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3 Under-The-Radar ETF Breakout Contenders

Summary With the market trading in a wide range since the beginning of the year, many momentum investors may be searching for signs of life in alternative areas. Several ETFs are showing positive technical divergences or signs of breakout that may warrant closer scrutiny. Solar stocks, consumer discretionary, and mid-cap stocks are excellent contenders. With the SPDR S&P 500 ETF (NYSEARCA: SPY ) trading in a wide range since the beginning of the year, many momentum investors may be searching for signs of life in alternative areas of the market. Just because the broad measure of U.S. stocks is waffling sideways, doesn’t mean that there aren’t suitable ETF candidates to add to your watch list at this juncture. The following funds are just a few of the ETFs I have been monitoring over the past several weeks as they show positive technical divergences from their peers. Guggenheim Solar ETF (NYSEARCA: TAN ) Solar stocks had a horrific year in 2014 that included various whipsaws and other erratic price action. They finished the year markedly lower despite positive net strength in large-cap indices such as SPY. However, they may be looking to turn those fortunes around in 2015 and have been showing a bias towards higher prices since bottoming in January. TAN is the largest renewable energy ETF with over $300 million in total assets. This fund tracks 29 global solar energy companies engaged in the manufacture, installation, and maintenance of solar power equipment. The index is composed of 47% U.S.-based companies, with the remaining allocation spread amongst China, Hong Kong, and other smaller nations. As you can see on the chart below, TAN had some brief consolidation at its 50-day moving average and is now marching back towards its long-term 200-day moving average. Since the beginning of the year, this ETF has gained more than 9% and is continuing to show positive relative strength versus many sector alternatives. Aggressive growth investors who can stomach heightened volatility may want to research solar ETFs as a possible comeback story for 2015. Consumer Discretionary Select Sector SPDR (NYSEARCA: XLY ) Consumer discretionary stocks are another area of the market that has shown strong momentum through earnings season. XLY is heavily dominated by media, specialty retail, and other luxury goods sellers such as Walt Disney (NYSE: DIS ) and Home Depot (NYSE: HD ). This ETF contains 87 large-cap stocks and charges an expense ratio of 0.15%. The strong vote of confidence for this sector came when it recently broke out above its 2014 highs and is continuing to show impressive overall strength. Many investors consider this ETF to be an indicator of consumer health, and judging by the price action, the trend of consumer spending habits continues in earnest. XLY will certainly be an important sector of the market to watch as a potential growth-focused momentum trade in 2015. iShares Core S&P Mid-Cap ETF (NYSEARCA: IJH ) Mid-cap stocks are another area of the market, similar to XLY, which has newly peeked out above its 2014 highs. IJH is the largest ETF in this space that tracks 400 mid-sized companies with market capitalization between $1.5 billion and $5 billion. This fund has over $24 billion in total assets and charges a modest expense ratio of 0.12%. While mid-cap stocks don’t always get as much recognition as their large or small-cap peers, they do have the potential to be successful long-term growth candidates. The positive technical move in this space should be viewed as a sign of building momentum that may lead to outperformance versus SPY in 2015. For my growth clients, I am accessing the mid-cap space through the Vanguard Mid-Cap ETF (NYSEARCA: VO ). This passive index follows a similar basket of 375 stocks and includes a lower expense ratio at 0.09%. The Bottom Line These growth themes show promising characteristics of momentum and strength versus plain-vanilla ETF alternatives. However, any new entrants in these ETFs should implement a stop loss or sell discipline to define your risk management strategy. In addition, when starting a new position, I typically recommend breaking up the trade in pieces so that you can add slowly over a limited time. This allows you to better control your cost basis and allocation size. Disclosure: The author is long VO. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.

General American Investors Company, Inc. Targeted By Activist Fund

Summary General American Investors Company, Inc. currently trades at a 13.94% discount to net asset value and has been targeted by the well-known closed end fund activist Phil Goldstein. Phil Goldstein has a long track record of fighting and winning proxy battles against closed end funds, whose boards resist initiating value enhancing liquidity events to benefit shareholders. A market neutral position, long GAM vs. short the S&P 500, offers an attractive opportunity for alpha generation based on the fund’s deep discount to NAV and involvement of activists. General American Investors Company, Inc. (NYSE: GAM ) is a diversified closed end fund that invests mostly in large-cap domestic common stocks. The fund has consistently traded at a double-digit discount to its net asset value for the past five years. The current discount is 13.94%. This past October, Special Opportunities Fund (NYSE: SPE ) submitted a shareholder proposal to General American Investors Company, Inc. requesting the Board of Directors to authorize a self-tender offer for all outstanding common shares at or close to net asset value. If more than 50% of the fund’s common shares are submitted for tender, then the tender offer should be cancelled and the fund should be liquidated or converted to an ETF or open-end mutual fund. If SPE is successful in its campaign, then shareholders stand to capture a windfall gain of as much as 14%. Special Opportunities Fund is a closed end fund run by the well-known hedge fund activist investor Phil Goldstein , co-founder of Bulldog Investors. SPE and Bulldog invest primarily in undervalued assets and engage in activism to unlock the value of their investments. SPE and Bulldog mainly target closed end funds which trade at large discounts to net asset value and pressure management to engage in value enhancing liquidity events, such as share repurchases or, in some cases, liquidation. They have had numerous successes with their activist campaigns and are not easily deterred once they set their sights on a particular target. GAM filed a preliminary proxy on February 6th, which includes the shareholder proposal submitted by SPE. The proxy also states that SPE is proposing to elect three of its own nominees as directors of the company. The Board of Directors of GAM has unanimously opposed the shareholder proposal and is recommending shareholders to vote against it. The board’s statement of opposition lists the standard multitude of reasons why they believe that the proposal is not in the best interest of shareholders. Many of the reasons are valid, but it is very difficult to argue that an event resulting in an instantaneous narrowing of the fund’s discount would not be beneficial to all shareholders. Since it is not the focus of this article, I won’t attempt to address the individual bullet points presented by the board. The list is too long to summarize, so please refer to pages 12-15 of the preliminary proxy for the details. Conclusion There are many different scenarios that can play out during this activist campaign. The most likely scenario is that the Board of Directors of GAM pursues a smaller buyback in order to placate Mr. Goldstein and avoid a proxy fight. Two of Bulldog Investors’ recent proxy fights may provide some insight into the potential expected outcomes. Firsthand Technology Value Fund (NASDAQ: SVVC ) entered into an agreement with Bulldog last May. Under the terms of the settlement , Bulldog agreed to withdraw its nominees for the fund’s Board of Directors and withdraw its proposals regarding termination of the fund’s investment management agreement. They also agreed not to present any proposals at the annual meeting and to vote their shares in accordance with the Board’s recommendations. In return, SVVC approved a plan to repurchase up to $10 million of common stock in the open market, and to conduct a self-tender offer for at least $20 million worth of common stock at 95% of net asset value. The fund also agreed to liquidate its Facebook (NASDAQ: FB ) and Twitter (NYSE: TWTR ) holdings and to distribute any net realized gains from those holdings to shareholders within 60 days of completing those liquidations. Facebook and Twitter accounted for close to 30% of the fund’s holdings at the time of the announcement. The net result for SVVC shareholders who submitted shares for tender was a return of more than 45% of their capital at close to NAV. Bulldog was also recently successful in pressuring Nuveen Investments to restructure two of its closed end funds and conduct a tender offer for 25% of the outstanding common shares at 98% of net asset value. Nuveen Global Income Opportunities Fund (MUTF: XJGGX ) and Nuveen Diversified Currency Opportunities Fund (MUTF: XJGTX ) were combined into a new fund called Nuveen Global High Income Fund (NYSE: JGH ). The net result for JGH shareholders who submitted shares for tender was a return of more than 43% of their capital at 98% of NAV. It is likely that SPE would agree to a similar proposal from GAM. Unfortunately, there is not a high probability of SPE’s proposal garnering more than 50% of shareholders’ votes due to the constituency of General American’s shareholder base. Only 30% of the outstanding shares are held by institutions and mutual funds. Small investors who own the remaining 70% of the fund tend to be apathetic when it comes to voting proxies. Let’s examine a few possible scenarios with hypothetical probabilities: Hypothetical Return Scenarios For GAM Outcome Potential Return On Shares Tendered At Current NAV Discount % Of Shares Submitted For Tender Total Return Probability Of Occurrence Probability Weighted Return Fund Liquidates Or Converts To Open-End Mutual Fund 13.94% 100% 13.94% 15% 2.09% Fund Initiates Tender Offer For 25% Of Outstanding Common Shares At 98% Of NAV 13.66% 49% 6.97% 40% 2.79% Fund Initiates Tender Offer For 10% Of Outstanding Common Shares At 98% Of NAV 13.66% 49% 2.79% 25% 0.70% Management Takes No Action And NAV Discount Remains Unchanged 0% 0% 0% 5% 0% Management Takes No Action And NAV Discount Widens To Five Year Low Of 16.4% -2.46% 0% -2.46% 15% -0.37% Expected Return 5.21% Although the above scenarios are hypothetical, they provide a framework to help assess the potential returns associated with different outcomes. They also reflect my best guess as to the final result. My opinion is that the majority of scenarios offer a favorable risk-reward profile for a market neutral position, long GAM common vs. short the S&P 500 ETF (NYSEARCA: SPY ). My recommendation is to enter into a market neutral position: long GAM and short 1.1X the dollar amount of the S&P 500. The reason for suggesting a hedge ratio greater than one to one is to account for the fact that the fund often employs leverage of approximately 16%, which magnifies returns relative to the S&P 500. The fund also held 8.5% of its assets in money markets as of year end, which will offset some of the effects of leverage. A one to one hedge ratio would not be my preference due to the aforementioned factors. The obvious risks to this trade are that GAM’s correlation to the S&P 500 breaks down and leads to an underperformance in GAM’s net asset value relative to the S&P 500. Another risk is a further widening of GAM’s discount to NAV. While these risks are by no means negligible, the broad diversification of the fund’s large-cap holdings tend to make it unlikely to diverge too much from the S&P 500. The fund’s discount to NAV has averaged approximately 14.3% for the past one, three, and five years, which is close to the current discount. The discount did, however, fall below 20% during the height of the financial crisis in 2008 and 2009. It is highly likely that the discount would widen dramatically again if another market panic sets in. Lastly, the success of this strategy hinges solely on SPE’s ability to succeed in its proxy campaign. The close of business on February 17, 2015 has been fixed as the record date for the determination of the stockholders entitled to notice of, and to vote at, the shareholder meeting. Investors who want to vote in favor of SPE’s proposal must purchase shares on or before February 10, 2015. Disclosure: The author is long GAM, SPE, SVVC, JGH. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I am currently long “GAM”, “SPE”, “SVVC”, and “JGH” and short “SPY”. I may initiate long or short positions in any or all of the aforementioned securities over the next 72 hours. I plan to vote in favor of SPE’s shareholder proposal and its nominees to the board of GAM.

The Impact Of Cash Flow On Asset Allocation Decisions

Guest Post: By Chris Scott Investors trying to make decisions on how to invest their savings face many complications that are frequently ignored in research papers on asset allocation. Often, it is assumed that a fixed lump sum of money is invested. But this is rarely the case in real-world investing for the individual investor. Typically, an investor will be either accumulating funds or drawing down funds, which results in regular cash flows into or out of investment accounts. These cash flows can have a significant impact on the investment results obtained, and therefore, should influence asset selection and asset allocation decisions. The objective of asset selection/asset allocation is to maximize return for a given amount of risk. When evaluating investment assets and making asset allocation decisions, asset volatility is a bad thing. Higher volatility typically means more risk. Higher volatility also reduces the geometric mean of returns (compound returns). When there are no cash flows into or out of an investment, this reduction in return from volatility drag (VD) can be estimated by: Or, to be more precise, we can calculate: VD is one of the reasons for generally trying to avoid or limit assets with high levels of volatility. However, periodic cash flow into an account changes the impact volatility can have on geometric returns. With regular contributions to an investment account, you are dollar-cost averaging into the investment. When the price of the investment increases, you purchase fewer shares. When the price of the investment decreases, you purchase more shares. To see how periodic cash flows into an account affect the geometric return of volatile investments, I ran a monte carlo simulation utilizing a normally distributed zero return investment with varying levels of volatility. Regular periodic cash flows of a fixed size were invested on a monthly basis. The size of the monthly cash flow tested ranged from 0.1% to 100% of the total initial account value. Each simulation trial was run for 60 months. After 100,000 trials for each set of parameters, the results of the trials were averaged. The graph below shows that even modest regular cash flows into an investment reduces the negative impact volatility drag can have on geometric returns. (click to enlarge) These are hypothetical results, and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. How do things change when using historical returns which exhibit serial auto-correlation, fat tails, and skewness? I repeated the simulation using monthly US stock market returns from 1926 to the present (returns are from the Ken French data library ). The returns were de-meaned and scaled to a desired standard deviation (average return is subtracted from each monthly return to produce a time series with an arithmetic average of zero, then multiplied by a scalar to increase/decrease the standard deviation). This results in 1000 5-year overlapping periods. The outcome shows that with actual returns, there is slightly more reduction in volatility drag compared to the monte carlo simulation. For reference, the monthly standard deviation for US stock market returns since 1926 has been 5.4%. (click to enlarge) These are hypothetical results, and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. So we can see that positive cash flow into an investment reduces the negative impact of volatility on returns, but that doesn’t mean an investor should blindly seek out volatility when there are significant positive cash flows into an account. Volatility hurts geometric returns. Ultimately, achieving good results is still about investing in assets with high expected returns. Typically, an investor will avoid or limit investments in high-volatility assets due to their risk. Positive cash flow into high expected return, high-volatility investments can reduce their perceived riskiness. To illustrate this, let’s consider the following assets: US cap-weighted stock market, US decile 10 momentum stocks – equal-weighted, and long-term US Treasury bonds (LTR). These three assets provide a set of risky assets with a range of returns and volatilities. Monthly Statistics LTR Mkt. Mom. Average Return 0.5% 0.9% 1.8% Standard Deviation 2.4% 5.4% 7.4% Using monthly returns from 1/1927 to 7/2014, rolling 5-year periods were simulated with varying levels of positive cash flow. (click to enlarge) These are hypothetical results, and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Historically, decile 10 momentum stocks produce fantastic returns, but with high volatility and drawdowns. Consistent with the previous simulations, average geometric returns improve with fixed regular monthly investments. With their lower volatility, long-term bonds show very little improvement, while decile 10 momentum stocks add 90 basis points of return for the high-cash flow scenario. The following charts represent drawdowns in a portfolio’s value, including the added funds invested. In other words, no adjustment is made for the increasing value of cash invested. So, if an investment experiences a decline of 10%, then additional cash of 5% is added to the portfolio that month, and it is treated as a 5% drawdown. (click to enlarge) These are hypothetical results, and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. (click to enlarge) These are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. (click to enlarge) These are hypothetical results, and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. With funds being invested monthly, the depth and duration of drawdowns are significantly reduced. Of course, the investment risk hasn’t changed, and the improved drawdown metrics are mostly a function of adding funds. The investment still experiences severe drawdowns in market crashes and the returns during the crash are horrible, but the pain of the drawdowns is muted by the cash flows. While it seems easy to discount this effect, it can provide an important mental benefit to the investor. The illusion of a rapid recovery in value can make the high-return/high-volatility asset seem more tolerable, enabling the investor to allocate more to risky assets, and therefore improving long-term results. It should be obvious that the 100% cash flow scenario applies to a young investor with no savings who is starting to invest. However, long-time investors who have built up substantial portfolios may wonder if any of this is useful for an investor whose cash flow into their investments is now small relative to their total portfolio value. Even in the case where an investor’s additional contributions are small relative to the entire portfolio, there still can be high positive cash flow situations. Due to government tax rules, there are significant restrictions on moving funds between different classes of accounts (IRA, Roth IRA, 401k, etc.). For example, if you change jobs, you start over with a brand new 401k account. You can rollover your 401k from your previous employer to an IRA to take advantage of the better investment options available in a brokerage IRA. The new 401k account will start with a zero balance, with no opportunity for funding other than from monthly payroll contributions. The 100% cash flow scenario would also apply to this case, providing an opportunity to allocate more to higher-risk/higher-expected return assets in the new 401k than in the other accounts. Now let’s look at what happens when there are negative cash flows. As you would expect, negative cash flow from a volatile investment further reduces geometric returns. Using monthly returns from 1/1927 to 7/2014, rolling 5-year periods were simulated with varying levels of negative cash flow. (click to enlarge) Again, long-term treasuries show little impact to geometric returns, but the momentum stocks’ geometric returns were reduced by 26 basis points at the highest withdrawal rate. So, there’s an impact from negative cash flow, but at sane withdrawal rates, the return reduction is fairly small. The impact to the drawdown metrics is more dramatic, but not always in the way you would expect. (click to enlarge) Maximum drawdowns worsen with increasing negative cash flows. These Great Depression drawdowns illustrate the extreme case of things going bad for a retiree invested in equities! (click to enlarge) Long-term treasuries suffer from their low returns, showing significant average drawdowns as the withdrawal rate increases. (click to enlarge) While the withdrawals seem to have a minimal impact on the portfolio recovery time for equities, that’s not the case. This chart only represents the recovery time where the portfolio recovered by the end of a 5-year period. On the next chart, you can see the significant increase in periods that ended without recovering from the drawdown. (click to enlarge) In the end, even with negative cash flow, it’s still about investing in assets with high expected returns. One could argue that taking withdrawals would naturally result in a declining portfolio value, which is to be expected and okay as long as you don’t run out of money, and therefore the worsened drawdown statistics with withdrawals are not relevant. However, the mental impact to a newly retired investor of a portfolio that declines and doesn’t recover year after year after year can be significant. I’ve intentionally only used individual assets rather than diversified portfolios to illustrate the impact of cash flows on risk and returns. By combining uncorrelated assets into a diversified portfolio, the overall risk/return characteristics of the investment can be improved, while all the same principles and effects associated with cash flows still apply. Ultimately, it is up to each investor to determine how much risk they can take and still sleep at night. Having an understanding of how your portfolio – and the assets in it – behave when there are positive or negative cash flows is an important aspect of getting a good night’s sleep! Original Post