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Consumer Staples Momo ETF Is A Winning Smart Beta Selection In A Defensive Sector

Investors looking for an ETF that is both defensive and has the potential for out performance should review PowerShares DWA Consumer Staples Momentum ETF. FINRA recently chimed in on Smart Beta ETFs with a Caveat Emptor opinion. As long as the US Dollar remains strong, this ETF should continue to excel. As with many previous market downturns, money has been flowing into the “safer” sectors of utilities, consumer staples, and telecom. If one looks at the recent high of the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) at $213.50 on May 21, the markets have fallen -9.3% as of Sept 23. Popular ETFs for these sectors are the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ), the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) and the SPDR S&P Telecom ETF (NYSEARCA: XTL ). Since May 21, utility and consumer staples investors have been rewarded with better relative declines of -5.9% and -4.9%, respectively, while telecom lost about market average of -9.8%. However, if one looked at the declines of these sector ETFs from their most recent highs, the carnage is a bit worse. Utilities peaked on Jan 29 and has declined -15.1%, telecom peaked on June 18 and has fallen -11.9%. Consumer staples peaked on Aug 5 and has declined -7.2%. On a year to date base, SPY is down -2.9%, XLU -8.5%, XTL -3.3%, and XLP -1.2%. Within these popular defensive sectors, consumer staples would seem to be the best performer for relative performance against a backdrop of an overall market decline. There are 13 consumer staples ETFs listed on ETFdb.com . YTD performance ranges from 9.39% for the PowerShares DWA Consumer Staples Momentum Portfolio ETF (NYSEARCA: PSL ) to -46.1% for the Global X Brazil Consumer ETF (NYSEARCA: BRAQ ). The top three YTD US performers were: PSL, the PowerShares Dynamic Food & Beverage Portfolio ETF (NYSEARCA: PBJ ) at 5.3% and the Guggenheim S&P Equal Weight Consumer Staples ETF (NYSEARCA: RHS ) at 2.5%. On a 1-yr, 3-yr and 5-yr basis, PSL has outperformed both the SPY and XLP, with the majority of its relative strength clocking in since Oct 2014. Prior, PSL mirrored SPY and bested XLP and the recent outperformance has lifted overall returns. According to etfdb.com, during the past year, PSL has returned 18.5% vs 7.5% for XLP, on a 3-yr basis, PSL has returned 70.5% vs 41.9% for XLP, and on a 5-yr basis, PSL has returned 123.7% vs 93.9% for XLP. A 3-yr graph of PSL vs SPY and XLP is below. What is the investment strategy of PSL that creates the outperformance? As a “smart beta” ETF, the underlying portfolio shifts quarterly centered on individual stock’s technical performance relative to the sector. PSL is a PowerShares ETF offered by Invesco. From their website : “The PowerShares DWA Consumer Staples Momentum Portfolio ((Fund)) is based on the Dorsey Wright® Consumer Staples Technical Leaders Index (DWA Consumer Staples Technical Leaders Index). The Fund will normally invest at least 90% of its total assets in common stocks that comprise the Index. The Index is designed to identify companies that are showing relative strength (momentum), and is composed of at least 30 common stocks from the NASDAQ US Benchmark Index. The Fund and the Index are rebalanced and reconstituted quarterly.” Zack’s comments on PSL: “Consumer staples sector is on the rise as it is directly linked with improving economic fundamentals, in particular the spending power, which has increased owing to cheap fuel and rising income. As such, PSL has been able to withstand global worries, gaining 2.6% so far in the second half. The ETF provides exposure to 32 stocks having positive relative strength (momentum) characteristics by tracking the DWA Consumer Staples Technical Leaders Index. It has amassed $203.4 million in AUM and trades in lower volume of 56,000 shares a day on average. Expense ratio came in at 0.60%. The product is pretty spread out across securities, with each holding less than 4.9% of assets. It has a definite tilt toward mid cap stocks while the other two market cap levels take the remainder. Food products, beverages and household durables are the key industries in the ETF having double-digit exposure each.” Momentum investing, aka “momo”, is a strategy of buying stocks that have generated high returns over the past three to twelve months, and selling those that have experienced poor returns over the same period. The ETF seeks investment results that correspond to the price and yield of the DWA Consumer Staples Technical Leaders Index, which evaluates companies based on a variety of investment criteria, including fundamental growth, stock valuation, investment timeliness and risk, comparative to others in the sector. From DWA website concerning their relative strength and top-down approach: “Relative Strength: Relative Strength, the measurement of how one security performs in comparison to another, is a key concept within Dorsey Wright’s methodology. Before investing in UPS, one should understand its recent performance relative to FedEx, or the S&P 500. The same logic can be applied to sector analysis, asset class evaluation, mutual funds, ETFs, commodities, fixed income, and even foreign countries. A relative strength matrix is like a massive tournament, where a huge quantity of investment options can be compared to one another – and we see who is strongest. Relative strength is the basis for virtually all of our managed products, where we select the best investment options from within a large universe of options. Top-Down Approach: We use primary market indicators to get a measure of overall risk, and then analyze broad industry sectors to determine which are in favor. We want to invest in sectors that are controlled by demand. We then select investments that have positive relative strength and have a good probability of outperforming the market. We do not feel compelled to be fully invested in stocks when an alternative investment (cash reserves) offers a more attractive opportunity. In fact, it is our belief that avoiding severe losses is extremely important in achieving strong market performance over the course of an entire market cycle.” PSL is one of 14 momentum driven ETFs utilizing various Dorsey Wright Technical Leaders Indexes and a list of other Indexes is found here . DWA offers an in-depth White Paper on the Dorsey Wright Strategy titled ” Relative Strength and Portfolio Management ” pdf. PSL was rebalanced on June 30 and the most recent list of stocks is below: (click to enlarge) Due to its focus on owning the top momentum stocks with quarterly rebalancing, investors should not be surprised at a high 83% Annual Turnover Rate. According to Morningstar, of the companies listed above, one was purchased in 2012, three in 2013, nineteen in 2014 and nine in 2015. The ETF’s industry allocation is broad based within the consumer staples sector and is reported by Invesco as follow: As the strategy includes NASDAQ stocks, PSL’s portfolio will have higher exposure to mid-caps and small-caps than its large cap S&P ETF brethren. Not only are smaller companies known for higher earnings potential, but usually are focused on domestic US markets rather than an extensive international network. Recently, the strength of the US Dollar has weighted on revenue growth and exchange rates for large cap companies, and this concern is usually less with smaller companies. The strength in domestic markets and reduced currency risk exposure may be a factor in these specific company’s current individual outperformance. The outperformance of PSL compared to XLP coincides with the meteorically rise in the US Dollar starting in Aug 2014. The average market cap in the portfolio is $14.5 billion and 72% of the portfolio are mid-caps or smaller. Below is a table offered by Morningstar of PSL valuation and growth matrix compared to the Benchmark of S&P 1500 Consumer Staples and the Category of Morningstar Defensive. While the comparison indicates PSL is trading at a higher valuation than the Benchmark and Category, its growth profile is also quite a bit higher. With Cash-Flow Growth 25% above the benchmark and Book-Value Growth more than double the Benchmark, a higher valuation would seem appropriate. This week, FINRA issued an Investor Alert titled, “Smart Beta-What You Need to Know”. The bottom line of the alert is the old adage: Know what you are buying and what the strategy is of the specific ETF. There are about 840 products that fall into a smart beta category, representing almost half of all the exchange-traded products listed in the U.S. and investors should understand that any strategy that aims to beat the market carries its own risks. “Recently, there has been significant growth in the number of financial products, primarily ETFs, which are linked to and seek to track the performance of alternatively weighted indices. These indices are commonly referred to as “smart beta” indices. They are constructed using methodologies that rely on, for example, equal weighting of underlying component stocks, or measures such as volatility or earnings, rather than market-cap weighting. Investors need to understand there is no free lunch here. Any time you are deviating from the market, you’re taking some kind of tilt. Understand what is the fund doing that is different than the market. That is a risk.” Investors looking for an ETF that is both defensive and has the potential for outperformance should review PSL to evaluate how it may fit into their current portfolio construction. As long as the US dollar stays strong and the international economies remain in question, this ETF should continue to reward long term investors. However, FINRA is correct: Caveat Emptor. Author’s Note 1: NASDAQ OXM (NASDAQ: NDAQ ) agreed to acquire privately-held Dorsey Wright Associates in Jan for $225 million. This will push NASDAQ into the smart beta ETF market in an aggressive manner. Author’s Note 2: Please review disclosure in Author’s profile.

Investing In Biotech: Tekla CEFs Or IBB?

Summary Biotechnology companies have experienced a sharp selloff, leaving many of them at favorable valuation. Some might consider this a timely opportunity for investing in biotech. One can invest in the biotech sector via passively managed ETFs or actively managed closed-end funds. Here, I compare the CEF alternatives for biotech to IBB. Biotech has been battered recently. Early in the year, there was all that talk of bubbles, which became something of a self-fulfilling prophecy, culminating in a lot of air slowly leaking from the inflated category. Then, the entire market entered its long-predicted, long-awaited correction and biotech dropped along with it. Finally, last Friday, the NY Times and Hillary Clinton piled on, taking issue with excesses by some in the industry, and the category tumbled as the week began. Depending on your view of things, biotech is dead in the water for the foreseeable future and to be avoided, or it’s become horridly oversold and ripe with bargains. If you’re in the first category, you might as well stop here because everything that follows is predicated on the point of view that biotech has generally fallen well below fair price levels. Morningstar’s analytics tend to agree. Here’s its view of the industry as of Sept. 21, which considers the industry to be 14% under fair value: (click to enlarge) It can, of course, go lower, but it hasn’t been this low since 2011. Ok, you’re still reading. Either you agree that biotech is an investable industry or you’re just hanging around to hear more. But, I’m not going to discuss the merits of the industry. That’s been done repeatedly and eloquently by others. DoctoRx is a particularly knowledgeable interpreter of the biotech space; his articles and instablogs are required reading on the topic. What I want to do is explore opportunities for investing in the industry. There are certainly very attractive individual holdings, but my inclination, especially in a volatile and unpredictable area such as this, is to invest broadly using ETFs and CEFs (closed-end funds). That will be the today’s topic. I’ll focus on one ETF and two CEFs. The ETF: iShares NASDAQ Biotechnology ETF (NASDAQ: IBB ) IBB is the standard bearer for biotechnology investors. The fund’s inception date is Feb. 5, 2001. It holds net assets of just over $9B in 145 names. Holdings break down at about 79% Biotechnology, 15% Pharmaceuticals, and 6% in Life- and Bio-Sciences Tools, Services and Supplies. The expense ratio is 0.48%. IBB is indexed to the NASDAQ Biotechnology Index. Components of the index must be listed on the NASDAQ, have a market cap of at least $200M, and trade an average daily volume of at least 100,000 shares. The ETF’s top holdings are: The Closed-End Funds: Tekla Capital Management Two closed-end funds have a longer history in biotechnology. Both are from Tekla Capital Management. Tekla Healthcare Investors (NYSE: HQH ) has an inception date of April 23, 1987. Tekla Life Sciences Investors (NYSE: HQL ) began on May 8, 1992. So, both funds have a long history behind them. The Tekla funds are very similar but have important distinctions. From the Tekla website : “HQH … is broadly based in healthcare. HQL is more focused on life science technology, … expanding the biotechnology focus a bit to include more agricultural biotechnology and environmental technology. Both Funds hold small emerging growth companies, however, given HQL’s technology focus the holdings tend to be somewhat smaller and a little more volatile. The Funds share the same portfolio manager, Daniel R. Omstead, PhD.” HQH has $1.21B in assets under management; HQL has $0.52B. Management fees are 1.13% for HQH and 1.32% for HQL. Top holding for the CEFs are: (click to enlarge) For most closed-end funds, income is a major consideration; HQH and HQL are no exceptions. The funds have a managed distribution policy that distributes 2% of the funds’ net asset values to shareholders quarterly. One can opt to receive the distributions in cash. However, befitting an investment arena that is primarily growth oriented, the default option is for shareholders to reinvest the distributions by receiving them as stock. Not surprisingly, as few of the funds’ holdings pay dividends, distributions are primarily from capital gains. If, however, gains are insufficient to meet the distribution, shareholders are paid return of capital. For both funds, the managers had to resort to return of capital for only two of their quarterly distributions, these for the first two quarters of 2009. Thus, for 28 years [HQH] and 23 years [HQL] have been able to return 8% annually to shareholders from capital gains and income with only 2 misses during the depths of the worst recession since the depression. Currently, HQH is priced at a slight discount (-1.13%) to its NAV and HQL is priced at a slight premium (0.71%). For both, premium/discount levels move up and down regularly. They tend to track each other closely for this metric. (click to enlarge) Performance Total performance for the ETF and the two CEFs over intervals covering up to the past five years is shown below (based on monthly data through Sept. 1, 2015, from Yahoo Finance). (click to enlarge) There is little to differentiate the funds on a performance basis. HQH has not outperformed both of the other two for any of these time spans. HQL has done so, primarily on the basis of its strong performance TTM. HQL’s returns are, as expected, somewhat more volatile. We can see this in this chart of rolling 12-month returns since 2007 (through Sept. 1, 2015). (click to enlarge) The CEFs seem to have deeper troughs, notably through the recession and during early 2014. Premiums and discounts affect the CEFs but not the ETF. The 2014 shortfall is to some large extent a consequence of the funds falling into deep discount valuations. IBB fell well below the CEFs in 2011. I’ve not done a maximum drawdown analysis, but it seems probable that IBB wins on that front but not by a large margin depending on the time frame being considered. HQH has better risk-adjusted returns as shown in this table (data for 3 years from Morningstar). IBB fares least well with its standard deviation indicating a much more volatile fund. HQH, HQL or IBB? It is interesting that there is little to distinguish these three funds on a performance basis over a substantial time scale. From reading the objectives, one might expect more divergence in the performance figures. However, looking at the top holdings, it is clear that, at least for the top ends of the funds’ portfolios, they are fishing in nearly identical ponds. One might be inclined toward the CEFs on those occasions when an investment can be timed to catch a deep discount. An entry at a -6% to -8% discount can cushion downside movements as they occur. And, as we see in the premium/discount charts above, those discounts have consistently returned to premiums over time. On the other hand, I would tend to avoid an entry into either HQH or HQL at any appreciable premium valuation in favor of purchasing IBB. One strategy might be to buy HQH or HQL when the discount is highly favorable, hold the CEF until it moves to a premium, then sell and invest the proceeds in IBB, repeating the cycle as appropriate. Income is a factor. For the investor interested in generating income, the CEFs are the clear choice. One could, of course, hold IBB and sell 2% of shares each quarter and likely end up in about the same place. But, to my mind, it is easier to simply have the fund managers do it for you. A strong advantage of HQH and HQL over nearly all other income-generating CEFs is their long record of increasing principal even after providing a payment of 8% on NAV annually. For both funds, market price has more than doubled over 5 years, and that’s after paying out 2% on NAV each quarter. This puts them at the very top of all closed-end funds. To illustrate how the funds would have rewarded an income investor, I present this chart showing total return (distributions reinvested) and price return (distributions taken as cash) for IBB, HQH, HQL and two equity-income CEFs from Eaton Vance. One is an unleveraged option-income fund (NYSE: ETV ); the other is a leveraged global equity fund (NYSE: ETG ). These may not be the best performers, but neither has been a laggard and, taken together, I think they are reasonably, albeit arbitrary, representatives of equity CEFs. (click to enlarge) The red-orange line shows growth of the fund with income withdrawn. HQH grew 160% while providing 8% cash to its investors annually. HQL grew 170% with the same cash yield. ETV and ETG generated higher distribution yields, but did so with essentially no growth of capital over the five years. For the investor focused primarily on growth, either of the CEFs has provided returns to IBB when held with the default option of taking the distributions as shares (blue lines). In closing, I’ll mention that there are other ETFs available to the biotech investor. I’ll be following up with a survey of those alternatives.

How Do Fund Flows Affect Fund Performance?

A study by Morningstar acknowledges that the relationship between fund flow (or investors’ purchases and redemptions of mutual funds) and fund performance may be stronger than previously considered. However, the study based on three-year performance of stock-picking funds between 2006 and 2014 revealed that funds with high inflows, stood a lower chance of outperforming peers. Large-cap funds attracting most inflows had an average return of 7.8%. This compares unfavorably with funds with biggest outflows offering an average return of 8.1%. In many cases, outperformers tend to attract inflows. The strong rally may have run its course, leading to the tepid performance of those high inflow funds. Also, funds with massive inflows will have to employ the cash; otherwise the cash in net assets may swell and thus affect the fund’s allocation style. The positive on the other hand is that increased cash can help fund managers invest them in new stocks or financial instruments, without selling the existing portfolio. This in turn keeps the turnover ratio low. (To learn more about turnover ratio, click Does Turnover Ratio Influence Mutual Funds? ) Thus, fund flows may have an impact, but not necessarily in all cases. This is better explained in Pimco’s legal disclosures to the PIMCO Total Return Fund (MUTF: PTTAX ) investors. It says purchases or redemptions “may cause funds to make investment decisions at inopportune times or prices or miss attractive investment opportunities. Such transactions may also increase a fund’s transaction costs, accelerate the realization of taxable income if sales of securities resulted in gains, or otherwise cause a fund to perform differently than intended. While such risks may apply to funds of any size, such risks are heightened in funds with fewer assets under management.” Fund Category Performance with Highest Inflow & Outflow in August This year, the bleeding continues for funds and particularly for active funds. According to Morningstar data, open-end mutual funds saw outflows of $31.9 billion in August. Interestingly, not all fund categories that saw the largest outflows in August were in the red for August. Similarly, inflows did not necessarily mean that funds ended up in positive territory. Except for Europe stock funds, five fund categories that had the highest August inflows have posted year-to-date losses. In August, all these five categories finished in the negative zone. The magnitude of losses in August for categories with highest inflows was significantly larger than those categories that saw largest outflows. Categories with Highest Inflows in August ($ in Million) Total Return (%) August YTD August YTD Foreign Large Blend 11880 80302 -7.1 -0.8 Multi-alternative 1464 11145 -2.3 -1.3 Managed Futures 1122 6220 -2.7 -1.5 Global Real Estate 982 1644 -5.7 -4.5 Europe Stock 943 4218 -6.1 2.5 Categories with Highest Outflows in August ($ in Million) Total Return (%) August YTD August YTD Intermediate – Term Bond -6711 29175 -0.4 0.1 Large Value -3866 -22052 -6 -5.3 Multisector Bond -3484 1920 -1.1 -0.4 Large Growth -3337 -26518 -6.4 0.3 World Bond -3116 13711 -0.9 -3.1 Source: Morningstar Top & Bottom-Flowing Active Funds Below we present the list of top and bottom flowing active funds for August: Top Flowing Active Funds Net Inflow ($ in million) Performance (%) Aug-15 1 Year Aug-15 1 Year DoubleLine Total Return Bond Fund (MUTF: DBLTX ) 965 12245 -0.3 -1 PIMCO Income Fund (MUTF: PONAX ) 750 10659 -1.2 -4.2 Strategic Advisers Core Fund (MUTF: FCSAX ) 743 2549 -4.8 -5 Brown Advisory WMC Strategic European Equity Fund (MUTF: BIAHX ) 680 725 -6.6 -3 T. Rowe Price Emerging Markets Stock ( PRMSX) 649 1940 -9 -20 As we can see, all these top flowing active funds had ended in the red for August and also over the last 1-year period. The reason is not necessarily the inflows, but as we know August has been a cruel month for the broader markets. However, once we compare the performance of active funds that had the biggest outflows, we will see that their loss was much larger. This is in contrast to the trend we noticed for the fund categories in August; where categories with largest outflows suffered relatively less losses. Bottom Flowing Active Funds Net Outflow ($ in million) Performance (%) Aug-15 1 Year Aug-15 1 Year GMO Asset Allocation Bond (MUTF: GABFX ) -2,018 -1,902 -0.6 -11.3 PIMCO Total Return (MUTF: PTTRX ) -2,015 -124,484 -1.1 -4 Templeton Global Bond (MUTF: TPINX ) -1,922 -6,013 -5.4 -14 Franklin Income Fund (MUTF: FKINX ) -1,473 -3,035 -4.4 -14.8 Oppenheimer Developing Markets (MUTF: ODMAX ) -1,059 -1,824 -10.6 -27 Source: Inflow/Outflow data from Morningstar; Performance data calculated using GoogleFinance. For the first time since Bill Gross quit PIMCO to join Janus , the PIMCO Total Return Fund was not at the bottom of funds with the most outflow. It took up the second seat instead. Its 1-year net outflow leads the pack, but the loss is not as much as others. PTTAX has lost 4% over the 1- year period, whereas the others including the Oppenheimer Developing Markets Fund, the Franklin Income Fund, the Templeton Global Bond Fund and the GMO Asset Allocation Bond Fund have suffered larger losses. Coming to Zacks Mutual Fund Ranks, the DoubleLine Total Return Bond Fund, the PIMCO Income Fund and the Templeton Global Bond are the only ones that currently carry a favorable rank. While DBLTX carries a Zacks Mutual Fund Rank #1 (Strong Buy) , the latter two carry Zacks Mutual Fund Rank #2 (Buy). The Strategic Advisers Core Fund and the PIMCO Total Return Fund have a Zacks Mutual Fund Rank #3 (Hold). Meanwhile, the T. Rowe Price Emerging Markets Stock Fund and the GMO Asset Allocation Bond Fund hold a Zacks Mutual Fund Rank #4 (Sell) and the Franklin Income Fund and the Oppenheimer Developing Markets Fund carry Zacks Mutual Fund Rank #5 (Strong Sell). As said, in certain cases there is more arts than science. Fund flows may be just a fraction of a factor to help a fund’s uptrend. Inflows may not translate into gains for mutual funds. Investors do not necessarily have to buy funds that are seeing strong inflows and vice versa. Link to the original post on Zacks.com