Tag Archives: seeking

Examining An ETF Strategy For Your U.S. Equity Exposure

Summary Reviewing several ETFs with exposure primarily to the U.S. equity space to see which combination will produce the highest risk-adjusted returns. I have used a mixture of large, mid, and small cap ETFs to get broad exposure to the U.S. stock market. Using fifteen years of historical data, I believe increasing exposure to a smaller-cap ETF will produce higher long-term risk-adjusted returns. With Christmas just around the corner, many investors begin their focus on asset allocation and reviewing their portfolios. It has been a turbulent year for global equities with many different macro events affecting returns throughout the world. With the recent economic news coming out of the U.S., specifically the Friday jobs report and the imminent rate hike from the Fed later in December, I’ve turned my focus onto the U.S. equity space to ensure my exposure to this market is balanced, poised for long-term growth, and well-diversified in terms of sectors. For the purposes of this article, I have narrowed down my selection of ETFs to include those that are simply focused on different market capitalizations within the U.S. equity space. That means I have eliminated funds that may be dividend-focused, value/growth focused, sector-specific, or other specialty funds. I’ve done this to keep my analysis simple and ensure I get as broad and diversified as possible. Once I narrowed it down my list, I had three broad categories – Large Cap, Mid Cap, and Small Cap – as defined by the fund companies themselves. Next, I wanted to focus on just a few from each category to see which performed better. For the Large Cap ETFs, I chose the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ). For the Mid Cap space, I chose the iShares Core S&P MidCap ETF (NYSEARCA: IJH ) as well as the SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ). Finally, for the Small Caps I only had one fund that had enough historical data to do the simulation, so I chose the iShares Core S&P Small-Cap ETF (NYSEARCA: IJR ). Timing When I was narrowing down my list of ETFs, I wanted to ensure they have been active long enough to see some of the more significant events of the last decade and a half. That way, the results would capture the tech bubble, the financial crisis, as well as the bull markets that accompanied them. Since most of the iShares ETFs were launched in May 2000, I chose to begin my analysis on July 1, 2000. SPY data by YCharts Assumptions All the daily share price data was pulled from Yahoo! Finance and I used the adjusted close price for all of my analysis. In addition, I used the 3-month treasury bill rates from the Federal Reserve website for each calendar year to calculate excess returns and risk-adjusted returns. Finally, I pulled the most recent MER information for each fund from Yahoo! Finance as well and reduced each year’s gross returns by that percentage before calculated the excess return information. Analysis Below is the summary of each of the five funds performance over the 15 years of data. To make my analysis easier, I used the last trading day of each year to calculate the yearly portfolio return to compare against the risk-free rate. (click to enlarge) Sources: Yahoo! Finance, Federal Reserve website As can be seen above, the small cap fund IJR offers the highest risk-adjusted return profile of the five funds I analyzed. Furthermore, you should note that as you move from the large cap funds of SPY and DIA to the mid-caps and then small, both absolute and risk-adjusted returns become stronger. I found this to be quite interesting as typically smaller cap funds comparatively have higher risk profiles. Since I wouldn’t recommend having all your U.S. equity exposure in one fund, I calculated some hypothetical portfolios with different weights for each of the three categories. From the data above, I also was able to narrow down which fund to use for each category; DIA for the Large Cap, IJH for Mid Cap and IJR for Small Cap. I also used $10,000 as a starting investment for each portfolio. Portfolio #1 – One third (1/3) invested in each of the three funds Portfolio #2 – 50% invested in the small cap, 25% in the others Portfolio #3 – 50% invested in the large cap, 25% in the others I found it quite interesting, although not surprising, just how much stronger the performance was on portfolio #2, which had 50% invested in the small cap ETF and ultimately how it also offered the strongest Sharpe Ratio. Overall, portfolio #2 outperformed the “standard” portfolio #1 by over 4.3% and the large-cap focused #3 by almost 12%. I also wanted to look at the sector breakdown of each fund to see if there was a significant difference in the three portfolios based on how the funds would be split up. As you can see below, there is some variance in the sector breakdown of each fund as you move from the large to small caps as well as with each portfolios’ hypothetical breakdown, but there is nothing overly significant to note. Most of the funds keep a relatively similar balance in the sectors with the exception of Real Estate which has zero exposure in the DIA. Conclusion I’ve always been well aware of the fact that, over longer periods of time, small cap stocks will tend to outperform large caps. For the most part, I was always of the impression that this higher return came with higher risk. However, after doing this analysis and seeing the results I would be inclined to increase my overall U.S. equity exposure to smaller cap companies as I am looking to hold onto this portfolio for an extended period of time. This sort of analysis is something I will continue to do each year to ensure if there are significant changes in the performance and risk profile of each fund that I capture them and adjust my investments accordingly.

Cheap Funds Dupe Investors – Q4 2015

Summary Comparison of AUM in funds with attractive holdings versus attractive costs. Distribution of ETFs and mutual funds by Predictive Rating and our two component ratings. Commentary on the shortcomings of traditional ETF and mutual fund research. Fund holdings affect fund performance more than fees or past performance. A cheap fund is not necessarily a good fund. A fund that has done well in the past is not likely to do well in the future ( e.g. 5-star kiss of death and active management has long history of underperformance ). Yet, traditional fund research focuses only on low fees and past performance. Our research on holdings enables investors to find funds with high quality holdings – AND – low fees. Investors are good at picking cheap funds. We want them to be better at picking funds with good stocks. Both are required to maximize success. We make this easy with our predictive fund ratings. A fund’s predictive rating is based on its holdings, its total costs, and how it ranks when compared to the rest of the 6700+ ETFs and mutual funds we cover. Figure 1 shows that 69% of fund assets are in ETFs and mutual funds with low costs but only 1% of assets are in ETFs and mutual funds with Attractive holdings. This discrepancy is astounding. Figure 1: Allocation of Fund Assets By Holdings Quality and By Costs Sources: New Constructs, LLC and company filings Two key shortcomings in the ETF and mutual fund industry cause this large discrepancy: A lack of research into the quality of holdings. A lack of high-quality holdings or good stocks. With about twice as many funds as stocks in the market, there simply are not enough good stocks to fill all the funds. These shortcomings are related. If investors had more insight into the quality of funds’ holdings, I think they would allocate a lot less money to funds with poor quality holdings. Many funds would cease to exist. Investors deserve research on the quality of stocks held by ETFs and mutual funds. Quality of holdings is the single most important factor in determining an ETF or mutual fund’s future performance. No matter how low the costs, if the ETF or mutual fund holds bad stocks, performance will be poor. Costs are easier to find but research on the quality of holdings is almost non-existent. Figure 2 shows investors are not putting enough money into ETFs and mutual funds with high-quality holdings. Only 94 out of 6706 (1% of assets) ETFs and mutual funds allocate a significant amount of value to quality holdings. 99% of assets are in funds that do not justify their costs and over charge investors for poor portfolio management. Figure 2: Distribution of ETFs & Mutual Funds (Count & Assets) By Portfolio Management Rating (click to enlarge) Source: New Constructs, LLC and company filings Figure 3 shows that investors successfully find low-cost funds. 69% of assets are held in ETFs and mutual funds that have Attractive-or-better rated total annual costs , our apples-to-apples measure of the all-in cost of investing in any given fund. Out of the 6706 ETFs and mutual funds we cover, 1524 (69% of assets) earn an Attractive-or-better Total Annual Costs rating. Clearly, ETF and mutual fund investors are smart shoppers when it comes to finding cheap investments. But cheap is not necessarily good. The PowerShares S&P SmallCap Utilities Portfolio ETF (NASDAQ: PSCU ) gets an overall predictive rating of Very Dangerous because no matter how low its fees (0.32%), we expect it to underperform because it holds too many Dangerous-or-worse rated stocks. Low fees cannot boost fund performance. Only good stocks can boost performance. Figure 3: Distribution of ETFs & Mutual Funds (Count & Assets) By Total Annual Costs Ratings (click to enlarge) Source: New Constructs, LLC and company filings Investors should allocate their capital to funds with both high-quality holdings and low costs because those are the funds that offer investors the best performance potential. But they do not. Not even close. Figure 4 shows that less than half (49%) of ETF and mutual fund assets are allocated to funds with low costs and high-quality holdings according to our Predictive Fund Ratings, which are based on the quality of holdings and the all-in costs to investors. Figure 4: Distribution of ETFs & Mutual Funds (Count & Assets) By Predictive Ratings (click to enlarge) Source: New Constructs, LLC and company filings Investors deserve forward-looking ETF and mutual fund research that assesses both costs and quality of holdings. For example, the PowerShares KBW Property & Casualty Insurance Portfolio ETF (NYSEARCA: KBWP ) has both low costs and quality holdings. Why is the most popular fund rating system based on backward-looking past performance? We do not know, but we do know that the transparency into the quality of portfolio management provides cover for the ETF and mutual fund industry to continue to over charge investors for poor portfolio management. How else could they get away with selling so many Dangerous-or-worse rated ETFs and mutual funds? John Bogle is correct – investors should not pay high fees for active portfolio management. His index funds have provided investors with many low-cost alternatives to actively managed funds. However, by focusing entirely on costs, he overlooks the primary driver of fund performance: the stocks held by funds. Investors also need to beware certain Index Label Myths . Research on the quality of portfolio management of funds empowers investors to make better investment decisions. Investors should no longer pay for poor portfolio management. Disclosure: David Trainer and Blaine Skaggs receive no compensation to write about any specific stock, sector or theme.

Is The Market Fair? Yes Vs. No

Summary Yes. Mostly. But not entirely. 3 recent exploitable examples. Is the market fair and efficient? Yes. Well, almost always. The second best piece of news I have for you is that markets work quite well. Few activities allow for so much success for the people who don’t even try. If you sign up for a marathon and get to the starting line but don’t try to run, you lose to every other runner. If you don’t try to beat the market, you simply sign up for an index fund or buy a passive ETF in the S&P 500 (NYSEARCA: SPY ), you beat about three quarters of other investors. No. Not entirely. The best piece of news I have for you is that market prices fail sometimes – and do so in ways that are exploitable for profit. One of the best books to date on the subject has one of the worst titles: You Can Be A Stock Market Genius . It reveals the world of spinoffs, merger securities, bankruptcy, restructuring, recapitalizations, stubs, and warrants. It is in such investment opportunities where the price system often fails to accurately reflect underlying value. Today, there are three such investment opportunities where the price system continues to fail. These are not prices that are off a bit. They are prices that are wrong. They include share class trades such as CBS / CBS.A , parent/sub stubs such as Yahoo! (NASDAQ: YHOO ), and closed-end fund IPOs such as CCD . CBS There are two related opportunities in CBS. The first is that there are two share classes, each with the same economic value. According to the company, CBS Corporation has two classes of common stock: Class A, which is the voting stock, and Class B, which is the non-voting stock. There is no difference between the two classes except for voting rights. Shares of CBS Class A and Class B common stock generally trade within a close price range of each other. There are, however, more shares of Class B common stock outstanding, and most of the trading occurs in that class. The second is that it is unlikely that CBS remains a standalone company after a transition from its 92-year-old founder and executive chairman departs his role. (click to enlarge) So, it is reasonable to expect the price difference to converge. Given the likelihood that it will get a takeover premium, it is probable that the convergence is upward from the current market prices. What should one do with such situations? CBS Class B shares (NYSE: CBS ) are probably a bargain around $50 per share, even if it remains a standalone company. They are even better if Time Warner (NYSE: TWX ) or someone else buys CBS after Redstone’s tenure. But what is even more interesting is that the share class spread will probably go to zero in such a deal. One way to capture this spread is to buy the B shares ( CBS ) while writing calls on the Class A (NYSE: CBS.A ) shares. For example, you can write May 2016 CBS.A $50 calls, These have a $5.40 bid and a $7.50 ask. This is an attractive amount of premium to capture in addition to the share class spread. In an efficient market, this opportunity should not exist. But it is there for the taking. Yahoo! Net of cash, Yahoo Japan, and Alibaba (NYSE: BABA ), the public capital market valued Yahoo’s core business at $0.11 as of the beginning of this month. The structure can probably be resolved in a number of different tax-efficient ways according to this recent analysis. Reasonable people can differ on the value of the core business, but the stub is probably worth somewhere in the range of $4-$5 per share. $0.11 is just wrong. Net of cash and the exposure to BABA and Yahoo Japan, if the process goes badly and the company performs poorly, the stub should at least double. If the process goes well and the company performs well, the stub should at least double again. CEF IPOs The CEF IPO is an opportunity to lose 8% of your money quickly, then much the rest slowly. They are useful for investors because they are the financial world’s equivalent of a ski mask on a warm sunny day in that any broker caught with one has identified himself as a likely swindler. While I am a longtime skeptic of boom era IPOs generally, my skepticism is greatest when it comes to initial public offerings of closed-end funds. With industrial IPOs, there is some pre-existing corporate asset being supplied. With CEFs, the IPO is driven by the demand. What CEFs get IPOed? Whatever the retail mass market wants. Whatever is most in favor, priced-in, or trendy is what gets invented and then sold to the trusting public. At least industrial IPOs initially pop 16% or so on average on the first day and only later lose investors’ money. But with CEF IPOs, there is not even that initial pop. Then, average CEFs are down about 8% within three months, 13% within five months, and 19% within a year. While there is a market inefficiency in the repeated ability to sell such CEFs to the public for a 5-10% premium to NAV, the market is subsequently efficient at wrenching that premium out of the price. Over a billion dollars of value has been transferred from CEF investors to underwriters on day one. That is about 8% of the money that they invested. There is zero evidence of skill in the (typically expensive) management of the remaining 92% of their money. It is instructive that only about 4% of investors in new CEFs are institutional investors compared with the 22% of investors following similar industrial IPOs. One recent example is Calamos Dynamic Convertible and Income (NASDAQ: CCD ). This has been a smashing success… for its underwriters are brokers. These wealth transfers are useful tools for investors to identify brokers who are willing to do anything and say anything to take your money. So far, it is right on schedule. The market squeezed out massive underwriting fees, losing 11% of value in 100 days (slightly ahead of the -8% historical average) and 25% within five months, well ahead of the -13% pattern such funds have seen in the past. This was not a problem; this was the plan. These can be good opportunities to buy at deep discounts to NAV. Nobody sells shares for no good reason like an investor who bought them for no good reason. By the time they have sold off, the investors are probably in the market for a new broker while the broker is in the market for his next mark. Conclusion The market is good. It is good enough to trust in its general fairness and approximate efficiency. You can put all of your money in passive exposure to equities, debt, and cash with the confidence that – on average and over time – you will get what you pay for. But it is also imperfect. For diligent bargain hunters, some durable inefficiencies include occasional share class spreads, cheap parent-subsidiary stubs, and broken CEF IPOs. It is possible to beat the market over the long-term by judiciously selecting securities within such categories. Is the market efficient? I find much of the academic literature that indicates significant efficiency to be persuasive, yet in my direct experience, I keep finding lucrative exceptions. What do you think and what have you found? Please use the comment section below to weigh in with your findings.