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GTAA Is For Real (Part 3): Why VBINX Is The Wrong Benchmark

To judge a strategy, it is critically important to identify an appropriate benchmark. For several reasons, comparing tactical strategies to “balanced portfolios” like VBINX is inappropriate. The Global Market Portfolio meets all the criteria for a proper benchmark, making it is the most appropriate baseline for assessing GTAA strategies. At our research blog, we recently posted an article discussing how many noteworthy investment commentators either misunderstand or misconstrue the salient qualities of Tactical Asset Allocation strategies. We encourage you to read the entire piece, but today’s post will be limited to the topic of benchmarking. One of the most common failings of the investment industry is the prevalence of poorly specified benchmarks. This is of critical importance because it’s easy for a knowledgeable but disingenuous professional to manipulate the facts in order to make any point they want. Want a simple way to boost results? Choose an easy benchmark for comparison. Want to dismiss performance? Choose a challenging benchmark. Recall that at root, a well specified benchmark should meet the following criteria: It is passive; It is investible, and; It reflects the investing opportunity set of the manager. While all of these criteria are individually valid, they are unified by a simple and profound benchmarking philosophy: The best benchmark for a tactical manager is the one they would own if everyone were forced to invest all their assets in a single, passive portfolio. Axiomatically, this portfolio would represent the average positions of all market participants, and would hold each asset in a percentage equal to its proportion of total market capitalization. This is not a new concept; U.S. large cap equity managers are typically benchmarked against a market cap weighted index of large-cap U.S. stocks. U.S. Investment Grade bond managers are benchmarked against a market cap weighted index of U.S. listed investment grade bonds. Cap weighted indexes are common and intuitive when they are constructed within a major asset class. But it is not immediately intuitive how to extend the concept to multi-asset universes like those employed by GTAA managers. As a result, GTAA strategy benchmarks often seriously misrepresent the risks and opportunities of the underlying strategies. Investment commentators who dismiss TAA often compare the results of GTAA strategies to a U.S. 60/40 balanced fund like the Vanguard Balanced Index Fund (MUTF: VBINX ). And this benchmark does have one thing going for it, especially if a commentator’s goal is to malign GTAA strategies: it is a very tough benchmark to beat over the past one, three and five years – perhaps the toughest in the world in USD terms. Unfortunately, it’s hard to see how this portfolio represents an appropriate bogey for GTAA strategies over the long-term. For one, this portfolio is insulated from global currency effects, which have been especially pronounced in the past few years with global QE programs in effect. Second, it ignores non-U.S. equity beta; while a focus on U.S. equities at the expense of international stocks has been a lucky bet for the past few years, it ignores the broader scope of GTAA strategies. Also, since the goal of GTAA strategies is to harvest premia from as many liquid global sources as possible, the strategies often incorporate alternative investments, like REIT and commodity ETFs, into their investible universe. These are not represented in a U.S. balanced fund benchmark. Fortunately, some analysts take a more enlightened view. In their quarterly ” ETF Managed Portfolios Landscape Summary ” report, Morningstar proposes a much more globally diversified benchmark. The report’s Global All Asset benchmark, copied below, is composed of 55% global stocks, presumably distributed geographically by market cap; 35% global bonds, split evenly between U.S. and international; and 10% commodities. Source: Morningstar Clearly the folks at Morningstar are trying to be more representative of the GTAA space, and their mix is certainly in the right ballpark. But it is also still rather arbitrary – how did they arrive at their weights? Have they weighted toward historical GTAA holdings? If so, is there any guarantee that historical holdings will be representative of future holdings? These are dynamic strategies after all. Do commodities deserve a 10% strategic weighting or is this informed by recency bias? In addition, the Morningstar benchmark is over 80% weighted to U.S. dollars. Does this represent a neutral currency policy? We stated above that it isn’t immediately obvious how to extend the market cap weighted benchmarks applied to traditional single-asset portfolios, such as equity or bond funds, to a multi-asset context. This isn’t strictly true. In a multi-asset situation, we would expect a passive portfolio to hold all asset classes in proportion to their respective market capitalizations. Consider a simple example where the aggregate global market has a value of $100 trillion, where $50 trillion is stocks and $50 trillion is bonds. In this case, a passive investor would hold 50% of their portfolio in bonds and 50% in stocks. Every participant in the markets could hold this exact portfolio without changing the overall composition of the market, so it is the only passive, neutral portfolio. As discussed in prior posts (see here and here ) Doeswijk et. al. determined the actual market value of every global financial asset (as of year-end 2012) and published their relative market capitalization weights in a 2014 paper. These weights describe the most passive global portfolio possible: the global market cap weighted portfolio (GMP). This portfolio reflects the average portfolio positions of all investors globally. Fortunately, an investible version of this portfolio can be very closely replicated with low-cost, U.S. listed ETFs (see Figure 5.) This portfolio uniquely meets all the criteria for an appropriate benchmark: it is definitionally the only passive portfolio; it is definitionally investible; and it covers the investible opportunity set for GTAA mandates because it includes all global investible assets. Figure 5. Investible Global Market Portfolio. (click to enlarge) Source: Interpreted from Doeswijk et. al. We would note that the global market cap weighted portfolio definitionally holds all assets in their native currency, and therefore reflects currency fluctuations in non-domestic asset classes. Over 50% of both global equity and bond sleeves in our proposed global market portfolio is impacted by non-U.S. currency exposure (the foreign equity exposure is hidden inside our global equity ETF). We believe this is the most appropriate benchmark for GTAA strategies. In the next and final chapter of our series on GTAA, we will examine the performance of a robust cross-section of live strategies, and show how GTAA strategies have delivered measurable alpha against well specified benchmarks, even over this most difficult phase of the market cycle. 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.

In A Rising Natural Gas Market Dynegy Is Worth Considering

Summary DYN is an electricity generation company with coal fired power plants. The Utility sector is a very challenging space right now for a variety of reasons. Experts project a 19% upside at current price levels. Dynegy (NYSE: DYN ) is an electricity generation company whose generation portfolio is primarily coal fired power plants. The company is weathering a difficult business environment for Utilities. Coal fired plants cannot compete with natural gas fired plants at such low natural gas prices. However, if the price of natural gas rises to historical norms, then DYN’s coal fleet will see operating margins increase, which will have a positive impact on DYN’s stock value. Market Overview and Trends: The electricity market is going through a challenging period of government regulation, low electricity prices, increased churn and demand stagnation. The increasing concern for climate change has spurred a wave of regulation in the Utility sector. Not only are these regulations fluid and complex, they are expensive. Cross-State Air Pollution Rule , MATS , CO2 Emissions , and Byproducts, Wastes, Hazardous Materials and Contamination, just to name a few. The price for electricity is set by baseload generation facilities which are natural gas fueled Combined Cycle Gas Turbines (CCGTs) which historically have had lower operating margins than coal fueled facilities, but with natural gas prices at near historic lows, CCGTs produce power at lower prices than coal. When CCGTs produce at a lower price than coal, coal facilities stop producing and start losing money. Innovations in how consumers measure and exchange electricity have become much more sophisticated over the last 20 years. For example, in the ERCOT market, people have the ability to switch retail providers instantly through the Internet. It has never been easier for a retail customer or business customer to switch providers, because of this, the industry is experiencing increased rates of customer churn. Energy efficiency across many levels of society have caused the general demand for electricity to grow at slower rates than ever before. People use more electricity than ever, but increases in efficiency have caused the growth rate for the electricity market as a whole to slow. * from the NASDAQ Business Positioning and Summary: Dynegy is primarily an electricity generation company. The company’s fleet consists of 15 power plants in five states. All nine of Dynegy’s baseload generation plants are coal and are located in the state of Illinois. The lion’s share of the other generation facilities are fueled by natural gas. As a final point, it is worth noting that DYN does not provide dividends. (click to enlarge) * from the 10-k Growth Strategy: from the 10-k Customer Focus: DYN’s commercial strategy seeks to lock in near-term cash flows while preserving the ability to capture higher values long-term as power markets improve. Further the company reduces market risk by linking generation directly to customer load which reduces the need to hedge. In the wholesale and retail spaces DYN plans little change. Continuous Improvement: The company has invested approximately $1 billion towards ensuring their facilities are safe, reliable, cost-efficient and environmentally compliant. The company also continues to employ their three year cost and performance improvement initiative, also known as PRIDE, which is expected to finish a year ahead of schedule. PRIDE’s targets were $135 million in operation improvements and $165 million in balance sheet efficiencies. Capital Allocation: The company’s foremost capital allocation strategy is to maintain an appropriate leverage and liquidity profile and to make the necessary capital investments to maintain the safety, compliance and reliability of our fleet. Additionally the company plans to expand their first lien collateral program to include additional hedging counterparties and lines of credit. Risk Management: Competition: There is increasing regional competition in the power markets due to an increase in the penetration and economic viability of distributed and renewable energy sources. The company plans to stay competitive by maintaining a low cost of production through managed fuel costs and reliability. Further the ability to compete effectively will be impacted by regulatory reforms designed to reduce GHG emissions. Current and Future Government Regulation: DYN is subject to a myriad of government regulations and environmental laws. The legal landscape is complex and ever changing and DYN will have to stay up to code on all of these issues. Here is a list of the major issues which impact DYN: The Clean Air Act, Cross-State Air Pollution Rule, MATS rule, NAAQS, The Clean Water Act, Coal Combustion Residuals, Climate Change. Market Liquidity and Counterparty Risk: The company transacts hedges in the Natural Gas, Coal and Power markets. If any of the counterparties experience deteriorating credit, then DYN’s hedges may not be honored. This would adversely impact the company. DYN tries to manage this risk by only transacting hedges with highly liquid counterparties and also by diversifying hedges across many different counterparties. Natural Gas Market Exposure: DYN purchases fuel for its Natural Gas power generation facilities under short-term contracts or on the spot market. As a result the company faces the risks of supply interruptions and fuel price volatility. Further profitable operation of the company’s coal-fired generation facilities is dependent upon coal prices and coal transportation rates. The company tries to mitigate these risks by entering into long-term transportation and supply contracts. Expert Opinion: (click to enlarge) * from Yahoo Finance The experts following DYN have moved from bearish sentiments in 2010-2012, to bullish in 2013-2015. Analysts have a median price target of $39.50 per share which gives the company a 19.33% upside at the current price of $33.31 per share. * from Yahoo Finance Analysts project DYN revenues to grow 22.1% between 2015 and 2016. Further the company has shown extremely strong sales growth of 86.7% and 158.3% year-over-year for the current quarter and the quarter ending Sept. 15th, respectively. Out of context the sales numbers look extremely bullish, however, they are more inline with expected levels and DYN had a poor year last year. Recent News: Dynegy Amends Employment Agreement with CEO Robert Flexon Dynegy Completes Duke Midwest Acquisition ; Transformational Growth for company Dynegy Completes EquiPower and Brayton Point Acquisitions from Energy Capital Partners C onclusion : Dynegy is an electricity generation company which derives much of its revenues from coal fired generation. Coal fired generation margins increase as the price of natural gas increases. I would recommend Dynegy to an investor looking for a very specific type of risk exposure. The investor needs to be looking for an asset that produces a predictable valuation, has less volatility in value than the general market and wants to gain from an increase in natural gas prices. Currently the beta of DYN is 0.11, which means that movement of DYN’s stock is relatively independent to the movements of the market at large. Further, natural gas prices have moved whip-saw market with a high bound of $3.1 and a low of $2.60 since the beginning of 2015. Additionally the experts see a 19% upside with DYN’s current stock price. So, if you find that you are an investor who wishes to gain an indirect and conservative exposure to a rising natural gas market, consider DYN. 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.

Growth And Upside Potential Highlight American Electric Power’s Bullish Credentials Going Forward

Summary Company has encouraging fundamental outlook due to increased efforts on getting a broader regulated asset base. Continuous investments in regulated operations such as transmission business give it huge opportunity for future rate base growth. AEP’s on-track cost containment plan will better its future earnings growth prospects. I have a bullish stance on American Electric Power (NYSE: AEP ); the company’s focus on getting a broader, regulated asset base and its escalated growth investments in the transmission business will better its long-term growth trajectory. In addition, the resolution of the company’s previously filled rate cases with West Virginia and Kentucky by the end of this month will strengthen its future top-line and cash flows. Owing to the attractive outlook of AEP’s future cash flows, I believe its dividend payment will remain attractive for investors. Moreover, the company’s on-track cost savings plan, “Lean deployment”, will continue improving its bottom-line. Furthermore, my price target calculation suggests a potential upside of approximately 25% for AEP. AEP’s Strategic Growth Drivers Remain Intact In the recent past, increased focus on infrastructure development investment by utilities has been positively affecting the industry fundamentals and performance. For 1Q’15, the earnings growth of the U.S. Utility Industry was 8.4% , well above the S&P-500’s growth of only 2.4% year-on-year. As far as AEP is concerned, the company has made great strides in becoming a high-quality regulated utility, with improved execution and better management of its intelligent strategic growth efforts. One of the most important strategic growth drivers, increased focus on regulated asset base, has been helping its financials grow at a decent pace. In fact, AEP’s management has reiterated their intentions to sell the company’s unregulated business under its plan of growing its regulated utility business; the decision is on hold until state regulators make a final decision about the company’s proposal regarding state subsidized purchase power agreement that will help it maintain 3,100MW of coal-fired capacity. AEP has requested regulators make the final decision regarding this matter, at least by October ’15. The prevailing uncertainty around the acceptance of the PPA agreement and the recent industry merchant divestitures make me believe that the company will either sell or spinoff its Ohio-based power generating subsidiary and the proceeds from the sale would be reinvested to support its growth-generating regulated transmission business. In fact, one of its former competitors, Dynegy, is interested in buying AEP’s unregulated assets. Since the transmission business is one of the most promising businesses of AEP, I believe reinvesting cash proceeds from the unregulated business sale in the transmission business will strengthen its long-term growth potentials. Moreover, the sale of Ohio plants (unregulated assets) will support its strategic move, which is away from de-regulated operations to regulated ones. In fact, the company has several multibillion-dollar projects in place for the next five-to-ten years, in order to grow its regulated asset base by improving the operational performance of its transmission business. Currently, AEP stands tall in the U.S. utility business with its major stake in several advanced transmission projects, and moving ahead, further increases in transmission project-related investments will improve its fundamentals. As part of its long-term growth plan, AEP has announced hefty investment of almost $4.8 billion in transmission projects from 2015 to 2017; I believe that these up-scaled investments in the transmission business will help the company’s rate base expand, which will increase its future cash flows and ROE. Moreover, increase in its earned returns will better AEP’s EPS growth. Furthermore, the company’s previously filed rate cases in West Virginia and Kentucky are expected to gain approval at the end of this month. AEP has requested a $227 million rate increase in West Virginia and a $70 million rate increase in Kentucky, which will allegedly go into effect on 1st July 2015. I believe that these recent rate hikes will portend well for raising the level of earned returns for the company and will add towards the certainty of its cash flow base success in the years ahead. On the bottom-line, AEP’s multi-year cost saving plan “Lean deployment” is working really well to get it a leaner cost base. Thus far, the company has completed the implementation of lean deployment at 13 distribution districts, whereas work at almost 19 more is still in process. Moreover, on the transmission business side, AEP has completed work on just one area and four more are scheduled for completion, this year. Given the fact that the implementation of lean deployment is keeping the company’s operational and management (O&M) expense down, I believe with the ongoing execution, cost efficiency gains from the lean deployment plan will keep on improving AEP’s earnings growth level. Safe & Sustainable Returns AEP’s strong growth prospects have been helping its cash flows grow and support its management’s dividend policy. With the increasingly healthy cash payments under its attractive dividend payment policy, the company has earned a strong five-year dividend growth rate of around 4.87%. Keeping track of its attractive dividend payment plan, AEP had recently announced another quarterly dividend payment of $0.53 , which translates into a dividend yield of 3.95% . Given the company’s strong strategic growth prospects and due to its management’s strong commitment towards paying healthy dividend payments, I believe AEP will have cash flows available to make and increase dividends in the years ahead. Guidance The company’s management has reaffirmed its guidance for 2015. AEP expects full year 2015 EPS to be in a range of $3.40-to-$3.60 . Also, it has maintained its stance about achieving long-term earnings growth in a range of 4%-to-6%. Thus far, the company has done pretty well in achieving allowed ROEs at its regulated subsidiaries; I believe its correct growth efforts and cost controls will help AEP achieve its anticipated 4%-to-6% growth rate in the years ahead. Risks The company’s future growth prospects will continue to face the risk of potential negative regulatory restrictions in its service territory. In addition, AEP’s inability to pull off well-timed, constructive regulatory rate base approvals by negotiating with FERC might pressurize its future growth prospects. Moreover, the company’s ongoing and planned development plans, if not properly executed, might burden its bottom-line with cost overruns. Furthermore, unfavorable temperature trends, environmental regulations and unforeseen negative economic changes are key risks hovering over its stock price performance. Price Target I reiterate my previously calculated price target of $69 for AEP, which was calculated using a dividend discounting method. In my price target calculations, I used cost of equity of 6% and nominal growth rate of 3%. Based on my price target, the stock offers potential price appreciation of 25%. Conclusion The company has an encouraging fundamental outlook due to its increased efforts on getting a broader regulated asset base. In fact, continuous investments in regulated operations such as the transmission business give it a huge opportunity for future rate base growth, which increases certainty about its future cash flows and earnings base. Moreover, the company’s on-track cost containment plan will better its future earnings growth prospects. As a matter of fact, the healthy future earnings growth will strengthen its cash flows, which will support its dividends. Furthermore, my price target calculations suggest a potential upside of approximately 25% for the stock. Analysts have also anticipated a healthy next five-years growth rate of 4.92% for AEP. Due to the aforementioned factors, I am bullish on AEP. 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.