Tag Archives: industry

My ‘Wisdom’ On Smart Beta And Factor Investing

The latest installment from Tadas Viskantas’s series on “financial blogger wisdom” (is that an oxymoron?) asked a bunch of smart people (and also me) about smart beta. I was short: Smart beta and factor investing are the newest versions of high(er) fee active management promising the fairy tale of “market beating” returns in exchange for higher fees and usually delivering lower returns (after taxes and fees). Regulars know I am not a big fan of Smart Beta and Factor Investing (sorry to all my friends in the industry who love these approaches!). For the uninitiated, Smart Beta basically involves taking an index fund and changing it so it captures a “smarter” type of return. For instance, you might take a market cap weighted index fund like the S&P 500 and equal weight it so that it doesn’t expose you to the procyclical tendencies of the market cap weighted fund which will tend to be overweight the riskiest stocks at the riskiest points in the market cycle. The evidence that this is countercyclical is weak as Vanguard has shown and as I expressed in my new paper . Further, you will generally pay higher taxes and fees in these funds without a high probability of better results. For instance, the equal weight S&P 500 has a pretty mixed performance versus the market cap weighted S&P as it’s performed better on a 10-year basis, but underperformed on all periods shorter than 10 years. The nominal returns are slightly better over longer periods, but that’s only because the equal weight fund has a much higher standard deviation with 95% of the total correlation. So, the intelligent asset allocator has to ask themselves why they’d pay for 95% of the correlation while guaranteeing higher taxes and fees without a reasonably high probability of better risk-adjusted performance? Should you really pay higher fees for the empty promise of “market-beating returns”? I say no. The same basic story can be laid out for factor investing. There’s a great irony in the idea that the founder of the Efficient Market Hypothesis says you can’t pick stocks that will beat the market, but you can construct index funds that will be comprised of the stocks that will beat the market. The problem is no one knows what are the right stocks to put in a “momentum” index before they earn the momentum premium. And just like active mutual funds, no one should pay a premium for an asset manager who claims that they can construct an index that will be comprised of stocks that will benefit from “market beating” returns in the future. You just end up guaranteeing higher fees and taxes in exchange for the empty promise of market-beating returns. To me, these are just the new forms of “active” investing charging people higher taxes and fees for indexing strategies that won’t outperform.

The Most Crowded Hedge Fund Bets At Year-End 2015

Most analyses of hedge fund crowding focus on their residual (idiosyncratic, stock-specific) bets. This is misguided, since over 85% of the monthly return variance for the majority of hedge fund long equity portfolios is due to factor (systematic) exposures, rather than individual stocks. Indeed, it is the exceptional factor crowding and the record market risk that have driven much of the industry’s recent misery (just as they have driven much of the earlier upswings). In Q4 2015, a single factor accounted for half of U.S. hedge funds’ relative long equity risk. We survey all sources of hedge fund crowding at year-end 2015 and identify the market regimes that would generate the highest relative outperformance and underperformance for the crowded factor portfolio. These are the regimes that would most benefit or hurt hedge fund investors and followers. Identifying Hedge Fund Crowding This piece follows the approach of our earlier articles on crowding : We processed regulatory filings of over 1,000 hedge funds and created a position-weighted portfolio ( HF Aggregate ) consisting of all the tractable hedge fund long U.S. equity portfolios. We then analyzed HF Aggregate’s risk relative to U.S. Market using the AlphaBetaWorks Statistical Equity Risk Model – a proven system for performance forecasting . The top contributors to HF Aggregate’s relative risk are the most crowded hedge fund bets. Hedge Fund Aggregate’s Risk The Q4 2015 HF Aggregate had 3.7% estimated future tracking error relative to U.S. Market; over two thirds of this was due to factor ( systematic ) exposures : Components of the Relative Risk for U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Source Volatility (ann. %) Share of Variance (%) Factor 3.10 69.07 Residual 2.08 30.93 Total 3.73 100.00 Simplistic analysis of hedge fund crowding that lacks a capable risk model will miss these systematic exposures. Among its flows, this comparison of holdings will overlook funds with no position overlap but high future correlation due to similar factor exposures. Hence, this simplistic analysis of hedge fund crowding fosters dangerous complacency. Hedge Fund Factor (Systematic) Crowding Factor exposures drove nearly 70% of the relative risk of HF Aggregate at year-end 2015. Below are the principal factor exposures (in red) relative to U.S. Market’s exposures (in gray): Significant Absolute and Residual Factor Exposures of U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Of these bets, Market (Beta) alone accounts for two thirds of the relative and half of the total factor risk, as illustrated below: Factors Contributing Most to Relative Factor Variance of U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Factor Relative Exposure Factor Volatility Share of Relative Factor Variance Share of Relative Total Variance Market 18.27 12.46 68.12 47.05 Oil Price 2.28 29.43 13.08 9.04 Bond Index -7.53 3.33 4.97 3.43 Utilities -3.10 11.28 4.77 3.30 Consumer -8.30 3.75 3.54 2.44 Energy -3.21 11.77 -2.96 -2.04 Health 4.79 7.22 2.54 1.75 Communications -1.67 11.98 1.91 1.32 Finance -6.89 5.08 1.68 1.16 Size -1.96 8.09 1.34 0.92 (Relative exposures and relative variance contribution. All values are in %. Volatility is annualized.) Thus, the most important source of hedge fund crowding is not a stock or a group of stocks, but systematic exposure to the U.S. Market Factor . When nearly half of the industry’s risk comes from a single Factor, fixation on the individual crowded stocks is particularly dangerous. The U.S. Market crowding alone explains much of the recent industry misery. In this era of systematic crowding, risk management with a robust and predictive factor model is particularly vital for managers’ and allocators’ survival. Hedge Fund Factor Crowding Stress Tests Hedge Fund Crowding Maximum Outperformance Given Hedge Fund Aggregate’s bullish macroeconomic positioning (Long Market, Short Bonds/Long Interest Rates), it would experience its highest outperformance in an environment similar to the March-2009 rally. In this scenario, HF Aggregate’s factor portfolio would outperform by 20%: Historical Scenario that Would Generate the Highest Relative Performance for the Q4 2015 U.S. Hedge Fund Aggregate Click to enlarge Source: abwinsights.com The top contributors to this outperformance would be the following exposures: Factor Return Portfolio Exposure Benchmark Exposure Relative Exposure Portfolio Return Benchmark Return Relative Return Market 66.04 120.07 101.80 18.27 83.00 67.50 15.50 Oil Price 87.13 1.53 -0.75 2.28 1.05 -0.51 1.56 Bond Index -6.29 -4.92 2.61 -7.53 0.31 -0.17 0.48 Energy -12.54 1.61 4.82 -3.21 -0.20 -0.61 0.41 Communications -17.62 0.52 2.19 -1.67 -0.10 -0.41 0.31 Hedge Fund Crowding Maximum Underperformance Given Hedge Fund Aggregate’s bullish macroeconomic positioning, combined with a long Technology and short Finance exposures, it would experience its highest underperformance in an environment similar to the 2000-2001 .com Crash. In this scenario, HF Aggregate’s factor portfolio would underperform by 8%: Historical Scenario that Would Generate the Lowest Relative Performance for the Q4 2015 U.S. Hedge Fund Aggregate Click to enlarge Source: abwinsights.com The top contributors to this underperformance would be the following exposures: Factor Return Portfolio Exposure Benchmark Exposure Relative Exposure Portfolio Return Benchmark Return Relative Return Finance 47.97 12.48 19.36 -6.89 5.27 8.26 -2.99 Market -14.21 120.07 101.80 18.27 -17.22 -14.48 -2.74 Technology -36.73 23.75 20.14 3.62 -9.83 -8.38 -1.45 Utilities 52.32 0.22 3.31 -3.10 0.10 1.51 -1.42 Consumer 12.36 14.87 23.17 -8.30 1.82 2.85 -1.02 Hedge Fund Residual (Idiosyncratic) Crowding A third of the year-end 2015 hedge fund crowding is due to residual ( idiosyncratic, stock-specific) risk. Valeant Pharmaceuticals International and Netflix are responsible for nearly half of it: Stocks Contributing Most to Relative Residual Variance of U.S. Hedge Fund Aggregate in Q4 2015 Click to enlarge Source: abwinsights.com Though there may be sound individual reasons for these investments, they are vulnerable to brutal liquidation. Given the recent damage to hedge funds from herding, these crowded residual bets remain vulnerable: Symbol Name Relative Exposure Residual Volatility Share of Relative Residual Variance Share of Relative Total Variance (NYSE: VRX ) Valeant Pharmaceuticals International, Inc. 2.67 43.72 31.56 9.76 (NASDAQ: NFLX ) Netflix, Inc. 1.57 54.62 17.15 5.30 (NASDAQ: JD ) JD.com, Inc. Sponsored ADR Class A 1.60 31.91 6.05 1.87 (NYSEMKT: LNG ) Cheniere Energy, Inc. 1.38 33.35 4.88 1.51 (NASDAQ: CHTR ) Charter Communications, Inc. Class A 1.79 20.31 3.08 0.95 (NYSE: TWC ) Time Warner Cable Inc. 1.85 16.14 2.06 0.64 (NYSE: AGN ) Allergan plc 1.83 14.62 1.66 0.51 (NYSE: FLT ) FleetCor Technologies, Inc. 1.18 19.61 1.23 0.38 (NASDAQ: PCLN ) Priceline Group Inc 1.12 20.10 1.18 0.36 (NASDAQ: MSFT ) Microsoft Corporation 1.54 14.13 1.10 0.34 (Relative exposures and relative variance contribution. All values are in %. Volatility is annualized.) Though stock-specific bets remain important, allocators and fund followers should pay particular attention to their factor exposures in the current environment of extreme systematic hedge fund crowding. Many may be effectively invested in leveraged passive index fund portfolio, with the added insult of high fees. AlphaBetaWorks Analytics address all of these needs with the coverage of market-wide and sector-specific herding, plus aggregate factor exposures of funds and portfolios of funds. Summary The main source of Q4 2015 hedge fund crowding, responsible for nearly half of the relative long equity risk, was record U.S. Market exposure. The main sources of Q4 2015 residual crowding were VRX and NFLX. Given the high factor (systematic) crowding among hedge funds’ long equity portfolios, current analysis of crowding risks must focus on the factor exposures, rather than individual positions. The information herein is not represented or warranted to be accurate, correct, complete or timely. Past performance is no guarantee of future results. Copyright © 2012-2016, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved. Content may not be republished without express written consent. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Will Consumer Staples ETFs Continue To Shine In 2016?

Despite a moderate recovery in the U.S. economy, investors are skeptical about the global issues that have been haunting the markets lately. The global economic slowdown and financial mayhem in China are the main reasons behind the stock market volatility and the decline in the global commodity complex. Also, stronger U.S. dollar, lower traffic and weakness in oil and other commodity sectors are adding to the woes. In fact, consumer confidence – a key determinant of the economy’s health – declined drastically in February, marking the lowest in seven months, signaling that the overseas turmoil is taking a toll on the U.S. economy. According to recent Conference Board data , the Consumer Confidence Index dipped to 92.2 in February from January’s revised reading of 97.8. This indicates the lowest level since July 2015. A slump in consumer confidence would definitely impact consumer spending, which accounts for over two-thirds of U.S. economic activity. The overall tone of the global market remains soft, as we can estimate from the GDP figures, according to the advance estimate released by the Bureau of Economic Analysis . GDP struggled at 1%, after advancing 1.9% and 3.8% in the third and second quarter of 2015, respectively. Nevertheless, market experts anticipate GDP growth of 2% for the January-March quarter on the back of an improving job scenario – with the unemployment rate hovering around 4.9% – and low gas prices that will help increase household wealth and eventually boost consumer spending. In addition to this, improving home sales, higher business and government spending and a buildup in inventories are some favorable economic indicators that play a key role in raising buyers’ confidence. We expect this positive sentiment to translate into higher consumer spending in 2016. Needless to say, the equity markets have become extremely volatile and the overall economic picture is quite bleak. However, we expect to witness a slow but steady recovery in the consumer staples industry, owing to the gradual improvement in consumer spending. Playing the Sector through ETFs Owing to its defensive nature, this sector is likely to outperform when equity markets are bearish and underperform when bullish. The instability in the sector due to factors like U.S. and global exposure can be countered with a wide array of ETFs. The ETFs can act as an excellent investment medium for those who are interested in a long-term exposure within the consumer staples sector. For those interested in taking a look at consumer staples, we have highlighted a few ETFs tracking the industry, any of which could be an attractive pick: Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ): Launched on Dec. 16, 1998, XLP is an ETF that seeks investment results corresponding to the S&P Consumer Staples Select Sector Index. This fund consists of 40 stocks of companies that manufacture and sell a range of branded consumer packaged goods. The top holdings include The Procter & Gamble Co. (NYSE: PG ), The Coca-Cola Company (NYSE: KO ) and Philip Morris International, Inc. (NYSE: PM ). The fund’s expense ratio is 0.14% and it pays out a dividend yield of 2.50%. XLP had about $9.345 billion in assets under management as of March 1, 2016. Vanguard Consumer Staples ETF (NYSEARCA: VDC ): Initiated on Jan. 26, 2004, VDC is an ETF that tracks the performance of the MSCI US Investable Market Consumer Staples 25/50 Index. It measures the investment return of large, mid, and small-cap U.S. stocks in the consumer staples sector. The fund has a total of 100 stocks, with the top three holdings being Procter & Gamble, Coca-Cola and PepsiCo, Inc. (NYSE: PEP ). It charges 0.12% in expense ratio, while the yield is 2.53% as of now. VDC managed to attract $3.1 billion in assets under management till Jan. 31, 2016. First Trust Consumer Staples AlphaDEX (NYSEARCA: FXG ): FXG, launched on May 8, 2007, follows the equity index called StrataQuant Consumer Staples Index. FXG is made up of 41 consumer staples securities, with the top holdings being Tyson Foods, Inc. (NYSE: TSN ), Hormel Foods Corp. (NYSE: HRL ) and Constellation Brands, Inc. (NYSE: STZ ). The fund’s expense ratio is 0.62% and the dividend yield is 1.67%. It had $2.44 billion in assets under management as of March 1, 2016. Guggenheim S&P 500 Equal Weight Consumer Staples (NYSEARCA: RHS ): Launched on Nov. 1, 2006, RHS is an ETF that seeks investment results corresponding to the S&P 500 Equal Weight Index Consumer Staples. This is an equal-weighted fund and constitutes 38 stocks, with the top holdings being Tyson Foods, Campbell Soup Company (NYSE: CPB ) and Reynolds American, Inc. (NYSE: RAI ). The fund’s expense ratio is 0.40% and dividend payout 1.75%. RHS had about $622.9 million in assets under management as of March 2, 2016. Fidelity MSCI Consumer Staples ETF (NYSEARCA: FSTA ): FSTA, launched on Oct. 21, 2013, is an ETF that seeks investment results corresponding to MSCI USA IMI Consumer Staples Index. This is a cap-weighted fund and constitutes 102 stocks, with the top holdings being Procter & Gamble, Coca-Cola and PepsiCo. The fund’s expense ratio is 0.12% and the dividend yield is 2.84%. FSTA had about $257.6 million in assets under management as of Jan. 31, 2016. Original Post