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Up For Debate Yet Again: Active Vs. Passive But This Time It’s The Emerging Markets

Summary Emerging Market Indexes are not representative of the overall universe. The commodity boom caused a widespread increase in asset prices, hurting active management. Falling commodity prices should create differentials in Emerging Market countries and companies, benefiting active management. When the term “emerging markets” was coined in the early 1980s it was an exciting time for those investors attracted to this young, inefficient, and rapidly growing set of markets. Earlier on in its evolution, if an investor could stomach the added risk, actively managed emerging market investments offered a very attractive and outsized return profile. Over time though, as these markets matured in size, sophistication, and popularity the differentiation between the active and passive investment approach began to narrow and as this occurred investors began to question whether it was still possible to earn alpha, or outperformance, through active management. At Lynx, we continue to believe emerging market active management is a value added proposition. In terms of number of securities, the emerging market, or EM, universe is very large, yet the interaction most passive investors have with these markets is through the MSCI Emerging Markets Index, which is a poor representation of the overall market. The index includes roughly 800 individual securities, while the overall emerging market universe has over 10,000 public companies. Additionally, there is the issue of sell-side analyst coverage or lack thereof (chart 1); while the number of companies in the BRIC countries far exceeds those of the S&P 500, the average number of analysts covering these names is less than half. More so, of the 800 securities included in the index over 650 are State Owned Enterprises or “SOEs”. SOEs are companies either owned by, or greatly influenced by, their respective governments; well-known examples are Gazprom (GSPFY) ( OTCPK:OGZPY )(Russia), Petrobras (NYSE: PBR ) (Brazil), and China Mobile (NYSE: CHL ) (China). The inherent risks associated with such companies are typically very different from private enterprises, as their balance sheets and overall strategies are most likely driven by a country’s geopolitical goals rather than by financial motivation. When investors purchase an MSCI Emerging Market Index based ETF, roughly 30% of the holdings are SOEs, ultimately adding additional risks that may not be fully appreciated. Chart 1 Now let’s turn to active management and the opportunities it may provide. Within the developed markets, the increasing level of efficiency has made it very challenging for active managers to outperform. Originally, the lack of efficiency among the emerging markets as compared to the developed countries was a significant talking point for EM active managers, but the question today is, does this dichotomy still exist? Through the use of statistical tools such as cross-volatility, correlations, and sector, country and stock dispersions, many have attempted to answer this question. Through a joint review by Lazard, Duke University and Russell Indices, it was discovered that dispersion between EM securities has actually increased in recent years, while in past years it had been fairly static (chart 2). However, recent research also indicates that correlations between various countries in the emerging markets have been moving upwards as of the mid-2000s (chart 3). In 2006 through 2009, correlations between the countries increased, while sectors, already high, remained elevated. The overall increasing correlations in the asset class, in theory, should reduce the opportunity for active management, but let’s combine the above statistical findings with today’s environment. Until recently, China has been the major driver of growth for both emerging countries, as well as commodities. Today these dynamics are shifting as China’s growth is slowing and transitioning to a service based economy. Commodity prices have plummeted in the last year, a sign that the rising tide that lifted all ships in EM over the last 15 years has passed. As a result, the rising correlations between countries, likely a function of the general commodity price boom, should begin to subside. This should cause the country correlations to begin to fall again, opening the door for more active management opportunities. An example that exists now is that of China and India. As Chinese growth has fallen, causing commodities to plummet, India has seen its economy expand, as it is a net importer of energy and is far more diversified than China. This kind of dichotomy should replay itself across many of the index constituents in the coming years. To see a similar example of the relationship between a macro boom, indiscriminate asset price appreciation and the struggles of active management in such an environment, please refer to the Lynx white paper titled, “How Much is Too Much to Pay for Performance: Our Views on Active and Passive Investing,” which lays out our argument for how the U.S. QE caused reduced cross-volatility between domestic stocks. In such an environment the value that active management brings to an investment universe is bound to be masked. Chart 2 (click to enlarge) Chart 3 *Lazard, “Country and Sector Contagion in Emerging Markets” To recap, this paper has discussed the case for active management in EM, and has provided data which suggests a reduced opportunity set for the strategy. Now let’s review actual emerging market mutual fund performance. RBC conducted a study indicating that EM mutual funds have maintained 2% of outperformance over the MSCI Emerging Market Index over a 5 year rolling time period (chart 4). What is telling though is that in recent years the outperformance has narrowed from over 7% in 2000 to 3% in 2014. The tightening may reflect the increased correlations between countries discussed above. However, the argument for active management still holds as outperformance has been maintained. In addition to overall outperformance, outperformance by individual managers also proves to be persistent (chart 5). Top tercile EM Fund managers have maintained top 2 quartile performance in almost 70% of quarters over a 3 year period, indicating that it is possible to outperform the market over time. Chart 4 (click to enlarge) Chart 5 (click to enlarge) In conclusion, though we have shown issues associated with both the active and passive approach, all told we do not believe investing passively in emerging markets is the ideal option. Active management, which comes in various forms, not only better maneuvers through these markets’ associated risks, but it takes advantage of shifting market dynamics and individual opportunities that a quantitative, market cap weighted index approach is likely to overlook. It is also important to emphasize that the most successful emerging market allocations will be those made by investors who are comfortable and accepting of a long-term investment period.

Why I Believe Terraform Power Is Still A Good Buy

Summary Despite the stock price decline, fundamentals remain on track. Dividend yield has improved to 6% plus. Strong stable cash flows, geographic diversification and a good mix of generation resources. Solar Energy will continue to grow in high double digits and TERP should benefit as the largest renewable energy yieldco. Yieldcos have been criticized by a lot of industry analysts recently. Given the downturn that the energy stocks are facing currently, yieldcos have failed to deliver the promised results. Having said that, I believe that yieldcos are a safe bet because of their low risk profile and ability to generate stable and predictable cash flows. Even when the entire energy market is going through a severe downturn, they should continue paying their dividends since their cash flows are quite stable. Everything was going well for Terraform Power (NASDAQ: TERP ), the spin off from SunEdison (NYSE: SUNE ), until July this year, when prices started to fall. Though the stock is down 40% since YTD, it has been frequently increasing its dividend and CAFD guidance. The stock has a current dividend yield of more than 6% with a market capitalization of $2.6 billion. Demand for solar energy will continue to increase such that more solar projects will require financing. TERP has a good portfolio of assets increasing dividend payouts in a regular manner. Despite the recent sharp price decline, TERP has maintained its dividend guidance for 2015. While the next year may not be great in terms of growth, TERP should be a good long term holding. Here’s why I think it’s a good buy 1) Renewable Energy Market Is Growing – There is no doubt about the fact that renewable energy is set to boom in the future. It is estimated that renewable energy could account for almost 80% of the world’s energy supply within four decades. As per the recent INDC filings, large countries will have to shift their focus toward solar, wind and other renewable forms of energy for their power needs. New solar projects will get launched in a regular manner and this will help the yieldco business model to flourish. 2) Largest Renewable Energy Yieldco – Terraform Power is well diversified with not only solar assets but also other renewable energy assets, such as wind energy projects. TERP occupies an advantageous position in the industry with a history of good performance. The company is going to slow down and consolidate, as its sponsor SunEdison is curtailing its expansion. 3) Good Liquidity Position to Support Acquisitions – Terraform Power had liquidity of ~$1.3 billion as if Q2 2015 to support further dropdowns and future targets. We currently have $1.3 billion of liquidity which is more than sufficient to support our growth needed for each of 2016 targets. We expect to use this liquidity to fund the Invenergy and Vivint Solar acquisitions, which will provide us with the capital that we need to meet our $1.75 DPS – Carlos Domenech CEO of Terraform. Source: SA Transcripts Source: TERP IR 4) Fundamental Performance Remains Quite Good – As can be seen from the table below, TERP’s performance has improved during the second quarter. The project pipeline also grew by 1 GW to reach 8.1 GW at the quarter end. 146 MW of dropdowns are expected to generate ~$21 million of unlevered CAFD annually over the next 10 years. Q1 ’15 Q2′ 15 Revenue (million $) 75 132 Adj EBITDA (million $) 52 108 CAFD (million $) 39 65 Dropdowns (in MW) 167 146 DPS ($) 0.335 5) High Yield – Terraform Power has been increasing its dividend payments as can be seen below. A yieldco primarily distributes its earnings as dividends to its investors and TERP has already achieved its full-year dividend per share target in the first quarter itself. The projected yield stands at 7.32% and the current yield is 6.32%. Date Amount 08/28/2015 0.335 05/28/2015 0.325 02/26/2015 0.27 11/24/2014 0.2257 Details of Recent dividends from Morningstar Downside Risks a) TERP’s performance is tied to SunEdison’s future performance – Though I was supportive of SunEdison’s acquisition strategy to become the leader in the renewable energy space, I agree that it has become a bit too aggressive. This has been a cause of concern for SUNE investors who have begun doubting the means to fund these acquisitions. One of the biggest risks for a yieldco is the fact that it’s heavily influenced by the actions of its sponsors. SunEdison is a strong renewable energy player today, but it needs to slow down to consolidate its acquisitions. SUNE’s stock price has taken a terrible battering after investors became alarmed over the increase in debt to finance its acquisitions. SUNE has corrected its course by canceling some of its acquisitions in India and Latin America. SunEdison’s stock price has started to stabilize after the management changed its strategy. However, TERP’s future is tied to SUNE’s performance. If it does not improve, then TERP will face a hard time in growing its assets. “We tried to do transactions the market couldn’t absorb. It started over a year ago but we got the brunt of it over the last two months.” – CEO Ahmad Chatila said in an interview. Source: Bloomberg b) Increased competition will result in higher acquisition costs – Even though the market has become slightly tough for yieldcos, there are still new ones in the pipeline. Canadian Solar (NASDAQ: CSIQ ) still plans to list its yieldco by the end of this year or early next year. There are other yieldcos such as 8point3 Energy Partners (NASDAQ: CAFD ) and NRG Yield. New yieldcos will increase competition, raising the acquisition cost for solar projects. Stock Performance and Valuation TERP stock currently trades at $18.3, which is 32% above its 52-week low price. The stock has lost 34% since the last one year and CAFD also is down 30%. The market capitalization stands at $2.6 billion, with a projected yield of 7.32% while CAFD’s stands at 4.37% . The current dividend yield of CADF is very low – a little more than 1%, while TERP’s stands at more than 6.3%. Conclusion Though the stock has been battered due to the general energy market slowdown and the skepticism around SunEdison, the yieldco has been performing quite well. Terraform Power has a lot of potential in the renewable energy space with a solid 27% diversification in wind energy. It has already achieved its full-year dividend per share target in the first quarter itself. SunEdison is a strong player in the energy market and Terraform Power will leverage from its leading position. Though there has been some unrest in the investor community I’m sure it will die soon, since solar energy is the future. Not only does yieldcos offer less volatility but are also more stable in dividend payouts. I support this yieldco platform and see the recent pullback as a good time to build a position.

Hedging Via Index Funds: 5 Winning Funds And 5 Surprising Losers

Summary I looked at a large collection of index ETFs, calculating their correlations with the S&P 500. I found five winning hedges and five losing hedges. Two ETFs in particular showed almost zero correlation to the US stock market: EEM and TAN. During the 2008 bear market, I lived in both Taiwan and China – at separate times, of course. While in Taiwan, I often heard complaints from the Taiwanese regarding poor American business practices: “Your banks went and screwed everything up for everyone.” Yet, while in China, I heard no such complaints. The people there seemed happy with their economy. The difference? Correlation. Market connection. While today, the US stock market is strongly correlated to that of China’s, a number of years ago it wasn’t. Perhaps China’s economy just recently became big enough to sync to the US economy. In that case, perhaps some other countries out there have stock markets uncorrelated to ours. If so, index funds on those markets would provide good hedging opportunities for bear markets, market corrections, and market crashes. My last study on investments uncorrelated to the US market unveiled some surprising results – you can read it here . Now, I intend to tackle a request from one of the readers of that last article: (click to enlarge) The request was to find CEFs, index ETFs, and sector ETFs uncorrelated to the S&P 500. In fact, these are actually three requests. I’m going to be tackling the question of index ETFs in this article, perhaps moving onto the former in the next article; and the sector ETF request is easily tackled – no sector ETFs are uncorrelated to the market. So, the main question is, “What index ETFs are uncorrelated with the S&P 500.” Immediately, my mind turns to indexes in certain countries. Later, I will show my findings on which countries have stock markets uncorrelated with the US market. But I will also look at other indexes unrelated to geography. Correlation First, we must define correlated. In a previous article, I spent some time talking about the theory behind correlation determinations. I direct you to that article if you wish to learn more. For now, let me just explain how I determined whether an investment was correlated to the S&P 500. I imported index data, ^GSPC, via Yahoo Finance using R, statistical software. Then, I imported various index ETFs that I thought might have low correlations. I ran correlation calculations on the index ETFs vs. ^GSPC, using a 5-year time frame. Any investment with a correlation between -0.3 and 0.3 was considered uncorrelated. In this way, the index ETFs chosen as Winners (those suitable for hedging) change a maximum of 20% per significant market move. The Close Calls, in contrast, change in the range of 20-40% when the market moves. The idea is to compose a portfolio of index ETFs that can act as a hedging portion of your portfolio. The end result was four ETFs uncorrelated with the market, with one index ETF in particular having two near-zero correlation funds. Some of the Winners and Close Calls may surprise you. Winners iShares MSCI BRIC ETF (NYSEARCA: BKF ) and iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ) . Money has been flowing out of emerging markets, yet emerging markets might just offer a strong hedging opportunity. Of particular interest is the slight, but significant, difference between BKF and EEM. While these two ETFs are strongly correlated, EEM has a near-zero correlation with the S&P 500, while BKF has a -0.25 correlation. Overall, I don’t think this difference is very important for most investors. Their yields are approximately the same: 2.4% for EEM and 3% for BKF. Either investment would be a good hedging tool, allowing exposure to emerging markets and providing dividends. However, the holdings of these funds differ to some extent. BKF heavily weights the its major holdings, with 40% of its holdings in China and 30% being financial services. Its biggest holdings are Chinese financial services, such as banks and insurance companies. In contrast, EEM more evenly disperses its holdings. In addition, because it is not forced to invest in BRIC countries, the fund’s two biggest holdings are Korean and Taiwanese companies: Samsung ( OTC:SSNLF ) and Taiwan Semiconductor Manufacturing (NYSE: TSM ). Also, in stark contrast to BKF, which only hold stock in developed countries, EEM dedicates 30% of its portfolio to developed markets, which equates to more exposure to technology stocks in this case. iShares MSCI South Korea Capped ETF (NYSEARCA: EWY ) : Surprisingly, this Korean ETF is uncorrelated to the US market. As you would expect, 40% of this fund’s holdings is dedicated to tech stocks, which can promise decent growth. The yield here is rather low, at 1.22%. Samsung, which makes up 30% of this ETF, has been underperformer in EWY’s portfolio for the past few years. If this were an ex-Samsung ETF, I could see it easily outperforming the fund as it is currently composed. Nevertheless, EWY is a good opportunity for both hedging and profiting from South Korea’s economy, which is set for a comeback. iShares MSCI Malaysia ETF (NYSEARCA: EWM ) : Malaysia was another country I checked, and I found this particular fund to be both uncorrelated to the S&P 500 and quite similar to the emerging market funds in terms of its portfolio allocation. EWM is 30% financial services, with Malaysian banks as its main holdings. This fund also gives you significant exposure to Malaysia’s utilities and consumer industries, and has a sweet yield of 3.76% Guggenheim Solar ETF (NYSEARCA: TAN ) : This ETF tracks the MAC Global Solar Energy Index. The holdings are about half US-based. Unlike the above funds, this ETF’s portfolio consists mainly of small and mid-cap stocks. TAN has a near-zero correlation with the S&P 500 – 0.04, to be exact – which is likely a product of it being cut both across a sector and across geography. The main countries involved in this portfolio are, unsurprisingly, the US and China. With a 2.15% yield, this is a great hedging opportunity, and is a suitable choice if you’re bullish on solar energy, which seems poised for a rebound since its fall in 2011. Close Calls In this section, we look at investments that made 20-40% movements in response to market moves. These are “Close Calls” – ETFs that you’d think would be uncorrelated to the general market, but which actually show a small or moderate correlation. They might still be good investments, but are not appropriate for hedging. iShares MSCI Mexico Capped ETF (NYSEARCA: EWW ) : With its disgusting ticker name, EWW is one of those geography-based index ETFs that I thought might be uncorrelated to the US market. Of course, that was wishful thinking, as Mexico and the US have a strong trade connection. However, the correlation is quite low, at 0.34. With Mexico becoming stronger in the world economy, EWW is a decent emerging market investment vehicle, but should not be used for hedging. iPath MSCI India Index ETN (NYSEARCA: INP ) : Listed as an ETN, INP tracks the MSCI India Total Return Index. India still shows a correlation with the US market, making this ETN a poor choice for hedging. However, depending on your outlook of the country, this might be a good choice. Personally, I’d choose BKF over this, as you’d still have exposure to India, be more diversified across geography and gain dividend payments. Guggenheim China Small Cap ETF (NYSEARCA: HAO ) : While all the China ETFs I checked were strongly correlated to the US market, this fund consisting of small-cap Chinese stocks shows a much lower correlation than the rest. If you want to invest in China, but fear a drop in the US market could damage your portfolio, HAO is a bit safer than other Chinese ETFs. Strange that a small-cap ETF would be safer, but for Americans, that seems to be the case. Fidelity MSCI Energy Index ETF (NYSEARCA: FENY ) : The energy market seems to be doing its own thing, regardless of the market. However, the market is generally moving upward while energy prices drop. Thus, checking the correlation between the two might be enlightening. The correlation between FENY and the market is small, but it’s there. A general market decline, then, should predict a slight increase in the energy market. FENY might be a good choice if you’re expecting a market correction or crash, and if you’re speculating that the energy market has hit its true bottom. Global Commodity Equity ETF (NYSEARCA: CRBQ ) : Much like the energy market, the commodity market has been moving opposite to the S&P 500, but appears rather uncorrelated. In fact, the correlation here is -0.44. The dollar, which is correlated to the market, is inversely correlated to the commodity market, which explains this moderate correlation. With its low liquidity, you should only buy this if you have no better way of investing in commodities and want to hold this ETF for the long term. I Want Your Input Obviously, I simply don’t have the time to cover every industry. While reading this article, you probably thought of at least one investment that should have gone in my “Winners” section. Let me know about it in the comments section below. Request a Statistical Study If you would like for me to run a statistical study on a specific aspect of a specific stock, commodity, or market, just request so in the comments section below. Alternatively, send me a message or email.