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Take The Long-Term View To Manage Volatility

By Tom Lee, Managing Director, Investment Strategy and Research, Parametric Volatility today is not materially above the long-term average. If we use the CBOE Volatility Index as a reference, volatility since the end of 2015 averaged a little over 21 ½. Long-term VIX averages in the high 19s. The reality is people think we are in a higher-volatility environment because we came from, historically, a relatively low-volatility environment. Volatility tends to cluster into regimes. The volatility environment we’re in now is more normal. What caused volatility to elevate? There are a lot of contributors to volatility. There are the experimental and divergent monetary policies that are being pursued across the globe, including negative interest rates. And there’s also an intuitive understanding that the longer we are in this experimental monetary policy phase, the higher the risk is of some unintended consequence. We’re going to have this uncertainty for a while. Asset allocation Having said that, I don’t think that volatility should drive changes in asset allocation. Volatility tends to cluster in regimes and it would be very hard for an investor to time an upward or downward move. I think investors should structure their portfolios for the long term. I would say that now is a very prudent time for investors to closely observe their portfolio and make sure they have transparency into all the risks they’re taking and address unintended risks. As an example, recently investors have become very interested in hedging their currency exposure – after the strong rally in the dollar. They’re hedging only after they’ve experienced the risk. We are advocates of investors trying to get ahead of the curve with respect to risk. Investors need to show fortitude as volatility picks up and not overreact to events in the market. Staying the course What can investment managers do? First and foremost, investment managers can come up with ways that help the client to stick to their policy portfolio. So, as an example, they can offer seamless rebalancing methodologies. Investment managers can be more transparent about their strategies. By this I mean every strategy has periods when the wind is at its back and periods where you’re running into the wind. Overall it’s helpful to be more transparent about what environments will be challenging for a strategy. And if managers are forthright with the client about this, it’s less likely the client is going to terminate them during a challenging period. Frequently, in hindsight, we see that these challenging periods were absolutely the wrong time to terminate a strategy. Low-volatility strategies Low-volatility strategies are always worthy of consideration but investors need to be conscious of what they’re getting into. Most strategies are constructed around two general themes, a risk metric construction process and a min-variance process. Risk metric just involves sorting the index by various volatility metrics. Minimum variance looks beyond risk metrics and incorporates correlations among securities. All low-volatility factor construction uses some type of concentration limits. You need to understand that these strategies don’t outperform in every situation, namely a down market. For example, the S&P 500 Low [Volatility] Index has underperformed the S&P approximately 15% of the time when the market was negative. So investors have to understand that they can have these downward surprises. If investors want to avoid these types of surprises, either asset allocation or diversification through the introduction of other risk premiums will provide them with greater certainty of low volatility when they most want it, and that’s in a negative market environment. Holding cash In regard to holding cash, I think it’s challenging for an investor in the long term. They are holding risk assets to fund future liabilities, which are growing faster than cash. Investors holding cash also struggle to realize when the market is bottoming so they can time their move out of cash into risk assets. If you are really thinking about holding cash as a modest form of protection, there are other strategies available. A very simple one is a disciplined covered-call selling program that will generate cash in a stressful environment and dampen some of the downside volatility. That, to us, would be more prudent than parking money in cash. Derivatives Derivatives can and have been used to control portfolio volatility. Historically investors have used long puts or put spreads to control downside risk in portfolios. I am generally not an advocate of this approach. It needs to be highly customized to the particular investor and it can lead to a lot of challenging decisions. How do you pay for the downside protection? Do you sell away upside? Experience shows that most investors become fatigued with the expense and tend to terminate programs, often right before a market experiences challenges. Options An alternative approach is to sell fully collateralized options. This approach seeks to capture the volatility risk premium, which is embedded in options. It often makes more sense to de-risk the portfolio and consider being a seller, rather than a buyer of the hedge. The first adopters of this type of strategy were endowments and foundations. More recently there is increased interest from Taft-Hartley funds that are dealing with particular pension funds and mark-to-market issues, as well as public fund investors. There are benefits of selling volatility in a transparent, liquid and fully collateralized manner. One preferred way of doing that is through index options and trying to capture what academic and market research has identified as the volatility risk premium. The result is that this premium can be captured in a transparent, liquid manner and it shows diversification benefits versus traditional assets. It can have a material and positive impact on a portfolio over time. Focus on the long term Many investors look at volatility and are fearful. They intuitively understand that rising volatility generally means more stressful market environments. Investors need to take a step back and focus on the long term, and not become reactionary or fall into short-term pitfalls and try to shuffle their portfolio to follow some latest fad. As markets evolve there may be better approaches available to them that allow them to achieve their ultimate objectives. So be open to new ideas. There’s a lot of really creative thought going on right now in different areas that maybe in a couple years will become more mainstream. 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.

Monday Morning Memo: Passive – Smart – Smarter – Active

By Detlef Glow Click to enlarge The Evolution of the European ETF Industry When the first exchange-traded fund (ETF) was introduced to the markets, it was clear that the aim of the portfolio manager was to track the returns of the underlying index of the fund as closely as possible. But since a fund faces some restrictions, such as transaction costs or limits on the maximum weighting of a single security in the portfolio, that are not applicable for the underlying index, the difference between the returns of the index and the ETF are in some cases quite significant. Since the investment industry (and therefore also the ETF industry) is always trying to optimize its processes, ETF promoters started to develop portfolio management techniques to minimize tracking error and the tracking differences of the ETFs. The Generation 2.0 ETFs not only aimed to track the performance of the underlying index as closely as possible, the managers also attempted to optimize the returns with modern portfolio management techniques to achieve additional income that contributed to their outperformance over the index. Looking at ETFs that try to generate outperformance the “old fashioned way,” the additional income must be seen as tracking error and therefore as a negative fact. These returns were, firstly, non regular returns. Secondly, modern portfolio management techniques such as securities lending or dividend optimization strategies added an additional layer of risk to the portfolio, for which the ETF investor might have not been compensated properly. Even though the quality of ETF returns has evolved significantly, there are still a number of critics around, since it seems in some cases to be easy to beat market-capitalization-weighted benchmarks. In other cases, such as with bond indices, critics say that market capitalization is the wrong way to build an index. These criticisms have led to the development of alternative weighted indices, ranging from simple equally weighted indices to highly complex methodologies that might employ quantitative and qualitative factors to determine the weighting of the securities in the index. But, even though some promoters offer ETFs that track an alternative weighted index, these kinds of products have not found their way into the portfolios of mainstream investors. But there was and still is scientific evidence that there are some factors in the markets-such as momentum, quality, size, and value-that investors can exploit to generate higher returns than those from a market-cap-weighted index. The introduction of these factors into the mainstream ETF industry started after the financial crisis of 2008 with the first minimum variance ETFs that suited the needs of investors looking for equity portfolios that don’t show as much volatility as their underlying markets. To make these products more appealing for investors, the ETF industry called these kinds of funds “smart beta funds.” The popularity of these products led to a race in the search for new factors that can be exploited by investors, since the index and ETF promoters wanted to offer new products to their clients. But the “new factors” found by the researchers were mainly market abnormalities that disappeared shortly after they were found, or the additional returns were too small to exploit in a profitable way, since transaction costs were eating away the premium. One of the major concerns of investors with regard to smart beta ETFs is that all the factors employed do not deliver consistent outperformance. In other words, smart beta ETFs show longer periods of underperformance that make it necessary for the investor to switch at the right time between different factors to avoid the longer periods of underperformance in their portfolio. But since the right timing is the hardest call in the portfolio management process, especially for retail investors, it seems likely that a number of investors shy away from these products. In the next product generation, the index and ETF industry are attempting to make the smart beta products even smarter by combining different factors. The products improve the common smart beta ETFs. In other words, they make the smart beta concept even smarter, since the factors described above do not deliver outperformance at any particular time. One of the aims of this approach is to build a portfolio that is either in different factors at the same time or that tries to switch between factors at the right time, i.e., to unburden the investor from the timing decision in order to capture as much premium from a single factor as possible. From these semi-actively managed portfolios it is only a small step to a fully active managed portfolio wrapped in an ETF structure. Even though some market observers would label this a scandal, the introduction of actively managed ETFs will be the next logical step for the industry. Even though the first ETF following an actively managed index in Europe wasn’t a success at all, a view to the other side of the Atlantic shows that actively managed ETFs can be successful. PIMCO was able to generate very high inflows when it launched its first actively managed ETF in the U.S. The success of PIMCO might be the reason more and more promoters of actively managed funds are preparing to enter the ETF market. From my point of view this makes a lot of sense, since the ETF wrapper is a very efficient structure that opens up new distribution methods for active managers. And, I don’t see a valid reason why promoters should not try to distribute their funds through all possible channels. But to be successful active ETF managers must not only have good products, they also must build the right infrastructure for trading their funds. To be successful in the ETF industry there needs to be more than a well-known name and the listing of products on an exchange. I strongly believe this introduction will work; we already see a number of active managed funds listed by market participants on the “Deutsche Börse” in Frankfurt. At the beginning the fund promoters did not support trading their funds on exchanges and in some cases tried to close down the trading, since they felt this distribution channel would offend their established distribution channels. Those times are over, but it is still not common to buy or sell a mutual fund on an exchange unless the fund has been closed for some reason. From my point of view the trading of actively managed ETFs will become a very common way to buy mutual funds for all kinds of investors, once fund promoters officially start to use this market as a distribution channel. It is not a question of if we will see actively managed funds traded as ETFs, it is only a question of when we will see this happen. The views expressed are the views of the author, not necessarily those of Thomson Reuters Lipper.

Best And Worst Q2’16: Financials ETFs, Mutual Funds And Key Holdings

The Financials sector ranks sixth out of the ten sectors as detailed in our Q2’16 Sector Ratings for ETFs and Mutual Funds report. Last quarter , the Financials sector ranked seventh. It gets our Neutral rating, which is based on aggregation of ratings of 38 ETFs and 249 mutual funds in the Financials. See a recap of our Q1’16 Sector Ratings here . Figures 1 and 2 show the five best and worst rated ETFs and mutual funds in the sector. Not all Financials sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 21 to 572). This variation creates drastically different investment implications and, therefore, ratings. Investors seeking exposure to the Financials sector should buy one of the Attractive-or-better rated ETFs or mutual funds from Figures 1 and 2. Figure 1: ETFs with the Best & Worst Ratings – Top 5 Click to enlarge * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings PowerShares KBW Property & Casualty Insurance Portfolio (NYSEARCA: KBWP ) is excluded from Figure 1 because its total net assets (NYSEARCA: TNA ) are below $100 million and do not meet our liquidity minimums. Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 Click to enlarge * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Schwab Financial Services Fund (MUTF: SWFFX ) is excluded from Figure 2 because its total net assets are below $100 million and do not meet our liquidity minimums. iShares U.S. Financials Services ETF (NYSEARCA: IYG ) is the top-rated Financials ETF and Fidelity Select Banking Portfolio (MUTF: FSRBX ) is the top-rated Financials mutual fund. Both earn a Very Attractive rating. iShares Residential Real Estate Capped ETF (NYSEARCA: REZ ) is the worst rated Financials ETF and Rydex Series Real Estate Fund (MUTF: RYREX ) is the worst rated Financials mutual fund. REZ earns a Dangerous rating and RYREX earns a Very Dangerous rating. 595 stocks of the 3000+ we cover are classified as Financials stocks. American Express (NYSE: AXP ) is one of our favorite stocks held by IYG and earns a Very Attractive rating. We previously published a case study outlining how AXP could boost its value by $50 billion by making strategic decisions to boost return on invested capital ( ROIC ). Over the past six years, American Express has grown after-tax profit ( NOPAT ) by 6% compounded annually. At the same time, the company has improved its ROIC from 12% in 2005 to a top-quintile 20% in 2015. However, some short-term issues, which we identify in our case study have left AXP undervalued. At its current price of $62/share, American Express has a price-to-economic book value ( PEBV ) ratio of 0.9. This ratio means that the market expects American Express’ NOPAT to permanently decline by 10%. If AXP can, instead, grow NOPAT by 6% compounded annually for the next decade , the stock is worth $98/share today – a 58% upside. Essex Property Trust (NYSE: ESS ) is one of our least favorite stocks held by REZ and earns a Very Dangerous rating. Essex earns its rating in large part to its misleading earnings. Over the past decade, GAAP net income has grown by 11% compounded annually. However, Essex’s economic earnings , its true cash flows, have declined from $7 million to -$249 million over the same time period. Further highlighting the deterioration of Essex’s operations, the company’s ROIC has halved from 8% in 2005 to a bottom-quintile 4% in 2015. GAAP earnings have propped up shares for too long, and ESS remains overvalued. In order to justify its current price of $225/share, Essex must grow NOPAT by 12% compounded annually for the next 11 years . After a decade of shareholder value destruction, the expectations baked in ESS remain too high. Figures 3 and 4 show the rating landscape of all Financials ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst ETFs Click to enlarge Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Mutual Funds Click to enlarge Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme. 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.