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Understand Your Smart Beta: A U.S. Min Vol Example

Summary Smart beta strategies are not always smart and are not just beta. USMV is a smart beta strategy that demonstrates alpha. Don’t buy USMV to reduce volatility, buy it because you believe it has alpha. Smart beta is active management and you should understand the source of outperformance for a given strategy. Smart beta strategies are not always smart and are not just beta. Smart beta ETFs can be used to take active positions relative to a given index. The goal of the smart beta ETF is to outperform the index, after adjusting for risk. This is the same goal as any other active investment strategy. There needs to be an underlying reason the active positions, in a smart beta ETF, will continue to outperform on a risk adjusted basis. The Theory: A great example is the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). USMV purchases a portfolio of U.S. equities such that volatility is minimized, given a set of constraints. From a marketing perspective it is a great idea. Who doesn’t want to buy lower volatility stocks? However, if USMV does not offer alpha then it serves no purpose in a portfolio. Now, let’s bring in the theory. CAPM says that all returns are explained by their exposure to market beta. CAPM assumes markets are efficient & normally distributed. I am not saying that CAPM is a perfect theory, but it should be the starting point for an analysis. The Fama-French Three Factor Model was the first “smart beta” model. The three factor model says there are other factors that can explain the return and tilting to those may factors increases risk adjusted return, i.e. alpha. Market inefficiencies need to exist for CAPM not to work and for a given smart beta strategy to work. Inefficiencies can come from several places including market structure, behavioral, information availability and other factors. The Formula: Smart Beta Strategy Return = Beta*(Market Return) + Alpha. The alpha can come from factor tilts that occur in smart beta. This assumes the risk free rate is 0.0%. The Inefficiency: Please don’t say you want to buy USMV to lower your volatility! You can buy the Vanguard S&P 500 ETF ( VOO) + cash to achieve the same exact beta, it is also a lot cheaper. Buy USMV for the correct reason. USMV outperforms the market, after adjusting for risk, because it picks up a market inefficiency. USMV has been shown to have an alpha of 4.2% from October 2011 to July 2015. (click to enlarge) It is important to understand the market inefficiency that USMV relies on. The inefficiency is from U.S. mutual funds owning cash and wanting a beta of 1 or higher. For a mutual fund to have a beta of 1, while also owning cash, it must purchase higher beta stocks. Therefore higher beta stocks (high volatility stocks) receive a higher flow of dollars. This makes lower beta stocks (lower volatility stocks) are cheaper than they otherwise would be. USMV owners are effectively taking their excess return from U.S. equity mutual fund investors. Conclusion: When Investing in Smart Beta… Certain smart beta strategies outperform the index due to inherent market inefficiencies. Understand the underlying reason why a smart beta strategy will outperform an index (at least check that it shows alpha historically after adjusting for market beta). Don’t buy USMV to reduce volatility, buy it because you believe it has alpha. If you want to reduce volatility then sell risky assets and buy cash. Smart beta is active management and you should understand the source of outperformance for a given strategy. USMV has historically shown positive alpha of 4.2% and I expect the market inefficiency that it relies on to continue. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Share this article with a colleague

Money Managers Hate Me For This One Weird Trick…

Summary An S&P 500 ETF should be the cornerstone of a well-diversified long term portfolio. I will compare the most widely known S&P 500 ETF SPY against two viable alternatives IVV and VOO. The metrics I will use are as follows: expense, historical performance, portfolio composition, total assets, volume, yield, NAV, standard deviation, and correlation. … Which is recommending that you buy the index and call it day. Boring? Perhaps. Sexy? Nope. You know what is nice though? Not having to work until you die because you were unable to save enough money for retirement. Having money to send your children to college. What else? Not getting ripped off by some “savvy money manager” that charges predatory fees. Sure you can Seek Alpha all your life, but who do you listen to? Why pay exorbitant fees for hit or miss advice? There is an optimal investment opportunity out there, and best of all, you only need access to a brokerage account to buy into it. It is called a low-cost S&P 500 ETF. Premise I firmly believe an index fund like the S&P 500 ETF (NYSEARCA: SPY ) should be a core part of a balanced long-term portfolio. The S&P 500 is comprised of 500 of the healthiest, strongest, and most widely traded stocks on the market. Investing in an S&P 500 ETF gives the investor diversified exposure to this valuable class of equities while mitigating single stock risk. I mentioned in another article that the S&P 500’s historical long term annual returns (assuming a 20-year time frame) have ranged from 5.5% to 18% . S&P averages roughly 10% returns year over year. Holding a long term-position in an ETF like SPY is intuitively the best investing decision you could ever make (I will likely write several additional articles on this subject). However, in this particular article I will focus solely on cross-analyzing and comparing the 3 primary S&P 500 ETFs available. I personally hold a long position in SPY, but I think it’s valuable to consider two alternatives iShares Core S&P 500 ETF (NYSEARCA: IVV ) and Vanguard S&P 500 ETF (NYSEARCA: VOO ). Correlation The first thing I look for in an ETF is a strong correlation to its underlying index. SPY, IVV, and VOO all display a direct and positive correlation to the S&P 500, so thankfully tracking error is not going to be a major issue. Historical Performance & My Biggest Concern Comparable returns have always grouped closely together. Interestingly, each ETF has tended to marginally outperform the S&P 500 index in the short and long run. In the last five years the index and each ETF saw around 14.75% returns annually. However, I believe this percentage is uncharacteristically high due to persistently and artificially low interest rates. This phenomenon is mostly guided by Fed backed programs which I believe have produced inflationary upward pressure on stock prices. My biggest concern for this ETF is that the stock market as a whole appears overvalued, and a market correction does not seem unfeasible (at least in the short term). As a long term investor, I am maintaining my position, but do not be surprised if these ETFs do not have future returns on par with the last five years. Comparing Key Metrics As I mentioned, I own SPY . However, I love this class of ETF, so I will not be offended if you choose to buy VOO or IVV instead. I do unequivocally recommend a long position in at least one of these. Key Metrics SPY IVV VOO NAV 208.46 209.72 191.13 Total Assets 175.95 Bil 69.8 Bil 34.33 Bil Average Volume 115.9 Mil 4.1 Mil 1.6 Mil 12-Mo. Yield 1.92% 1.99% 1.96% Expense Ratio 0.09% 0.07% 0.05% Standard Deviation 8.55% 8.56% 8.56% At first glance, SPY is the most expensive choice and offers the lowest 12-Month yield. Additionally, if you reexamine the charts I included above, you will see that VOO outperforms both IVV and SPY in the long term. However, I believe SPY derives additional value from its high liquidity. This liquidity attracts institutional investors which in turn works to lower expense. After extensive research I found that SPY is more cumbersome than IVV and VOO. Each ETF is valuable in its own way which I will soon discuss. Portfolio Composition I wanted to compare each fund’s portfolio composition by sector weighting. I found that VOO, then IVV, and finally SPY (ranked best to worst) held different sector weightings. I created an excel sheet using Morningstar data to compare and contrast each. SPY SPY Portfolio Weightings Sector Weightings % Stocks Benchmark Category Avg. Basic Materials 2.76 2.99 3.26 Consumer Cyclical 11.16 12.04 11.88 Financial Services 15.63 15.21 16.26 Real Estate 2.18 3.26 2 Sensitive Communication Services 3.94 3.73 3.62 Energy 6.91 6.82 7.62 Industrials 10.73 11.31 11.57 Technology 17.9 17.36 17.05 Defensive Consumer Defensive 9.67 8.77 8.87 Healthcare 16.26 15.63 15.59 Utilities 2.87 2.87 2.29 Critics of SPY claim it is clunky and inefficiently weighted. That claim seems overly bombastic, but there is some truth to it. SPY is underweight in: Basic Materials Consumer Cyclical Real Estate Industrials Overweight in: Financial Services Communication Services Energy Technology Consumer Defensive Healthcare Equally Weighted: IVV IVV Portfolio Weightings Sector Weightings % Stocks Benchmark Category Avg. Basic Materials 2.76 2.99 3.26 Consumer Cyclical 11.16 12.04 11.88 Financial Services 15.63 15.21 16.26 Real Estate 2.19 3.26 2 Sensitive Communication Services 3.94 3.73 3.62 Energy 6.92 6.82 7.62 Industrials 10.72 11.31 11.57 Technology 17.9 17.36 17.05 Defensive Consumer Defensive 9.66 8.77 8.87 Healthcare 16.26 15.63 15.59 Utilities 2.88 2.87 2.29 IVV has portfolio allocations identical to SPY. In regards to its benchmark (S&P 500), IVV is: Underweight in: Basic Materials Consumer Cyclical Real Estate Industrials Overweight in: Financial Services Communication Services Energy Technology Consumer Defensive Healthcare Equally Weighted: VOO VOO Portfolio Weightings Sector Weightings % Stocks Benchmark Category Avg. Basic Materials 2.98 2.99 3.26 Consumer Cyclical 11 12.04 11.88 Financial Services 15.15 15.21 16.26 Real Estate 2.11 3.26 2 Sensitive Communication Services 4.02 3.73 3.62 Energy 7.85 6.82 7.62 Industrials 10.91 11.31 11.57 Technology 17.84 17.36 17.05 Defensive Consumer Defensive 9.34 8.77 8.87 Healthcare 15.97 15.63 15.59 Utilities 2.83 2.87 2.2 VOO, in my opinion, has a better allocated portfolio and more attractive weightings. Underweight in: Consumer Cyclical Real Estate Industrials Overweight in: Communication Services Energy Technology Consumer Defensive Healthcare Equally Weighted: Basic Materials Utilities (mostly) Financial Services Investment Strategy Recommendations Whichever ETF you choose, my overall recommendation will remain the same. For this reason I will mention my overall strategy before jumping into an analysis of each ETF. Buy and hold a long position and establish a DRIP ( Dividend Reinvestment Plan ). Try to make monthly contributions to increase the compounding effect over time. Do not worry or hyper focus on short term price fluctuations. It’s difficult (if not impossible) to predict what the market is going to do. In the long term, however, you should expect attractive positive returns. Additionally, you will be able to sleep better knowing you were able to mitigate single stock risk by owning a diversified ETF. SPY SPY is structurally inefficient (compared to its alternatives), but it is cheap, well-covered, and highly liquid. You really can’t go wrong with a long buy and hold position in SPY. I would recommend SPY for beginners and institutional investors. IVV IVV is cheaper than SPY and offers the highest dividend yields (marginally). IVV is also more liquid than VOO. I would recommend IVV for high net worth individuals. VOO VOO is the cheapest and most efficiently weighted option. This Vanguard ETF historically has performed the highest of the three. While, VOO is less liquid than IVV and SPY, it is still adequately liquid. VOO does a better job of tracking the underlying index. VOO is arguably the best choice of the three. I would recommend VOO for those with some investing knowledge looking to graduate from SPY. Why Bother with an S&P 500 ETF? I could talk endlessly on this subject. I’ve already written a little bit about it, but the short answer boils down to this. Seeking alpha is a difficult, risky, and sometimes perilous journey fraught with misunderstanding, bad advice, and cognitive bias . There are a few intelligent individuals out there (and on this site) that have been able to beat the market. For the most part, however, most investors do not beat the S&P 500 . So why not just buy into it? Money managers generally do not beat the S&P 500, and they will charge you a management fee that significantly bites into your returns over time. To illustrate this, let me include one of my favorite graphs. It is easy to fall into the arms of professional money managers because we are intimidated by their financial expertise and “insider knowledge.” Often they will rationalize their exorbitant and predatory fees with backwards logic. Just invest in the index. I promise you’ll be better off. Conclusion Buy and hold a long term position in either SPY, IVV, or VOO. It could be the best investment decision you will ever make. If you don’t want to fruitlessly waste time trying to beat the market; if you don’t want to fall prey to faulty investment advice or get gouged by fees; if you want to manage risk and make money with minimal financial knowledge – invest in the index. I’m really not leading you astray here. I’m not the first person to make this recommendation and I hope I’m not the last. Don’t believe me? Listen to what Warren Buffett has to say. In regards to instructions Buffett laid out in his will, “My advice to the trustee could not be more simple: Put 10% of cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund” Side note: He recommended Vanguard Afterwards : Follow me down the rabbit hole as I cover a variety of Index ETFs (Vanguard or otherwise) to perfect your portfolio. In spite of Buffett’s advice, there is a whole world of high performing, highly diversified, low cost ETFs that deserve some attention. Disclosure: I am/we are long SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Dividend ETFs: Another Canary In The Coal Mine?

Bloomberg reports that money is flowing out of dividend-focused ETFs. That’s a big change after years of inflows. Pair this up with the REIT and Utility selloff, and maybe dividend investors should start getting worried. Years ago, coal miners would bring canaries into the mines with them. Not because they wanted to have a mascot around, but because canaries were more sensitive to deadly gases. When the bird died, it was time for the humans to run for the exits. Right now, the shift taking place in income-oriented stocks could be flashing just such a warning sign. Who doesn’t love an ETF? According to Bloomberg , Vanguard Dividend Appreciation ETF (NYSEARCA: VIG ) has seen more money flow in its doors every year since it was created in 2006. Until this year, that is. Roughly $800 million has left the roughly $20 billion fund so far in 2015. And VIG isn’t alone. According to Bloomberg the dividend ETF category, with about $100 billion in assets, has seen roughly $2 billion in outflows this year. Now that’s not a huge amount of money percentage wise, but it’s a clear indication that the popularity of dividend ETFs is waning. And that’s a big deal. But what’s going on? For starters, as the Federal Reserve has talked about raising short-term interest rates, the market has already started the process. The rate on 10-year treasuries has inched up from 1.6% to 2.3% this year. VIG yields around 2.2%. Why take the risk of owning stocks if you can get the same yield from a treasury? And to add insult to injury, VIG is down roughly 2% so far this year while sibling Vanguard S&P 500 ETF (NYSEARCA: VOO ) is up about 2%. VOO yields around 2%, for comparison. So VIG is lagging the broader market and it doesn’t offer much of a yield advantage compared to the S&P 500 Index. Once again, why bother with VIG? Bigger picture But that’s not the whole picture. For example, real estate investment trusts have also fallen out of favor. Vanguard REIT Index ETF (NYSEARCA: VNQ ) is down around 4% so far this year and roughly 12% from its early year highs. And Vanguard Utilities ETF (NYSEARCA: VPU ) is down roughly 11% this year and nearly 15% from its early year highs. So dividend ETFs aren’t the only ones facing performance headwinds. Note that market watchers have commented on the asset outflows from these two funds this year, too. The take away is that sectors of the market that are associated with dividend investing aren’t the bright spots they once were. They are lagging and seeing investor outflows. And it’s worth noting that VNQ and VPU both have higher yields than the 10-year treasury. So investor flight is about more than just yield. The most likely reason for all of this bad news is investor sentiment. And that’s a potentially dangerous thing if it starts to snowball. At that point it could easily turn into an avalanche of selling. Remember Benjamin Graham’s Mr. Market isn’t sane, the prices he offers sometimes appear ridiculously high and ridiculously low. This is just another way of explaining the pendulum nature of the market, in which prices move back and forth from the extremes. Over long periods, the prices may make sense, but over short periods that’s not really the case. The next shoe to drop? There’s no way to tell, of course, what might cause what’s happening to dividend-focused investments to turn into an avalanche. However, there’s a pretty big issue coming to a head right now: the Fed and short-term rates. Some suggest that any rate hike will be small so it will have little impact on companies. And, thus, should lead to little change in stock prices. You could also argue that any hike will be driven by economic improvement, though I’d argue that the economy is hardly robust and stable right now. But these counter arguments miss the emotional impact, which is what drives stock prices over short periods of time. And it also ignores the multi-year run up in the prices of dividend-focused investments. For example, despite their recent pull backs, VIG, VNQ, and VPU are up still up roughly 70%, 55%, and 40%, respectively, over the past five years. That’s down from early year highs and you could easily argue that the declines so far this year for REITs and utilities have brought at least these two sectors back into buying territory. This thesis, however, ignores the usual market pendulum from extreme to extreme. Yes, the pendulum swings through rational, but that normally happens as it’s swinging to the other extreme. In other words, I don’t think now is the time to be aggressive. I think caution is still in order. And until the Fed actually starts raising rates, uncertainty will be your enemy. So I think the canaries are starting to choke. Perhaps it’s not time to exit the mines just yet, but I’d sure be making plans to do so if you own anything speculative. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.