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New ETFs Offer Alternative Approaches To Income And European Equity Markets

By DailyAlts Staff Bond prices have been falling over the past several months as investors are becoming increasingly convinced that the Federal Reserve will hike short-term interest rates in the U.S. later this year for the first time since 2006. Higher short-term borrowing rates will increase the rates of return demanded by investors, and newly issued bonds with higher interest rates will make existing bonds at fixed yields less attractive by comparison – this will be bearish for the bond market. Higher rates are also likely to give the dollar strength, relative to foreign currencies, since higher-yielding currencies are more attractive to foreign investors. These factors make for a challenging environment for investors, but fortunately, new liquid alternative products have been designed to address the challenges of higher interest rates and a volatile foreign exchange market. Two such products – the Global X YieldCo Index ETF (NASDAQ: YLCO ) , offering non-bond investment income; and the PowerShares Europe Currency Hedged Low Volatility Portfolio ETF (NYSEARCA: FXEU ) , providing European equity exposure without the currency risk – both launched in May. YieldCo Index ETF YieldCos are an “emerging asset class of income-generated assets,” according to a statement announcing the launch of the Global X YieldCo Index ETF. Most YieldCos, which are often compared to Master Limited Partnerships (MLPs), are in the renewable energy sector. “YieldCos exhibit three key investment characteristics many investors have been looking for: high current income, lower volatility, and the potential for dividend growth,” according to Jay Jacobs, a research analyst at Global X Funds. YieldCos are typically formed when existing energy companies spin off assets such as wind or solar farms, with long-term contracts designed to return cash to shareholders. Unlike MLPs, YieldCos are set up as traditional corporations and therefore don’t require K-1 tax forms. “We are excited to provide investors with access to a new source of potential alternative income, which has traditionally been limited to MLPs and REITs,” said Mr. Jacobs. “YLCO allows investors to participate in this growing field of yield-generating renewable energy projects.” The expense ratio for YLCO is 0.65%. For more information, visit the ETF’s fund page at globalxfunds.com . Currency-Hedged Low Volatility The PowerShares Europe Currency Hedged Low Volatility Portfolio ETF is based on the S&P Eurozone Low Volatility USD Hedged Index, and aims to provide investors with exposure to European stocks without the currency risk and with dampened volatility. The index is based on a simple methodology: The 80 stocks from the S&P Eurozone BMI Index with the lowest realized volatility over the past 12 months are selected and then weighted inversely according to volatility. The portfolio is then 100% currency-hedged to the U.S. dollar using rolling one-month forward contracts that are adjusted monthly. “International investing is often accompanied by the risks of uncertain stock selection and foreign exchange fluctuations,” said Dan Draper, Managing Director and Head of Invesco PowerShares, in a recent statement. “FXEU allows participation in the European equity market’s potential upside while aiming to protect portfolios from potential market downturns.” The expense ratio for FXEU is 0.25%. For more information, visit the fund’s product page .

Avoiding The Pitfalls Of Factor-Based Investing

By DailyAlts Staff The proliferation of smart beta ETFs may be a relatively recent phenomenon, but the risk factors used to construct smart-beta indexes – most notably value, momentum, low beta, quality, illiquidity, and size – have been a popular topic for financial researchers for nearly three decades. Building off the early handful of factors, factor-based investing has since been expanded to as many as 250 distinct factors that have allegedly generated historical outperformance, but Research Affiliates’ Jason Hsu, Vitali Kalesnik, and Vivek Viswanathan argue that the supposed outperformance of most (if not all) of these new factors is illusory, based on cherry-picking by researchers and “artifacts” of the data. In fact, Mr. Hsu and his colleagues believe at least one of the traditional factors may be unlikely to generate superior risk-adjusted returns going forward. The researchers make their case in the Summer 2015 edition of The Journal of Index Investing , in an article titled “A Framework for Assessing Factors and Implementing Smart Beta Strategies.” Factor Robustness Hsu, et al. allege that economists, financial researchers, and other quantitative analysts are constantly trying to determine new factors, and that only their positive results are likely to get published. New research undermining an existing and semi-popular factor is unlikely to make it to the stage of peer review, according to Research Affiliates. This means that investors, advisors, and other decision-makers must test would-be factors for robustness themselves. Behind the quantitative data, Hsu, et al. insist that factors must be based on economic intuition and make sense within a theoretical framework – otherwise, they’re likely to be statistical noise. Factor premiums can be based on risk or behavioral issues, but in either case, they should span across geographic markets. If back-testing reveals a factor premium for U.S. stocks, that same premium should be evident in Japan and elsewhere. But when analyzed across geographic regions, only the value and low-beta factors consistently hold up; while momentum, quality, and illiquidity are mixed; and size shows no consistency whatsoever. (click to enlarge) Factor Perturbations Since legitimate factors must make intuitive sense, it stands to reason that they should hold up under “perturbations” of their definitions. For example, the value factor is typically defined with book-to-price ratio, but dividend yield and earnings yield (earnings-to-price) also make sense. Therefore, if the value premium were only evident when measured according to book-to-price, the theoretical framework would crumble. Fortunately for value investors, Research Affiliates’ research indicates that value holds up well under a variety of definitions – as do the momentum, low-beta, and illiquidity factors – but quality and size do not. (click to enlarge) Size Doesn’t Matter? According to Hsu, et al., the small-size factor premium is based on back-testing that includes several months of major small-cap outperformance back in the 1930s, and the factor has not generated alpha since its discovery in the early 1980s. Of course, the 1930s were a time of deflation (strengthening dollar) and the 1980s kicked off a 30-year bull market in bonds (weakening the dollar), which could play a significant role in the data. Today, it is generally assumed that small-cap stocks – with a higher degree of U.S. dollar exposure – benefit from a strong currency. Implementation and Allocation Hsu, et al.’s paper looks into implementation and allocation issues, as well, and notes that transaction costs are rarely taken into account by factor-based investors – and this is a mistake. To maximize risk-adjusted returns, factor-based investors should rotate their portfolios only as often as is necessary to capture the factor premium, and no more. The authors say that factor allocation faces many of the same challenges as asset allocation, and that smart-beta solutions should be customized to meet individual investors’ unique risk tolerances. For more information, visit researchaffiliates.com to download a pdf copy of the paper .

Utility CEFs For Defensive Income

Summary Utilities have gone from overvalued to a more reasonable valuation. At appropriate valuation, the utility sector offers opportunity for defensive income investing. This article summarizes nine utility closed-end funds with a median distribution yield of 7.6%. Only a few months ago the utility sector was overvalued. Such is the nature of a bond-substitute investment when bond yields collapse and investors look for safe income elsewhere. But the sector has given back 15% since last January’s high and overvaluation is much less the case. (click to enlarge) Figure 1: Dow Jones Utility Average ( google finance ). Although still about 7% above the 52 week low, the sector has been trading below its 20, 50 and 100 day simple moving averages, and appears to have found support recently (see chart in Fig. 1). An income investor wary about the prospects of a looming correction may well be considering this background as a reason to focus attention on this most defensive of sectors. When I’m looking for income investments, my first stop is to look to closed-end funds. For one thing, CEFs can provide excellent income relative to ETFs or holding individual stocks. For another, CEFs tend to overreach sector movements, so when a sector like utilities approaches bargain territory, sector CEFs may exaggerate the apparent value. Utility Closed End Funds Cefconnect.com lists nine utility funds. These are summarized below: Fund Market Cap % USA Blackrock Utility & Infrastructure Trust (NYSE: BUI ) $314,921,520 72.7% Duff & Phelps Global Utility Income Fund Inc. (NYSE: DPG ) $694,255,355 57.0% Wells Fargo Advantage Utilities & High Income Fund (NYSEMKT: ERH ) $108,982,680 46.4% Gabelli Global Utility & Income Trust (NYSEMKT: GLU ) $77,567,946 61.5% Gabelli Utility Trust (NYSE: GUT ) $298,074,054 100.0% Macquarie/First Trust Global Infrastr/Util Div & Inc Fund (NYSE: MFD ) $137,707,333 41.8% Macquarie Global Infrastructure Total Return Fund Inc. (NYSE: MGU ) $306,986,780 36.6% Cohen & Steers Infrastructure Fund Inc (NYSE: UTF ) $1,877,774,640 58.0% Reaves Utility Income Fund (NYSEMKT: UTG ) $844,916,800 100.0% Two of the nine are purely domestic; the others are global in scope. All but one of the funds currently sells at a discount to NAV. GUT maintains a premium of 28.4%. This leaves the Reaves Utility Fund as the only wholly domestic utility CEF to be priced at a discount (-4.15%). Figure 2. Premium/Discount status of Utility CEFs ( cefanalyzer.com ) Distributions Distributions range from a low of 6.1% to a high of 8.7%. Median distribution for the nine funds is 7.6%. Figure 3. Utility CEF distributions on price and NAV (cefanalyzer.com). Typical of closed-end funds, these distributions exceed that of utility ETFs such as, for example, the Guggenheim S&P 500 Equal Weight Utilities ETF (NYSEARCA: RYU ) with a current yield of 5.3% or the iShares Global Utilities ETF (NYSEARCA: JXI ) currently yielding 3.14%. The enhanced yields are achieved by the usual equity closed-end fund strategies of leverage (for 8 of the funds) and option-writing for the remaining fund. In addition, some of the funds generate income from utility debt instruments including bonds and preferred shares. (click to enlarge) Figure 4. Percent leverage for utility CEF portfolios (cefanalyzer.com). Total Returns The following charts show total returns on NAV and Market Price for 1, 3 and 12 months. Figure 5. Total return for utility CEFs on NAV (top) and Market Price (bottom) basis (cefanalyzer.com). None has turned in a gain on NAV for the past month, as one would expect from the utility sell-off noted in Figure 1 above. GUT has managed a positive price return over that time as its premium has increased from an already high 25% to 28%. During this time most of the remaining funds have seen their discounts deepen. Z-Scores Looking carefully at these return performance charts it becomes clear that for several of the funds, price returns are not tracking NAV returns. BUI, for example has suffered declines in market price while turning in respectable gains on NAV relative to its peers. This situation can be demonstrated most effectively by looking at Z-scores, which quantify the relationship between current premium/discount and mean premium/discount status. Figure 6. Z-Scores for 3, 6, and 12 months for utility CEFs (cefanalyzer.com). The Z-scores for GUT illustrate the extent to which its premium has been increasing relative to its average status for this metric. The current premium is more than 2 standard deviations greater than the average premium for each of the time periods shown. Contrast that with BUI whose discounts for 3 and 12 months are approximately 3 standard deviations below their means with Z-scores of -3.1 for both 3 and 12 months and -2.4 for 6 months. UTF, DPG and ERH also have low negative Z-scores. If one believes that reversion to mean discount/premium status is a likely predication, then these three funds would seem attractively priced on this basis. Summary and Selections Investors seeking high-income yield with defensive characteristics may want to look carefully at the utility sector. I think it’s a fair generalization that defensive investing is not something one normally associates with leverage, so the inclination would be to look to funds with no or minimal leverage. For the nine closed-end funds that comprise the sector’s offerings, only one is effectively unlevered (BUI, 0.9% leverage). The remaining funds carry 15% to 36% leverage. Investors who choose to focus on domestic utilities have only two choices: GUT and UTG. To my thinking there is no contest between the two; GUT’s unsustainable premium takes it out of my consideration. UTG sells at a discount of -4.1%, but this is somewhat higher than its 3 and 12 month mean discounts, and higher than all but one of the 8 discounted funds (MFG at -1.8%). UTG’s distribution yield (6.24%) is the second lowest of the group. The remaining funds carry discounts from -12 to -14%. One of these stands out for having an exceptionally deep discount relative to its historical status. BUI’s yield is an attractive 7.8%, a bit above the median yield of 7.6% for all the funds. These factors, along with its unleveraged status, makes it my choice from this group of funds. In closing I’d like to present a snapshot of the portfolios of my two picks here. Both are nearly entirely equity. UTG includes 4% MLPs and less than 1% preferred stock and corporate bonds. Both are more diverse than strict utility-sector portfolios. BUI holds 53% Utilities, 25.7% Energy and 12.5% Transportation. UTG breaks its portfolio down by industry rather than sector, with the top three being Multi-Utilities, 27.8%; Oil, Gas & Consumable Fuels, 18.5%; and Transportation Infrastructure, 16.03%. Top ten holdings for each are: UTG   NextEra Energy Inc (NYSE: NEE ) 5.25% DTE Energy Holding Company (NYSE: DTE ) 4.87% ITC Holdings Corp (NYSE: ITC ) 4.72% Union Pacific Corp (NYSE: UNP ) 4.66% Verizon Communications Inc (NYSE: VZ ) 4.25% American Water Works Co Inc (NYSE: AWK ) 3.94% Duke Energy Corporation (NYSE: DUK ) 3.65% SCANA Corp (NYSE: SCG ) 3.64% Dominion Resources Inc (NYSE: D ) 3.57% BCE Inc (NYSE: BCE ) 3.45% Time Warner Cable Inc A (NYSE: TWC ) 3.10%         BUI   NextEra Energy Inc 4.35% CMS Energy Corp (NYSE: CMS ) 3.86% Sempra Energy (NYSE: SRE ) 3.81% Dominion Resources Inc 3.77% Dominion Midstream Partners LP (NYSE: DM ) 3.62% Shell Midstream Partners LP (NYSE: RDS.A ) 3.52% Duke Energy Corporation 3.37% National Grid Plc (NYSE: NGG ) 3.31% Atlantia SPA ( OTCPK:ATASY ) 2.96% American Water Works Co Inc 2.78% Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in BUI over the next 72 hours. (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.