed out many times. I could repeat what’s been discussed many times. For example, when you engage in shorting your upside is limited and downside unlimited – the unfavorable reverse of going long. Instead, I will focus on what I see as the most important points for me and perhaps where I’ve added some original thought. When you short-sell a stock, the odds are against you What separates investing from gambling? Sure, investing isn’t done in a casino, it’s much more calculated, there’s far more money in it, etc. The biggest difference though, is that when you gamble, there is a negative expected value – the odds are against you. The casino takes a cut. When you invest, there is no golden rule saying it has to be a favorable bet, but equities in the US have been increasing rather consistently for over 150 years (see Jeremy Siegel’s excellent book Stocks for the Long Run ). Studies of “rules-based” systematic investing styles like buying the lowest 10% of the market by EV/EBIT and rebalancing annually will often include the returns of the opposite decile (the highest 10% of the market by EV/EBIT in our example). The idea is that the larger the gap in returns between the two poles, the more predictive value the metric has. So what’s the point? Well when you look at these studies, it’s surprisingly hard to find one where the worst decile is actually delivering negative returns. This is significant because it means that stocks don’t only appreciate substantially on average, it’s also hard to find some that will go down at all. For myself and presumably many other investors, this odds-against-you fact is a total deal breaker. I remember in high school, I would print out the Las Vegas odds of each weeks NFL games and offer to do straight bets with anyone on any game so long as I had the favorite. I was okay with this activity because by picking the favorite without paying for it, I had a positive expected value – even though I didn’t know that term at the time. Several months ago, I was viewing the Ultimate Fighting Championship with family and someone suggested we bet on the fights. We would pool money and bet on who would win the fight and what round (or decision) they would win in The gamble was, on the surface zero-sum. No one was taking a cut of the bets. And I did research. I immediately pulled out my smartphone and looked up the favorite in each fight. I then looked up what percentage of UFC fights end by knockout versus decision. (click to enlarge) 41% of fights go to decision. Assuming a three round fight (most fights are 3 rounds, championship fights are 5), that 41% is significantly higher than the 25% it would be if each outcome were equally likely. So in each fight, I picked the favorite by decision with some confidence that I had a positive expected value. I won three out of the four fights we bet on. My approach to these situations where the game is explicitly zero or positive sum is in stark contrast to negative expected value situations. Casinos take a cut of all bets by structuring games such that odds are slightly in their favor. The lottery usually has a very negative expected value because: the winnings are taxed at the highest federal income rate and by your state as well municipalities take a huge cut (it’s a significant source of revenue for them) the advertised prize is not a present value, it’s usually a long-term annuity – taking the cash up front means getting far less there could be multiple winners that split the winnings, and the probability of this increases when the pot is large and many tickets are sold, offsetting the EV benefit of the higher pot. I’ve never engaged in these sorts of activities and would have a lot of trouble forcing myself to. It is counter to the investor mindset. But short sellers do just this. On average, they will lose money. The expected value is negative. The idea, though, is that by doing deep enough research and being opportunistic enough, they can make the expected value positive. This is tough for me to accept. First, the odds are dramatically against them on the surface. If stocks appreciate 9.5-10% a year in nominal terms, those odds are far worse for the short seller than some casino games. For example, in blackjack, the odds of you winning versus the dealer are 48%. Roulette is something like 47.4%. If stocks are appreciating 9.5-10% that’s the equivalent of ~45%. And that’s just the direct costs. Then there’s taxes, dividends you must pay on the shares you short, borrowing costs on hard to borrow stocks (unfortunately, many of the stocks with the best short cases have the highest borrowing costs because everyone wants to short them). This is somewhat offset by the fact that you can (I believe) use some of the cash you receive from the sale upfront for other things in the interim. I believe this depends on your creditworthiness as perceived by your broker, the size of the short sale relative to your assets, etc. Some brokers may require you to keep the margin in cash, which eliminates this benefit. The bottom-line: short selling is a negative expected value activity, so why do it? What are you optimizing? Value Investors Club is a great site. The quality of research is very high and there are some smart people on it – some of the smartest people in the investment industry, in fact. That’s why it confounds me that some of these investors are so short-focused. Some of these investors have written 25 articles and like 23 of them are shorts. Some of the smartest investors with the highest profiles are also heavy shorters. David Einhorn and Bill Ackman come to mind. Ackman now describes his firm as primarily long but opportunistically short, which may be the case, but historically he’s done a lot of shorting. I have a theory that these investors are attracted to shorting precisely because the expected value is worse than going long. It’s harder. It requires deeper research. It’s intellectually stimulating. It’s exhilarating. These things probably really appeal to smart people with a chip on their shoulders for some reason. But what is investing about? Is the goal of investing to optimize return or optimize intellectual stimulation? Most investors agree verbally that it’s all about return, but most don’t behave that way – and there are other examples. Obsessions over volatility, dividends, minimizing taxes, etc. are all examples of other things I’ve found many investors trying to optimize through their behavior. Buffett has said a few insightful things on this topic: “You don’t get points for difficulty” The mono-linked chain metaphor The one-foot hurdle metaphor It is certainly understandable that for investors capable of analyzing and understanding very difficult situations, it is challenging to focus on easy ones. Conclusions I have some other thoughts like the idea of specialization – maybe an investor, for some reason like a deep skeptical streak, is much better at shorting than going long – but they will have to wait for another post. This article is just me putting my thoughts to paper. At this point, I’m comfortable recommending that most investors (including myself) focus on positive expected value situations to optimize return and that means avoiding short selling.

This Biotech ETF Has Thus Far Delivered On Its Potential

Summary The ALPS Medical Breakthroughs ETF – a fund focused on companies in late stage clinical trials – has jumped over 20% YTD, far outperforming small cap & biotech counterparts. This ETF looks for companies with at least one drug in stage II or stage III clinical trial. The fund’s managers have demonstrated a solid albeit short track record over the ETF’s nine month history outperforming small cap, biotech and pharma indices. This ETF was hit especially hard during this week’s rout in biotech. At the beginning of the year, I profiled the ALPS Medical Breakthroughs ETF (NYSEARCA: SBIO ). It’s a fund that is trying to carve out a unique niche in the biotechnology space by investing in those companies engaged in late stage clinical trials. By their very nature, these companies and the ETF itself are a high risk, high reward proposition but in its brief nine month history the fund has been able to deliver on its potential. First off, let’s review the investment criteria of the fund… To qualify for this ETF the company must have at least one drug in either stage II or stage III clinical trial. Often times these companies are very small (currently about 70% of fund assets are devoted to either small cap or micro cap businesses) and generate little if any revenue. Their upside is captured in either the success of the drug in trial or the possibility of being acquired by a larger company. Since its inception at the beginning of the year the fund has delivered against just about any benchmark you can think of. While the fund has whipsawed around and experienced the high degree of volatility that one would expect from a small cap biotech ETF the fund has managed to deliver outsized returns in its short existence. Consider its performance against the biotech indices… SBIO Total Return Price data by YCharts Biotechs in general have performed well this year beating the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ) by a large margin and more than doubling up on the SPDR Biotech ETF (NYSEARCA: XBI ). The ALPS ETF does have a roughly 50-50 weighting of both biotechs and pharmaceutical companies but this chart demonstrates how this ETF is handily beating both the SPDR S&P Pharmaceuticals ETF (NYSEARCA: XPH ) and the iShares U.S. Pharmaceuticals ETF (NYSEARCA: IHE ) for the pharma sector as well. SBIO Total Return Price data by YCharts Measuring against the small cap ETFs (the iShares Core S&P Small-Cap ETF (NYSEARCA: IJR ) and the Vanguard Small Cap ETF (NYSEARCA: VB )) yields similar results. SBIO Total Return Price data by YCharts Perhaps a fairer comparison comes when you look at this ETF against the ETF that debuted just a couple of weeks earlier – the BioShares Biotechnology Clinical Trials ETF (NASDAQ: BBC ). SBIO Total Return Price data by YCharts I say a fairer comparison instead of a good comparison because while the two ETFs share a similar strategy of going after clinical trial companies the stocks they target are quite different. For example, the ALPS ETF typically invests in nothing with a market cap greater than $5B. In comparison, the BioShares ETF has over half of its assets in companies with market caps greater than $10B. Perhaps it’s not surprising that the BioShares ETF has performed much more in line with its counterparts. It’s not all smooth sailing though with biotechs though. Biotechs in general lost roughly 10% of their value this past week alone giving shareholders a first hand look at the risks involved in these emerging companies. Putting further pressure on biotechs was the news that Hillary Clinton is looking to rein in prescription drug costs and place a monthly cap on some premiums. This is campaign season and everything we hear from politicians at this point should probably be taken with a whole shaker of salt but potential revenue limits could be a consideration going forward. Conclusion Nine months is a very short time to be judging performance but it’s encouraging to see how well the fund managers have been able to outperform in such a challenging environment. The short track record has done wonders in attracting investment to the fund as it already has $160M in AUM – far more than the roughly $28M managed by the BioShares ETF. An overall expense ratio of just 0.50% also helps its cause. The focus on companies engaged in later stage clinical trials offers greater intrigue. By stage II or III, the drug has cleared its initial hurdles and stands a much better chance of making it to market and that helps remove a level of risk and uncertainty. However, we have many examples of what happens to a company’s stock if its drug fails in trial. While the home run potential is there with many of these companies there’s also a huge downside risk if the drug fails to get approved. So far, the initial results are encouraging as the managers have had an albeit small degree of success in picking the right stocks. I like the promise of this ETF, although I’m also waiting to see how the managers perform over a longer time frame.