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Investors Need To Understand The Risks Of Smart Beta

By Rhea Wessel The low-yield environment has many investors seeking new sources of outperformance. One development has been the growth of so-called smart beta investments, a $400 billion ETF market with a strong flow of funds from both institutions and retail investors. But are such funds really “smart” and do they truly have the potential to boost performance? To answer such questions, CFA Institute Magazine turned to Nick Baturin, CFA , formerly head of portfolio analytics at Bloomberg. He also spoke at the CFA Institute Annual Conference in Frankfurt in 2015. In this interview, Baturin discusses the rise of smart beta, its counterpart “dumb alpha,” and the need for investors to educate themselves about risks in this area. CFA Institute: First of all, what is smart beta? Nick Baturin, CFA : Smart beta investments are funds and ETFs that have a non-traditional weighting scheme that goes beyond cap weighting. There are many different types out there – equal-weighted, inversely risk-weighted, optimized to minimize risk, fundamental-weighted, factor tilts, dividend tilts, and dividend-weighted ETFs. There’s a whole taxonomy out there. The latest entrant in this space is a hybrid product which combines several themes into one. An example is the iShares enhanced index funds. These are active funds and they trade based on some of BlackRock’s research into well-known anomalies – the value anomaly, the quality anomaly, the size anomaly – and they optimize risk as well. They act like an active management quant fund but somewhat simplified. BlackRock does not give you all of their proprietary model insights that they use for their other actively managed quant funds. They give you a dumbed-down version of that. However, they’re also charging lower fees than for their actively managed quant funds. Another thing to note about smart beta indices: They have to rebalance a lot more often than passive buy-and-hold index funds, which are cap-weighted and typically rebalance just once or twice a year. You’ve talked about “dumb alpha.” What is that? There’s a lot of marketing hype going on. When I call smart beta “dumb alpha,” that’s a view that’s somewhat non-traditional. Obviously, it wouldn’t sit well with smart beta fund providers. I call it dumb alpha because traditional quantitative investors have known about these style tilts for several decades. They bet on factors such as value and momentum, quality and size. These have been used in quant investment strategies forever. I call them generic alpha factors rather than proprietary alpha factors. The difference between generic and proprietary is that proprietary cannot be easily replicated. You have some secret sauce, perhaps, at your own firm that only you know about, whereas with a value factor or size or momentum, everyone knows about it. You can implement this in a very straightforward manner. In that sense, it’s dumb alpha because you don’t need any complex implementation engine for it. What I’ve seen with smart beta is partially a marketing effort to rebrand these traditional generic alpha factors as smart beta funds. All they do is give you exposure to these traditional, generic quant factors, but in the ETF wrapper, and they charge a higher fee. So, basically, it’s a rebranding effort in my opinion. Is the higher fee justified? Well, the higher fee can be partially justified by the higher trading costs of these funds. And certain factors do have long-term outperformance records over the market portfolio. But you have to be very judicious. With a smart beta fund, the burden of decision as to what to invest in is no longer on the fund manager. It’s now on the investor. Should smart beta strategies be included in participant retirement plans? Fundamentally weighted funds bet on the value factor, but investors can also get value-factor exposure by investing in the Vanguard Value Fund, which is a cap-weighted fund which also gives you value exposure, but a lot cheaper. You have to be judicious. You cannot expect a retail investor to know the difference between smart beta and stupid beta and to evaluate the cost versus benefit tradeoff. If you call all smart beta ETFs “smart,” that becomes a confusing soup to choose from. You have momentum, you have value, you have quality, you have size; you have fundamental-weighted, risk-weighted. It’s a complicated array of products that is exposing retail investors to a lot more choices. This will take them a long time to learn about. I don’t think they are in a position to really drill down in much detail. Would I include smart beta in participant retirement plans? Possibly, but you have to select low-cost versions implementing well-known ideas that have been demonstrated to work over a long time and in different markets, like a value tilt. That’s a pretty solid factor. That’s one of the best ones out there. Is a fundamentally weighted index a good way to capture that? A fundamental index comes with additional attributes (factor exposures other than value) that are offered as a bundled deal. In that sense, a pure value tilt is probably a better exposure vehicle for retirement plans. If you are a retail investor, you are typically not sophisticated, and you respond to marketing and hype. It’s our job as investment managers to be honest with these investors and really explain performance beyond the hype. They have to know the risks and the rewards of investing in these products, and there are risks. The term smart beta is a great marketing slogan, and it has caught on. What are the risks? You may have a period of massive underperformance of a particular strategy. There’s a lot of academic research that says that actively managed funds collectively underperform passive cap-weighted indices in the long run. Vanguard founder John Bogle thinks that everything that’s not an index fund is a fraud. But does it mean that the market is truly efficient and there are no anomalies? No. There are anomalies. And there are risks – mainly, that any strategy will underperform. Let’s say everybody in the world piles into value strategies. Then value will stop working. The market-cap-weighted index is the only index that can theoretically be held by every investor in the market. You will all get the same exposure. But in the real world, there will always be some winners and some losers. After a lot of dollars flow into these smart beta funds, they will eventually stop working. We’ll have cut off the branch we were sitting on. What’s next in the world of smart beta? I’d say hybrid products that erase the boundary between active management and smart beta are where things are headed. Those are truly multi-factor, risk-aware investment strategies. These haven’t caught on just yet. The largest is just over 100 million in assets. That’s not a lot by the standards of the ETF market. But, nevertheless, these hybrid products that combine several anomalies in a risk-controlled way under one vehicle will become popular. It depends on the performance and the marketing. I think the marketing is a huge aspect of it all. We live in a low-yield environment with investors who are desperate to outperform the traditional indices and asset classes, so I think marketing has a huge role to play in whether or not these hybrid products catch on. What should investors watch out for in smart beta? There are definitely things to watch out for. I’d say don’t start out cold. You’ve got to educate yourself. Beware of risks. Beware of costs. Invest in more robust ideas, like value. Momentum isn’t robust. On that basis, my heart lies with lower-cost solutions that offer you a cheap value tilt. These are traditional cap-weighted value funds. They score highly for me because they are cheap and deliver on that factor tilt. There’s going to be periods of underperformance. At least over the very long term, you stand a chance of outperforming traditional cap-weighted indices. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Passive Investing – I Doth Protest Too Much

One of my favorite blogs, The Monevator blog , did a brief write-up on my new paper this weekend . If you don’t read their website you’re missing out because they consistently post some of the best financial content around. Anyhow, they had a very fair and objective view of the paper and approach to portfolio construction. However, one point that I seem to lose a lot of people on is my discussion of active and passive investing. So, I wanted to take this space to clarify a bit. Financial commentary doesn’t have a uniform definition for passive investing. Googling the term brings up the several different results: Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio. – Wikipedia Passive investing is an investment strategy involving limited ongoing buying and selling actions. – Investopedia The first definition is vague because there are limitless numbers of market cap weighted indexes these days, some of which are not well diversified and not low fee. Additionally, why should passive indexing be limited to market cap weighted index? Is it really correct to say, for instance, a fund like MORT , with 23 REIT holdings, reflects passive investing better than say, the equal weight S&P 500 ETF? An “index” is a rather arbitrary construct in a world where there are now tens of thousands of different indexes. The second definition is equally vague since an investor can hold a handful of stocks in a buy and hold strategy and limit ongoing buying and selling. Clearly, we shouldn’t call that passive investing in the sense that a low fee indexer would advocate. The new technologies such as ETFs have really muddled the discussion here as there’s now an index of anything and everything. So, as Andrew Lo notes: “Benchmark algorithms for high-performance computing blurred the line between passive and active.”¹ Along the traditional low fee indexing thinking I am tempted to define passive indexing as any low fee, diversified & systematic indexing strategy. But that could include all sorts of tactical asset allocation strategies that have systematic allocations. I don’t think it’s appropriate to call a tactical asset allocation strategy “passive”. So we’re back to a very blurry area in this discussion. In order to clarify this discussion I arrived at the following simple distinction: Active Investing – an asset allocation strategy with high relative frictions that attempts to “beat the market” return on a risk adjusted basis. Passive Investing – an asset allocation strategy with low relative frictions that attempts to take the market return on a risk adjusted basis. This definition has its own problem because we have to define “the market”. Is “the market” the USA, global stocks, global bonds, etc.? I’d argue that “the market” is the Global Financial Asset Portfolio, the one true benchmark of all outstanding financial assets. Therefore, anyone who deviates from this portfolio is making active decisions that essentially claim “the market” portfolio is wrong for them. This would mean that the only true “passive” strategy is following the GFAP. Obviously, not everyone does that and in fact, probably no one does it perfectly so that would mean we’re all basically active. Some people are active in silly ways (like day traders) and others are active in smart ways (diversified inactive indexers). Of course, I am a full blown supporter of low fee, low activity indexing. So please don’t confuse this as an attack on “passive indexing”. And yes, I am admittedly being overly precise. I certainly doth protest too much as Monevator says. But I am really just trying to establish a cohesive language here because I see too many people these days claiming they’re “passive” when they’re really being quite active. The worst offenders of this language problem are high fee asset managers who sell “passive” strategies cloaked as low fee platforms. I find that dishonest and extremely harmful. A little bit of clarity in this discussion is helpful in my opinion. ¹ – What is an Index? Lo, Andrew.

Southern Company: A Safe High-Yield Dividend Stock For Retirees

Yield-starved investors should familiarize themselves with Southern Company (NYSE: SO ), a highly dependable business that has paid dividends every quarter for more than 65 consecutive years. With a high yield of 4.4%, low stock price volatility, and a track record for outperforming the S&P 500 Index over the last 30 years, Southern Company is the type of business that we like to review for our Conservative Retirees and Top 20 Dividend Stocks portfolios. Business Overview The Southern Company is a major producer of electricity in the U.S. that has been in business for more than 100 years. The holding company’s four retail regulated utilities serve approximately 4.5 million customers across Georgia, Alabama, Florida, and Mississippi. Approximately 90% of Southern Company’s earnings are from regulated subsidiaries, and the company also has a small wholesale energy company. Industrial customers account for 28% of the company’s sales, followed by commercial (27%), residential (27%), and other retail and wholesale (17%). By power source, coal generated 33% of Southern Company’s total megawatt hours in 2015, gas accounted for 47%, nuclear was 16%, and hydro power was 3%. The company’s mix of business and geographies will significantly change in the second half of 2016 when it closes its acquisition of natural gas utility AGL Resources. Southern Company’s customer count will double to roughly 9 million, and its energy mix will shift from 100% electric to a 50/50 mix of electric and gas. Business Analysis Utility companies spend billions of dollars to build power plants and transmission lines and must comply with strict regulatory and environmental standards. As capital-intensive regulated entities, utility companies typically have a monopoly in the geographies they operate in. As a result, the government controls the rates that utilities can charge to ensure they are fair to customers while still allowing the utility company to earn a reasonable return on their investments to continue providing quality service. Each state’s regulatory body is different from the next, and some regions have been better to utilities than others. The Southeast region has been friendly to businesses, and Southern Company operates in four of the top eight most constructive state regulatory environments in the U.S. according to RRA: Click to enlarge Source: Southern Company Investor Presentation Southern also maintains strong relationships with regulators in part due to its reputation and the reasonable rates it currently charges, which are below the national average and perceived as being more customer-friendly. The South region is also one of the fastest-growing in the country, which makes Southern Company a relatively more attractive utility than many others. While regulation protects Southern Company’s monopoly business and helps it generate consistent earnings, it also makes growth more difficult. The company’s earnings have grown by about 3% per year historically, but its planned merger with AGL Resources is expected to boost earnings growth to a 4-5% annual clip. In late 2015, Southern Company announced plans to acquire AGL Resources for approximately $8 billion. AGL is the largest U.S. gas-only local distribution company, serving about 4.5 million customers in seven states and generating approximately 70% of its earnings from regulated operations. The combined company will now serve roughly 9 million customers and diversify Southern Company’s revenue mix from being 100% electric to a 50/50 mix of electric and gas customers. The deal also somewhat reduces the impact from the company’s large construction projects that have been delayed and provides a new array of growth projects to invest in. Furthermore, we like that AGL will provide some regulatory diversification for Southern Company by expanding its reach into several new states. Finally, it’s worth mentioning that Southern Company is the only electric utility in the country that is committed to a portfolio of nuclear, coal gasification, natural gas, solar, wind, and biomass. The company has committed $20 billion to developing a portfolio of low- and zero-carbon emission generating resources, including investments in natural gas, solar, wind, and integrated gasification combined cycle technology. As seen below, the company’s mix of resources is expected to become more diversified over the next five years, reducing its dependency on coal. A diverse generation fleet reduces the company’s risk of being overly dependent on any one source of energy. Click to enlarge Source: Southern Company Investor Presentation Southern Company’s Key Risks Utility companies generally have lower business risk than many other types of businesses. Their biggest risks are usually regulatory in nature – customer rates are decided at the state level and materially impact the return a utility company gets on its major capital expenditures. In Southern Company’s case, its main states in the Southeast have historically had generally favorable regulatory rulings. The acquisition of AGL Resources will also diversify the company’s regulatory risk. EPA regulations are another challenge. There is increased scrutiny around coal and nuclear power, which could result in higher spending to remain compliant with safety and emissions standards. If Southern Company cannot pass these costs through to customers, shareholders would take the hit. Project execution is another big risk facing the company. Southern Company has taken on several major capital projects in recent years. The company is building a coal-fired power plant in Kemper County, Mississippi, and two nuclear plants at Plant Vogtle in Georgia. The coal gasification project in Mississippi was originally expected to cost $5 billion and go into service in 2014, but it has been delayed by two years and experienced over $1 billion in additional costs. While the Kemper County facility is finally nearing completion, it’s uncertain how the project will be paid for. A Wall Street Journal article from May 22, 2015, cited that Southern informed state regulators that it might need to raise electricity rates by as much as 41% a month for households to pay for the project. The company was ultimately bailed out by an approved 18% rate increase in August 2015, although the increase was temporary and later revised to 15% . Southern Company is only about 26% finished with construction of its nuclear plants in Georgia. This project has seen its costs escalate from an estimated $14.1 billion in 2009 to over $20 billion today (Southern’s share of the project’s cost is less than $10 billion). It has also been delayed by more than three years. While the cost overruns and delays on these massive projects are certainly a black eye for the company and do not help its regulatory relationships in the effected states, we do not believe they impair Southern’s long-term earnings power. However, there is risk that these projects receive unfavorable rate treatment with regulators. Finally, Southern Company’s acquisition of AGL Resources creates some risk. This was a large deal that comes at a time when the management team is already facing challenges with the company’s large capital projects. AGL gets Southern into a new business (gas utility) and brings exposure to new states that have different regulatory bodies. Dividend Analysis: Southern Company We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Dividend Safety Score Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak. Southern Company’s dividend payment appears very safe with a Dividend Safety Score of 86. If we exclude charges related to increased cost estimates for the company’s large construction projects, Southern’s earnings payout ratio in 2015 was 75%. While we prefer to see a lower payout ratio for most businesses, we can see that Southern Company’s payout ratio has remained between 70% and 80% for most of the last decade. Source: Simply Safe Dividends Utility companies can also maintain relatively high payout ratios compared to most businesses because their financial results are so stable. Customers still need to use a certain amount of electricity and gas regardless of economic conditions, making utilities one of the best stock sectors for dividend income . As seen below, Southern Company’s sales only fell by 8% in fiscal year 2009, and its stock was flat in 2008, outperforming the S&P 500 by 37%. Utility companies are generally great investments to own during economic downturns. Source: Simply Safe Dividends We can also see that Southern Company’s reported earnings have remained remarkably stable over the last decade. The dip in recent years was caused by constructed-related charges. Otherwise, the steady earnings results look almost like interest payments coming in from a bond. Southern’s earnings growth isn’t exciting, but it’s dependable. Source: Simply Safe Dividends As a regulated utility company, Southern generates a moderate but predictable mid-single digit return on invested capital. The slight dip was due to write-offs on its capital projects, but the favorable regulatory environment in its key states has helped it earn somewhat higher returns than many other utility companies. We expect the company’s returns to improve as its large projects finally come on-line. Source: Simply Safe Dividends Utility companies maintain a lot of debt to maintain their capital-intensive businesses. Southern Company most recently reported $1.4 billion in cash compared to $27.4 billion in debt on its balance sheet. While this would be a concern for most companies, the stability of Southern’s earnings and strength of its moat alleviate much of this risk. The company also has over $4 billion available in its credit facility and maintains investment grade credit ratings with the major agencies. Click to enlarge Source: Simply Safe Dividends Despite the challenges Southern Company is facing with its major construction projects, the safety of its dividend still looks great. The company maintains a reasonable payout ratio for a utility company, earnings are predictable each year, and its key operating states have provided a historically favorable regulatory environment. Dividend Growth Score Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak. The dependability of utility companies’ dividends comes at the price of growth. Southern Company’s dividend has grown at a 3.9% annualized rate over the past decade, and the business has a very low Dividend Growth Score of 9. The company most recently increased its dividend by about 2% in April 2015, marking its 14th consecutive raise. Source: Simply Safe Dividends While Southern Company is 11 years away from joining the dividend aristocrats list , we believe it has a good chance of getting there. The company’s dividend growth rate could even increase in coming years. Management believes the AGL Resources merger could increase Southern’s long-term earnings per share growth from 3% to 4-5%, which would allow for slightly greater dividend raises. Valuation SO’s stock trades at 17.4x forward earnings estimates and has a dividend yield of 4.36%, which is below its five-year average dividend yield of 4.46%. If the AGL merger increases the company’s long-term earnings growth rate to 4-5% as management expects, the stock appears to offer total return potential of 8-9% per year. We think the stock looks to be about fairly valued today, and it’s worth noting how the predictability of Southern’s business has resulted in very low stock price volatility. The chart below shows the volatility of each of the 20 utilities in the Philadelphia Electric Utility Index (UTY). Southern Company had the lowest level of volatility through the five-year period ending on 12/31/2014. Source: Southern Company Annual Report Conclusion Southern Company is a blue chip dividend payer in the utilities sector. The last few years have been disappointing due to delays and cost overruns with some of the company’s major construction projects, but the long-term outlook appears to be intact. Southern Company’s stock appears to be reasonably priced and offers a dependable income stream for those living off dividends in retirement. It’s hard not to like a business as sturdy and reliable as this one. 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.