Tag Archives: function

RWX: Not My First Choice For International Real Estate

Summary RWX has too much volatility and correlation to the S&P 500. The dividend yields aren’t bad, but they aren’t great enough to justify the investment. The high expense ratio hammers home my view that this just is not an attractive way to do international investing. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve risk adjusted returns relative to the portfolios that normal investors can generate for themselves after trading costs. A substantial portion of my analysis will use modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce the total portfolio risk level. In this article, I’m reviewing the SPDR Dow Jones International Real Estate ETF (NYSEARCA: RWX ). What does RWX do? RWX attempts to track the investment results of the Dow Jones Global ex-U.S. Select Real Estate Securities Index. The ETF falls under the category of “Global Real Estate”. Does RWX provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as the basis for my analysis. I believe SPY, or another large cap U.S. fund with similar properties, represents the reasonable first step for many investors designing an ETF portfolio. Therefore, I start my diversification analysis by seeing how it works with SPY. The correlation is about 84%, which is high enough that RWX does not offer the level of diversification benefits that I would like to see. Standard deviation of monthly returns (dividend adjusted, measured since January 2007) The standard deviation isn’t going to make a strong case for investing in RWX. For the period I’ve chosen, the standard deviation of monthly returns is 142% of the deviation for the S&P 500. Due to the combination of volatility and correlation, it is not viable to use RWX as a way to reduce the portfolio risk if the major holding in the portfolio is SPY or another major domestic equity ETF since most major domestic equity ETFs have extremely high correlations to SPY themselves. I don’t believe historical returns have predictive power for future returns, but I do believe historical values for standard deviation of returns relative to other ETFs have some predictive power on future risks and correlations. Yield The distribution yield is 3.03%. This may be one of the strongest areas for the ETF, but investors can find similar levels of yield on domestic equity REIT ETF investments with lower levels of risk. Expense Ratio The ETF is posting 0.59% for an expense ratio. Since I focus on buying ETFs with expense ratios below 0.10%, the costs on this investment are way above my comfortable threshold. However, the overall international REIT ETF sector has high expense ratios. Market to NAV The ETF is trading at a 0.21% premium to NAV currently. I think any ETF is significantly less attractive when it trades above NAV. The premium to NAV is a little surprising since the trading volume (over 600,000) should be enough to mitigate any meaningful deviation from NAV. On the other hand, when I look at the average monthly premium/discount to NAV, I see that over the last year the ETF has often bounced between trading at premiums and discounts to NAV. The most notable period was October of 2014 when the ETF averaged a premium of nearly 1.5% to book value. Largest Holdings The diversification within the ETF is pretty weak as demonstrated by my chart of the top holdings. (click to enlarge) Despite the large positions in a few of the holdings, doing individual due diligence on each investment would be fairly difficult. Investors buying into the international REIT ETF will need to rely on markets being at least somewhat efficient. Allocation by Country The following chart breaks down the holdings by country. (click to enlarge) When it comes to international diversification, I’m fairly happy with the way the portfolio is set up. For it being a real international fund, I would prefer some exposure to Africa and South America in the portfolio, but on the whole, diversification is fairly solid. It is a pet peeve for me when funds label themselves as international and then put 40% to 70% of the portfolio in a single foreign country. Conclusion In my opinion, it is difficult to make a solid argument for the use of the SPDR Dow Jones International Real Estate ETF under modern portfolio theory. The high level of volatility combined with the high correlation leaves investors requiring a higher expected level of return on the investment. I don’t see that as a likely result when the ETF is charging a high expense ratio. The holdings would have to significantly outperform the S&P 500 over the long term to provide enough returns to compensate investors for the additional risk. On top of the higher level of returns, the ETF also has to be able to cover the higher expense ratios. In short, I’m just not seeing a compelling long-term option for inclusion in my portfolio. 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: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

The Low Volatility Anomaly: A Theoretical Underpinning

Summary This article introduces a discussion of the theoretical underpinning for the Low Volatility Anomaly, or why lower-risk investments have outperformed higher-risk investments over time. It features long time interval studies of the Low Volatility Anomaly from famed academics, supplementing the more recent 25-year study referenced in the introductory article to the series. The article discusses the divergence between model and market of one of the most oft-cited financial concepts. Given the long-run structural alpha generated by low volatility strategies, I want to dedicate a more detailed discussion of the efficacy of this style of investing for Seeking Alpha readers. Providing a detailed theoretical underpinning of the strategy or detailing multiple examples of its outperformance can prove challenging in a single blog post, so I am providing a more academic examination of the topic over multiple articles that each zero in on a separate proof point describing the strategy. In the first article in this series, I provided an introduction to the Low Volatility Anomaly with an example depicting the outperformance of a low-volatility (NYSEARCA: SPLV ) bent to the S&P 500 (NYSEARCA: SPY ) relative to the broader market and high-beta stocks. In this second article, I am going to begin to delve into a theoretical underpinning for the Low Volatility Anomaly and demonstrate that it has been proven in research dating back to the 1930s. Theoretical Underpinning for the Low Volatility Anomaly Since its introduction in the early 1960s, the Capital Asset Pricing Model (CAPM) has permeated the investment management landscape. CAPM is used to determine a theoretically appropriate required rate of return of an asset added to a diversified portfolio. This model takes into account the asset’s sensitivity to non-diversifiable risk, which is oft represented through the beta coefficient. In CAPM, in what has become one of the most fundamental formulas of modern finance, the expected return of an asset is equal to the risk-free rate plus the product of beta multiplied by the difference between the expected market return less the risk-free rate, as seen in the following equation: E(R a ) = R f + Β a *(E(R m )-R f ) The idea of beta is axiomatic to many investment managers. Investment discussion is littered with the concept of beta. High-beta investments have higher expected returns and above-market risk. As we move back down the security market line (SML), the inverse is then true for low-beta investments, characterized by lower expected returns and below-market risk. Empirical evidence, academic research and long time series studies across asset classes and geographies have shown that the actual relationship between risk and return is flatter than the model or market expectations suggests. At the extremes, and as shown in the graphs above in this article, the relationship between risk and return might indeed be negative. Understanding the shortcomings of CAPM and the market’s misinformed notion of the relationship between beta, risk and expected return could produce a normative arbitrage opportunity that is exceedingly capital-efficient. If the Capital Asset Pricing Model held in practice, we should see a linear relationship between beta and return as predicted by the model. Low-beta/lower-volatility assets would be expected to generate proportionately lower returns than the market. Since CAPM can be mathematically derived, and this series will subsequently demonstrate that it has failed in empirical tests, then the assumptions underpinning CAPM must be unable to hold in practice. Criticisms of the Capital Asset Pricing Model are almost as old as the model itself, but the model’s simplicity and utility have become ingrained in modern finance nonetheless. In 1972, Black, Scholes and Jensen, in a study of NYSE-listed stocks from 1931-1965, found that when securities were grouped into deciles by their beta, a time series regression of these portfolios’ excess returns on the market portfolio’s excess returns indicated that high-beta securities had significantly negative intercepts and that low-beta securities had significantly positive intercepts – a contradiction to the expected finding from the CAPM model. An excerpt of their findings is tabled below, expanding the scope of the Low Volatility Anomaly far longer than my simple twenty-five year charts. High-beta stocks (left) had negative alpha, and low-beta stocks (right) had positive alpha. (click to enlarge) Excerpted from “The Capital Asset Pricing Model: Some Empirical Tests” by Fischer Black, Michael Jensen and Myron Scholes (1972) Three years later, Robert Haugen and James Heins produced a forty-year study that demonstrated that, over the long run, stock portfolios with lower variance in monthly returns experienced greater average returns than riskier cohorts through multiple business cycles, and that relative returns were time series-dependent. Fischer Black (1993) and Robert Haugen (2012) would both produce academic papers decades later with expanded market data sets that demonstrated the efficacy of low volatility strategies. Black, enshrined in the nomenclature of an option pricing model that won his frequent collaborator Myron Scholes a Nobel Prize after Black’s death, updated his previous study conducted with Scholes and Jensen in 1972 to include data through 1991. A period that takes us from their early Depression-era study and links it with our S&P data from 1991 to current. (click to enlarge) Excerpted from “Beta and Return: Announcement of the Death of Beta Seem Premature”, Fischer Black 1993 In the chart above, one can see that in this expanded sample period, low-beta stocks (right) again did much better than predicted by CAPM (positive alpha), and high-beta stocks did worse still. Robert Haugen published several papers in the subsequent decades focused on the low volatility anomaly. In 1991, Haugen and collaborator Nardin Baker demonstrated that a low volatility subset of the capitalization-weighted Wilshire 5000 would have outperformed from 1972 to 1989. Shortly before Haugen’s death in early 2013, Baker and Haugen demonstrated that from 1990 through 2011, in a sample set that included stocks in twenty-one developed countries and twelve emerging markets, low-risk stocks outperformed in the total sample universe and in each individual country – a study I have previously referenced in past articles. Excerpted from: Low Risk Stocks Outperform within All Observable Markets of the World. Baker and Haugen (2012) If CAPM is a descriptive, but not practicable, model of investing, then violations of its underpinning assumptions could serve as possible explanations for successful strategies that appear to deviate from what one would expect from the model. The following pages are dedicated to examining how violations of CAPM’s assumptions lead to market returns that deviate from expectations. Sharpe (1964) formalized the assumptions underpinning Markowitz’s (1954) Modern Portfolio Theory . With the market fifty years later still thinking about risk-adjusted returns in a ratio bearing his name, it seems prudent to use Sharpe’s underlying model assumptions: Investors are rational and risk-averse, and when choosing among portfolios, they care only about maximizing economic utility of their one-period investment return; A common pure rate of interest, with all investors able to borrow or lend funds on equal terms; Homogeneous investor expectations, including expected values, standard deviations and correlation coefficients; The absence of taxes or transaction costs. The second of these underlying assumptions will form the basis of our first hypothesis, Leverage Aversion, for the existence and persistence of the Low Volatility Anomaly, which will be captured in the next article in this series. 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 SPLV, SPY. (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.

CEMIG – A Good Company Facing Some Bad Storms

Summary The company lost the concessions for about 40% of its electricity production, and the effect of that should lower net income by 50%. It is a stable company not at risk of bankruptcy, getting close to the bottom with its current price decline. The positive long-term economic outlook for Brazil should also positively influence CIG. The downside risk of investing in CIG is about 35%, and the upside expectation is about 100% or more in the next few years. Stable but state-owned energy company Companhia Energética de Minas Gerais (NYSE: CIG ) operates in generation, transmission, marketing and distribution of electricity, energy solutions (Efficientia S.A.) and distribution of natural gas (Gasmig) in 23 Brazilian states and in Chile. The Cemig Group comprises of the holding company (Cemig), its two main wholly-owned subsidiaries – Cemig Geração e Transmissão S.A. (‘Cemig Generation and Transmission,’ or ‘Cemig GT’) and Cemig Distribuição S.A. (‘Cemig Distribution,’ or ‘Cemig D’) – and other subsidiaries and affiliates; a total of 206 companies, 18 consortia and two Equity Investment Funds (FIPs). With a direct interest of 26.06%, CIG also controls Light S.A., an electricity distributor serving 31 cities in the state of Rio de Janeiro, a region with over 11 million consumers. CIG also has an interest of 43.36%, exercising control, in the transmission company Taesa (Transmissora Aliança de Energia Elétrica S.A.). As part of a growth strategy increasingly aiming to expand in renewable energy sources, in 2014, CIG became part of the control block (27.4%) of Renova, a leading company in Brazil’s wind power market, which also owns investment portfolios in solar and other renewable sources. The controlling stockholder of CIG is the State of Minas Gerais in Brazil, which owns 51% of the common (voting) shares. Another major stockholder is AGC Energia S.A., holding 32.96% of the common shares. CIG is a strongly-positioned energy company that is state owned. Every investor should be aware of the ownership issue because according to Transparency International , Brazil should improve on transparency in local governments and integrity in public contracting. As you will see later, those are the issues that are hammering CIG at the moment. Macro look CIG has been hammered with really bad news lately (about this later), and when this is combined with the trouble the Brazilian economy is currently going through, a 70% decline in its share price in the last 3 years should not be a surprise. Figure 1. shows that the Brazilian currency has depreciated by 50% in relation to the US$ in the last 5 years, and the depreciation trend is still strong. An investment in CIG is not only an investment in a company, but also a currency bet. Figure 1. USD vs. BRL (click to enlarge) Source: xe.com On the other hand, Brazil is currently in an economic slowdown that does not affect CIG because it is a non-cyclical company, and according to the World Bank , Brazil’s economy is expected to fall by 1.3% in 2015 but grow in 2016 by 1.1% and 2.0% in 2017. The turnaround in the economy could be a positive sign for investing in Brazil and will presumably have a positive impact on the currency. Also a turnaround would be very helpful for CIG because of its short-term debt structure (Figure 2.) with an average debt cost of 7.05% in real terms (currently, the inflation in Brazil is just below 9%). Figure 2. CIG’s debt (click to enlarge) Source: Cemig IR Current bad news that hammered the stock To find out what is really happening, you have to search for Brazilian news agencies because news about CIG flies under the radar of the big international news agencies. A few days ago, CIG managed to finance only 60% of the one billion R$ offering with a 7.97% interest rate. The most plausible reasons for that are the high debt of Brazilian energy companies in general and the current out-of-favor status of the sector. Before the failed financing issue, Fitch also degraded CIG’s credit rating from “AA” to “AA-” because of its aggressive acquisition plans, high dividend payout ratio, and political risks. But the most important bad news is the loss of the concession contracts for the Jaguara, São Simão, and Miranda hydroelectric plants that accounted for about 40% (Fitch 36% and Diariodocomercio 45%) of the company’s electricity generation potential. The loss of the contracts should have a negative impact of R$1.5 billion on CIG’s annual EBITDA. Consequently, it should impact a little bit less than 50% of CIG’s net profits that were at R$3.1 billion for 2014. Valuation Because of the currency risk, I will base my valuation on the dividends in order to clearly see what an international investor can expect in the future. The current dividend is US$0.15 per share; it is 25% of the 2014 net earnings and not 50% as usual and statutory due to the low levels in the electricity-generating water reservoirs. As soon as the financial situation of the company stabilizes and the water levels rise, CIG will pay out the rest of the dividend up to the statutory 50% of the net earnings for 2014. I am going to continue using the 25% payout ratio to take a large margin of safety. In the worst case scenario, assuming that CIG will not be able to renegotiate the concession contracts for the Jaguara, São Simão and Miranda hydroelectric plants, its net income will probably fall by 50% and the dividend will fall accordingly. Thus, in the future, we can expect a dividend of US$0.07 per share and EPS of around US$0.28. If we add the 15% depreciation of the Brazilian Real (R$) in relation to the US dollar, we get a constantly lower dividend in real terms for international investors. So in the worst case scenario, with all the risks accounted for, and expecting a P/E ratio of around 8, the share price of CIG should be US$2.24, a downside risk of 35% at the moment. Conclusion I am not sure that all will be so bad as it is at the moment, and that the current situation with the concessions is final. If the company manages to renegotiate the contracts, and we see a turnaround in the Brazilian economy with lower interest rates, CIG’s strong growth strategy would be boosted, and it could become a very successful investment. By keeping the current EPS of US$0.65 and by adding a P/E ratio of 10, we find ourselves very quickly with a US$6.5 valuation per share. As soon as the economic situation in Brazil improves, and the management works out a deal with the government for the concessions, the stock has a very large positive potential. I would put the downside risk to US$2.24 and the upside expectation to US$6.65 in the next two years. So the upside expectation is about 100%. Due to the current financial problems and concession contract issues, I will not initiate a position at the moment but wait to get better buying opportunities with a larger safety margin. I believe CIG is a sound company that is currently in a bad internal and macro position but without any bankruptcy risks on the horizon, and getting very close to the bottom of its price decline (the time frame for the bottom should be about one or two years; that for me is very short term but for the majority of investors a very long term). 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.