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3 Tips For Investing In Emerging Markets

By Tim Maverick Having been a neglected asset class for some time, emerging market stocks are enjoying a healthy rebound so far in 2016. The story of how we got here is a familiar one. When developing stock markets got overbought, they became overvalued. As a result, nervous investors – mainly from the United States – dumped those assets. But the selloff led to a sharp 180-degree turn – emerging markets then traded at a 28% discount to developed countries. Research Affiliates, founded by noted investor Rob Arnott, explains that emerging market stocks have only been cheaper than current levels six times. Each of those periods sparked an average five-year return of 188%. That should grab any investor’s attention. So what’s the best way to invest in emerging stock markets? Based on my decades of experience as both an advisor and an investor, I’ve compiled three quick tips to help you make sense of this market trend . Tip #1: Do NOT Use Index Funds I’m not a fan of index funds in general… but especially when it comes to emerging markets. It’s a sure-fire way to be unsuccessful. Why, you ask? First, because indices severely restrict your investable universe. And they’re usually restricted to the most overbought and overvalued stocks. Case in point: The Institute of International Finance points out that only $7.5 trillion out of a total of $24.7 trillion in emerging market equities are covered by indices from MSCI and JPMorgan (NYSE: JPM ). The rest are simply ignored as if they don’t exist. Yet, it’s those ignored stocks that usually boast the best bargains and room for growth. Tip #2: Avoid The Closet Index Trackers Even if you do avoid index funds directly, there’s another problem: “Closet trackers.” These are fund managers who like playing it safe. They couldn’t care less about outperforming the benchmark index for their shareholders. These managers have at least 50% of their funds in index stocks, so their funds will mimic the underlying index. Needless to say, that’s not what you want. Worryingly, a study from the World Bank revealed that 20% of equity funds were index trackers or closet trackers. This is a complete waste of money from an investor’s viewpoint. You’re paying for active management, but you’re not getting it. One example of a mutual fund company that usually goes off the beaten track and often invests in smaller companies is the Wasatch Core Growth Fund No Load (MUTF: WGROX ). Though I do not own their emerging market fund, I do own their frontier markets fund – Wasatch Frontier Emerging SmallCountries Fund (MUTF: WAFMX ) – for exposure to the smaller frontier markets. Please note: The fund is closed to new investors if you try buying it through your brokerage, but if you go directly to the fund company, it’s still open. Tip #3: Get Local Exposure If you truly want exposure to developing markets, guess what? You’ll need to own shares in local companies. And while it may seem like a clearer route to a profit, don’t do what many U.S. advisors espouse and have your sole exposure through multinational companies. Yes… there are many great multinationals with huge emerging market businesses – a company like Colgate Palmolive Co. (NYSE: CL ) comes to mind – they’re not the best way to gain exposure to developing markets’ economic growth. I like to use this analogy when explaining this point to clients: Let’s say a Japanese investor wanted exposure to the U.S. economy. His broker recommends Toyota Motors Corp. (NYSE: TM ). After all, Toyota sells a lot of cars in the United States. Silly, right? Toyota shares aren’t a good way to play the overall U.S. economy, as the stock only represents a very select fraction of market success. Neither is investing in emerging markets solely through multinationals. Investing in emerging local companies is the best way to profit from more specific foreign trends. There are all manner of resources available these days for researching foreign companies and stocks. It does take a bit of work, but the rewards can be well worth the time. Alternatively, you can leave the work to proven, active fund managers. Regardless of which route you prefer, now is a good time to build positions in emerging markets. Original Post

The Teleology Of Smart Beta

By Craig Lazzara As assets tracking factor indices grow, so does the attention paid to evaluating and promoting these so-called “smart beta” funds. Even the nomenclature attracts attention. Professor William Sharpe, famous among other things for introducing the concept of beta to academic finance, has said that the term “smart beta” makes him ” definitionally sick ,” and lesser lights than he have also voiced reservations about the terminology. Recently, one of the financial community’s best journalists opined that smart beta may be less smart than many of its practitioners allow. How should an investor evaluate a “smart beta” strategy? One fair way is to evaluate it against the claims its advocates make, which requires that those claims be made explicit. A factor index provides exposure to stocks with certain common characteristics. Are those characteristics desirable in themselves, or desirable only because they are a means to a different end? What, in other words, is the telos of a smart beta index? This question puts a certain burden on both manager and investor, as clarity, already a moral virtue, becomes a practical necessity . For example, suppose an investor is sold a value-driven “smart beta” ETF. Its managers say (truthfully) that it will hold only stocks with above-average yields and below-average P/E ratios. The investor buys the fund, and several years later, finds that his “smart” ETF has underperformed the dumb old cap-weighted index from which its constituents were drawn. But the ETF’s stocks were cheap when they were bought and they remain cheap. Ought the investor to be aggrieved? And if so, with whom – with himself, or with his ETF manager? Of course, in our simple example, the investor may not have been fully clear, not even with himself, about his underlying assumptions. He may have told himself that he bought the ETF in question because he wanted to own undervalued stocks, and this may even be true, as far as it goes. But it may not go far enough. Perhaps the fuller truth is that he wanted to own undervalued stocks as a means of outperforming a cap-weighted benchmark. And smart beta’s failure to outperform, in this case, is as irksome as would be the underperformance of an active manager (although perhaps less painful in view of smart beta’s presumably lower fees). The investor, in other words, needs to understand his own motivation. Does he want factor exposure in itself, or because it is a means to a different end? An investor who undertakes factor exposure as a means of outperforming should be aware that, just as no active manager outperforms all the time, neither does any factor index. The investor should strive to understand the conditions that will make for a factor’s success. Equally, he should strive to understand his own goals and motivations . Disclosure: © S&P Dow Jones Indices LLC 2015. Indexology® is a trademark of S&P Dow Jones Indices LLC (SPDJI). S&P® is a trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a trademark of Dow Jones Trademark Holdings LLC, and those marks have been licensed to S&P DJI. This material is reproduced with the prior written consent of S&P DJI. For more information on S&P DJI and to see our full disclaimer, visit www.spdji.com/terms-of-use .

Floating Rate ETFs In Flux

This article originally appeared in the April issue of WealthManagement Magazine and online at Floating Rate ETFs in Flux . With fed rate hikes likely coming at a slower pace, investors flee some floating-rate notes. Nearly a year ago, as part of our survey of alternative income funds (” Alternative Alternative Income “), we picked through a number of floating-rate note (FRN) portfolios to find the potential best-of-class performance should interest rates rise. Well, since then rates have risen by 34 basis points in the three-month Libor and 26 basis points in the three-month T-bill yield. Curiosity compels us to revisit the floater funds to see how the asset class has fared. Not all these portfolios are alike, so one shouldn’t expect uniform results. The vast majority of the $9.8 billion held by exchange traded fund (ETF) versions are invested in corporate securities. And, among these, there’s further differentiation by credit ratings. Most investors are attracted to funds holding high-yield securities, though significant assets are committed to investment-grade paper. The junk/quality split is 54/40 with the remaining 6 percent in municipal and Treasury notes as well as a fund devoted to variable-rate preferred stock and hybrid securities. Money Flows Overall money has flowed out of the 12 ETFs plying the floater trade over the last 12 months. Net redemptions of $417 million reduced the category’s asset base by 4 percent. This wasn’t a wholesale dumping; it was more tactical. Some segments lost assets, some gained. And that’s a story in itself. Junk note funds lost nearly 16 percent, or $986 million, while ETFs invested in higher-grade corporate notes saw inflows of nearly 5 percent, or $183 million. At the same time, there was a $5 million, or 45 percent, boost in the newer (and smaller) Treasury segment. The single fund devoted to municipal notes bled assets, losing $27 million, or 28 percent, of its base while the other singleton, the variable preferred stock ETF, tripled in size with $408 million in net creations. Two trends are at work here. Some of the high-yield assets migrated to safer havens, namely bank-grade and Treasury paper. Mainly, that’s been an escape from duration risk. Money’s also being drawn to the equity side in response to more encouraging economic data. The second trend is a mercenary search for yield. Consider the inflow to the preferred stock ETF. Dividend yields for variable preferreds indexed in the Wells Fargo Hybrid and Preferred Securities Floating and Variable Rate Index exceed 5 percent, significantly higher than the rates earned by junk notes. Investors believe that stocks, common or preferred, are okay to buy again. Especially if they produce lip-smackin’ income. The insulation from duration risk is a boon. So, let’s take a closer look at the cash thrown off by these ETFs, along with their return characteristics. High-Yield Corporate Floaters The 600-lb. gorilla among high-yield floater ETFs is the $3.7 billion PowerShares Senior Loan Portfolio ETF (NYSEARCA: BKLN ) , which owns more than 70 percent of the segment. As BKLN goes, so goes the segment. Buoyed by a market-weighted 4.22 percent dividend yield, high-yield ETFs collectively earned a total return of -2.54 percent over the past 12 months. The segment’s discernible duration is 2.27 percent, making it the most rate-sensitive in the asset class. When benchmarked against the i Shares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ) , a broad market bond index tracker with a duration of 5.53 percent, you can see the bargain made by FRN investors: Aiming for higher dividends and less rate sensitivity, they settled for lower overall returns. Despite its middling dividend yield, assets have flowed to the First Trust Senior Loan ETF (NASDAQ: FTSL ) in the past year. FTSL is actively managed with a mandate that allows the portfolio to be invested in non-U.S. paper and equities. Net creations have boosted the fund’s asset base by 87 percent. Investment-Grade Corporate Floaters Dividends are a lot lower in the bank-grade segment. With a collective “A” credit rating, the segment’s market-weighted yield is just 0.58 percent. Modified duration, at 0.12 percent, is very low as well. Like high-yield corporates, total returns have been negative, though at -0.40 percent, less so. The $3.5 billion iShares Floating Rate Bond ETF (NYSEARCA: FLOT ) sets the segment’s pace, though the fund to beat has been the SPDR Barclays Investment Grade Floating Rate ETF (NYSEARCA: FLRN ) . FLRN is the only corporate floater that produced a positive total return over the past year. Treasury Floaters Floating-rate Treasury paper, with its low yield and virtually nonexistent duration is really a cash substitute. Investors, wary of potential Fed rate hikes, have goosed up the segment’s small asset base in the last 12 months. It’s the only segment, too, that’s produced a positive, albeit small, total return. Nearly all the segment’s assets are held in the iShares Treasury Floating Rate Bond ETF ( TFLO) . Other Floaters There are a couple of ETFs at the corners of the floating-rate market. The PowerShares Variable Rate Preferred Portfolio ETF (NYSEARCA: VRP ) , claiming the highest dividend yield in the class, earns the variable moniker in more than one way. It’s been one of the category’s more volatile issues, and ended up losing money overall in the past 12 months. A stablemate, the PowerShares VRDO Tax-Free Weekly Portfolio ETF (NYSEARCA: PVI ) , owns municipal bonds, rated AA- on average, that can be redeemed weekly. Duration is negligible, which make the fund a cash substitute. With no dividend stream, however, the total return pretty much reflects its holding costs. No wonder the fund lost assets. An Overview The side-by-side comparison in Chart 1 shows how the category’s biggest funds behaved over the past 12 months. Three ETFs-FLOT, PVI and TFLO-varied little from their starting values, but BKLN and VRP wobbled significantly. Such volatility speaks to inherent risk. Floating-rate funds limit duration risk so they’re obliged to take on more credit risk to generate attractive returns. We seem to have reached a risk inflection point, though. By and large, investors are fleeing the risk in the high-yield corporate market. That exodus, in great part, reflects investor perceptions that Fed rate hikes may be coming at a slower pace than originally expected. The advantage of holding variable-rate securities, then, has diminished, making other assets more appealing.