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Minimum Volatility Stocks: Out-Of-Sample Performance Of USMV Buy & Hold Models

Originally published on Dec. 16, 2014 The backtest reported in this article showed that ranking the holdings of USMV , the iShares MSCI USA Minimum Volatility ETF, and selecting a portfolio of the 12 top ranked stocks, provided higher returns for the buy & hold portfolio than for the underlying ETF. To test these findings out-of-sample we launched the Best12[USMV]-July-2014on Jun-30-2014 and the first sister model Best12[USMV]-Oct-2014 on Sep-29-2014. Holdings and performance have been published weekly on our website since then. So far to Dec-15-2014 these portfolios have gained 19.2% (6.8%) and 10.5% (5.3%), respectively. (USMV gains are in brackets.) The test will be expanded by the launch on Jan-5-2015 of the second of the three sister models quarterly displaced, the Best12[USMV]-Jan-2015, which again will consist of the 12 highest ranked stocks of the then point-in-time holdings of USMV. Eventually there will be four quarterly displaced Best12[USMV] models at iMarketSignals to check whether the out-of-sample [OOS] performances of the models exceed those of USMV over the same periods. Only when the OOS periods are long enough can one decide whether this is a profitable investment strategy. One can probably assume this to be the case if by the end of next year the combined returns of the models are indeed significantly higher than the combined returns of USMV for the corresponding periods. Although the performance of the two models have been considerably better than that of USMV, one should not commit capital in the expectation that strategies that worked well in-sample, and for a few months OOS, are therefore also bound to do well in the future. Backtest Parameters It is relatively simple to “overfit” an investment strategy so that it performs well in-sample, but the more complex a model is, the higher the likelihood of the OOS performance to underperform the backtest’s results. Therefore a simple algorithm with only a few parameters was chosen, with buy- and sell rules kept to a minimum, details of which were provided in the original article. The model should also be tax-efficient because the holding period for each stock will normally be at least one year long. Current Holdings and Return to Dec-15-2014 for Best12[USMV]-July-2014 Of the portfolio’s initial holdings of 12 stocks, 11 of them gained value since inception on Jun-30-14, with the portfolio showing a 19.23% return to Dec-15, while iShares’ USMV gained 6.77% over the same period. A starting capital of $100,000 at inception grew to $119,230, with fees and slippage accounted for. Table 1 below shows the current holdings, unchanged since inception, and return for each position. (click to enlarge) (click to enlarge) The performance graphs of $100 invested in the Best12[USMV] and SPY (the ETF tracking the S&P500), is shown below, with the red graph indicating the value of Best12[USMV]-July-2014 and the blue graph depicting the value of SPY. (click to enlarge) (click to enlarge) Current Holdings and Return to Dec-15-2014 for Best12[USMV]-Oct-2014 Of the portfolio’s initial holdings of 12 stocks, 11 of them gained value since inception on Sep-29-14, with the portfolio showing a 10.53% return to Dec-15, while iShares’ USMV gained 5.30% over the same period. A starting capital of $100,000 at inception grew to $110,530, with fees and slippage accounted for. Table 2 below shows the current holdings, unchanged since inception, and return for each position. (click to enlarge) (click to enlarge) The performance graphs of $100 invested in the Best12[USMV] and SPY (the ETF tracking the S&P500), is shown below, with the red graph indicating the value of Best12[USMV]-July-2014 and the blue graph depicting the value of SPY. (click to enlarge) (click to enlarge) Following the Models At our website, the weekly performance update could be followed already from July 2014 onward. It was originally predicted that a 12-stock model should outperform USMV, which the results of the July and October models so far confirm. (The weekly updates can also be viewed by non-subscribers to iM in the archive section, delayed by a few weeks.) To track performance over an extended OOS period we will be adding, additional to the Jul-2014 and Oct-2014 models, another two similar models, the Jan-2015 and Apr-2015 models. At inception each model will have a 12-stock portfolio selected from the point-in-time holdings of USMV. The universe from which stocks are selected will be updated every three months for each model with the universe corresponding to the then current holdings of USMV. Current holdings of the models, which may not be included in the new universe, will be added to the universe. This will ensure that stocks are not sold because they may be omitted from future holdings of USMV, and the models can keep their holdings for at least one year as stipulated by the sell rules. It is expected that by April 2015 the combined stock holdings of the four models will be about 20% of the holdings of USMV, about 30 different stocks. The portfolio is expected to show better returns than USMV, provided that the OOS performance continuous to confirm the backtest’s results. Appendix Combined Holdings The combined models hold 18 different stocks of which 6 are represented in both models as shown in the table below. Combined Holdings of Best12(NYSEARCA: USMV )-July and Best12( USMV )-Oct Ticker Nr. of times in combination Sector AZO 1 Consumer Discretionary BBBY 1 Consumer Discretionary DG 2 Consumer Discretionary DLTR 1 Consumer Discretionary ROST 1 Consumer Discretionary CVS 1 Consumer Staples PRE 1 Financials TRV 1 Financials Y 1 Financials CAH 2 Health Care ESRX 1 Health Care MDT 1 Health Care LMT 1 Industrials LUV 2 Industrials MMM 1 Industrials PCP 2 Industrials EBAY 2 Information Technology SNPS 2 Information Technology

The Worst Price And Long-Term Bargains

Originally published on Dec. 21, 2014 Professional investors and their political economies are very much interested in the price discovery functions of the securities and commodity markets. Prices translate into performance. Unfortunately, past performance leads to future individual investment decisions and asset allocations. In viewing the results for any given year, the last or terminal price plays an important role in the calculation of the resulting performance. Thus the December 31st (and to a much lesser extent June 30th) prices play a disproportionate role in the calculation that produces rankings, bonuses and job longevity. (Our actuarial friends would prefer multiple-date averaging calculations to “Last Trade on Last Day” as a better representative to what was happening.) For 2014 in particular, I suspect the quality of the last prices will be weak. Due to restrictions as to the size and deployment of capital on various trading desks, the normal capital absorption capacity will be limited. Further, many organizations have already determined the size of gains and losses that they wish to sustain for the year. Thus there will be less buying power available on the last trading day of the year. Remember, the absolute final price on the last increment of trading will determine performance. In some prior years we saw a concerted effort on the part of performance players to ramp up prices of what they held in the last hour of trading. In some extreme cases there were efforts through short sales and other techniques to lower important prices for securities owned by specific competitors. Ahead to December 31, 2014 At the moment I expect a slow year-end day, but I am prepared for a spike in either direction on the last day which could be well reversed on the first trading day of 2015. In a relatively dull performance year the level of distortion is likely to be 1% or under. From a performance analysis viewpoint I will pay more attention to year-to-date performance through November and/or the latest twelve month performance through the end of January, 2015. These mathematical machinations have some value in managing portfolios that have limited duration found in operational and some shorter-term replenishment portfolios. It should have no impact on decisions for endowment and legacy portfolios. These refer to our Timespan L Portfolios™, which are segmented by investment period focus. Better performance warnings After a week when some of our holdings from bottom to top gained 5%+, for example T Rowe Price (NASDAQ: TROW )*, I start to get nervous about rising volume sucking in sidelined cash. (NASDAQ OMX* stock volume almost tripled from 773,829 shares to 2,225,599 shares in two days.) These reactions need to be put into perspective. My old firm, now known as Lipper Inc., produces a daily index for each of 30 equity investment objectives. The components of these indices in the more numerous groups are the thirty largest funds. In the smaller groups the number of components can be as small as ten. Examining the performance roster I noticed the large-caps were up 10%, multi-caps 9-10%, mid-caps slightly under 8%, and the small-caps 1.7%. What this suggests to me is that in a period of declining liquidity, institutional investors continued their large-cap affection. Small-caps were the best performing investment objective asset based group in 2013, demonstrating their recovery potential. The first warning in terms of a possible blow off will be when small-caps become once again performance leaders and the investing public throws an extra $100 billion+ into small caps which can happen. The second warning is excessive focus on market capitalization as a screen for choosing investments. I note that on a five year compound annual growth rate basis there is little to separate the different investment objective groups’ performance; the entire range for these indices was a low of 13.92% for large-cap value, to a high of 15.77% for multi-cap growth funds. This narrow performance spread reminds me of one of the phrases that I learned at New York racetracks: one could throw a blanket over the leading horses at a heated finish line. In other words, even with all the traditional handicapping skills, the results of close races can not be successfully predicted. I would suggest that if in the future we have another five year like the last, investors should be pleased to be under the blanket of a 13.92% to 15.77% performance range, and not try too hard to pick the single best winner. Target Date funds may not be optimal There is another factor that may change the level of flows going into equities. The most popular inclusion in many 401(k) and similar plans are Target Date funds. The plans that are adopting these relatively new vehicles would be doing their beneficiaries a favor if they instead had chosen the mutual fund industry’s original product which was the Balanced fund where the managers made investment allocations between stocks, bonds and cash based on their outlook. Lipper Inc. has 12 indices of Target Date funds broken down largely by maturity or retirement dates with performance on a year-to-date basis of +4 to +5%. None of them has done as well as the Lipper Balanced Fund Index gain of +7.03%. In the right hands, most potential retirees would be better off in a Balanced fund. Often the better performance of a Balanced fund is due to its investment into reasonably high quality equities. Benefiting from discontinuous forecasting I have often said that I can and want to learn from smart people, thus I read Howard Marks’s letters. Howard is the very smart Chairman of Oaktree Capital and an old friend. He devoted his latest insightful letter to what can be learned from the current decline in the price of oil. He focuses on the failure of most forecasts of the price of oil. These failures created what Wall Street Journal columnist Jason Zweig has called the “Petro Panic” which dropped stock and bond markets globally. Howard focused on the fact that oil price predictions were extrapolations of the past, adjusted perhaps by plus or minus 20%. This is similar to most predictions coming out of the financial community. I would suggest that these are not really helpful on two grounds. Most often the impact of the forecast is already in the price of the stock or bond in question. In addition, big money is only earned or lost when the old model is disrupted. Three long-term items on my screen In our Time Span Portfolios approaches, the final portfolio which is the Legacy Portfolio is expected to include securities from various successful disruptors. While there is a place at the right time and price for investing in secular growers, they are not usually the sources of extraordinary gains. These are what I like to find. I do not have the same scientific background as many of my fellow Caltech Trustees; therefore it is unlikely that I will invest client money on the basis of what is in a laboratory. I need to enter into the process later when my reading and some of my contacts can guide me in the right direction. Let me share three examples that I am looking into: 1. The first is the global shortage of retirement vehicles. Almost no nation has sufficient retirement capital in private hands to meet the increasing retirement needs of large portions of its population. Europe is particularly troubled or should be with more people going into retirement, living longer, and fewer competent workers. I believe some of these needs can and hopefully will be met by mutual funds sold wisely to the public. Two of the investments in our financial services private fund portfolio address these needs. Both Franklin Resources (NYSE: BEN )* and Invesco (NYSE: IVZ )* have strong retail and institutional distribution in Europe as well as in Asia. Their current stock prices are based on the perceived value of their present business and are paying little to nothing for their potential. At some point I believe either or both will show more earnings power internationally than domestically. *Securities held personally and/or by the private financial services fund I manage 2. The second item is one that I have only a tiny direct exposure; it is an expected exponential growth in the service sector within China and some of its neighbors. 3. The third potential actually ties back to the concerns created by the Petro Panic that is the announced long-term strategy of Toyota to get rid of gasoline cars. I am trying to determine what else will be needed as people change their driving habits. Disclosure: Holdings in TROW, BEN, IVZ.

A Contrary Play For The Patient Investor In 2015

Summary For investors who are looking for inexpensively valued stocks that may be poised to benefit from mean reversion, energy stocks are now on the radar for a rebound in 2015. There are many factors that influence the outlook of energy stocks, but valuation and the price of oil are two places to start. Oil prices had a material decline in 2014. At the same time, energy stocks are showing inexpensive valuation based on their price-to-book-value ratio. By Nick Kalivas The recent plunge in oil prices has created a dramatic re-pricing of stocks in the energy sector. For investors who are looking for inexpensively valued stocks that may be poised to benefit from mean reversion (the theory that stocks move toward their average price over time), energy stocks are now on the radar for a rebound in 2015. Let’s take a look at historically large declines in the oil market and valuations in the energy sector to get some perspective. Examining historical price declines The energy sector is likely to find the most buying interest when the crude oil market is near a bottom, but picking a bottom in any market is never easy and may be a fool’s game. Over the past 10 years, the price of the S&P 500 Energy Sector has a 0.829 correlation to the price of West Texas Intermediate (NYSE: WTI ) crude oil. 1 Since the mid 1980s, there have been five times where the price of WTI has posted a decline of at least 40% from closing month high to closing month low. The table below compares those five historical periods with 2014’s price drop. (At the time of this writing, there were a few days left in December, so I used the Dec. 23 closing price of $56.52 to represent the month-end price.) Major Oil Market Declines Based on Monthly Closing Prices of WTI *Dec 23, 2014 price assumed as month-end close. Source: Bloomberg LP as of Dec. 23, 2014 Past performance is no guarantee of future results. The table indicates that the average and median durations for price declines are 10.3 and 8.0 months. If December 2014 were to mark a current low, the duration of the sell-off would be on the shorter side of history, at just six months. It seems like a bottom may be more likely in January or February 2015. The table highlights that the current decline of 46.4% (using the Dec. 23 close of $56.52) would be on the lower end of the distribution. The average and median declines are 55.2% and 54.1% respectively. The period most like the present (1985/1986, when the market was last awash in excess oil supply) saw a drop of 63.3%. The decline in 2008/2009 seems to be extreme as it was driven by a global economic and financial meltdown. Extrapolating based on historical examples is not without risk, but points 1 and 2 suggest that in 2015, we could see a close in the price of WTI in the $45 to $50 area in January or February, which could represent the bottom of the oil price plunge and lead to a cyclical recovery in energy shares. Examining energy sector valuations One way to examine the value of the energy sector is through the price-to-book-value ratio (P/B), which is affected not only by changes in companies’ stock price, but also by changes in the value of companies’ assets (book value). Monitoring this ratio over time helps to adjust for the impact of industry ups and downs. Oil properties and reserves are subject to impairment charges and changing values based on industry conditions – nonetheless, at some point the potential negatives are reflected in share prices. The P/B per share can shed light on when extremes are priced. Both the S&P 500 and the S&P SmallCap 600 Energy sectors appear to be approaching areas of perceived value based on their P/B ratios. At writing, the P/B of the S&P 500 Energy Sector was 1.78 and on the lower end of the range seen since 1990. The ratio had lifted from a low of 1.605 on Dec. 15, 2014. These P/B ratios compare to an average of 2.39 going back to 1990. 1 (The black dotted lines represent two standard deviations above and below the average price, which would be considered extreme pricing levels.) Source: Bloomberg LP as of Dec. 23, 2014. Past performance is no guarantee of future results. An investment cannot be made directly in an index. Valuation appears even more depressed looking at the S&P SmallCap 600 Energy sector where the price to book value ratio was 0.923. The ratio has lifted from a recent low of 0.78 on Dec. 15, 2014 and compares to an average of 2.02 going back to 1995. 1 Source: Bloomberg LP as of Dec. 23, 2014. Past performance is no guarantee of future results. An investment cannot be made directly in an index. Evaluating energy stocks There are many factors that influence the outlook of energy stocks, but valuation and the price of oil are two places to start. Oil prices had a material decline in 2014, although it is too early to say they have bottomed and history may argue for more weakness into the New Year. At the same time, energy stocks are showing inexpensive valuation based on their P/B ratio, and valuation suggests investors may want to put the energy sector on their shopping list for 2015. Investors seeking exposure to the energy sector may want to consider the PowerShares Dynamic Energy Exploration & Production Portfolio (NYSEARCA: PXE ) or the PowerShares DWA Energy Momentum Portfolio (NYSEARCA: PXI ).* PXE tracks an index that invests in exploration and production companies based on price momentum, earnings momentum, quality, management action, and value. PXI holds stocks that are displaying relative price strength. They are two smart beta solutions for investors looking for non-market-cap-weighted investment in the oil sector. Investors focused exclusively on the small-cap sector may want to consider the PowerShares S&P SmallCap Energy Portfolio (NASDAQ: PSCE ). 1 Source: Bloomberg LP as of Dec. 23, 2014 Important Information *Effective Feb. 19, 2014, changes to the fund’s name, investment objective, investment policy, investment strategies, index and index provider were made. Dorsey Wright & Associates, LLC replaced NYSE Arca, Inc. as the index provider for the fund, and the name of the index changed from Dynamic Energy Sector IntellidexSM Index to DWA Energy Technical Leaders Index. In addition, the name of the fund changed from PowerShares Dynamic Energy Sector Portfolio to PowerShares DWA Energy Momentum Portfolio. Important information The S&P 500 Energy Index is an unmanaged index considered representative of the energy market. The S&P SmallCap 600 Energy Index is a capitalization-weighted index that includes the energy sector companies within the S&P SmallCap 600 Index. Correlation indicates the degree to which two investments have historically moved in the same direction and magnitude. Price-to-book-value ratio (P/B ratio) is the ratio of a stock’s market price to a company’s net asset value. There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The fund’s return may not match the return of the underlying index. Investments focused in a particular industry or sector, such as the energy sector and the oil and gas services industries are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments. The momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole, or that the returns on securities that have previously exhibited price momentum are less than returns on other styles of investing. Investing in securities of small-capitalization companies may involve greater risk than is customarily associated with investing in large companies. Beta is a measure of risk representing how a security is expected to respond to general market movements. Smart Beta represents an alternative and selection index based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both. Smart beta funds may underperform cap-weighted benchmarks and increase portfolio risk. The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE All data provided by Invesco unless otherwise noted. Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. 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