Search This Blog


Monday, September 15, 2014

Should You Hedge the Currency Risk on Your European Stocks ?

The outlook for the European economies has moved lower in the past weeks. This due to the immediate news of the crisis in the Ukraine and sanctions as well as weaker economic data. In response the European Central Bank has engaged in another round of interest rate easing with every intent of keeping this policy in place for an extended period of time. An additional goal of the policy is to weaken the Euro making exports more attractive.

Where does that leave the outlook for European stocks. I have noted in earlier blogs that the European stock markets carry significantly lower valuations than US stocks and Germany in particular has fallen sharply as a result of the Ukraine crisis.

I have also noted that investing in European stocks, particularly through the ETFs is not as much an investment in the economies of those countries but rather in a group of major multinational corporations. Those corporations carry lower valuations than US stocks but compete with them around the world. A weaker dollar will make the European companies more price competitive. Additionally remember that the weaker US economy and stronger dollar vs the Euro will hit US multinationals' exports to Europe.

  1. So with the case for European stocks perhaps not as negative as the headlines should one hedge the currency risk...the impact of a lower Euro cutting into the returns of European stocks for US investors (already reflected in the US$ price of Europe ETFs trading in the US?

There are three things that I learned in over a decade working in the currency markets prior to working with individual investors.

  1. Exchange rates are notoriously difficult to predict. But...
  2. Exchange rates tend to move based on interest rate differentials--money flows out of low interest rate currencies to higher interest rate currencies (the "carry trade" is a major factor traders/investors borrow in the lower interest rate currency and invest in the higher.
  3. Once a trend is established in currencies it tends to last for a considerable period of time...but when that reverses it reverses sharply
  • With regard to  the ECU/$ exchange rate we can point to to the following factors already in place:
  1.  The interest rate differential (higher dollar) in place..and the US is in a mode of  looking to raise interest rates after a long period of Central Bank policy cutting rates...the date is unknown but the direction is. The ECB on the contrary has indicated it plans to keep rates low for an extended period. In other words the interest rate differential is near certain not to reverse and the likelihood is very high it will widen
  2. The ECB favors a weaker Euro
  3. A strong trend towards a weaker Euro agains the $ is already in place. Ten year chart below:

What does a weaker Euro mean for investors in European stocks through a US $ denominated ETF:
a lower dollar will reduce any gains on the European stock investment and of course increase losses.

What can be done: One of the great things about ETFs is that the innovation and competition gives access to individual investors strategies that were once available only to large institutional investors. In some cases it gives them access to strategies they would be better off avoiding. But in the case of currency hedging this is a great innovation.

There are several ETFs which hedge (eliminated) the currency risk from European stock investments. Many of them are new, not liquid and have minimal assets under management...likely a good idea to avoid them However the Wisdomtree hedged European ETF(HEDJ) has none of those issues and is worth considering.Although it is tied to an index different than those of the major Euro area etfs (EMU and FEZ) the holdings are close enough to make it an effective hedge.

Here are the top 20 holdings in HEDJ with their % of the portfolio  as you can see almost all of the top holdings are major multinational companies(with the notable exception of two major Spanish banks)

1. Anheuser-Busch InBev NV (ABI) BE 6.08
2. Banco Bilbao Vizcaya Argentari (BBVA) ES 5.67
3. Telefonica SA (TEF) ES 5.65
4. Sanofi-Aventis SA (SAN) FR 4.98
5. Banco Santander SA (SAN) ES 4.77
6. Unilever NV (UNA) NL 4.42
7. Siemens AG (SIE) DE 4.27
8. Daimler AG (DAI) DE 4.00
9. Bayer AG (BAYN) DE 3.14
10. LVMH Moet Hennessy Louis Vuitt (MC) FR 2.83
11. L\''Oreal SA (OR) FR 2.82
12. Bayerische Motoren Werke AG (BMW) DE 2.80
13. E.ON SE (EOAN) DE 2.36
14. Sap AG (SAP) DE 2.32
15. Schneider Electric SA (SU) FR 1.94
16. Koninklijke Philips Electronic (PHIA) NL 1.87
17. Danone (BN) FR 1.74
18. Heineken NV (HEIA) NL 1.35
19. ACS Actividades de Construccio (ACS) ES 1.35
20. Airbus Group (AIR) NL 1.33

As the Euro has weakened as of late due to ECB policies the use of  HEDJ has shown its usefulness not only has the currency risk been eliminated the gain on the exchange rate has offset declines in the European stocks

But in all investments nothing is guaranteed, Over the last 12 months hedging away the currency risk has reduced returns over considerable periods of time.

The strategy of replacing an etf with currency risk (FEZ,EMU for example) with a hedged currency etf like HEDJ for all of part of one's European stock investment might be worth a look.

But remember that not all European ETFs contain only ECU denominated stocks. VGK for example contains a large allocation to UK stocks of course denominated in Sterling. The Bank of England has moved to a tightening mode. Between last September and the beginning of July Sterling was on a strong positive trend rising from $1.60 to $1.70...before falling back to close to $1.60 since July in response to the possibility Scotland will vote to breakaway from the UK....thus demonstrating how difficult exchange rates are to predict.

Tuesday, September 9, 2014

You May Be Surprised I Agree WIth This Article

The WSJ carries an interesting article making the case for a simple 3 ETF portfolio

Many "Bogleheads"—a group of investors who favor index investing as inspired by Vanguard Group founder John Bogle —suggest a three-fund portfolio consisting of the U.S.-focused Vanguard Total Stock Market Index fund, Vanguard Total International Stock Index, and Vanguard Total Bond Market Index. Together, the three mutual funds, which also offer ETF shares, track more than 15,000 global securities.
One possible allocation is 40% U.S. stocks, 20% international stocks and 40% bonds. That Vanguard portfolio, rebalanced annually, returned an average of 7.14% a year over the last decade, a little less than the 8.07% return of the Dow Jones U.S. Total Stock Market Index and the 8.62% return of the MSCI All Country World ex USA index, and well above the 4.52% return of the Barclays U.S. Aggregate Bond Index.

You might be surprised to know that I have no problems with that advice.
As a reader of this blog can no doubt see I think there are ways to improve on this allocation: tilting the portfolio towards value stocks and holding a different mix of international and bond allocations thatn those in the instruments listed above.
But someone holding such a portfolio would be better off that probably 90% of other investors certainly better off than those that fill their portfolio with actively managed mutual funds and individual stocks.  Not only are portfolios the choice of many "do it yourselfers" they are also the portfolios many clients hold when they are wroking with a broker or advisor.,,,not to mention those that have "special products' or "alternative investments" in their holdings.
Of course there is one other requirement that is noted in the article
Experts also are quick to point out that even a simple portfolio needs tending—investors shouldn't just set it and forget it.
"The biggest pitfall [for all investors who decide on an asset mix and invest accordingly] is behavioral, when people don't want to rebalance," says Brad McMillan, chief investment officer at Commonwealth Financial Network in Waltham, Mass., and San Diego. For instance, if equities have taken a hit, you should consider buying more equities and selling off other asset classes, and "that's extraordinarily hard to do," he says.
In fact it could be argued that one valuable function of an advisor is simply to prevent...or point out and try to prevent...clients from falling into all the behavioral pitfalls in investing ...which seem invatiably to result in buying high and selling low.
One system for choosing what funds to hold in a portfolio clearly ist the right path choosing funds based on the Morningstar "stars" rating sysem.
A WSJ article reviews the record of 5 star funds
Take a list of the top-rated mutual funds from years ago—those with five-star ratings from Morningstar Inc. MORN -0.43% —and look at them now. The sobering fact: You'll see many once-proud, five-star funds have dropped to four stars, three stars or worse.....
a separate study suggests it is even more difficult for a leading fund to stay at the top: S&P Dow Jones Indices analyzed 715 top-performing mutual funds, focusing on U.S.-stock funds for the past four years through March, and found that only two stayed in the top 25% through a four-year period.
A lot of advisers, of course, think everyone should put their money in low-cost index funds because managers can't beat the market over the long term.(Put me in that camp)
But hope springs eternal (and the folk at the WSJ have bills to pay and morningstar has reports to sell).
So the article adds te following
 For those who are looking for more-active managers, though, the Morningstar data offer lots of lessons.
Seems to me the better lesson is to skip the actively managed funds.

"Slippage The Hidden Costs of Managed ETF Porftolios

Among the costs of actively managed mutual funds often cited by critics such as John Bogle is the hidden cost of “market impact”. Market impact is the change in market price created when a large mutual fund decides to liquidate or initiate a position in a particular stock. Depending on the size of the trade and the particular stock the active fund manager can find that as he buys (sells) stock he pushes the price up (down) increasing the impact on the funds returns.

Portfolios made up of ETFs were thought to alleviate this problem. Trades were to be infrequent and when the trades were exercised in relatively small amounts by individual investors the impact would be small. However the growth of large “managed ETF programs” and “robo advisors” may mean that the “slippage factor” may have returned through these programs reducing the returns for investors in these programs.

Managed ETF programs have grown tremendously over recent years as brokers and investment advisors “outsource” the management of ETF portfolios to large managers. The strategies and frequency of the trading varies. But observers have already noted that the large trades can have significant impact on market prices. The impact can be further aggravated because some of these managers both manage accounts directly and issue “buy and sell alerts” which individual advisors and large brokerage firms implement on their own. Thus not only are there trades directly from the advisor entering the market but trades from other sources making the same buy/sells as well. The result when the orders hit the market is that the trades can move the market creating the same ‘slippage” as active stock manager’s experience. For the client that means an unseen cost.

An article by Matt Hougan in  focuses on the large flow created by some of these managers although it doesn’t specifically reference the slippage article. He writes that through use of the fund flow data on the website it is possible to isolate ETF activity that generates one time large trade flows and those that represent a trend in flows in and out of an asset class. He notes that often there are large flows in a particular ETF even though similar flows may not be present in other ETFs in an asset class.

He offers the example of large one day flows in three US treasury etfs, His explanation:
The fact that all those flows occurred on one day suggests that a single large investor made these decisions, as opposed to "investors" in general. In fact, we can probably even guess which investor made these bets: Good Harbor Financial.
Good Harbor is a large, well-run ETF strategist firm with $10 billion invested in quant-driven ETF strategies. It rebalances its portfolios twice a month—once on the 15th and once at the end of the month—which coincides perfectly with the timing of these flows (due to settlement delays, fund flows don't always appear the day an investor buys a fund).
What we're seeing in the flows for IEF, SHY and IEI is Good Harbor getting nervous, not the market in general. That's a worthwhile signal—Good Harbor has a great track record—but it's just one opinion. And in fact, a quick glance at this morning's preliminary flows numbers suggest big outflows in both SHY and IEI, two of the Good Harbor targets in question.

I have no idea whether Good Harbor is a well-run strategist with a good track record or not. I do know that by looking at the flows from their trades and the market behavior on those days it is clear that their trading has a market impact. It also seems quite possible that if an analyst like Mr. Hougan knows the dates of the rebalancing then so do some market participants who may try to profit from that information to the detriment of Good Harbor. The examples in his articels  are from Etfs in US Treasuries which have large numbers of assets, large daily volume, and good liquidity, yet the trades by this one manager clearly have impact on the market in those ETFs. It would only be reasonable to assume such impact would be even greater in the case of other less liquid ETFs.

 The charts of the one month flows from are below. Below each graph I have put a price/volume graph (2 months) of the same ETF. In all three cases there was an increase in the day’s trading indicator of market volatility—relative to other trading days. In fact there are other large trading range days that also occur on the 1st and 15th of the month the rebalancing dates for Good Harbor.

Here's the chart for IEF in August fund flows for August and below it price/volume for July and August

And here is the same data for SHY

And here for IEI

Good Harbor is only one of a number of large managed ETF portfolio managers. Many market participants have noted that their trades can have significant intraday market impact which may be a drag on returns. As the assets under management of these managers grows the impact is likely to increase. Furthermore there is a rapid growth in robadvisors internet based portfolio management with allocations that are rebalanced at fixed dates. As these grow there is more potential for increasing the number of large trades that create volatility and perhaps distort prices for brief periods

What are the implications for individual investors? That is the subject of my next blog on the subject.

Monday, September 8, 2014

More Bad News for Active Managers

The latest edition of the Standard and Poors SPIVA report that evaluates active fund managers vs their benchmark indices has just come out. The results seldom differ much
 As Reuters reports:

S&P Dow Jones Indices just published its mid-year scorecard of S&P indices versus active funds (SPIVA). Active funds are the funds that attempt to offer some sort of superior return relative to some benchmark.
"According to the data, 59.78% of large-cap managers, 57.84% of mid-cap managers and 72.79% of small-cap managers underperformed their benchmarks," said Aye Soe, director of index research and design. This is for the 12-month period ending June 30, 2014.
Fund managers have a knack for getting lucky over short-term periods. When you extend the performance period from 12-months to 5 years, the results are much uglier.
"The past five years have been marked by the rare combination of a remarkable rebound in domestic equity markets and a low-volatility equity environment," Soe added. "This combination has proven to be difficult for domestic equity managers, as over 70% of them across all capitalization and style categories failed to deliver returns higher than their respective benchmarks."

A Contrary Indicator ?


Market bears now scarcer than any time since 1987

Monday, September 1, 2014

Maybe Investors Should Worry More About Hong Kong and Less About the Ukraine

WSJ today

Hong Kong Election Ruling Stirs Fear Over City's Status as Finance Hub

Some Business and Political Leaders Warn Beijing's Decree Threatens to Undermine Pillars of Hong Kong's Success

Friday, August 29, 2014

Burton Malkiel on Stock Valuations in the US and in Emerging Markets

Prof Burtom Malkiel author of the investment classic Random Walks Down Wall Street has a column in the WSJ on stock valuations

On the US
There is a disagreement about the sustainability of current lofty stock market valuations.
One camp argues that the market is dangerously overvalued. The so-called CAPE ratio—the price-earnings multiple for the market based on cyclically adjusted earnings averaged over the past 10 years—stands at over 25, well above its long-run average of about 15. Today's CAPE has been exceeded only during the market peaks of 1929 and early 2000 and 2007.....
Another group of forecasters are convinced that stocks are reasonably valued. The main competitors for stocks in individual and institutional portfolios are bonds. And yields on fixed-income securities are at all-time lows. ...
While continued low rates can justify high stock prices, the CAPE followers are correct as well. Long-run equity returns from today's price levels are likely to be considerably lower than their 10% long-run average.......
On Emerging Markets
All equity portfolios should include emerging markets. Emerging markets, accessible through broadly diversified, low-cost, emerging-market exchange traded funds, represent half of global economic activity. ....
Emerging equity markets also have far more attractive valuations. CAPEs for emerging markets at less than 15 are little more than half the levels in the U.S., and they stand at ratios close to their all-time lows. Just as CAPEs do reasonably well predicting long-run returns in the U.S., so they are also effective predictors in emerging markets,