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TAO: Real Estate In China Offers More Risk Than Returns

Summary TAO has been fairly volatile and feels even more dangerous to me because I’m bearish on China. Due to a low correlation with SPY, TAO would appear to fit reasonably in a diversified portfolio. The long term challenge for TAO is very high expense ratios that eat into any returns the ETF produces. Despite a high expense ratio, the holdings are fairly concentrated which may be one reason for the high volatility on the ETF. The Guggenheim China Real Estate ETF (NYSEARCA: TAO ) seeks to track the performance of the AlphaShares China Real Estate Index. I have to admit that I’m biased in looking at TAO as an investment because I’m a large bear on China. I believe equity values have been moving too high and domestic retail investors are holding meaningful positions in the Chinese equity market. If the market turns south it won’t just be a loss of equity valuations, it will mean less cash available for the domestic investors to spend on their other life expenses. In my opinion, that compounds the problem of holding exposure to China. Risk When measuring the historical volatility of investments in the SPDR S&P 500 Trust ETF ( SPY), the monthly standard deviation of returns has been almost twice as high as the deviation for SPY since the start of 2008. On the other hand, the correlation on monthly returns was only 65.5% which is fairly attractive. I put together a chart showing the changes in risk between holding a position that is simply invested in the S&P 500 versus mixing some TAO into the portfolio. (click to enlarge) Despite the very high level of risk for TAO, the low correlation does help it fit within the context of a portfolio. I’m not big on investing in China, but for investors that want to buy REIT exposure in China the added volatility at 5% of the portfolio isn’t too bad. Liquidity is challenging The average trading volume is only around 90,000 shares per day. If looking to invest in TAO, I would be applying a liquidity premium to the minimum acceptable level of expected returns. Yield The distribution yield is 2.33%. For being classified as real estate, the distribution is not as high as I would like to see it. When you see high volatility, low liquidity, and weak yields it is creating the perfect storm for investors to lose part of their portfolio since panic in selling could result in some fairly awful prices being realized. Expense Ratio The gross expense ratio is .95% and the net expense ratio is .71%. Simply put, that is way higher than what I am willing to pay on any ETF investment regardless of the exposure. These niche investment areas can result in fairly weak competition and fairly high expense ratios. Largest Holdings The diversification within the portfolio is fairly weak. Just over 50% of the value of the portfolio came from the top 10 holdings. (click to enlarge) Conclusion I’m bearish on China and I’ve found an international REIT ETF that offers investors high volatility, high expense ratios, and only moderate levels of diversification. It’s too bad investors can’t actually short stocks with no trading costs the way economic theory suggests. With such a high expense ratio it would be tempting to short the ETF and go long the underlying stocks to obtain the alpha from avoiding the expense ratio. Too bad it doesn’t work like that in the real world. That leaves me with no better option than just avoiding this investment. I wasn’t bearish on China a year ago. When the prices were more reasonable, I had no problem with exposure to the Chinese equity market. On fundamental valuations the market may not seem too bad, but any weakness could hurt the consumers which would hurt the fundamentals of the companies. If the prices fell far enough after adjusting for declining fundamentals, I wouldn’t mind buying exposure to China again. However, if I did that I would still be looking to get that exposure with a much lower expense ratio. 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.

Does Your Portfolio Have A Margin Of Safety?

By Ronald Delegge Building an architecturally sound investment portfolio doesn’t happen by chance. A structurally strong and healthy portfolio is organized into three basic parts: 1) the portfolio’s core, 2) the portfolio’s non-core, and 3) the portfolio’s “margin of safety.” All portfolio parts complement each other by deliberating holding non-overlapping assets. Let’s talk about the part of the portfolio that represents the “margin of safety.” The concept “margin of safety” was originally developed in the 1930s by Benjamin Graham and David Dodd, the founders of value investing. Their idea was applied to selecting individual stocks at undervalued prices to help people become better investors. In the context of the individual investor, the “margin of safety” represents the capital or money that a person absolutely cannot afford to risk to potential market losses. Like an insurance premium, this money gets set aside from a person’s core and non-core portfolio to be invested in fixed accounts with principal protection and liquidity. (click to enlarge) Some people have deceived themselves into believing their investments require no margin of safety. This group generally believes they are too wealthy, too experienced, and too smart to have a margin of safety inside their portfolio. Ironically, this same group of people that invest without a margin of safety (or insurance), have insurance (or margin of safety) on their automobile, home, health, and life. Why is there an illogical disconnect between the need to protect physical assets, while simultaneously ignoring the financial ones? “I’m a long-term investor” or “the stock market always bounces back” are common excuses for investing without a margin of safety. Unfortunately, both of these techniques are not a credible form of portfolio risk management. Diligent and proper risk control is always proactive versus being passive or reactive. Others may claim that investing in bonds or physical assets like gold is their portfolio’s margin of safety. This too is erroneous. Why? Because bonds and precious metals are subject to daily fluctuations just like stocks and can lose market value. Gold’s almost 40% loss in value since mid-2011 is a tough lesson on why you shouldn’t use assets that are prone to market losses as a form of portfolio insurance. Similarly, those who have invested in long-term treasuries as a form of portfolio insurance have suffered losses near 8% over the past three-months alone! When is the best time to implement your portfolio’s margin of safety? Like insurance coverage, the prudent investor acquires a margin of safety within their investment portfolio before they need it. Put another way, the timing of when you implement your portfolio’s margin of safety is mission critical. Think about it this way: Would it be logical to attempt to buy insurance coverage after you’ve already had an automobile accident or after your home has been destroyed? Of course not! Similarly, would it be logical to implement a margin of safety after your portfolio has suffered catastrophic losses? Of course not! To be fully protected, you must prepare ahead. In summary, implementing your portfolio’s margin of safety should happen when market conditions are favorable, not when it’s raining cannonballs. And if you’re caught in the unfortunate situation where you failed to implement a margin of safety during good times and market conditions have deteriorated, the next most logical moment to implement your margin of safety is immediately. Disclosure: No positions Link to the original article on ETFguide.com

Why You Should Be Playing Defense In This Market

Summary Why you should always be thinking about protecting your assets. Why holding cash is always a good idea. What you can learn from history and China about playing defense for maximum wealth generation. Ouch. That’s how I felt in 2008 when my portfolio was down 28.6%. The S&P was down 37% that year but I certainly didn’t care about having beaten the market. I’m supposed to be indifferent to how the market is doing and to take a long term focus. After all, that’s what I tell people all the time. But I remember it clearly. I was in Seoul, Korea getting married while the market was crashing. Obviously, I wasn’t concerned because I was sweating bullets while waiting at the altar. Also, being on the other side of the world helps drown out the noise. Then it was straight to the honeymoon and by the time I woke up, the market was in ashes. I was excited though and I had to sneak away to the resort lobby and hurriedly put in some trades before my newlywed wife noticed that I was missing. But despite all that, when 2008 came to an end, my portfolio was hurting by 28.6%. It wasn’t hurt from losing money. The hurt was due to the wasted opportunities I couldn’t take advantage of because I was 100% invested. The Current Situation At the moment, I have 20% in cash which provides flexibility and the opportunity to act if needed. Here’s what Prem Watsa, “Canada’s Warren Buffett”, once said during a conference call about having a high cash position. As far as the 30% cash, remember, that can change. So in 2008, and we had this position in 2007, in 2006. 2008, things turned the financial markets. Stock markets dropped… about 50%… And Tom, the only people who could benefit from that were the people who had cash or government bonds. And so we are conscious of that in our history. Cash gives you options, gives you the ability to take advantage of opportunity but you have to be long-term. We have built our company with a long-term view. Our long-term results are excellent. For example, in 2007, ’08, and ’09, the 3 years, 2007, 2008, 2009, we made $2.8 billion after tax, our book value went up by 150%. Since that time, we haven’t done a lot. But we’ve said to our shareholders that we are long-term focused, our results are lumpy and we never know when it can change. But the cash gives us a huge advantage in terms of taking advantage of opportunity as and when they come. It’s not just in the stock market. People who had the cash to scoop up cheap real estate, businesses or even liquidated inventory to flip have all done well while other people were running scared. Warren Buffett says something similar. We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially. So are you 100% invested or do you have some room to take advantage of opportunities if it comes up? Are you willing to sacrifice 1-2% in potential returns by holding cash, or are you trying to squeeze out every basis point possible without considering what could happen? Cash Does Nothing and Is a Bad Investment True. If you’re talking about a long term horizon greater than 10 years, that is. Holding cash isn’t a popular choice because you feel like you are missing out on opportunities while everyone else is making money . Instead of holding cash, financial commentators prefer to recommend defensive companies, even after the stock market plummets when fear is supreme. But that’s the worst time to be buying defensive stocks anyways because everyone else is thinking the same thing. Plus, it assumes you have the cash to buy defensive stocks to begin with. If cash isn’t your thing, then the next best thing would be rebalance your portfolio from speculative growth picks to recession proof businesses and sleep well at night. Ditto. Learn from History and the Current Chinese Market In Howard Marks memo titled “Ditto”, there’s a section that outlines the cycle in attitude towards risk. 1. When economic growth is slow or negative and markets are weak, most people worry about losing money and disregard the risk of missing opportunities. Only a few stouthearted contrarians are capable of imaging that improvement is possible. 2. Then the economy shows some signs of life, and corporate earnings begin to move up rather than down. 3. Sooner or later , economic growth takes hold visibly and earnings show surprising gains. 4. This excess of reality over expectations causes security prices to start moving up. 5. Because of those gains – along with the improving economic and corporate news – the average investor realizes that improvement is actually underway. Confidence rises. Investors feel richer and smarter, forget their prior bad experience, and extrapolate the recent progress. 6. Skepticism and caution abate; optimism and aggressiveness take their place. 7. Anyone who’s been sitting out the dance experiences the pain of watching from the sidelines as assets appreciate. The bystanders feel regret and are gradually suckered in. 8. The longer this process goes on, the more enthusiasm for investments rises and resistance subsides. People worry less about losing money and more about missing opportunities. 9. Risk aversion evaporates and invests behave more aggressively. People begin to have difficulty imagining how losses could ever occur. When you look at how Howard Marks explains this cycle, it’s clear that history may not repeat, but it does rhyme. And it’s currently rhyming in China. (click to enlarge) My mother-in-law theory is that when my mother-in-law wants to get into the stock market or starts to recommend stocks as an investment, it’s time to move to cash. That’s what happening in China though. But look to history. (click to enlarge) The US market is different to the Chinese market, but it’s a lesson nonetheless and something to keep at the back of your mind. How Far Will the Market Continue Going Up? I consider myself an optimistic person and many times, it has worked against me. A lot of the times, I don’t want to think about the bad things that could happen and I end up pushing it under the bed. And this market isn’t easy to invest in. Most hedge funds aren’t even in positive territory after fees this year. But will the market continue to go up forever? Don’t think so. There has to be a crash correction. My way of playing defense is to be alert and not contempt. I don’t trust or listen to market news or forecasters because they are just as clueless as me about what the market will do next. All I can say about forecasters and market predictions is to quote the following. There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know. – John Kenneth Galbraith How Do I Play Defense? Here’s how I do it. I’ve printed out Seth Klarman’s thoughts on holding cash and read it regularly or whenever I feel like I’m missing out. Read Howard Marks memos, Buffett letters and other papers and book on behavioral finance. I highly recommend What I Learned Losing a Million Dollars . It’s one of those books that make you grow. But reading books outside of investing keeps me fresh and always provides new insight on how I can improve. I don’t talk about stocks with non value investing people, which means I never talk about stocks at all in day to day life. Maintain a buy list. Remind myself to stop overpaying because valuation matters more than ever . There is a time for offense, but right now, I’m playing more defense. Offense wins games, but defense wins championships. So where are you at the moment? Offense or defense? 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.