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Factor-Based Investing: 5 Practical Considerations

Summary Though factor-based investing has garnered heightened attention recently, related concepts have existed for decades. Factor-based investing potentially offers transparency and control over risk exposures in a cost-effective manner. Factor-based investing is a framework that integrates factor-exposure decisions into the portfolio construction process. By Scott N. Pappas, CFA; Joel M. Dickson, Ph.D. In this paper, we review, discuss, and analyze factor-based investing, drawing the following conclusions: Factor-based investing can approximate, and in some cases replicate, the risk exposures of a range of active investments, including manager- and index-based strategies. Factor-based investing can be used to actively position investment portfolios that seek to achieve specific risk and return objectives. Factor-based investing potentially offers transparency and control over risk exposures in a cost effective manner. A factor-based investing framework integrates factor-exposure decisions into the portfolio construction process. The framework involves identifying factors and determining an appropriate allocation to the identified factors. But what are factors? Factors are the underlying exposures that explain and influence an investment’s risk.[1] For example, the underlying factor affecting the risk of a broad market-cap-weighted stock portfolio is the market factor, also called equity risk. That is, we can consider market exposure as a factor. In this case, not only does the factor exposure influence the risk of a market-cap portfolio, but it has also earned a return premium relative to a “risk-free” asset (often assumed to be short-term, high-quality sovereign debt). Historically, this premium has been a reward to the investor for bearing the additional risk inherent in the market factor. It’s important to note, however, that not all factor exposures are expected to earn a return premium over the long term. That is, factor exposures can be compensated or uncompensated, a critical distinction in any factor-based investing framework. The market factor, for example, has historically earned a return premium, and the general expectation that this premium will persist is what has encouraged investors to purchase broadly diversified stock portfolios. In contrast, some factor exposures are not compensated. Although a relationship may exist between the variation in an investment’s returns and a particular factor, it does not hold that this risk will be rewarded: The factor may simply reflect an idiosyncratic risk that can be removed through effective diversification. For example, the company-specific risk of a single stock should not have an impact on the performance of an effectively diversified portfolio. Although this paper focuses on historically rewarded factors, or factor premiums, we reemphasize that investors should be aware of the distinction between rewarded and unrewarded factors. Indeed, factor-based investing is premised on the ability to identify factors that will earn a positive premium in the future. A large range of factors have been analyzed and debated in the academic literature, and many of these have been used by investors. Figure 1 outlines seven commonly discussed factor exposures that are notable both for the extensive literature documenting each, and for the empirical evidence of historical positive risk-adjusted excess returns associated with them. We do not attempt to exhaustively analyze these factors; rather, we briefly emphasize relevant aspects for investors to consider in evaluating the factor-based approach. Two points should be mentioned at the outset: First, investors may knowingly or unwittingly already hold certain factor exposures within their portfolios. For example, a portfolio of stocks with low price/earnings ratios is likely to have exposure to the “value” factor. Second, the investment case for some factors is subject to ongoing debate- namely, whether past observed excess risk-adjusted returns will continue going forward. Predecessors of factor-based investing Despite the recent interest in factor-based investing, related concepts have existed for decades. For example, value investing, discussed in Graham and Dodd (1934), can be considered a type of factor-based investing. Rather than diversifying across the entire market, value investors focus on a subset of stocks with specific characteristics such as attractive absolute or relative valuations. As this approach gained in popularity, style indexes (both value and growth, for instance) were introduced to better measure the performance of style investors and to provide them with passive vehicles to replicate the returns of active investors. Whether through an index or active management approach, style investing allows portfolios to be created with a style tilt, or, put another way, a factor exposure. Style investments were specifically designed to have return and risk characteristics that differ from those of the broad market. Traditional quantitative-equity investing can also be considered a relative of factor-based investing. Similar to value portfolios, traditional quantitative-equity portfolios are often deliberately allocated to stocks that exhibit certain traits or characteristics. In contrast to style investors, however, traditional quantitative investors generally allocate across a wide range of characteristics-for example, value, momentum, and earnings quality-in an attempt to achieve higher risk-adjusted returns. Traditional quantitative investors may also dynamically adjust allocations in an attempt to generate returns through timing. Again, this approach is based on the belief that portfolios constructed in this way offer risk-and-return characteristics that differ from those of other methods such as indexing. By systematically constructing investment portfolios, factor-based investing uses principles similar to those of both style and traditional quantitative equity investing. In this respect, factor-based investing is simply an evolution of these existing techniques (see Figure 2). Academic research on factor-based investing Academic research related to factor-based investing is extensive (see the “Theory behind factor-based investing”). This paper’s analysis highlights two main areas of special relevance for potential factor investors. The first body of research examines the relationship between factor exposures and returns, specifically the degree to which exposures can explain and influence returns. The second examines the performance of portfolios that allocate to factor exposures. This body of work highlights the theoretical benefits of factor-based investing. Factor exposures and returns As the investment universe has grown beyond stocks and bonds, the drivers of investment returns have become less transparent. Although the relationship between a stock portfolio and the broad market, or a bond portfolio and interest rates, is often clear, it may not be the case for other more complex strategies. Often, it is not immediately obvious what affects the returns of investments such as those in an active portfolio, hedge fund, or alternatively weighted (smart-beta) index. As reported in a number of academic studies, however, factor exposures appear to influence the return of these sometimes complex investments. For example, Bhansali (2011) demonstrated that common factor exposures exist across a diverse range of investments. Research has also shown that the returns of various indexes can be explained by factor exposures. For instance, Amenc, Goltz, and Le Sourd (2009), Jun and Malkiel (2008), and Philips et al. (2011) found that the return on alternatively weighted indexes can be explained by factor exposures. Figure 4 illustrates this point by showing the estimated factor exposures of U.S. equity style categories. The chart shows a strong relationship between factor exposures and style categories. Overall, there is evidence of a relationship between returns and factor exposures across assets, indexes, and style categories. In addition to explaining returns on asset-class investments, research has demonstrated that excess returns generated by active managers can also be related to factor exposures. Bender et al. (2014) provided evidence that up to 80% of the alpha (excess return) generated by active managers can be explained by the factor exposures of their portfolios. Similarly, Bosse, Wimmer, and Philips (2013) demonstrated that factor tilts have been a primary driver of active bond-fund performance. Both studies showed not only that factors play a role in determining the returns of passive investments, but that they also appear to play a critical role in the returns of successful active managers. Portfolios of factor exposures An understanding of factor exposures provides investors with the opportunity to move the focus of the allocation decision from asset classes to factor exposures. The factor-based investing framework thus attempts to identify and allocate to compensated factors-that is, to factors expected to earn a positive return premium over the long term. Research into the factor framework has flourished in recent years and has found that the approach has the potential to improve risk-adjusted returns when used in conjunction with a range of investment portfolio configurations. For example, studies have compared the performance of factor portfolios to a traditional 60% U.S. stocks/40% U.S. bonds portfolio (Bender et al., 2010); diversified funds that include global stocks and bonds, emerging markets, and real estate and commodities (Ilmanen and Kizer, 2012); alternative asset portfolios (Bird, Liem, and Thorp, 2013); and portfolios of active managers (Bender, Hammond, and Mok, 2014). This research has demonstrated that, historically, factor-based investing has improved risk-adjusted returns when combined with a range of diverse portfolios. Practical considerations in factor-based investing The academic research discussed in the preceding section has demonstrated the potential benefits of the factor framework. This section adds practical context to those findings by reviewing five issues that we believe can each strongly affect the success of a factor approach. Again, an in-depth discussion of each issue is beyond the scope of this paper; we simply raise the issues as important considerations when evaluating a factor-based framework. The issues are: implementation, selecting a portfolio’s factor exposures, explaining factor returns, future return premiums, and return cyclicality. Implementation Although the academic literature provides high-level insight into the merits of factor-based investing, few studies have addressed practical implementation issues. One issue, portfolio turnover, for example, may affect investment performance, as a result of transaction costs. That is, actual investment performance may differ from reported academic performance, and these differences will vary depending on the specific factor an investor seeks exposure to. For instance, factor-based investments associated with small or illiquid stocks may present capacity and liquidity issues that are unique to those specific factor-based investments. Although it may be difficult to quantify the exact impact of implementation costs, investors should be aware of the potential for investment performance to vary from reported academic performance. How factor exposures are defined may also affect performance. Differences between broad-market index definitions of asset classes are generally small and result in relatively tight return dispersions across the different definitions. In contrast, factor definitions can differ substantially and may exhibit relatively large return dispersions across different definitions of the same factor. Figure 5 compares the ranges of outcomes experienced for different definitions of market-cap-weighted and factor-based investments. The figure shows that although a group of investors may be invested in the same factor, variations in how that factor is defined may result in a wide range of investment outcomes. Factor exposures, whether generated by passive vehicles or active managers, may require a high level of due diligence to ensure that they offer performance consistent with an investor’s objectives. Selecting a portfolio’s factor exposures Various factors have been analyzed in academic and industry research. Unfortunately, there is no definitive list of what is or isn’t a factor. Further complicating the matter is a continuing debate over the definition of compensated and uncompensated factors. For instance, some factors have demonstrated a strong relationship to the volatility of returns, but have not generated excess returns. Other factors have historically produced excess returns, but there is no guidance as to whether these returns will continue into the future. The allocation decision can be as important in factor-based investing as it is in traditional asset allocation. Not only is the choice of factors an important influence on future returns and risk, but so too is the quantity of factors used in a portfolio. Much of the research highlighting the effectiveness of factor-based investing is based on broadly diversified portfolios of factors. Much like asset-class portfolios, factor portfolios rely on the diversification benefits of different return streams-the larger the number of investments with low or uncorrelated returns, the greater the potential diversification benefits.[2] Factor-based investing has been shown to be particularly effective when applied across asset classes. However, it should be noted that factors associated with different asset classes may still exhibit a high level of correlation. Investors evaluating the factor framework should consider their ability to gain exposure to a range of distinct factors and should be aware that diversification benefits may be limited if portfolios are not effectively diversified across those factors. Explaining factor returns Debate continues on the investment rationale supporting certain factor returns. In some cases-for example, the equity market factor-a strong economic rationale exists for an excess return premium. The equity market premium has been deeply researched, and, although there is uncertainty over the future size of the premium, it is widely accepted that over the long term a positive excess return (above the “risk-free” rate) will be associated with the equity market factor. For many other factors, however, both the logic and economics explaining potential return premiums are subject to debate. Figure 6 briefly summarizes the investing rationale supporting our seven sample factors. There are two main schools of thought on the rationale behind factor returns-risk and investor behavior. Briefly, the risk explanation posits that return premiums are simply rewards for bearing risk or uncertainty. This explanation, consistent with rational asset pricing, assumes that investors obtain return premiums as a reward for being exposed to an undiversifiable risk. The unequivocal view of the equity market factor is that it earns investors a premium as a reward for bearing the uncertainty of the value of future cash flows. In contrast, the behavioral argument holds that certain factor returns are caused by investor behavior. That is, investors make systematic errors that result in distinct patterns in investment returns. Systematic errors, for example, have been offered as an explanation for the existence of the momentum effect. Although the return premiums of some factors have been shown to be clearly related to risk, debate over the source of returns for other factors is more contentious. Nonetheless, investors should be aware of the arguments surrounding specific factors, as this may shape whether and how they allocate to these factors. Future return premiums Expected returns are an important consideration for any investment. Although investors may already be familiar with a range of factor exposures and confident that those exposures will generate positive future returns over the long term, the future returns of other factor exposures may not be so clear. Indeed, there is some conjecture over whether the historical returns associated with certain factors will persist in the future. For example, Lo and MacKinlay (1990), Black (1993), and Harvey et al. (2014) contended that the empirical evidence is a result of data-mining. As it stands, the debate is far from settled and continues in academia and industry. As discussed in the preceding subsection, the investment rationale for certain factors is open to debate. If the behavioral explanation holds for a factor, it may indicate a risk that the return premium may disappear if investors recognize their errors and modify their behavior accordingly-thus adding another layer of uncertainty to the future return premium. Investors may also fear that once a factor has been identified in the academic literature, it will be arbitraged away. Van Gelderen and Huij (2014) have argued against this, however, finding evidence that excess returns from factors are sustained even after they are published in the academic literature. Clearly, although investing in general is associated with a great deal of uncertainty, factor-based investing, of its own accord, has additional unique complexities that investors should consider when evaluating expected returns. Return cyclicality Similarly to asset-class returns, factor returns can be highly cyclical, and investors should be aware that individual factors may underperform for extended time periods. Although this risk is not unique to factor-based investing, it highlights the need for a long-term and disciplined perspective when assessing the factor-based investing framework. As we previously noted, empirical research on factors has found evidence that over the long term some factors have earned excess returns. That research has also demonstrated that the same factors can underperform for lengthy periods. A key component in capturing any potential long-term premium is the investor’s ability to stay the course during periods of poor performance. Figure 7 displays the relative performance of the seven sample factors. The figure illustrates the cyclicality of factor performance: No single factor has consistently outperformed the others during the ten-year period studied. In addition, all factors-at some point in time-have experienced both relatively good and poor performance. Again, this underscores how essential it is to take a long-term perspective when evaluating the factor framework. Applications of factor-based investing Having discussed the theory and practice of factor-based investing, we next focus on its application. First, we discuss why factor-based investing is active management. Second, we consider the risk-and-return characteristics of portfolios of factors. Factor-based investing is active management We believe that a market-cap-weighted index is the best starting point for a portfolio construction discussion. Such a portfolio not only represents the consensus views of all investors, but it has a relatively low turnover and high investment capacity. Constructing a portfolio to obtain factor exposures, however, is an active decision. Factor exposures are often built by creating portfolios of assets around a common characteristic-for example, a portfolio of stocks with high dividend yields. More complex factor implementations may also use leverage or short selling. In each case, factor-based investing involves investors making explicit, or, in some cases, implicit, tilts away from broad asset-class representations expressed by market-cap weights. Investors contemplating factor-based investing should consider their tolerance for active risk. Indeed, tolerance for active risk is a key determinant in the extent to which an investor embraces the factor framework. Whatever the configuration, Vanguard views any portfolio that employs a non-cap-weighted scheme as an active portfolio. Achieving risk-and-returns objectives Figure 8 illustrates excess returns and volatility for the seven sample factors for 2000-2014. Factor exposures can be implemented in a number of ways; to reflect this, the figure presents results for both long-only and long/ short implementations of the value, credit, size, and momentum factors. For the market and term factors, the figure shows long-only results exclusively. For the 15-year period, returns and risk have varied across factors. The figure emphasizes that the way in which factor exposures are implemented can result in differences in performance. As shown, the performance of long/short and long-only implementations has varied significantly for the value, momentum, size, and credit factors over the analysis period. As discussed earlier, much of the research examining the effectiveness of factor-based investing has demonstrated its potential to improve diversification. Such a benefit, however, can depend on how the factor exposures are implemented. Figure 9 compares the correlation between the equity factors of momentum, size, and value with the market factor for both long/short and long-only implementations. For the three factors, a large difference was shown between correlations experienced by long/ short and long-only investors. Correlation was higher for the long-only implementations, which maintain large residual exposures to the market factor. The long/short factors, by contrast, remove much of the market-factor exposure through offsetting short positions, consequently reducing the correlation to the market. The potential diversification benefits of a factor can depend greatly on how the factor is implemented in the portfolio and on whether a distinct exposure to the factor can be obtained. Investors may also consider the potential for factors to generate excess returns. Historically, certain factors have achieved returns in excess of the broad market. While we caution against extrapolating past returns into the future, investors may believe that specific factor exposures offer a prospect for outperformance. We view factor-based investing as taking on active risk even if it is achieved through a passive or index construct. Therefore, we reiterate that before seeking outperformance through allocations to factors, investors should consider their tolerance for active risk. Investors who are comfortable accepting active risk, and confident about their expectations for future returns from factors, may find the factor-based investing framework suitable. But, an important note: Investors taking the view that factor-based investing will outperform over the long run must exercise the discipline required to achieve that return objective. That is, during the inevitable periods of underperformance against the market, investors must be willing to maintain investment allocations through rebalancing and continued investment. Potential benefits of factor-based investing A key takeaway from the academic literature is that many assets, indexes, and active investments have underlying exposures to common factors. Not only can investors access factor exposures in a variety of ways, but they may be doing so unintentionally. Investors may thus ask, what is the most efficient way to gain exposure to factors? An explicit focus on factors can be used to efficiently manage portfolio exposures. In particular, factor-based investing offers potential benefits in transparency, control, and cost. Transparency Previously in this paper, we reviewed research showing that factor exposures can explain and influence returns for a range of diverse investments. A portfolio’s factor exposures, however, may not be clearly apparent. Investors may already have a range of factor exposures in their portfolio-either explicitly through deliberate decisions or implicitly as a result of their investment process. It may be obvious, for instance, that a market-cap-weighted equity index offers exposure to the market factor, but for other investments the factor exposures may not be as clear. More opaque investment vehicles may simply offer factor exposures that can be accessed in a more efficient way. Investments that offer a clear methodology and define their factor exposures may be more effective vehicles for investors. By deliberately focusing on factor exposures as part of the portfolio construction process, investors can potentially gain a clearer understanding of the drivers of portfolio returns. Control A portfolio may already have factor exposures implemented through a variety of investments. For example, some fundamentally weighted, or smart-beta, indexes provide a value factor exposure that varies over time. In contrast, an investment that explicitly targets the value factor may provide a more consistent factor exposure. Investors should consider whether they require direct control of their factor exposures. Although a factor exposure that varies over time may be appropriate for some investors, others may want more direct control over their portfolio’s factor exposures. The decision to delegate factor exposures to a manager or an index, or to maintain direct control over factor exposures, is an important one for investors considering a factor-based framework. Cost Factor exposures can be generated through a number of different investments, and each of these vehicles may charge different levels of fees. In some cases, an investor may be paying high fees to obtain factor exposures that could be available to the investor through a more cost-effective vehicle. By allocating directly to a factor, rather than indirectly through another investment vehicle, investors may be able to access factor exposures more cost-effectively. For example, a passive investment in a factor portfolio may be more cost-effective than an investment through a high-cost active manager or a high-cost index. Each of these investments might offer similar return distributions, but the management fees paid may make the direct factor exposure a more cost-effective approach. To the extent investors have access to low-cost, factor-based investments, such a framework may offer a more prudent way to construct a portfolio. Conclusion Vanguard believes that a market-cap-weighted index is the best starting point for portfolio construction. Factor-based investing frameworks actively position portfolios away from market-cap weights. As discussed here, academic research has demonstrated that the returns on a diverse range of active investments can be explained and influenced by common factor exposures. Using factor-based investments, investors may be able to replicate these exposures. Factor-based investing seeks to achieve specific investment risk-and-return outcomes, greater transparency, increased control, and lower costs. When evaluating a factor-based investing framework, investors should consider not only their tolerance for active risk but the investment rationales supporting specific factors, the cyclicality of factor performance, and their own tolerance for these swings in performance. References Amenc, Noel, Felix Goltz, and Veronique Le Sourd, 2009. The Performance of Characteristics-Based Indices. European Financial Management 15: 241-78. Banz, Rolf W., 1981. The Relationship Between Return and Market Value of Common Stocks. Journal of Financial Economics 9: 3-18. Basu, Sanjoy, 1977. Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis. Journal of Finance 32: 663-82. Bender, Jennifer, Remy Briand, Frank Nielsen, and Dan Stefek, 2010. Portfolio of Risk Premia: A New Approach to Diversification. Journal of Portfolio Management 36: 17-25. Bender, Jennifer, P. Brett Hammond, and William Mok, 2014. Can Alpha Be Captured by Risk Premia? Journal of Portfolio Management 40: 18-29,12. Bhansali, Vineer, 2011. Beyond Risk Parity. Journal of Investing 20: 110,137-47. Bird, Ron, Harry Liem, and Susan Thorp, 2013. The Tortoise and the Hare: Risk Premium Versus Alternative Asset Portfolios. Journal of Portfolio Management 39: 112-22. Black, Fisher, 1993. Beta and Return. Journal of Portfolio Management 20: 8-18. Bosse, Paul M., Brian R. Wimmer, and Christopher B. Philips, 2013. Active Bond-Fund Excess Returns: Is It Alpha . . . or Beta? Valley Forge, Pa.: The Vanguard Group. Carhart, Mark M., 1997. On Persistence in Mutual Fund Performance. Journal of Finance 52, 57-82. Fama, Eugene F., and Kenneth R. French, 1992. The Cross-Section of Expected Stock Returns. Journal of Finance 47: 427-65. Fama, Eugene F., and Kenneth R. French, 1993. Common Risk Factors in the Returns on Stock and Bonds. Journal of Financial Economics 33: 3-56. Graham, Benjamin, and David Dodd, 1934. Security Analysis. New York: McGraw-Hill. Harvey, Campbell R., Yan Liu, and Heqing Zhu, 2014. . . . and the Cross-Section of Expected Returns. Working Paper. Durham, N.C.: Duke University; available at http://papers. ssrn.com/abstract-2249314. Ilmanen, Antti, and Jared Kizer, 2012. The Death of Diversification Has Been Greatly Exaggerated. Journal of Portfolio Management 38: 15-27. Jun, Derek, and Burton G. Malkiel, 2008. New Paradigms in Stock Market Indexing. European Financial Management 14: 118-26. Lintner, John, 1965. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. Review of Economics and Statistics 47: 13-37. Lo, Andrew W., and A. Craig MacKinlay, 1990. Data-Snooping Biases in Tests of Financial Asset Pricing Models. Review of Financial Studies 3: 431-67. Mossin, Jan, 1966. Equilibrium in a Capital Asset Market. Econometrica 34: 768-83. Philips, Christopher B., Francis M. Kinniry Jr., David J. Walker, and Charles J. Thomas, 2011. A Review of Alternative Approaches to Equity Indexing. Valley Forge, Pa.: The Vanguard Group. Ross, Stephen A., 1976. The Arbitrage Theory of Capital Asset Pricing. Journal of Economic Theory 13: 341-60. Sharpe, William F., 1964. Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk. Journal of Finance 19: 425-42. Treynor, Jack, 1961. Market Value, Time and Risk. Unpublished manuscript, 95-209. Van Gelderen, Eduard, and Joop Huij, 2014. Academic Knowledge Dissemination in the Mutual Fund Industry: Can Mutual Funds Successfully Adopt Factor Investing Strategies? Journal of Portfolio Management 40: 114: 157-67. Footnotes We consider investable factors in this paper. Another perspective would be to consider economic factor exposures-for example, categorizing investments according to their exposure to economic growth or inflation. This is true only to a point. Although we know of no research on the topic, it is likely that the incremental diversification benefits of additional factors would decrease as the number of factor exposures in a portfolio increases. Notes about risk and performance data: Investments are subject to market risk, including the possible loss of the money you invest. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. Diversification does not ensure a profit or protect against a loss in a declining market. Performance data shown represent past performance, which is not a guarantee of future results. Note that hypothetical illustrations are not exact representations of any particular investment, as you cannot invest directly in an index or fund-group average.

Today’s Most Competitive Emerging Country ETF Investment

Summary From a population of some 350 actively-traded, substantial, and growing ETFs this is a currently attractive addition to a portfolio whose principal objective is wealth accumulation by active investing. We daily evaluate future near-term price gain prospects for quality, market-seasoned ETFs, based on the expectations of market-makers [MMs], drawing on their insights from client order-flows. The analysis of our subject ETF’s price prospects is reinforced by parallel MM forecasts for each of the ETF’s ten largest holdings. Qualitative appraisals of the forecasts are derived from how well the MMs have foreseen subsequent price behaviors following prior forecasts similar to today’s. Size of prospective gains, odds of winning transactions, worst-case price drawdowns, and marketability measures are all taken into account. Today’s most attractive ETF Is the ProShares Ultra MSCI Emerging Markets ETF (NYSEARCA: EET ). Yahoo Finance profiles this ETF as follows: The investment seeks daily investment results, before fees and expenses, that correspond to two times (2x) the daily performance of the MSCI Emerging Markets Index®. The fund invests in securities and derivatives that ProShare Advisors believes, in combination, should have similar daily return characteristics as two times (2x) the daily return of the index. The index includes 85% of free float-adjusted market capitalization in each industry group in emerging market countries. The fund is non-diversified. The fund currently holds assets of $37.5 million and has had a YTD price return of +1.9%. Its average daily trading volume of 14,205 produces a complete asset turnover calculation in 41 days at its current price of $64.90. A typical bid~offer spread is 0.6%. Behavioral analysis of market-maker hedging actions while providing market liquidity for volume block trades in the ETF by interested major investment funds has produced the recent past (6 month) daily history of implied price range forecasts pictured in Figure 1. Figure 1 (used with permission) The vertical lines of Figure 1 are a visual history of forward-looking expectations of coming prices for the subject ETF. They are NOT a backward-in-time look at actual daily price ranges, but the heavy dot in each range is the ending market quote of the day the forecast was made. What is important in the picture is the balance of upside prospects in comparison to downside concerns. That ratio is expressed in the Range Index [RI], whose number tells what percentage of the whole range lies below the then current price. Today’s Range Index is used to evaluate how well prior forecasts of similar RIs for this ETF have previously worked out. The size of that historic sample is given near the right-hand end of the data line below the picture. The current RI’s size in relation to all available RIs of the past 5 years is indicated in the small blue thumbnail distribution at the bottom of Figure 1. The first items in the data line are current information: The current high and low of the forecast range, and the percent change from the market quote to the top of the range, as a sell target. The Range Index is of the current forecast. Other items of data are all derived from the history of prior forecasts. They stem from applying a T ime- E fficient R isk M anagement D iscipline to hypothetical holdings initiated by the MM forecasts. That discipline requires a next-day closing price cost position be held no longer than 63 market days (3 months) unless first encountered by a market close equal to or above the sell target. The net payoffs are the cumulative average simple percent gains of all such forecast positions, including losses. Days held are average market rather than calendar days held in the sample positions. Drawdown exposure indicates the typical worst-case price experience during those holding periods. Win odds tells what percentage proportion of the sample recovered from the drawdowns to produce a gain. The cred(ibility) ratio compares the sell target prospect with the historic net payoff experiences. Figure 2 provides a longer-time perspective by drawing a once-a week look from the Figure 1 source forecasts, back over two years. Figure 2 (used with permission) What does this ETF hold, causing such price expectations? Figure 3 is a table of securities held by the subject ETF, indicating its concentration in the top ten largest holdings, and their percentage of the ETF’s total value. Figure 3 (click to enlarge) Source: Yahoo Finance This shows how leveraged ETFs do their magic. The top ten holdings of EET are mainly swaps contracts in the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ), with a value per share of 184.57% of the EET share. The 4.01% in bonds helps balance out the 2x relationship of price change in EET with the underlying Emerging Markets Index security. But that doesn’t tell much about what the investor has driving his investment. To find that out, we look at the holdings of EEM: Source: Yahoo Finance That’s better, and shows the emphasis on Financial Services and Technology, making up almost half of the portfolio. Unfortunately, the offshore nature of virtually all the underlying equity holdings are ones that we do not have information support from arbitrage activities in derivative markets, so our analysis of this dimension of EET must stop here. In markets as unpredictably dynamic as this, wide variations in market experience seem to be the rule. A comparison of the data row for EET from Figure 1 with a similar one from an ETF proxy for the U.S. market helps to highlight the unique and attractive features of EET. For EET: For the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) : The Sell Target for EET offers 3 times as much potential gain as the U.S. market proxy, SPY. But it exposes the investor to worst-case price drawdown exposure that is more than twice as large. Still, taking Sell Target and Drawdown as Reward and Risk elements, EET is favored with a ratio of 3 to 1, rather than SPY’s 2 to 1. Just as importantly, the ability to recover from extreme price drawdowns and achieve some or all of the upside potential is indicated by each one’s Win Odds out of 100. For the U.S. market proxy that desired objective has been accomplished 7 out of every 8 times. EET has achieved it a bit better than 6 out of 8. But the payoff for EET at a net (including losses) average of +15.6% is 5 times bigger than the U.S. market’s +3.5%. Since both alternative investments took 9-10 weeks to achieve their gains, the Annual Rates of Return [AROR] from price change gains is also 5 times better, 115% to 21%. EET’s relatively small sample of prior experiences, only 9 in the past 5 years is not surprising or troubling, given its presently depressed price, relative to its forecast. That is measured by its Range Index. When negative, it tells by how much the current market quote is below the least justifiable forecast price. Here a -43 means it is cheap by nearly half its total forecast price range. The U.S. market proxy, on the other hand is presently priced right about at its mid-point, with only slightly more upside than downside. A quick reference to the small thumbnail picture in Figure 1, of the past 5 years distribution of Range indexes, emphasizes how extreme (and opportune) is the current pricing. Conclusion EET provides attractive forecast price gains, supported by a recognized index of major established investments in emerging countries. The daily forecast graphic and its weekly extracts over the longer period of two years demonstrate the cyclic nature of the ETF. Its dynamic character offers an opportune point in time to take advantage of world events that may be distracting investors’ attention from the potentials presented here. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Taking Stock: Putting Equity Valuations In Perspective

Summary Investors feel there’s little margin for error in equity markets when macro concerns such as rising interest rates and geopolitical hot spots are part of the equation. Valuations matter and investors are overly concerned with the downside and are failing to appreciate the impact of solid macro fundamentals. We may certainly see market dips, but history shows that short-term losses not caused by deteriorating fundamentals are often recovered quickly. Lately, hardly a day goes by without a headline proclaiming that developed market equity valuations are rich. Throw in macro concerns such as rising interest rates and geopolitical hot spots, and it’s no surprise that investors feel there’s little margin for error in equity markets. In this commentary, I’d like to steer away from the headlines and offer some perspective on valuations and how much they matter relative to other return drivers. In my view, investors are overly concerned with the downside and failing to appreciate the impact of solid macro fundamentals, improving earnings in Europe and Japan, and global accommodative central bank policy-forces that are sufficient to maintain or elevate equity valuations further. We may certainly see market dips, but history shows that short-term losses not caused by deteriorating fundamentals are often recovered quickly. Looking at Price/Earnings Ratios (P/E) 1 from Multiple Angles There are numerous ways to analyze valuations. I prefer 12-month forward P/Es because of their intuitive nature-they are the price of a stock divided by median analyst expectations for earnings over the next 12 months. They answer the question: How much are investors willing to pay for this stock, given what the market expects earnings to be over the next year? As Figure 1 shows, P/Es for these developed markets are reasonable, relative to long-term averages. FIGURE 1: 12-Month Forward P/E Ratios (click to enlarge) Sources: IBES; Datastream. With any valuation method, it is useful to compare current valuations to history and to other markets. Today, market consensus is that equity valuations in the U.S., Europe, and Japan are high, suggesting stocks are expensive. But valuations can rise and fall as economic regimes change, so it’s important to look at longer-term metrics as well, for a more complete picture. For example, Figure 2 shows that compared to their five-year history, valuations in all three developed equity markets are in at least the 97th percentile, meaning that forward P/Es have been cheaper 97% of the time over the last five years. However, looking back at the last 20 years, current valuations generally seem more reasonable, as evidenced by lower percentiles and higher median P/Es over that period. The U.S. and Europe do appear more expensive relative to short- and long-term history, but Japan is a different story, seeming cheap relative to its 20-year historical median, and more expensive relative to the recent five-year period. Investors should remember that during the mid- and late 1990s, the Japanese equity market experienced a bubble with very high valuations. Nonetheless, I believe it’s better to include the total history instead of subjectively excluding specific time periods, as other regional equity markets have experienced bubbles as well. FIGURE 2: Comparing Current Valuations to Historical Time Periods Sources: IBES; Datastream; Wellington Management. FIGURE 3: Comparing Current Valuations Across Regions Sources: IBES; Datastream; Wellington Management. Comparing the valuations of regional markets can also be informative. Figure 3 shows that the current P/E difference between the U.S. and Europe is 1.17, meaning U.S. equities are trading at a premium relative to their European counterparts. However, the median P/E differences over the past five and 20 years are 2.01 and 1.88, respectively, meaning that U.S. equities have historically been more expensive relative to Europe than they currently are. Put another way, European equities look expensive relative to U.S. equities today. On the other hand, Japan currently trades at a P/E discount of 2.07 versus the U.S., but over the past 20 years, Japan’s equity market traded at a 2.88 premium, and has traded close to parity with U.S. equities over the past five years. As a result, Japan looks cheap relative to the U.S. over both time periods. Considering Other Factors Valuations are only one input, and investment decisions should be based on multiple factors. For example, despite Europe’s relatively unattractive equity valuations, it remains one of my favored equity markets for more fundamental reasons. Earnings In the simplest terms, equity total returns can be thought of as the sum of dividends, earnings growth, and the P/E multiple. Valuations expand and contract, according to market cycles and investor sentiment, while dividends are fairly stable. The other important consideration is earnings. I think the earnings picture in Europe and Japan is more positive than that of the U.S. In Europe, earnings should benefit from lower fuel prices and a weak euro. In Japan, the management teams of many large companies are focusing more on adding value for shareholders by increasing returns on equity and capital. I’m less optimistic about earnings in the U.S. As Figure 4 shows, U.S. profit margins-which rose steadily following the financial crisis-appear to have peaked in 2013. At the same time, employee compensation as a percentage of gross domestic product (NYSE: GDP ) 2 -which had been falling over the same period as U.S. companies squeezed efficiencies out of everything, including labor, to prop up profits-may have turned a corner. The trend may have reached its limit; after almost eight years of record margins, wages are just beginning to rise, suggesting that earnings could suffer. FIGURE 4: Rising Wages and Falling Profits Could Squeeze U.S. Earnings U.S. Corporate Profits and Labor Compensation as % of GDP Sources: Bureau of Economic Analysis; Haver; Wellington Management. Note: This chart uses a four-quarter moving average of corporate profits after tax, with inventory and capital-consumption adjustments, as well as a four-quarter moving average of total employee compensation. Inventory and capital consumptions adjustments smooth out infrequent corporate behavior such as inventory buildups and capital consumptions. Macro Fundamentals Investors also need to consider the effects of macro fundamentals on equity markets. In the U.S., fundamentals are solid but are challenged by a stronger dollar and weaker growth in the first quarter, although some of that may be weather-related. Improved earnings in Europe and Japan are due, in part, to improving fundamentals in those regions. Business and consumer confidence in Europe is increasing, and the lower euro is helping to boost exports. Germany has been growing strongly and boasts a record-low unemployment rate of 4.7%, which should support more domestic consumption. The European Commission recently forecast that even countries that experienced negative growth last year, such as Italy, are expected to rebound into positive territory, and Spain is expected to grow 2.8% this year, double the 2014 rate. Overall, Europe still suffers from high unemployment, which will need to come down for the recovery to be sustained. But even a slight acceleration in growth from current low levels would likely be perceived by equity investors as an important development. Wellington Management’s macroeconomists expect 2015 eurozone GDP growth of around 2%. This is above consensus and reflects our general optimism on the region. I am also optimistic about the Japanese economy. Japan imports almost all of its energy, so it has enjoyed an outsized benefit from cheaper oil. The Bank of Japan’s quantitative easing program has led to improved terms of trade via a weak yen, and Japanese companies have been reporting record profits. In addition, as I mentioned above, companies in Japan are beginning to reallocate capital for shareholders’ benefit. One of the catalysts for this shift is macro in nature. The Japanese government has pushed for the creation of an index (JPX Nikkei 400) comprised only of those companies that meet high standards of corporate performance and return on equity. The Bank of Japan and the world’s largest government pension fund, Japan’s Government Pension Investment Fund, now use this index to measure performance of their equity portfolios. All these changes should contribute to solid growth for Japanese equities. Importance of Differentiating Between Noise and Signal As always, risks can weaken an investment thesis. Four major risks on investors’ minds are: a Greek exit from the euro, an escalation of the Russia/Ukraine conflict, a hard landing for China’s economy, and a significant rise in interest rates. If any of these risks come to fruition, I would expect a sustained sell-off in global equities. I believe the risks of these events occurring are low, but I would expect noise related to them could result in isolated, albeit sharp, sell-offs. This would cause short-term pain, but analysis I’ve done on this issue shows that the effect on equities tends to be short-lived and these dips are often buying opportunities. Sell-offs of at least 2% occur an average of nine times per year in the S&P 500 Index, but the market generally recovers in short order. Figure 5 (which uses U.S. data, but is illustrative of developed markets as well) shows that median 10-, 30-, and 60-day total returns following sell-offs of 2% or more are, on average, greater than returns following any random day. The results are even more compelling when controlling for the economic environment. When the U.S. Purchasing Managers Index (PMI) 3 (a metric used to help gauge economic strength) is above 50, signaling economic expansion, total returns following a 2% or greater sell-off are around twice as high as those following any random day. I expect the U.S., European, and Japanese economies to continue expanding in the near term. The recovery effect indicates that “tail risks” from exogenous factors can impact daily returns, but markets ultimately focus on fundamentals and recover from panic-driven one-day dips. Note: Due to the heterogeneity of emerging markets, I have limited the scope of this commentary to developed markets. FIGURE 5: U.S. Stocks Have Historically Rebounded After Most Sell-Offs S&P 500 Forward Total Returns Sources: Bloomberg; Institute for Supply Management; Haver; Wellington Management. Note: The analysis uses S&P 500 Index total returns over 10-, 30-, and 60-day forward periods since 1989. The PMI used is the Institute for Supply Management’s Composite Index. The blue diamonds represent the median return over 10, 30, and 60 days following any random day, regardless of the prior day’s performance. The orange squares represent the median return over 10, 30, and 60 days following a 2% or greater loss. The green triangles represent the median return over 10, 30, and 60. Investment Implications Developed equity valuations are reasonable. While valuations look rich over the recent past, a longer history suggests they are closer to fair value. Consider factors beyond valuations. Investors should also consider potential earnings growth and economic fundamentals. Favor Europe over the U.S. Despite rising valuations, a virtuous cycle of a weak euro, quantitative easing, and cheap oil is forming, and earnings should benefit. Favor Japan over the U.S. In addition to attractive valuations, Japanese companies are recording record profits and focusing on maximizing shareholder value. Notes 1 Price-Earnings Ratio is valuation ratio of a company’s current share price compared to analyst median 12 month forward per-share earnings. 2 Gross Domestic Product is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period. 3 Purchasing Managers Index (PMI) is an indicator of the health of the economy. Disclaimer: Investors should carefully consider the investment objectives, risks, charges, and expenses of Hartford Funds before investing. This and other information can be found in the prospectus and summary prospectus, which can be obtained by calling 888-843-7824 (retail) or 800-279-1541 (institutional). Investors should read them carefully before they invest. All investments are subject to risks, including possible loss of principal. Investments in foreign securities may be riskier than investments in U.S. securities. Potential risks include the risks of illiquidity, increased price volatility, less government regulation, less extensive and less frequent accounting and other reporting requirements, unfavorable changes in currency exchange rates, and economic and political disruptions. These risks are generally greater for investments in emerging markets. The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice or as the views of Hartford Funds. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. All information and representations herein are as of May 2015, unless otherwise noted. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.