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Thursday, September 3, 2015

How are Those Alternative Asset Classes Working Out

So called "alternative asset classes" have gained increasing popularity over the last few years. In fact they are in included in the portfolios of "robo advisors" aimed at inexperienced small investors.

These instruments are touted as providing returns uncorrelated wit standard asset classes thus giving additional diversification. Another benefit that is marketed is as an income producer in an environment of low interest rates.

I think it was Warren Buffett who stated that when the tide goes out we can see who is naked. A review of some of the major "alternative asset classes' shows that in many cases they simply added risk often unanticipated to portfolios.

First off here are the major asset classes for comparison

ACWI total world equity  -4.9% ytd       -8% one month

VTI total US equities  -3.8% ytd            -6.8% one month

AGG total US bonds +.4% ytd                -.3% one month

Master Limited Partnerships
These have been seen as attractive due to their relatively high yield. But they also are concentrated in the energy sector. The price of oil has declined causing the same for the MLPs. Additionally as is the case in many of these assets they are all interest rate sensitive ad prospects of lower rates hurts their performance.

AMLP  -13.4% ytd  -3.2% one month

REITs  This is again seen as a good source of income stream and a diversifier to stocks. As s the case of  MLPs they are also highly interest rate sensitive

VNQ   -8% ytd  -7.7% one month

Commodities: This too has been touted as a diversfier away from stocks, It has generally been touted as an inflation hedge although the data on that is far from conclusive. A far better inflation hedge is inflation protected bonds. The increased exposure to commodities has not diversified portfolios from the recent market decline it has exacerbated it. The stock market selloff around the world began with China and the slower economic growth in China has driven commodity prices lower well before the stock selloff.In fact commodities have fallen so much earlier in the year that they actually have declined less than the world stock markets in the pas month.


-17.1% ytd -2.1% one month

Emerging market bonds: This has been a major target fro investment by those seeking higher yields than those available in US $ bonds. I have written numerous times that the modest pickup in yield is outweighed by the additional currency and other risks. The currency movements in emerging markets has hit this asset class hard.

-12.4% ytd  One month -4.6%

"Smart Beta"

"Smart Beta" has been a buzzword in investment industry over the last few years. Most of these are variants of value investing and these types of passive funds and etfs have existed for a long time.

Value strategies have suffered during the market rally which has been driven by momentum/growth stocks and have actually fallen more than the overall market last month. But these results should not be surprising value strategies are for patient investors and gain their long term performance during recoveries from market selloffs

VTV Large Value -6.9% one month  -6.4%

VBR Small Value  -5.9% one month      -5.4%

Dividend and Dividend Growth strategies: These have gained a tremendous following. Apparently there is a large group of investor either through mutual funds, stock picking or ETFs that have flocked to higher dividend stocks and those with a record or rising dividends. Many of these investors argue that as long as the portfolio throws off attractive dividends, the price fluctuations don't matter.I find this argument illogical but it is not the place to "debate" that here.

Such portfolios tend to be highly correlated with interest rate moves higher rates drives down prices. Also the great interest in these stocks has led to high valuations with sectors like utilities often reaching above market average p/es.

SDY dividend champions
-6.9% ytd   -6.4% one month

Momentum and Minimum Value

Two "smart beta" strategies that are relatively new to the ETF marketplace do offer something different and are based on some rigorous academic research. While there is never any guaranteed that what has worked in past markets will work in the future the results have been interesting.

These two seem to have in fact given exposure to factors different than"value" or "growth"

Momentum strategies have performed as advertised: stronger than market performance in strong up markets and potentially worse markets during selloffs and higher than market volatility. There is considerable overlap between momentum and "growth stocks" but there performances have differed.

MTUM  +2.5% ytd  -6.4% one month

Minimum Variance strategies are designed to be less volatile than the overall markets thus outperforming in down markets and underperforming in strong up markets and net providing better risk adjusted returns than the market. Although there is overlap with value indices they are distinctive enought to produce different returns

USMV     -1.1 ytd                -5.6% one month

Many researchers have argue that combing momentum and minimum volatility indices in a portfolio offers potential for better risk adjusted returns than the overall market. Time will tell the "live" data set when these instruments have traded is too short.

Monday, August 31, 2015

How Did Those Robo Advisors Do Last Week...We Will Likely Never Now

Robo advisors are to a large extent a black box. While the client can know his allocation he really has no idea how the transactions are executed in the markets. The past week trading was very erratic with many trading halts and large discrepancies between the trading prices of ETFs and the "intrinsic value" (value of the underlying securities) and wide swings in individual stock prices many transactions executed through any automated basis had a high likelihood at being executed at unattractive prices that didn’t represent "fair value" and were soon reversed.

August 24 was the most notable example with multiple trading halts and wide swings of ETF values. Any human being (like me) could look at a screen and know something was very wrong creating a trading environment that was best avoided. For example several of the dividend ETFs were trading at prices far lower than the drop in the S+P 500 Etf even though there was a large overlap in the holdings of the two. The dividend etf price simply couldn't represent fair value. And many stocks traded down close to 10% at the open and quickly recovered a significant part of those losses.

Investors should have learned long ago not to place stop loss" orders in the market as they are likely to be executed during "flash crash" type events when markets take unusual short term moves. A more sophisticated investor would also know that with the exception of a few of the largest ETFs it is bad trading practice or place market as opposed to limit orders. And in market conditions that prevailed most of the day on August 24 and at other times during the past week, the volatility and numerous trading halts for stocks made it best practice to simply refrain from trading.

Many of the algorithmic traders and high frequency traders that provide liquidity in normal markets simply did the same. Turning off their computers or placing very wide bid ask spreads. Market makers in ETFs unable to execute trades in many of the underlying stocks did the same. All of this further complicated market conditions and left those with market or stop loss orders literally paying the consequences.

It will be impossible to know how the robo advisors performed in these markets. At some point a researcher far more capable than me will measure the actual performance of the ETF portfolios of the "robos" vs the performance of the ETFs in their allocations based on market closing values. That would give some measure of any "value added" or "slippage" because of the transactions of these robo advisors.

The most interesting/complex test case of the impact of robo advisors execution is the case of Wealthfront.

Unlike other robo advisors which make use of ETFs. Wealthfront uses what it calls a" third generation tax loss harvesting strategy" which makes daily transactions which according to their description optimizes tax savings.

Wealthfront makes use of what it calls a unique tax optimizing strategy. There is a well-known strategy of tax loss harvesting of replacing one etf with a short term loss with another essentially identical ETF (for example two total US stock market ETFs) to realize a tax deductible loss without changing strategy. This is a widely used tax management tactic used by many individual investors and "non robo: advisors. 

In order to avoid "slippage" a loss in performance due to the trades in tax harvesting it is best to do this with tow essentially identical ETFs in quiet markets .An example would be a sale of a position in the Vanguard total stock market  Etf when there was an imbedded loss and when the ETF was down .5% for the day immediately executing the buy part of the tax harvesting with a purchase of the ishares total stock market etf when it is also down .5%. That would create the tax loss with no impact on portfolio performance. Any slippage between the two trades would affect portfolio performance. For instance in a volatile market the sale might be done with the one ETF down .5% and the purchase made when the other ETF in the trade was down only .2% the net "slippage" of .3% on the trade was the difference between the sell price and the buy price.

Wealthfront claims it is unique in two ways. Not only do they execute tax harvesting transactions on a daily basis they also do it with their own portfolios of individual stocks rather than with listed ETFs, generating individual stock trades. They call this "direct indexing"

 As Wealthfront explains it:
Instead of using a single ETF or Index Fund to invest in U.S. stocks, Wealth front’s Tax-Optimized Direct Indexing directly purchases up to 1,001 individual securities on your behalf — up to 1,000 stocks from the S&;P 500® and S&;P 1500® Indices and an ETF of much smaller companies.
This allows us to take advantage of the countless opportunities for tax-loss harvesting presented by the movement of individual stocks, to further improve your investment performance. Combined with our Daily Tax-Loss Harvesting service, we believe this could add as much as 2.03% to your annual investment performance.
Wealthfront uses a similar strategy in which it replicates the total stock market index with a smaller number of individual stocks.

Wealthfront does these transactions on a daily basis. The assumption is that this generates greater tax savings than for instance doing the tax loss harvesting periodically based on the status of the individual account simply swapping between two ETFs.

I am sure this "optimized" strategy works in back testing on a computer, although Wealthfront claim of a single number for client tax savings is questionable given the different tax status of individual clients. Wealthfront notes

But two other major questions remain:

There can be two drags on performance:

Does Wealthfront's replication strategy work? Since Wealthfront doesn’t actually buy the ETF does its replication match that of the corresponding ETF?

While the tax harvesting may create tax losses what is the impact on portfolio performance?

The large number of transactions increases the possibilities of slippage. The buys and sells in the accounts may not be executed at zero cost. The transactions may not be executed such that the net result of the buys and sells does not create an outcome lower than the movement in the S+P 500. So the tax savings may potentially be higher...but the large number of tax harvesting strategies may actually be a negative for portfolio performance.

 Wealthfront uses this strategy on accounts with balances as low as $10, 0000 meaning daily tax harvesting numbering possibly several hundred trades a year of tiny size.  Is it necessarily true that the net result of 100 individual stock trades generating $1000 a year in tax losses in a $10,000 account (a high number since it would be 10% of the account value) in tax harvesting losses produces a better outcome than one trade between ETFs generating that same $1000 in tax losses And of course the more trades particularly since they entail purchases and sales of individual stocks. The more opportunity for slippage. In fact with that number of trades the cumulative impact of the bid ask spread could add up significantly. And as Wealthfront grows. In assets its tax harvesting trades will have greater impact on the market, making it even more difficult to avoid slippage

Did the strategy that worked in computer research work in highly volatile markets? The history of markets is full or automated strategies that worked on research based on years of data. Until the markets hit a highly volatile period. When these strategies run into illiquid markets. Those outcomes predicted by computer modelling disappear. A notable example was "portfolio insurance" in 1987. As noted many algorithmic traders and high frequency traders have their own "circuit breakers" when markets get too volatile and/or valuations across securities seem to be far away from fair value they turn off the computers and watch the market chaos. Humans both professional and some nonprofessionals have learned the same thing: to sit back and wait under such market conditions.

But Wealthfront was active in the markets on August 24.

Wealthfront CEO   proudly told Bloomberg that Wealthfront's tax loss harvesting did over $200 million of trades on August 24...the most volatile trading day in years.

And this anecdotal article reports on a client notes

The account had been easy enough to set up—skim a few questions, assess a few options, and voilĂ —all within a few minutes from the comfort of our couch. But, on Monday, as the Dow tumbled more than 1000 points, he watched as the service rapidly rearranged his account on the fly. “I’ve been constantly refreshing,” he texted, “and it’s a roller coaster.”
He was startled, concerned, and a little bit confused. But the service was doing exactly what it was supposed to do. Betterment, Wealthfront, and FutureAdvisor say their services not only take the headache out of investing, but offer real opportunities when the market dips. The question is how well this will work—and how well the services can retain their clients—in the long-term, especially when the market takes a turn for the worst, or, one day, heads into a recession.
Wealthfront may have generated tax losses and as seen in the above quote rapidly adjusted portfolios (with account size as small as $10,000).but was what the impact on the performance. Wealthfront’s tax strategy entails buying and selling individual stocks. For the strategy to work there should be minimal "slippage" the down movement on the stock should be equal to the decline on the stock purchased. If not the net gain or loss will cause the portfolio return to differ significantly from the index performance.

Call me skeptical that Wealthfront was able to execute its tax loss harvesting strategy which involves buying and selling individual securities without significant slippage and thus drags on performance. On August 24 over 1200 stocks and ETFs had trading halts which are put in place when there are swings of 5% or more in the stock. Numerous stocks had volatile swings particularly at the open of trading. How did Wealthfront's optimized tax harvesting manage in these markets executing $200 million worth of trades ?

It certainly wouldn’t have been easy given the market environment. To give just two examples of the market environment on August 24 that would have been faced by Wealthfront's direct indexing consider he performance of two widely traded SP 500 stocks. Citigroup opened trading on August 24 at 48 traded 6% higher an hour later the spread between high and low for GE was even larger trading at the open at 19.87 before recovering to 23.87.

As Wealthfront actively traded on August 24 it isn’t hard to imagine that their trading got them caught taking "tax losses" at extreme lows and buying back other stocks that didn’t have similar losses. Buying a stock down 10% and replacing it with one that had fallen only 8% would result in a loss vs the index far in excess of any tax savings.

August 27 was another roller coaster as the Dow opened 200 points higher dropped 300 points mid-day and recovered 300 points at the close. It is reasonable to assume that Wealthfront’s tax harvesting trading was active throughout and also found it difficult to avoid slippage.

Analyzing Wealthfront’s tax management trading and its impact on performance vs the index it is trying to replicate would be extremely difficult if not impossible.. Most likely Wealthfront will keep that information proprietary and it will be difficult to ever discover.

But it is clear that tax harvesting strategy through replication is not as simple as it sounds. And in fact may produce little if any benefit compared to a far more simple strategy of periodically swapping between ETFs when there are "harvestable" tax losses that are significant. And to wait until markets are orderly to execute the trades. 

Thursday, August 13, 2015

Emerging Markets...This May Surprise You

The headlines of the past two months have been all about the "bursting of the bubble" in the Chinese stock market and more recently the impact of the Chinese currency devaluation announced this week.

I have written on a number of occasions that the term emerging markets has little usefulness since the countries that fall withing that category (and indices) are so diverse. China obviously has its own dynamic and in my view actually falls into a category of its own since it is an economy that can have great impact on emerging markets but the impact of those other emerging markets on China is limited.

Additionally the Asian non China emerging market countries have far different economies than those of Latin American countries, most of whom are dependent on commodity exports.

So looking around the emerging markets this year it is the Latin American emerging markets that have performed most poorly even worse than the Chinese A shares the epicenter of the Chinese stock market bubble bust.

Below are year to date  returns (growth of $100,000 top) returns and standard deviation bottom For emerging markets (VWO), Latin America (ILF),Emerging Asia (GMF) and China A shares (ASHR).I think many would be surprised that even after the bursting of the bubble. ASHR is not only the only one showing a positive return,.it's return is 7.4% almost 3 x as large as the S+P 500's 2.6%

Growth of $100,000 Year to Date

ASHR (gold) ILF (blue) VWO (black) GMF (green)

Total Return (top) Voaltility (bottom)

And here is the same data for the last 3 months even during this period of a 16.7% drop in the Chinese A Shares (ASHR), the Latin America fall was more severe -18.7%

Wednesday, June 10, 2015

More on Robo Advisors..How Well Do They Get to Know You Before Investing Your Money ?

I have written 2 previous posts on the shortcoming of robo advisors. Probably the most important is that they know virtually nothing about you before they determine your portfolio, They are not set up to take account of your tax situation which is crucially important as well as many other factors related to personal circumstances. For instane what if a  family plans to have additional children or an investor plans to make a radical career change such as leaving a job with a steady salary to start their own business ? It doesn't take much thought to imagine the many,many other factors that could be added to the list.

A comparison table of robo advisors below.lists the following as inputs uesed to determine a portfolio allocation:

Future Advisor: 2 factors: age and risk tolerance

Wealthfront 10 question financial questionaire

Wisebanyan questionaire risk score

You REALLY Don't Know What is Inside Your Mutual Fund

The biggest advantage to ETFa other than their low cost is their transparency, For those indices using publicly available indices one can know exactly what the portfolio owns at any time. Even if the fund falls into the category of those "smart beta" funds such as Powershares PRF and PRFZ the fund still has a selection process that doesn;t change a clear definition of where in the market it invests.

This is not the case for actively managed mutual fund. This is very often the case even if he fund is to target a particular sector of the market such as small cap stocks. If one looks at the prospectus the manager often has discretion to invest outside the category (in this case small caps) for a percentage or even at times all of the portfolio. The article notes

The WSJ has an excellent article pointing how hard it is both to know what an actively managed mutual fund is even more difficult to "get under the hood" to know more about the strategy the manager is pursuing.

What a Fund’s Top 10 Holdings Don’t Tell You

Top 10 lists are fun, easily digested and make people feel they are in the know. But a mutual fund’s list of top 10 holdings isn’t as satisfying.
That is because the listed holdings aren’t necessarily still the fund’s favorites.A mutual fund is permitted to delay reporting portfolio holdings for as long as 60 days following the end of its fiscal quarter. In practice, many funds publish a complete list of their holdings on their websites 30 days after the quarter ends. Top 10 holdings and their percentage weightings in the portfolio frequently are made available online monthly with a 10- or 15-day lag.s are frequently out of date, and don’t say much about overall strategy....

 top 10 holdings are just a starting point to evaluate a fund.“It’s only one piece of a broader puzzle as to how that fund is managed,” says Mr. Rotblut.
Fitting the pieces together requires digging into a mutual fund’s inner workings: long-term results, manager tenure and expenses. Investors also should be aware of the four P’s that investment advisers tend to consider when selecting funds for clients—investment process, the people managing the fund, their performance record and the reputation of the fund’s parent company....
The article also notes:
Research shows that for stock funds, factors including sector allocation and style consistency influence returns more than the selection of individual stocks. In other words, in evaluating a fund, where and how a manager invests is more telling than what’s being bought and sold. 
The style consistency problem is eliminated with most ETFs. Sector allocation is of course eliminated in the case of style specific ETFs or in the case of bonds bond ETFs designed to invest based on a particular index either broad bond market or specific maturity or type of bond.

Other factors mentioned are more or even fully transparent with ETFs
 Fitting the pieces together requires digging into a mutual fund’s inner workings: long-term results, manager tenure and expenses. Investors also should be aware of the four P’s that investment advisers tend to consider when selecting funds for clients—investment process, the people managing the fund, their performance record and the reputation of the fund’s parent company.

For ETFs long term results are far more useful because the methodology for the ETF is consistent for an actively managed fund past results say virtually nothing about future results especially since in many cases the manager changes over the period reported. Fees are transparent for ETFs and actively traded mutual funds...although there are ETFs available with fees far lower than active funds many below .10%.


 Portfolio turnover—a measure of trading activity—is also telling. If a fund’s turnover is greater than 50% annually, top holdings might shift even more rapidly. This is especially the case with small-cap and midcap stock funds, which tend to see more trading.Turnover below 50% indicates that management is being more patient and holding on to stocks longer. 
Portfolio turnover in an ETF is limited to portfolio rebalances and in virtually no cases does it come close to 50%.

Tuesday, June 9, 2015

MSCI On Including A Shares...Not Yet

MSCI announced that it was holding off on including A shares in it's emerging markets index.

MSCI Inc. held off from adding China’s mainland stocks to its benchmark indexes, opting to work with the nation’s securities regulator to overcome remaining obstacles to inclusion. Shares dropped in Shanghai.
The index provider expects to put yuan-denominated equities, also called A shares, in its global benchmarks after settling investor concerns about accessibility and share ownership through collaboration with the China Securities Regulatory Commission, according to a statement issued Tuesday. MSCI said a decision on inclusion may come at any time.
Chinese authorities have been pushing for an MSCI endorsement as they seek to elevate the status of mainland markets on the world stage and make the yuan a more international currency. Efforts to open up local shares to foreign investors, including an exchange link with Hong Kong, have already helped propel a $6.5 trillion surge in the value of Chinese equities over the past year.
“Some might regard it as disappointing that it didn’t happen immediately,” Shane Oliver, the head of investment strategy at AMP Capital Investors Ltd. in Sydney, which manages about $124 billion, said by phone. “By the same token, it looks like it’s going to happen anyway at some point. It’s just a question of when. They’ve just got some remaining issues to resolve.”
The Shanghai Composite Index retreated as much as 2.2 percent, before paring declines to 0.5 percent at the noon-time break.
The possible addition of mainland equities to MSCI’s global indexes has been a divisive issue among fund managers. Even as China’s stocks more than doubled over the past year, foreigners have been cautious about entering a market where retail investors account for 80 percent of trading.

Boring stocks

WSJ  in a recent  article noted  the outperformance of "boring stocks"based on theri definition of boring industriesc the data but

 I am not surprised . As noted in the article this is really  subset of value stocks. And it is well know that over long term what are considered value stocks (low measures such as price/earnings or price/book outperform

The article notes:

We find that our predictions are supported by the data: Boring industries are better investments than exciting industries,”

The converse of this finding has been observed for long data periods. High valuation small cap stocks value stocks (low measures such as price/earnings or price/book outperform. It has long been known that categories of stocks that get bid up to high valuations are poor performers long term. These are referred to by observers as "lottery tickets",glamour stocks or shooting stars and usually have high valuations. Within this group the absolute worst performing stocks are those that were recent ipos which can be considered the ultimate lottery ticket since they often have no earnings and certainly no long term track record of financial performance. In fact many of these stocks can be said to have a price/earnings ratio of infinity since they have no earnings.

This a well known outdcme of the many findings of behavioral finance. Investors are attracted to stocks in the news and those that have the potential for quick large gains. There are certainly ipos and small cap growth stocks that generate eye popping returns in the short term although they generally return to reality, but the likelihood of picking one, and particularly picking a successful portfolio of them is low on a statistical basis. But nobody talks about their losers in this category at the cocktail party or barbeque and there are seldom articles about these in the media. So the prospects of “finding another google” seem more likely than they are.

The key is to take advantage of behavioral flaws in the market, .., many investors gravitate toward exciting industries in search of standout returns. That creates opportunities for investors to find undervalued stocks in sectors with less sizzle, Mr. Rudderow says nt.
Not surprisingly the a above quotation comes from "the investment officer of Mount Lucas Management, a firm in Newtown, Pa., that has $1.7 billion in assets under management and offers value funds including the large-cap Mount Lucas U.S. Focused Equityfund.
“It’s hard to be smarter than other people in something like Tesla,” where the potential for big gains is obvious, Mr. Rudderow says, “and it’s easier to be smarter than other people in boring stocks.”
I am particularly skeptical about the long term success of active managers vs. their benchmark in this case active value managers vs value indices or passive investments (not called “smar beta” active manager.
But I would say all the great long term investors have had a value oriented approach particularly when they are likely to have investors willing to view their investments as long term. The classic of this group is Warren Buffett. But many parts of his strategy such as buying non public companies and more recently buying spinoffs of public companies and taking them private indicates he may feel that the days of easy pickings in stocks are gone. Interestingly enough he has stated publicly that whatever money of his left to his wife will be passively invested in the S+P 500 not even it seems in Berkshire Hathaway stock managed by his hand picked successors.
Here is a chart comparing value vs growth indices and the S+P 500 (which is tilted towards large growth stocks).

Small cap value (yellow) Large cap value (green) S+P 500 (blue)
 Large cap growth (blue), small cap growth (red)