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Stocks And Gold: A New Balanced Portfolio

High valuations and low rates make it necessary to build balanced portfolios. Gold can be a good diversifier for US stocks. Trend following approaches can add value. Leonardo Da Vinci is credited with stating that “simplicity is the ultimate sophistication.” Daniel Khaneman added credence to Da Vinci’s belief in his book, Thinking Fast and Slow . Khaneman pointed out that “complexity may work in the odd case, but more often than not it reduces validity.” In essence, Khaneman made the case that simpler is in fact better. The same is most likely true for investing. Despite the fact that our financial system is filled with complex financial products, and often chaotic feedback mechanisms, simple investment strategies tend to work better over the long run. For example, over the last decade, an investor would have been better served to buy a low cost S&P 500 index fund over investing in active managers. Over 80 percent of the active managers failed to outperform their respective benchmarks over that period. This is despite their large research teams, sophisticated investment strategies, and years of training. The simple process of buying an index fund and holding it over the ten year period would have been superior. Index funds are great, but buy and hold is hardly the optimal investment strategy. The macroeconomic environment, valuations, and the prevailing price trends should be considered. Simple, rules-based approaches can be used to adequately account for dynamic markets. The article, Value and Momentum: A Beautiful Combination , is a great example of using two simple, yet opposed systems, to formulate a sound overall investment methodology. The purpose of this paper is to explore a new twist on a balanced approach to investing through a simple system. Courtesy of Doug Short US stocks are severely overvalued by most measures that demonstrate historical accuracy. Chart 1 gives a pretty good summary of the overvalued state of stocks using several respected measures of market valuation. Thus, long-term investors should diversify their investment in the US equities market with other asset classes. The first thought that normally comes to mind is to diversify in different asset classes of equity. Many value investors would point to the undervalued emerging and international stocks suggesting that they may offer better future returns than the US stock market. The problem with this idea is that global stocks tend to be highly correlated with US markets during periods of stress. During the summer months of 2008, most stock market asset classes fell together. Correlations between different classes of equity moved towards one, signifying a lack of diversification and an increase in portfolio risk. Bonds are also typically referenced as a good diversifier when paired with equity investments. This is normally the case as bonds have a tendency to dampen the volatility of the overall portfolio over time. The problem with diversifying into bonds in a long-term portfolio is the fact that interest rates are historically low and we are thirty years into a bond bull market. At some point, in the next twenty years, one would expect interest rates to be higher than the current rates. That expectation could lead to poor returns for bonds, especially if all the monetary stimulus turns around to haunt us with inflation. Consequently, it made sense to us to scour other asset classes with historically low correlations to stocks but with the ability to protect a portfolio against inflation or rapidly rising interest rates. With the backdrop of accommodative central banks, record debt levels in developed nations, slow growth, and deflationary conditions, gold became the asset class of choice. Partly for the controversy, as investors hate and love the yellow metal. Our view of gold is primarily price related as we are quantitative investment managers. However, from a fundamental perspective, gold makes a lot of sense as a portfolio hedge. It is a currency in its basic form and hedges against the fall of other global currencies. Therefore, we decided to test out a new balanced investment approach where we diversified US stocks with gold. Since we do not believe that volatility is risk, we did not determine our weightings to stocks and gold through volatility targeting or risk budgeting approach. Living up to our heretic ways, we instead equally weighted the two asset classes and ran a comparison versus the S&P 500 from 1972 through 2014. The hypothetical results were as follows: (click to enlarge) Chart 2: Stocks vs. Stocks & Gold Clint Sorenson, CFA, CMT Data Courtesy of NYU Stern School of Business, Global Financial Data, Morningstar1 The two strategies did a good job growing the initial investment over the time period. Although, the drawdown was much less for the portfolio of 50 percent stocks and 50 percent gold. The S&P 500 fell more than 55 percent during the time period referenced above. The 50 percent stock and 50 percent gold portfolio fell a maximum of 31 percent. Growth was similar between the two strategies. $1 million invested in 1972 would have become over $72 million in the S&P 500 through 2014. The same amount put into the balanced portfolio would have turned into almost $59 million. Obviously, the S&P 500 would have been the overall winner in a competition of growth over this period of time. We decided to apply a simple trend following method to the balanced portfolio for further comparison. The rules are as follows: Measure each asset class (US Stocks and Gold) against their 8 month simple moving averages If the closing monthly price is above the moving average, the portion of the portfolio would be invested in the asset class (Buy Signal) If the closing monthly price is below the moving average then the portion of the portfolio would be invested in the 10 year US Treasury (Sell Signal) The following table embodies all possible portfolio allocations: Allocation Range Stocks (NYSEARCA: SPY ) 0-50% Gold (NYSEARCA: GLD ) 0-50% US Ten Year Treasury (NYSEARCA: IEF ) 0-100% Applying the simple buy and sell discipline to the balanced portfolio makes all the difference historically. Since 1972 $1 million invested in the trend following approach grows to over $286 million. This is significantly more than the S&P 500 or the static 50/50 (Stock/Gold) portfolio. Furthermore, the growth comes on the back of reduced drawdown. The maximum drawdown of the trend following portfolio is only slightly more than 18 percent. Applying the simple trend filter allows for enhanced return and reduced risk. Historically, it has made sense to rent bonds during periods where stocks and gold have entered negative trends. (click to enlarge) Chart 3: Trend approach to Gold and Stock portfolio Clint Sorenson, CFA, CMT Data Courtesy of NYU Stern School of Business, Global Financial Data, Morningstar2 It is our opinion that we are in the third equity market bubble in the past fifteen years. Historically high valuations, large amounts of public and private debt, unprecedented monetary support, and negative real interest rates have challenged the common approaches to portfolio construction. We hope we have demonstrated a way to simplify diversification using a portfolio of stocks and gold. A sound investment approach does not have to be complicated to generate attractive results. 1. For the 50/50 strategy of Stocks and Gold, we used index data through 2005 and then ETF data from 2006 through 2014. We used SPY to replicate the S&P 500 and GLD to replicate gold. 2. For the trend following strategy of Stocks and Gold, we used index data through 2005 and then ETF data from 2006 through 2014. We used SPY to replicate the S&P 500, GLD to replicate gold, and IEF to replicate the 10 year Treasury bond.

Best And Worst Q4’15: Energy ETFs, Mutual Funds And Key Holdings

Summary The Energy sector ranks last in Q4’15. Based on an aggregation of ratings of 21 ETFs and 59 mutual funds. OIH is our top-rated Energy ETF and FSESX is our top-rated Energy mutual fund. The Energy sector ranks last out of the 10 sectors as detailed in our Q4’15 Sector Ratings for ETFs and Mutual Funds report. The Energy sector funds won last place in the prior quarter as well. It gets our Dangerous rating, which is based on aggregation of ratings of 21 ETFs and 59 mutual funds in the Energy sector. See a recap of our Q3’15 Sector Ratings here . Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the sector. Not all Energy sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 25 to 150). This variation creates drastically different investment implications and, therefore, ratings. Investors seeking exposure to the Energy sector should buy one of the Attractive-or-better rated ETFs or mutual funds from Figures 1 and 2. Figure 1: ETFs with the Best & Worst Ratings – Top 5 (click to enlarge) * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings The PowerShares Dynamic Oil Services ETF (NYSEARCA: PXJ ) is excluded from Figure 1 because its total net assets are below $100 million and do not meet our liquidity minimums. Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 (click to enlarge) * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings The Van Eck Market Vectors Oil Services ETF (NYSEARCA: OIH ) is the top-rated Energy ETF and the Fidelity Select Energy Service Portfolio (MUTF: FSESX ) is the top-rated Energy mutual fund. OIH earns an Attractive rating while FSESX earns a Neutral rating. The PowerShares DWA Energy Momentum Portfolio ETF (NYSEARCA: PXI ) is the worst-rated Energy ETF and the BP Capital TwinLine Energy Fund (MUTF: BPEAX ) is the worst-rated Energy mutual fund. Both earn a Very Dangerous rating. National Oilwell Varco (NYSE: NOV ) is one of our favorite stocks held by Energy ETFs and mutual funds. It earns our Attractive rating. Over the past four years, National Oilwell has grown after-tax profits ( NOPAT ) by 11% compounded annually. The company earns a return on invested capital ( ROIC ) of 8% and has generated over $1.1 billion in free cash flow on a trailing twelve-month basis. Across the energy industry, share prices have been collapsing over the past year, but National Oilwell’s business does not deserve the decline in its shares. At its current price of $38/share, NOV has a price to economic book value ( PEBV ) ratio of 0.6. This ratio implies that the market expects National Oilwell’s profits to permanently decline by 40% from current levels. If National Oilwell can grow NOPAT by just 1% compounded annually over the next five years , the stock is worth $80/share today – a 110% upside. It’s easy to see just how low the expectations baked into NOV have become. Tesoro Corporation (NYSE: TSO ) is one of our least favorite stocks held by Energy ETFs and mutual funds and earns our Very Dangerous rating. Since 2011, Tesoro’s NOPAT has declined by 1% compounded annually despite the oil industry witnessing high growth rates prior to 2014. Over the same timeframe, Tesoro’s ROIC has fallen to 6% from 12%. Despite the deterioration of the business, TSO has increased nearly 400% since 2011, which has left shares greatly overvalued. To justify its current price of $102/share, Tesoro must grow NOPAT by 10% compounded annually for the next 11 years. This scenario seems rather unlikely given that NOPAT has only declined lately. With such lofty expectations embedded in the stock price, it’s easy to see why Tesoro is one of our least favorite Energy stocks. Figures 3 and 4 show the rating landscape of all Energy ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst ETFs (click to enlarge) Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Mutual Funds (click to enlarge) Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Thaxston McKee receive no compensation to write about any specific stock, sector or theme.

Q4 Outlook For REIT ETFs

After a strong performance last year, the real estate investment trust (REIT) space has lost ground this year, largely reflecting Fed-centric anxieties. The total return from the FTSE NAREIT All REITs Index decreased 4.52% for the year through September 30 against a 27.15% positive return in 2014. The group’s recent weak performance notwithstanding, the outlook for REITs remains favorable. The Fed uncertainty no doubt remains a dominant theme for the industry, but the central bank appears in no hurry to start the monetary policy normalization process, particularly following the recent bout of soft economic data. The “bad data”, ranging from weaker job additions in September, the decline in counts in the two ISM surveys, the dip in the Consumer Price Index (CPI) and weak manufacturing activity have raised doubts about reaching the Fed’s inflation rate target for a rate hike. Now, October seems to be almost off the table, and chances of a December hike are trending low, adding further cheer to the REIT space. No doubt, REITs’ dependence on debt for acquisitions, development and redevelopment activities make them gainers when rate remains low. Also, their dividend yield grabs investors’ attention more than yields on fixed income and money market accounts in times like this. But a low rate environment cannot be a perpetual one. While REITs (those having shorter leasing periods) with the power to adjust their rent quickly to a rate hike look quite bankable, the individual market dynamics of different asset types owned and managed by the REITs would be needed the most for the stocks to excel. After all, everything is not possible virtually, and one will eventually need “real space” for economic activities. For this special hybrid class, this is their most fundamental strength, and their ability to boost shareholders’ value through steady dividend payouts makes them all the more attractive. Dividends Still Standing Tall U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends. And as of September 30, the dividend yield of the FTSE NAREIT All REITs Index was 4.44%, while the yield of the FTSE NAREIT All Equity REITs Index was 3.97%. Clearly, the REITs continue to offer decent yields and outpaced the 2.28% dividend yield offered by the S&P 500 as of that date. Capital Access Moreover, REITs have been proactive in the capital market in recent years, leveraging the low rate environment to improve their financials. As of September 30, REITs raised over $49.0 billion in initial, debt and equity capital offerings (IPOs – $1.4 billion, Secondary Common – $20.3 billion, Secondary Preferred – $2.1 billion and Secondary Debt – $25.3 billion). This indicates the rise in investors’ confidence in this sector and their willingness to pour money into it. Exploring the Sector Through ETFs In this backdrop, we believe this is the right time to explore the sector through ETFs, so as to reap the benefits in a safer way. Considering the return prospects from dividend income and capital appreciation, we have tracked the following REIT ETFs, which could be worth considering: Vanguard REIT Index ETF (NYSEARCA: VNQ ) The fund, launched in 2004, seeks investment results by tracking the performance of the benchmark MSCI US REIT Index, which is used to gauge real estate stocks. The fund consists of 145 stocks of companies which acquire office buildings, hotels, and other real property. The top three holdings are Simon Property Group Inc. (NYSE: SPG ), Public Storage (NYSE: PSA ) and Equity Residential (NYSE: EQR ). It charges 12 basis points (bps) in fees (as of May 28, 2015). VNQ managed to attract $26.2 billion in assets under management till October 16, 2015. iShares U.S. Real Estate ETF (NYSEARCA: IYR ) Launched in 2000, IYR follows the Dow Jones U.S. Real Estate Index that measures the performance of the real estate industry of the U.S. equity market. The fund comprises 118 stocks, with its top holdings including Simon Property Group Inc., American Tower Corporation (NYSE: AMT ) and Public Storage. The fund’s expense ratio is 0.43% (as of August 31, 2015) and the 12-month trailing yield is 3.94% (as of September 30, 2015). It has around $4.4 billion in assets under management as of October 16, 2015. SPDR Dow Jones REIT ETF (NYSEARCA: RWR ) Functioning since 2001, RWR seeks investment results of the Dow Jones U.S. Select REIT Index. The fund consists of 97 stocks that have equity ownership and operate commercial real estate, with the top holdings being Simon Property Group Inc., Public Storage and Equity Residential. The fund’s expense ratio is 0.25% (as of October 19, 2015), and the dividend yield is 3.21% (as of October 15, 2015). RWR has over $3.1 billion in assets under management (as of October 16, 2015). Schwab U.S. REIT ETF (NYSEARCA: SCHH ) This fund debuted in 2011 and tracks the total return of the Dow Jones U.S. Select REIT Index. It consists of 97 stocks that own and operate commercial real estates. The top three holdings are Simon Property Group Inc., Public Storage and Equity Residential. It charges 7 bps in fees (as of October 9, 2015), while the trailing 12-month distribution yield is 2.39%. SCHH boasts $1.7 billion in assets under management (as of October 16, 2015). First Trust S&P REIT Index ETF (NYSEARCA: FRI ) Launched in May 2007, FRI is an ETF that seeks investment results of the S&P United States REIT Index, which gauges the U.S. REIT market and retains consistency, depicting the overall market composition. The fund comprises 157 stocks, with the top holdings being Simon Property Group Inc., Public Storage and Equity Residential. The fund’s net expense ratio is 0.50% (as of May 1, 2015) and the 12-month distribution rate is 2.73% (as of September 30, 2015). FRI has about $206.5 million in net assets under management (as of October 16, 2015). Original Post