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ETF Product Development: Innovation Versus Over-Engineering

ETF Product Development: Innovation Versus Over-Engineering Source: Wiki Commons ETF Product Development: When Innovation Turns into Over Engineering This quarter’s volatility has produced some early victims, notably some high profile hedge funds and quantitative market-neutral based strategies . As a former quantitative equity portfolio manager, I lived through the infamous August 2007 Quantitative Meltdown , where highly levered strategies using a combination of value and momentum were forced to liquidate all at once causing significant losses tied to what had been historically strong performing strategies. With this quarter’s sharp underperformance of similar strategies, the concern floating out amongst trading desks is whether we’re seeing another forced unwind of such strategies, particularly ones focused on price momentum, which had been one of the better performing strategies in recent periods. In discussions with a handful of capital market desks, I don’t get the sense that there is as much leverage employed today as there was in 2007, but one never knows until the counter-trend unwind exhausts itself. In some ways, the August 2007 Quant Meltdown served as an early warning signal of the fragility of capital markets resulting in the Great Financial Crisis of 2008. Much has been written about this period (and more recently in film, such as The Big Short ), but I highly recommend reading a Demon of Our Own Design written by Richard Bookstaber, who formerly headed firm-wide risk management at Salomon Brothers. In a nutshell, Bookstaber maintains that a system designed with ‘complexity’ and ‘interdependence and tight coupling’ is prone to normal accidents, whether nuclear power plants or leveraged financial vehicles tied to the performance of subprime mortgage-backed derivatives. It’s a cautionary tale particularly for Wall Street whose lifeblood is tied to increasing innovation that can quickly mutate into over-engineering. Complexity when combined with leverage leaves the financial markets more prone to liquidity-driven accidents and contagious selling of unrelated market segments. Correlations spike to one where diversification no longer matters as long as the investment program is only invested in safe assets. ETF Innovation: Know What You’re Buying Becoming Increasingly More Difficult This quarter’s market-neutral meltdown partly inspired this blog post, but it was primarily due to an analysis of a recently-introduced multi-strategy ETF designed to provide U.S. equity market exposure but with lower volatility and greater risk-adjusted returns. First, ‘smart’ beta (factor) investing is not ‘smart’ at all but just a reformulation of the Dimensional Fund Advisors’ (DFA) strategy of investing in areas of the market which have afforded higher risk premia over the long run. ‘Small cap’ and ‘value’ factors outperform over the market because they come with higher risks which investors are compensated for over the long run – these factors are no ‘smarter’ than a traditional market-cap based approach such as the S&P 500. Corey Hoffstein from Newfound Research published a recent piece on ETF.com in which he makes this astute observation about smart beta investing: “It is important to point out that for the long-term premiums to exist in these factors, they must be volatile over time. The excess return generated by one investor is at the detriment of another. If the returns were not time-varying, they would be viewed as “free.” In that case, there would be significant money inflow into the style, driving up prices and valuations and driving down forward expected returns until the premium converged to zero. Quite simply, volatility in the premium itself causes weak hands to fold, passing the premium to the strong hands that remain . [Underline Emphasis Added by 3D]” Smart beta investing is not a free lunch but one with real risks involved, such that the largest harvests of risk premia occur when weaker investors are bailing out at just the wrong time. Now ETF product innovation is a good thing as it has afforded investors access to market segments and themes only available to institutional investors. ETF product innovation has captured the systematic elements of many actively-managed strategies and has helped expanded the list of options to DFA like-minded investors who no longer wish to be constrained to the Fama/French 3-factor world. But new entrants to ETF sponsorship along with more participation from institutional investors has resulted in a new cycle of product innovation characterized by increased complexity. ‘Dynamic’ management of market exposures represents the latest innovation. Rather than providing a static exposure to, say, currency hedging, the ETF sponsor implements a rules-based dynamic hedging scheme designed to generate superior risk-adjusted performance over a static hedged or fully unhedged equivalent. The chase for ‘dynamic’ management introduces a new layer of complexity into the underlying exposure an ETF is designed to achieve. This brings us back to an analysis of a recently-launched ETF whose objective is to generate superior risk-adjusted returns over traditional asset classes through a combination of long and short positions where the short exposure is dynamically managed. Consider the components: ‘Long’ position weightings are based on a multi-factor approach combining value and growth metrics. The long weighting is further adjusted for its volatility characteristics (lower volatility stocks receive an incrementally higher weighting). The short exposure is designed to hedge out equity market risk. It is implemented using short S&P equity futures. These same value and growth metrics are used to determine the hedge ratio where the ETF can be 0%, 50%, or 100% hedged to market risk. Some variants of this approach provided by other ETF sponsors use a separate top-down business cycle indicator to determine the hedge ratio or base the hedge ratio on momentum-driven technical analysis. Now consider the complexity embedded in this approach as well as the interlocking dependencies making it more vulnerable to the type of accidents of the kind found in Bookstaber’s narrative. The ETF investor must ask, “What exposure am I ultimately buying with this ETF?” It is not a straightforward answer because the exposure is contingent on how this ETF is positioned given the latest market conditions. In addition, multiple things have to go right in order for this ETF to achieve its objective. The choice of factors must be correct. How the factors are mixed and weighted must be correct. The hedge ratio must be correct (market timing is an historically dubious exercise). But what ultimately is this ETF trying to achieve? It’s trying to achieve that elusive equity market free lunch – high capital market returns associated with equity investing but without as much risk. But that sort of objective flies in the face of capital markets pricing theories and would be expected to achieve the opposite, namely lower risk-adjusted returns when you factor in the ETF’s complexities and underlying fees. Many aspects of this strategy would have to perform consistently well in order for the ETF to achieve its objective, whereas, the failure of just one aspect can result in underperformance or an accident (especially if it were combined with leverage). When it comes to strategic beta or complex ETFs, it is imperative to know what you’re buying and why you’re buying it. Ask yourself, “What is this ETF designed to achieve and how does it fit within your asset allocation?” If simpler solutions are available to achieve a similar objective, then opt for simple over complexity. Product innovation is welcomed to a growing marketplace, but it a balance must be struck between innovation and system complexity. That is the elegance of design. 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. Additional disclosure: The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as of February 22, 2016 and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing sales@3dadvisor.com or visiting 3D’s website at www.3dadvisor.com.

Indonesia Slashes Rates Again: ETFs In Focus

Indonesia’s central bank cut its benchmark interest rate for the second time this year in its efforts to improve sluggish economic growth. Bank Indonesia (BI) slashed its benchmark interest rate by 25 basis points to 7%. BI had undertaken a similar sized cut in January after keeping rates unchanged for the last 10 months of 2015. The recent rate cut was largely expected as the majority of economists surveyed by Reuters had predicted that BI would cut the key rate by 25 basis points. In its efforts to ease the economy, BI not only lowered interest rates but also reduced the reserve requirement on rupiah deposits by 1 percentage point to 6.5%, effective from March 16. This move is expected to boost liquidity by more than $2.5 billion (34 trillion rupiah). These measures from the Indonesian central bank come closely on the heels of the U.S. Federal Reserve taking a dovish stance with hopes of further rate hikes fading. The Indonesian bank stated that its measures to ease monetary policy are aimed at achieving solid macroeconomic stability with reduced inflationary pressure against a backdrop of uncertain global markets. It further pointed out that it will continue to work with the government to control inflation, stimulate domestic economic growth and bring about structural reforms. The Indonesian president, Joko Widodo, popularly known as “Jokowi” has been quite vocal about his wish to see interest rates fall further to spur growth. As per a Bloomberg report, Indonesia’s economy expanded just 4.79% last year, the lowest since 2009. This year, with inflation under control, the overall sentiment is that the rates could be slashed further. In 2016, BI expects inflation to be around the mid-point of its target range of 3% to 5%. Apart from Indonesia, several other countries are also following the strategy of monetary easing, which generally comes in the form of an interest rate cut, to boost growth. Earlier this year, Bank of Japan’s (BOJ) move to impose a negative interest rate for the first time surprised the markets. The BOJ Governor Haruhiko even stated that there will be no limit to efforts for easing monetary policy. The central bank may further expand asset purchases if required. Other Asian countries including Taiwan and Bangladesh have cut rates. Meanwhile, the European Central Bank (ECB) has also hinted on further policy easing in its March 2016 meeting. Investor sentiment towards Indonesia has improved following its liberalization developments by easing restrictions on foreign investment in several industries including films, restaurants and healthcare earlier this month. Jokowi’s move to deregulate the traditionally protectionist economy should help in accelerating growth and making the Indonesian business environment more conducive for new investment. A Closer Look at 3 Indonesian ETFs In the light of these developments, we highlight three ETFs – the iShares MSCI Indonesia ETF (NYSEARCA: EIDO ) , the Market Vectors Indonesia Index ETF (NYSEARCA: IDX ) and the Market Vectors Indonesia Small-Cap ETF (NYSEARCA: IDXJ ) – that have gained 6.2%, 7.2% and 6.2%, respectively, in the last 10 days. All three have a Zacks ETF Rank of 3 or a ‘Hold’ rating with a High risk outlook. EIDO This is the most popular ETF tracking the Indonesian market with AUM of $344.3 million and average daily volume of almost 756,000 shares. The fund tracks the MSCI Indonesia Investable Market Index, holding 86 securities in its basket while charging 62 bps in annual fees from investors. The product is somewhat concentrated in both sectors and securities. The top five firms account for almost half of total assets, while from a sector point of view, financials dominates the fund’s assets with 38% share. The fund has a heavy tilt towards large-cap stocks at 84%. IDX This ETF follows the Market Vectors Indonesia Index, holding a basket of about 45 companies that are based or do most of their business in Indonesia. The product puts about 54.6% of total assets in the top 10 holdings, suggesting moderate concentration. Large caps are pretty prevalent, as these make up 83% of assets. With respect to sector holdings, financials again takes the largest share at 34.9%, followed by consumer staples (18%) and consumer discretionary (14.4%). The product has amassed $98.1 million in its asset base while it trades in volumes of around 89,000 shares. It charges 58 bps in fees per year from investors. IDXJ Unlike the other two, this is a small-cap centric fund. It is unpopular and less liquid having AUM of $5.3 million and average daily volume of about 2,000 shares. The fund tracks the Market Vectors Indonesia Small Cap Index and charges 61 bps in annual fees. Holding 29 stocks, the product does a decent job of spreading out as the top 10 securities hold about 62% weight. However, it is a bit concentrated from a sector outlook, as financials takes the top spot at 42.1% while industrials and energy round off the next two positions at 23% and 14.7%, respectively. Original Post

4 Utility ETFs Gaining Despite Lackluster Q4

At the tail end of the earnings season, the retail and utility sectors are the only ones with a number of companies yet to report results. As per Earnings Trend report, earnings of all the utility companies that have reported so far are down 5% year over year for the fourth quarter of 2015, with 21.4% of the companies beating the Zacks Consensus Estimate. Meanwhile, revenues are down nearly 13.3% for the quarter, with none of them surpassing the Zacks Consensus Estimate. The utility sector failed to impress in its fourth-quarter results with earnings and revenue miss from some of the major players in the space, including Duke Energy Corporation (NYSE: DUK ) and Dominion Resources Inc. (NYSE: D ). Although some companies like NextEra Energy (NYSE: NEE ) managed to beat on earnings, revenues came short of expectations. However, the slowdown in U.S. economic growth, Chinese market turbulence and plunging oil prices along with other factors resulted in a bearish environment, which led to demand for securities from sectors that provide a safer option. Thus, the utility sector, which is considered to be one of the safer options when the market is exhibiting a high level of volatility, managed to remain in the green over the last one month despite lackluster results (read: 3 Utility ETFs in Focus on Market Downturn ). Below we have highlighted the quarterly results of the aforementioned utility companies in detail. Duke Energy Duke Energy reported adjusted earnings of 87 cents per share for the quarter that fell short of the Zacks Consensus Estimate of 94 cents by 7.4%. However, quarterly earnings increased by a penny year over year on the back of higher retail pricing and wholesale margins in the regulated business. Total revenue was $5,351 million, lagging the Zacks Consensus Estimate of $5,709 million by 6.3%. The company has provided 2016 earnings guidance in the range of $4.50 to $4.70 per share. Shares of the company declined 1.4% (as of February 19, 2016) since its earnings release. NextEra Energy NextEra Energy’s quarterly adjusted earnings of $1.17 per share beat the Zacks Consensus Estimate of $1.11 by 5.4%. Earnings climbed 13.6% year over year on the back of higher revenues from Florida Power & Light Company. However, revenues of $4,069 million missed the Zacks Consensus Estimate by 2.6% and decreased 12.8% from the year-ago level. NextEra reiterated its earnings guidance of $5.85-$6.35 for 2016. Shares of the company went up 7.5% since its earnings release (as of February 19, 2016). Dominion Resources Dominion Resources’ quarterly earnings of 70 cents per share lagged the Zacks Consensus Estimate of 87 cents by 19.5%. Earnings decreased 16.7% from 84 cents per share in the prior-year quarter due to mild weather conditions in its service territories, absence of a farmout transaction and the impact of bonus depreciation. The company’s operating revenues of $2,556 million also missed the Zacks Consensus Estimate of $4,092 million by 37.5% and declined about 13.1% year over year. Dominion expects to earn 90 cents to $1.05 per share for the first-quarter 2016 compared with 99 cents per share in the year-ago period. The company expects earnings for 2016 in the range of $3.60 to $4.00 per share. Shares of the company fell 3.8% since its earnings release (as of February 19, 2016). ETFs in Focus Mixed results notwithstanding, many utility stocks managed to hold up gains over the past one month, sending the related ETFs higher. This has put the spotlight on utility ETFs. Below we discuss four of these ETFs having a sizeable exposure to the above stocks, holding Zacks ETF Rank #3 (Hold) with a Medium risk outlook (see all Utilities/Infrastructure ETFs here ). Utilities Select Sector SPDR (NYSEARCA: XLU ) XLU is one of the most popular products in the space with nearly $7.6 billion in AUM and average daily volume of roughly 14 million shares. The fund tracks the Utilities Select Sector Index and holds 31 stocks with NextEra Energy, Duke Energy and Dominion Resources among the top five spots with a combined exposure of nearly one-fourth of its total assets. Sector-wise, Electric Utilities (57.82%) dominates the fund followed by Multi-Utilities (38.85%). The fund charges 14 bps in investor fees per year. The ETF has posted gains of 7.3% in the past month (read: 4 Utilities to Buy in a Bear Market ). Vanguard Utilities ETF (NYSEARCA: VPU ) This ETF tracks the MSCI US Investable Market Utilities 25/50 Index. The fund holds 82 stocks in its basket. Duke Energy, NextEra Energy and Dominion Resources occupy the top four positions in the fund with a combined exposure of a little more than 20%. More than half of the fund’s assets are invested in Electric Utilities followed by Multi-Utilities (33.8%). The fund has amassed almost $2 billion in its asset base and trades in a moderate volume of 175,000 shares per day. The fund has a low expense ratio of 0.10%. The ETF has surged 7.6% in the last one-month period. iShares Dow Jones US Utilities (NYSEARCA: IDU ) The fund follows the Dow Jones U.S. Utilities Sector Index and holds 59 stocks in its basket. Duke Energy, NextEra Energy and Dominion Resources are placed among the top five stocks in the fund, together accounting for a share of more than 21% of total assets. On a sectoral basis, Electric Utilities (53.28%) and Multi-Utilities (34.51%) hold the top two positions in the fund. The fund manages an asset base of around $764 million and exchanges about 199,000 shares per day. It is a bit expensive with 44 bps in annual fees. IDU was up 7.5% in the last one-month period. Fidelity MSCI Utilities ETF (NYSEARCA: FUTY ) This ETF tracks the MSCI USA IMI Utilities Index. The fund holds 83 stocks in its basket. Duke Energy, NextEra Energy and Dominion Resources are among the top four in the fund with a combined exposure of a little more than 20%. More than half of the fund’s assets are invested in Electric Utilities followed by Multi-Utilities (33.8%). The fund has amassed almost $231 million in its asset base and trades in a moderate volume of 140,000 shares per day. The fund has an expense ratio of 0.12%. FUTY was up 7.5% in the last one-month period. Original Post