Tag Archives: management

The Limits Of Risky Asset Diversification

Do you want to reduce the volatility of your asset portfolio? I have the solution for you. Buy bonds and hold some cash. Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments. Those buying stocks stuck to well-financed “blue chip” companies. The diversification from investor behavior is largely gone (the liability side of correlation). Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets. But beyond that, hold dry powder. Think of cash, which doesn’t earn much or lose much. Think of some longer high quality bonds that do well when things are bad, like long treasuries. Photo Credit: Baynham Goredema . When things are crowded, how much freedom to move do you have? Stock diversification is overrated. Alternatives are more overrated. High quality bonds are underrated. This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best. First, I don’t like infographics or video. I want to learn things quickly. Give me well-written text to read. A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs. Here’s the problem. Do you want to reduce the volatility of your asset portfolio? I have the solution for you. Buy bonds and hold some cash. And some say to me, “Wait, I want my money to work hard. Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?” In a word the answer is “no,” though some will tell you otherwise. Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments. Those buying stocks stuck to well-financed “blue chip” companies. Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include: Growth stocks Midcap stocks (value & growth) Small cap stocks (value & growth) REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.) Developed International stocks (of all kinds) Emerging Market stocks Frontier Market stocks And more… And initially, it worked. There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers. Now, was there no diversification left? Not much. The diversification from investor behavior is largely gone (the liability side of correlation). Different sectors of the global economy don’t move in perfect lockstep, so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them. How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally? Why do I hear crickets? Hmm… Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought: Timberland Real Estate Private Equity Collateralized debt obligations of many flavors Junk bonds Distressed Debt Merger Arbitrage Convertible Arbitrage Other types of arbitrage Commodities Off-the-beaten track bonds and derivatives, both long and short And more… one that stunned me during the last bubble was leverage nonprime commercial paper. Well guess what? Much the same thing happened here has happened with non-“blue chip” stocks. Initially, it worked. There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers. Now, was there no diversification left? Some, but less. Not everyone was willing to do all of these. The diversification from investor behavior was reduced (the liability side of correlation). These don’t move in perfect lockstep, so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies). Yes, there are some that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short. Many of those blew up last time. How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally? Why do I hear crickets again? Hmm… That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point. Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets. But beyond that, hold dry powder. Think of cash, which doesn’t earn much or lose much. Think of some longer high quality bonds that do well when things are bad, like long treasuries. Remember, the reward for taking business risk in general varies over time. Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%). This isn’t a call to go nuts and sell all of your risky asset positions. That requires more knowledge than I will ever have. But it does mean having some dry powder. The amount is up to you as you evaluate your time horizon and your opportunities. Choose wisely. As for me, about 20-30% of my total assets are safe, but I have been a risk-taker most of my life. Again, choose wisely. PS – if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification. You will have to wait for those ideas to be forgotten. Wait to see a few fund closures, and a severe reduction in AUM for the leaders…

5 ETFs Losing Half Or More Of Its Value In 2015

Overall, 2015 has not been good for the U.S. equity market, caught up as it was in a vicious circle of never-ending woes. It all started with Fed uncertainty, a strong dollar and slumping commodities, and then extended to geopolitical tensions and global growth concerns, especially in China. Additionally, the U.S. economy, which was growing at a faster rate in over a decade in 2014, has cooled off substantially this year. While healing labor market, a gradual recovery in the housing market, robust auto industry, and cheap fuel are driving growth, persistent weakness in manufacturing activity, plunging oil prices, and shaky consumer confidence are posing threats to economic expansion (read: 5 ETFs for Loads of Holiday Shopping Delight ). As a result, the major indices – the S&P 500 and Dow Jones – are in the red territory from a year-to-date look, losing 0.3% and 1.4%, respectively. In fact, a number of products have been crushed, piling up huge losses for many ETFs. Below, we have highlighted five ETFs that have been hit badly so far in 2015 and might continue their rough trading in the months ahead if the trends persist unabated. First Trust ISE-Revere Natural Gas Index ETF (NYSEARCA: FCG ) – Down 56.5% Natural gas producers have been the biggest laggard this year on falling natural gas price. This trend is likely to continue in the months ahead given declining demand, increasing production, and growing global glut. Additionally, the expectation of a milder weather for late December – the key period that drives heating demand – will push the natural gas price lower. The Energy Information Administration (NYSEMKT: EIA ) expects heating bill to decline 13% this winter (read: No Winter Cheer for Natural Gas ETFs? ). Consequently, FCG, which offers exposure to U.S. stocks that derive a substantial portion of their revenues from the exploration and production of natural gas, is down 56.5% in the year-to-date time frame. It follows the ISE-REVERE Natural Gas Index and holds 30 stocks in its basket, which are well spread out across components with none holding more than a 7.1% share. The fund has amassed $172 million in its asset base while charging 60 bps in annual fees. Volume is good with more than 1.7 million shares exchanged per day on average. The ETF has a Zacks ETF Rank of 5 or ‘Strong Sell’ rating with a High risk outlook. First Trust ISE Global Platinum Index ETF (NASDAQ: PLTM ) – Down 54.3% The precious metal space has been hit by the double whammy of the broad market commodity rout and rate hike concerns. Robust supply and dwindling demand are weighing on the price of platinum since the start of the year. Additionally, the prospect of a rate hike backed by solid job numbers and moderate inflation has dampened the appeal for platinum. As such, PPLT has fallen 54.3% so far this year. The fund provides exposure to the companies that are active in platinum group metals mining by tracking the ISE Global Platinum. In total, it holds 18 securities in its basket with double-digit concentration in the top three firms. Other firms do not hold more than an 8.07% share. South African firms take the largest share in the basket at 27.6% followed by double-digit exposure each in Australia, United Kingdom, United States, Russia and Canada. Market Vectors Coal ETF (NYSEARCA: KOL ) – Down 54.0% Coal has fallen completely out of favor over the past few years due to the thriving alternative energy space and weak global industry fundamentals. The depletion of fossil fuel reserves, global warming and high fuel emission issues, new and advanced technologies as well as more efficient applications are making clean power more feasible, reducing the demand for the black diamond. These are making it difficult for the coal miners to sustain their profitability and margins. As a result, the ETF targeting the global coal industry has seen a wild ride and was off nearly 54% so far this year. KOL tracks the Market Vectors Global Coal Index. Holding 27 securities in the basket, the fund is concentrated in the top 10 holdings at 64.6% of total assets. It has a Chinese focus accounting for 28.4% of the portfolio while U.S., Australia and Canada round off the next three. The fund has amassed $42.5 million in its asset base and trades in average daily volume of 71,000 shares. Expense ratio came in at 0.59%. KOL has a Zacks ETF Rank of 4 or ‘Sell’ rating with a High risk outlook. Yorkville High Income MLP ETF (NYSEARCA: YMLP ) – Down 52.7% MLP was the worst hit corner from the oil price carnage with YMLP shedding the most – 52.7% in the year-to-date time frame. Being an interest rate sensitive sector, these securities will be further impacted by rising rates. This bearish trend is likely to continue as the Fed is on track to increase rates as early as next week. The fund follows the Solactive High Income MLP Index, charging investors 82 bps in annual fees. Holding 26 stocks in its basket, it is highly concentrated in the top 10 holdings at 58.3%, suggesting higher concentration risk. Oil & gas pipeline products take the top spot from a sector look at 40%, followed by oil refining & marketing (12%), and oil & gas drilling (10%). The product has managed $101.3 million in AUM and trades in moderate volume of 137,000 shares. SPDR S&P Metals & Mining ETF (NYSEARCA: XME ) – Down 50.0% Thanks to plunging metal prices and weak global trends, this broad metal & mining ETF has also lost half of its value. Acting as leveraged plays on underlying metal prices, metal miners tend to experience huge losses than their bullion cousins in the slumping metal market. In particular, a strong U.S. currency is making dollar-denominated assets more expensive for foreign investors, thereby dulling the appeal for these commodities. The ETF offers a broad exposure to the U.S. metal and mining industry by tracking the S&P Metals & Mining Select Industry Index. Holding 30 stocks in its basket, it uses an equal weight methodology and does not put more than 6.8% of assets in a single security. In terms of industrial exposure, steel makes up a large chunk at 49.3%, while diversified metals and mining, and gold round out the next two spots with double-digit allocation each. The product has $242.4 million in AUM and trades in solid trading volumes of more than 2.6 million shares per day on average. It charges 35 bps in fees and expenses. Link to the original post on Zacks.com

Third Avenue Focused Credit’s Investor Freeze Re-Affirms Advantage Of Closed End Funds

Third Avenue Focused Credit shutting the gate on redemptions. A reminder that traditional open-end mutual funds can suffer “runs on the bank” if they hold illiquid assets during nervous market periods. Reminds us that closed end funds are the safer vehicle to hold high yield and other more illiquid asset classes. Third Avenue Focused Credit Fund ( TFCIX , TFCVX ) just dropped the bombshell that they are freezing the fund and barring investor withdrawals as it seeks an orderly liquidation. TFCIX, as a sort of “vulture fund,” operates at the lowest end of the high-yield bond spectrum, specializing in bankruptcies, turnarounds and other bottom-of-the-barrel opportunities. I had personally been quite enamored of the fund when it was launched in 2009 as a vehicle to take advantage of post-crash credit market bargains. In that sense I saw it as a vehicle for retail investors to get in on the opportunities typically only available to hedge fund and other institutional investors. The fund’s “Achilles Heel” turned out to be its status as a traditional “open end” mutual fund, where investors could liquidate their positions on a daily basis. In fact, in recent years it was the only open-end mutual fund I had continued to hold, feeling personally more comfortable with closed end funds where, if other investors want to bail out, they have to sell their fund on the open market, and cannot demand the funds’ portfolio managers cash them out at NAV by selling fund assets. That is a much safer vehicle for holding potentially illiquid assets, as high yielding assets like junk bonds, MLPs, BDCs, etc. have turned out to be recently. I started selling out my TFCIX a few months ago (as I explained in an article in early November), not because I was worried about the fund freezing its assets (I wasn’t that smart), but rather because I saw a unique opportunity, since it was an open-end fund offering cash back at full NAV value, to take advantage of that and put the funds back into the market via closed end funds at 10% discounts (or more.) So that’s what I did, completing my exit later in the month. By way of post mortem, I ran the numbers on my total investment in TFCIX over the past six years. I collected back 34% of the total investment in dividends over the holding period, about 8% per annum, accounting for the timing of the investment (i.e. it wasn’t all outstanding the entire period). Then I gave back about 25% of the total investment in capital loss. That means I only made about 9% in total on my money, spread over 6 years. An opportunity cost, for sure, and a waste of earning power, since if invested better it would have been earning 6-7%. But – fortunately – not a disaster. To me this reinforces: · The attractiveness of closed end funds as the vehicle of choice for holding high-yielding illiquid assets, since you have the option of sitting out periods of market volatility while clipping your coupons and waiting for the storm to pass; and · The advantages of holding high yielding assets (equity and fixed income) in general, as a hedge against market losses, since the cash flow acts as a buffer over time to offset market depreciation.