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The Low Volatility Anomaly: Mid Caps

The Low Volatility Anomaly describes portfolios of lower volatility securities that have produced higher risk-adjusted returns than higher volatility securities historically. This article provides additional evidence for Low Volatility strategies by showing the factor’s success in mid-cap stocks. Provides historical comparison of returns between low volatility mid cap stocks versus broad mid cap indices and the benchmark large cap index. Thus far in this series, our most oft used description of the Low Volatility Anomaly in equity markets has been depicted through the use of a factor tilt on a large cap index. In the introductory article to this series on Low Volatility Investing, I plotted the cumulative total return profile (including reinvested dividends) of the S&P 500 (NYSEARCA: SPY ), the S&P 500 Low Volatility Index (NYSEARCA: SPLV ), and the S&P 500 High Beta Index (NYSEARCA: SPHB ) over the past twenty-five years. In an article last week , I showed that the Low Volatility Anomaly extends to small cap stocks as well as the S&P Smallcap 600 Low Volatility Index has also outperformed the broader S&P Smallcap 600 over the last twenty years, producing annual total returns of nearly 14% per annum. The volatility-tilted indices for both the small and large cap indices are comprised of the twenty percent of index constituents with the lowest (highest) volatility within the S&P 500 based on daily price variability over the trailing one year, rebalanced quarterly, and weighted by inverse (direct) volatility. The low volatility tilt of both the small and large cap indices produced both higher absolute returns and much lower variability of returns than the broader market gauges. This article will answer the question of whether such a factor tilt delivers alpha in the space in-between – the mid-cap stock market. Fortunately for our examination, Standard & Poor’s has also developed the S&P MidCap 400 Low Volatility Index . Similar to the S&P 500 Low Volatility Index, this benchmark tracks the twenty percent of the S&P MidCap 400 (eighty stocks) with the lowest realized volatility over the past year, weighted by an inverse of that volatility, and then rebalanced quarterly. While the index was launched in September 2012, Standard & Poor’s has back-tested data for over twenty years. Below is a graph of the cumulative total return of the S&P MidCap 400 Low Volatility Index, the S&P MidCap 400 Index, and the S&P 500. (click to enlarge) Source: Standard and Poor’s; Bloomberg As you can see above, the S&P MidCap 400 Index (white line; replicated through the ETF MDY ) readily bests the S&P 500 (yellow line). This outperformance is consistent with my article on 5 Ways to Beat the Market that demonstrated the structural alpha available through the size factor, which has been well documented in academic research (F ama & French, 1992 ). Some readers have also contended that the outperformance from Equal Weighting, which was also one of my “5 Ways ” is attributable to the size factor as well and more reminiscent of a mid-cap strategy given the lower average capitalization of equally weighting versus traditional capitalization weighting, but I contend that the contrarian re-balancing also contributes to the alpha-generative nature of that strategy. Whatever the source of the structural alpha, mid-caps have outperformed large-caps over long-time intervals. Low Volatility mid-caps have outperformed the broad mid-cap index on a risk-adjusted basis, but not on an absolute basis like the Small and Large Cap strategies. In tabular form, one can readily see that each of the small cap, mid cap, and large cap Low Volatility indices produce higher risk-adjusted returns with lower variability of returns than the broader market gauges from which they are constructed. The lower downside in the market selloff in 2008 greatly contributes to the lower variability of the Low Volatility indices. (click to enlarge) The PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA: XMLV ) seeks to replicate the performance of the S&P MidCap 400 Low Volatility Index with a 0.25% expense ratio. Like many of the Low Volatility ETFs, XMLV is a post-crisis innovation with a track record dating only back to February 2013. The ETF has only $100M of AUM, and thirty-day average volume of only 14,600 shares, similar AUM to the SmallCap Low Volatility ETF (NYSEARCA: XSLV ), but about 2/3 of the trading volume. Again similar to the Small Cap Low Volatility Index, I would be remiss if I did not mention that financials currently account for nearly half of the fund weighting (REITs 27.3%, Insurance 16.6%, Banks 3.8%). As I covered in a recent comparison between the PowerShares S&P Low Volatility ETF versus the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ), industry concentrations in the S&P indices are uncapped, unlike the MSCI versions, and this lack of constraints has historically led to risk-adjusted outperformance and more variable industry concentrations over time. A reader of my article on Small Cap Low Volatility contended that they disfavored these funds because of the potential higher sensitivity to higher rates given the financial bent. Rates are moderately higher in 2015, and XMLV has delivered market-beating returns. I would point out that if higher rates lead to higher return volatility, then these stocks will be attributed lower weights or excluded from the fund at the quarterly rebalance date. As described in now fourteen recent articles on the Low Volatility Anomaly, I am a believer in the relative risk-adjusted outperformance of low volatility strategies. While Mid-Cap Low Volatility did not deliver the absolute outperformance versus the Mid Cap Index over the historical sample period, it still strongly outpeformed on a risk-adjusted basis. Versus the S&P 500, which many use as their benchmark, MidCap Low Volatility still delivered 3% per annum of outperformance with less than three-quarters of the return volatility. I am also a believer in the long-run outperformance available through the size factor that favors smaller and mid-capitalization stocks. Resultantly, I am evaluating an entry into a modest position to XMLV to provide some additional diversification to the Low Volatility portion of my long-term portfolio and will monitor the efficacy of this ETF vehicle as it matures. Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon Disclosure: I am/we are long SPY, SPLV, XSLV. (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.

Tactical Asset Allocation – My Ideas From 30 Years Of Learning

Summary How to create an investment portfolio using Tactical Asset Allocation. Three key measures I use are interest rates, valuation, and growth outlook. When selecting countries or regions, consider demographics, job growth, urbanization, debt levels, geo-political risk and currency effects. Tactical Asset Allocation (TAA) is defined as a dynamic investment strategy that actively adjusts a portfolio’s asset allocation . My goal in this article is to share with you the ideas that I have developed over the past 30 years, and to encourage discussion amongst readers, so as we can all learn from each other’s ideas and experiences. Introduction As a financial adviser, I must first consider a client’s risk profile. Younger clients with less capital invested will typically be prepared to take on more risk, and older clients will usually be comfortable taking on less risk. To keep it simple, I consider the following four asset classes: Cash, Bonds (CDs), Property and Equities. NB: I may also add Infrastructure (when interest rates are low to medium) or other sector funds, on occasion, as a small percentage of the portfolio. In determining my clients’ asset allocation, I consider the following factors: Interest rates Valuation Growth outlook Interest Rates The table below guides me, as does the 10-year Bond rate versus the equities dividend yield. BEST WORST Interest Rates Number 1 Number 2 Number 3 Number 4 Low (0-3%) Property Equities Bonds (CDs) Cash Medium (3-6%) High (6%+) Cash Bonds (CDs) Equities Property NB: The above % interest rates above are based on the reserve bank rate. Typically, the actual lending rates are around 2-3% higher. NB: When interest rates are “Medium” (3-6%), then their effect on the four asset classes is fairly neutral. Interest rates falling is better for bonds (CDs), property and equities. Interest rates rising is better for cash. Valuation My preferred valuation measures for asset allocation are: Price Earnings (P/E) Ratio : I look at a region or country’s P/E, both historical (last year’s earnings) and forward P/E, where available. My rule of thumb is to buy heavily as the P/E heads towards 10 and sell heavily as the P/E heads towards 20. A P/E of 15 is considered neutral. Having said that, I will also factor in interest rates. The Rule of 20 holds that P/E should be 20 minus the current interest rate. E.g., USA’s P/E should currently be 20 – 0.25 = 19.75. This makes allowance for times of extreme interest rates, as does the table below on interest rates. Long-term Charts of a Country’s Equity Index : Here, I simply view a 10- or 20-year chart and see if the index is above or below its trend line. Above being overvalued, below undervalued. Growth Outlook I will assess the following for a region’s or country’s growth outlook; GDP – Current year and forecast for next year. Earnings Per Share (EPS) – Forecast for next year. I will take a look at the following factors: Demographics – Is there a rising middle class, a growing work force or wealth effect? (You can read my article on demographics here , and the one on the rising Asian middle class here .) Job growth (unemployment) – Is the country gaining jobs? Urbanization – Is the country urbanizing? Debt levels – Are household debt levels low? Geopolitical risk and quality of government – Is there low geopolitical risk? Currency valuation – Is the currency undervalued? Trying to factor in all of the above is, of course, no easy task. Nor is it an exact science, but rather, is an art form, in my opinion. Having said that, I will give an example below of how I am currently (as of August 2015) recommending to my Australian clients, based on the above. Moderate-Risk Australian Client – $1m (AUD) Cash – 30% Bonds (Term Deposits, or TDs) – 0% Property – 20% Equities (comprising Asia) – 40% Sector funds – 10% (comprising Global Infrastructure – 5%, Global Resources – 5%) NB: TDs in Australia are the same as CDs in USA. Discussion on the above Tactical Asset Allocation Cash – 30% : Low percentage, as aggressive client and interest rates are very low. The reason to maintain 30% is to have cash available (to protect and invest) in case we see a severe market correction. Cash rates in Australia are still around 2.5% p.a. Bonds – 0% : Zero percentage, as interest rates are falling in Australia. 0% to International bonds, as the rates are already very low in developed markets. Could consider Asian or emerging market bond funds, where the rates are around 5-6% p.a., but there would be currency risk. Property – 10% in Australian-listed property : Low percentage due to earnings growth outlook being weak, with a weak Australian economy and rising unemployment. Low interest rates and fair valuation (P/E 15) suggest some exposure is necessary. Finally, most Australians already have very large $ exposure to an overvalued residential property sector. 10% in Global-listed property : Low interest rates are favourable and valuations fair. Equities – 40% : High percentage due to low interest rates, fair valuations in some regions/countries, strong growth prospects in Asia (demographics mostly good, rising middle class set to triple in size by 2020, according to DBS , with good jobs growth, urbanization, mostly low household and government debt levels, mostly low geo-political risk, and mostly good governments). Global Infrastructure – 5% : Low due to valuations being somewhat elevated. Could go to 10%, based on low global interest rates. Global Resources – 5% : Low, as this sector has been smashed down, and Asian demand for resources will pick up, with 290 million new homes required by 2020 and massive infrastructure projects planned. The valuations may look a bit high, but they are based on very low commodity prices at present. The following P/Es and growth outlook were part of the consideration. Australia: P/E – 15.67, Growth outlook – Poor Asia: P/E – 17.05, Growth outlook – Strong USA: P/E – 19.92, Growth outlook – Average-to-poor Europe: P/E – 19.11, Growth outlook – Average-to-poor Japan: P/E – 16.91, Growth outlook – Average-to-poor The above allocations will certainly lead to many debates, and this is healthy. US investors will naturally have more exposure to their local assets, which will avoid currency risk. They may choose to hold a percentage in US shares, given that the long-term outlook for US companies is strong. I do not disagree with that. My concerns are for non-US investors buying into the US late in the bull run, with a high valuation and a high USD. The main point of this article is to give investors some ideas on how they can go about building their portfolios, with consideration to both risk and return. For me, as discussed, I like to start with interest rates, then consider valuations and growth outlook. I always keep one eye on risk control and the other on optimizing returns, based on the client’s risk tolerance. 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. Additional disclosure: The information in this article should not be relied upon as personal advice.

Baby Boomers: Cash Is NOT Trash

Summary Record low cash allocations exist in the market. Investors should use this as a contrary indicator and raise cash. Think safety first in a market this extended. With persistent, historically low interest rates, it’s no wonder people think ‘cash is trash’. Cash equivalents (Money market, U.S. government T-Bills, etc.) essentially yield nothing so it seems like a very logical place to avoid as one approaches, or has recently entered, retirement. But that’s exactly where we think you should be overweighting. It runs so contrary to most investors, which is precisely why it’s so actionable. Little thought exists to what happens if the stock market sells off and remains low for a long period of time. The only fear evident in the current environment is being underinvested and missing out on further gains (evident last week when the VIX hit 10.88, the third lowest reading since before the financial crisis). The nest egg many baby boomers have toiled for and nurtured is very vulnerable if positioned too aggressively, whether in a reach for yield scenario (junk-rated debt, MLPs, REITs, BDCs) or simply being fully invested, possibly even on margin, to buy solid ‘blue chips’. There is no shortage of scary commercials by asset managers insinuating that you’ll run out of money in retirement unless you’re fully invested (with them). Prudential’s (NYSE: PRU ) commercials come to mind (“How old is the oldest person you’ve ever known?)”. But a scarier one might feature someone trying to re-enter the work force in a few years whose portfolio’s value has been cut in half. Contrary to popular opinion, the stock market’s function is not to provide you with an income stream to live off of . Cash is not Trash But first, is there really an aversion to holding cash? Unequivocally, yes. Here’s two data points that bear out the aversion to cash: 1) The data we’ve seen in mutual funds corroborates this. There have been record lows in cash on a sustained basis with another new all-time low in the mutual fund cash ratio of 3.2% for June. This low demand for cash is remarkable and is one of several factors we believe portends a steep market selloff in the not too distant future. While it’s true that cash levels have been low for years now, we think a turn is imminent. A worrisome chart we came across from Acting Man illustrates the sentiment very well: (click to enlarge) In the chart above (we tweaked it a bit – we added the orange line, the yellow and pink shaded zones and the boxed labels with red arrows and try and put into context the severity of the current complacency) that for the entire period of the 1980s and most of the 90s (until the dotcom boom kicked in), cash levels were dramatically higher, ranging between 7%-12% versus today’s 3.2%. In fact, the ratio during the entire yellow-shaded range was also markedly higher than the 6% we saw during the panic at the March 2009 lows . To put things into perspective, the U.S. market capitalization was around $2 trillion near the beginning of the yellow shaded area and is now almost $25 trillion, according to Bloomberg . If cash levels even begin to return to these former (one might say ‘responsible’) levels, given the amount of money currently invested in our stock markets, there will be a severe shock to our economy and way of life. 2) We also see this by looking at retail accounts, where the money market ratio (assets in money market funds and not invested in the stock market) is a measly 2.47%, which is just off the all-time low of 2.45% earlier this year. Again, people are fully invested and probably reaching for yield. There has been an intensifying decline in the money market ratio over the last 4 years built on the dual pillars of extreme complacency and continued optimism. Many boomer retail accounts have been heavily invested in three sectors that have, unfortunately, probably all peaked – REITs (NYSEARCA: VNQ ), utilities (NYSEARCA: XLU ) and energy MLPs (NYSEARCA: AMLP ). We’ve been amazed at the amount of follow-on equity offerings (often overnight or ‘spot secondaries’) for energy stocks, often MLPs, over the last few years. This is a key source of financing for MLPs. We’ve already witnessed the carnage for high-yield bonds of the energy sector with the Shale collapse – when the appetite on the institutional side really disappears for their junk debt, these companies will be scrambling for capital even more than they are now. On the retail side, the retail investor’s powder is running dry, as it appears to be now given the above ratios, and the selling pressure should persist, especially as natural gas and crude oil should continue their slides. We see WTI getting back to the low $30s. Back to the Future Below is a great chart of the Dow Jones Industrial Average going back to 1900 (we added some data to try and give some perspective). In the early 1980s, everyone was in cash (and avoiding the stock market) when 3-month T-Bill rates were over 16%. The stock market had essentially gone sideways for about 17 years (1965-1982), investors were exhausted from the whipsaws and economic conditions (inflation) were terrible. People just wanted to be in cash. “Why risk it in a stock market going nowhere when we can get these high Treasury yields”? Eyeballing the chart above, mutual fund cash levels then were roughly 11% (versus 3% today). Completely logical thinking but also completely wrong. The market ascended around 14-fold over the next 17 years. (click to enlarge) Below is some monthly data from the St. Louis Fed on 3-month U.S. Treasury bill yields: A logical investor in 1982, seeing this data set above and the long-term Dow Jones chart, probably followed the Flock of Seagulls hit from that year and ‘Ran so far away…’ from the stock market. It is really amazing to see these numbers from the early 1980s, especially when compared to today’s yields: A logical investor in 2015, looking at the last two years of T-Bill rate data above, might say, “why would I put my money into this instrument that pays [essentially] nothing, when I can put it into the stock market that has been on fire for 6 straight years. There’s plenty of individual securities paying high single-digit returns, and the overall market yield is about 2% (which is 2% more than nothing) – I need the yield to live off of.” Sounds perfectly logical, but we think many investors are ignoring the risk side of the equation and only looking at the return side. A measly 2% market yield is unacceptable for a tremendous amount of market risk, in our opinion. We think these miniscule T-bill (or money market) rates are exactly where investors should be going at this point . From page 445 of Robert Prechter’s book , Conquer the Crash, from October 1998 through March 2008, the S&P 500 returned 3.84% while investments in U.S. T-Bills returned 30.22%. Today’s investors should be listening to ‘Timber’ by Pitbull and the message it portends. Safety with Benefits Here are three benefits for raising cash – 1) your capital will be preserved (at a time when markets look very frothy), 2) you have the potential for an increase in purchasing power if the deflation we’re seeing around the world hits here, which seems more likely than not and 3) you’ll reap the benefit of higher rates by rolling over whatever ultra-short term investments you’re in (T-Bills, money market funds, etc) and especially any floating rate securities the money market fund has. We want ‘cash’ in a money market fund that will hold up through a crisis or a sustained interest rate rise. Don’t forget, money market funds are portfolios of debt (shorter term and safer types, but debt nonetheless). You may even want to avoid a more traditional money market fund and opt for a lower yielding one that’s tilted towards very short-term Treasuries. But the government shutdown debacle in 2013 showed that there is risk involved in even that. ( Recall the yield on one-month T-Bills shot up from two basis points to sixteen in a week when there were very real worries of a default on short-dated T-bills). The dysfunction in Congress was serious enough that firms like BlackRock (NYSE: BLK ), JPMorgan (NYSE: JPM ) and Fidelity were scrambling to sell or reshuffle their securities (T-bills in the money market funds) that were most likely to be impacted by a default. So it might pay to ‘diversify’ with a couple different money market funds (preferably held at different brokerage accounts) if you have that option. There’s even some ETFs that try to achieve similar safety. Charles Schwab (NYSE: SCHW ) has the Short-Term U.S. Treasury ETF (NYSEARCA: SCHO ) which we prefer to Vanguard’s Short-Term Bond fund (NYSEARCA: BSV ) which is slightly longer in maturity and has commercial paper. Summing it Up Again, we like the idea of raising cash. Cash in a bank, referred to as ‘free cash’ at some institutions. Now if your assets are in a deferred retirement account, taking the money out would probably incur a tax liability (and possible penalties). So if you want to avoid that, liquidating perhaps one of the funds you have but keep the sale proceeds in the sweep account (presumably some type of money market fund). As long as it stays in the account, there won’t be any distribution so you’ll avoid tax or penalty as a result of that. If you have a defined contribution plan like a 401(k), you should have a few choices and look closely at the ones with the lowest yield. Lower yield money markets will probably have more of a short-term treasury component and less repurchase agreements, commercial paper and ‘asset’-backed securities which could become problematic in a crisis and certainly aren’t worth the risk for potentially another fraction of a percent in interest. By taking a portion of your money, if interest rates rise, you will benefit by rolling into higher and higher rates (given the short duration). We like the idea of putting at least a quarter of your portfolio into cash (or an equivalent) given these market levels. If you are adamant about not selling anything outright, one option could be simply taking the dividends you are getting in your funds and not reinvesting them – instead take them as cash and they’ll automatically go into the sweep vehicle or money market. If interest rates rise, you’ll benefit if you own ultra-short investments such as T-Bills since you’ll have the flexibility to roll over the investments as rates go higher. It appears more than likely that rates in the U.S. have bottomed and is being confirmed by the 3-month LIBOR. This should usher in a new era of rate increases worldwide. Raising cash on one-quarter of your portfolio plus hedging another quarter of your portfolio with the long-dated put option (an idea we highlighted in last week’s article ) could effectively cut your portfolio’s risk by half for the next almost 2 ½ years. As we’ve said before, we think now is a time to think independently and play defense with your portfolio and we look forward to the future when we can ‘back up the truck’ when things really go on sale. But that time doesn’t appear to be any time soon. 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. Additional disclosure: I/we are not registered investment advisors and these ideas are not recommendations to buy or sell any specific security.