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Do Price Targets Matter In Volatile Markets? (And, Why Alpha Theory Should Be A Starting Point Even In Turbulent Times)

This blog was co-authored with Alpha Theory’s Customer Relations Manager, Dana Lambert. “Stock prices will continue to fluctuate – sometimes sharply – and the economy will have its ups and downs. Over time, however, we believe it is highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate.” – Warren Buffett, famed investor “While many have portrayed the current environment as a highly risky time to invest, these individuals are likely confusing risk with volatility. We believe risk should be determined based on the probability that an investor will incur a permanent loss of capital. As market values have declined substantially, this risk has actually diminished rather than increased. “- Bill Ackman, Pershing Square 3Q08 Investor Letter The recent market environment has proven challenging for many funds, including Alpha Theory clients. The market has been volatile, but the real challenge is directionality. As of September 28, the S&P was down 11% over the prior 49 trading days, with 30 of the 49 days being down. Alpha Theory clients generally benefit from pure volatility (large ups and downs without a direction) because they are buying on dips and selling on rises (mean-reversion). The problem with a uniformly down directional market is that clients are continually getting indications to add to their longs and trim their shorts – the proverbial “catching the falling knife”. Although Alpha Theory cannot overcome persistent negative correlation between scenario estimates and outcomes – in other words inaccurate research – it does offer three options to help clients deal with these circumstances. OPTION #1 – RAISE PREFERRED RETURN. When the price of an asset falls, its probability-weighted return (PWR) rises. When the PWR rises, the normal action is to increase your position size. But when all asset prices fall, all PWRs rise and thus the longs become more attractive and the shorts less so. This suggested increase in long exposure may not be tenable and there may be a general skepticism regarding the price targets. In this situation, a manager can raise the preferred return for longs and thus raise the ‘hurdle rate’ required to be a full position in his or her fund (i.e., before you required only a 40% PWR to be a full position, but in this market environment you require 60%). This will immediately lower long exposure and only suggest adding to the best ideas. In the extreme example of February 2009, clients raised their hurdle rates to 70% or 80% and were able to see quickly numerous compelling ideas and how to shift capital appropriately. OPTION #2 – RELATIVE INDEX ADJUSTMENT. As the market falls, the “market multiple” decreases – which has ripple effects through the price targets in Alpha Theory. For those who cannot re-underwrite all of their targets for the new market paradigm, the application offers an easy-to-use feature called ‘Relative Index Adjustment’. This basically adds back the move of the market to an asset’s expected return, and the following would be an illustrative example. If the market is down 11%, then most assets’ prices will also be down and their suggested position sizes will increase. Now let’s turn on the Relative Index Adjustment. If every asset is down 11%, commensurate with the market move, then Alpha Theory will adjust the prices so that there is no change (-11% Stock Move minus -11% Market Move = 0% change) and thus no suggested change in position size. The beauty of this system is that you can turn it on and off and the Market Move is calculated since the last price target update. So if an analyst updates a price target, the Market Move gets set back to zero because the analyst would take into account the new “market multiple.” OPTION #3 – RE-UNDERWRITE CONSERVATIVE PRICE TARGETS. Fundamental investors recognize that there is no absolute intrinsic value for each asset because their assumptions are subjective. There is, however, a range of assumptions that span from aggressive to conservative. Down markets imply that pushing your assumptions to the conservative end of the spectrum may be appropriate. After doing this, you can see which assets are still suggested buys and which are not. The confidence imbued by using the most conservative assumptions allows you to be aggressive with add and trim decisions. A few views to help isolate where to start the re-underwriting process are: Performance view : shows those assets that have suffered the most on an absolute and relative basis Group by Risk/Reward within 10% : groups the assets that are within 10% of Reward and 10% of Risk targets (click to enlarge) While consideration of the aforementioned steps certainly is appropriate, as you develop conviction about downward directionality for the market, it is also worth noting that volatile markets can often be followed by periods of relative calm and distinct upwardly-biased directionality – and of course this has been the pattern for the past several years now. So where in one week an analyst or PM sees a 1-year target as likely to be unachievable, the next week suddenly the expected return gap narrows considerably. In short, just when you may be losing faith in your targets, they can quickly fall back into an attainable range. Directional markets that move quickly are challenging for many reasons. It is easy to throw up your hands and rationalize that “price targets don’t matter” or “our research is wrong”. It is hard to restrain those emotions and redouble your efforts to find the value that has been exposed in the quick, volatile relocation of asset prices. To do so requires a rigorous, disciplined process that begins with retesting assumptions (i.e., raising return hurdles, adjusting for the market move, and setting more conservative targets). If, after re-underwriting price targets and portfolio inputs, Alpha Theory is still recommending upsizings, then you can feel confident in your actions … even in a volatile, directional market.

Think Flexible With Emerging-Market Asset Classes

By Morgan Harting A midyear sell-off in emerging-market stocks highlighted the challenges investors face in volatile times. We think a flexible approach that spans the asset classes can help. Equities dropped by about 25% between April and August, and volatility spiked to levels not seen since the mid-2013 “taper tantrum.” The cause: investors fretted about slowing Chinese growth, weaker commodity prices and looming US Federal Reserve rate hikes. It was particularly tough for passive equity investors whose exposure was concentrated in the BRIC countries – Brazil, Russia, India and China. Don’t Pay for Beta in Emerging Markets This experience seemed to reinforce the notion that investors shouldn’t “pay for beta,” particularly in emerging markets. Passive equity strategies in that arena can be as much as 50% more volatile than in developed markets. The added return needed to justify a passive equity allocation requires a lot of conviction – or disregard for higher volatility. The good news is that emerging markets are still pretty inefficient. Active managers can add value by generating higher returns to justify higher risk, or by reducing the risk in passive strategies. We think the flexibility to tap multiple asset classes in one portfolio – including bonds – can be effective. It’s a compelling way to get more active, seeking to dampen volatility and improve risk-adjusted returns. Episodes like the taper tantrum – a global sell-off across asset classes – can disrupt things. But we think those are the exception, not the rule, in cross-asset diversification. In the recent downturn, multi-asset strategies did indeed outperform passive broad-market equity strategies. Multi-Asset: Newer to Emerging Markets Developed-market multi-asset strategies have been around for a while, but the emerging-market versions are relative newcomers. Many investors still prefer asset-class “pure” emerging-market strategies: all equity or all debt. As the thinking goes, it’s better for managers to focus on asset-class expertise than venture into other areas. We think high volatility in passive emerging-market equity changes the argument. Investors should use every tool to reduce risk and preserve returns. Multi-asset emerging-market approaches offer a tool that controls volatility better than just moving to lower-volatility stocks. The average volatility of emerging-market stocks? It’s 22% over the past decade. For bonds, it’s less than 5%, and with much less downside risk. The recent sell-off in emerging markets has made the volatility and downside risk-reduction benefits more evident, as these managers have outperformed meaningfully. The Case for Crossing Asset-Class Boundaries Granted, some active managers are very skilled in individual asset classes. But no matter which emerging-market asset class you’re in, the main return driver is broad emerging-market risk. The proof is in the return patterns. Over the past decade, the correlation between emerging-market stocks and bonds has been 0.7, much higher than the 0.1 between developed-market equity and debt. 1 With so many common return drivers among emerging asset classes, it seems to make more sense to manage emerging-market equity and debt together in a single portfolio than it does with developed markets. After all, the correlation between US and Japanese stocks is just 0.5, 2 but it’s hardly controversial anymore to suggest one manager for a global equity portfolio. Many investors want to take part in emerging-market growth and may see today’s attractive valuations as an enticing entry point. But they also might question whether it’s really worth it after factoring risk into the equation. We think multi-asset approaches offer a way to reduce some of that risk. Morgan C. Harting, CFA, CAIA Portfolio Manager – Multi-Asset Solutions 1,2 For the 10-year period ending September 25, 2015. Emerging-market stocks represented by the MSCI Emerging Markets Index; emerging-market bonds by the J.P. Morgan EMBI Global; US and Japanese stocks by their respective MSCI indices. Disclaimer: MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Finding Bargains Among Emerging Markets Bond CEFs

Summary The discounts associated with emerging markets CEFs are at historic highs, with many discounts over 2 standard deviations from the mean. Emerging markets CEFs have been significantly more volatile than their ETF counterparts. ESD, EMD and MSD had the best risk-adjusted performance among the CEFs analyzed. Over the past several weeks, I have been writing about potential bargains among Closed End Funds (CEFs). This week I will continue the series by analyzing the risks and returns associated with Emerging Markets (NYSE: EM ) Bond CEFs. Before jumping into the analysis, I will provide a quick review of some of the characteristics of this asset class. The term emerging market refers to securities domiciled in a country that is considered to be emerging from an under-developed economy to a more mainstream environment. These countries are typically in Africa, Eastern Europe, the Middle East, Latin America, and some Asian countries. Many of these economies depend on either exporting commodities or providing services to the more developed world. There are several subclasses of EM bonds. For example, EM bonds may trade in either the currency associated with their country or trade in U.S. dollars. In addition, EM bonds may be corporate bonds or government treasuries (which are usually referred to as sovereign debt). Some of the reasons for investing in the bonds of emerging markets include: EM bonds offer higher yields than comparable bonds from developed countries. As the credit worthiness of an emerging economy improves, the rating of the bonds may improve leading to capital gains. EM bonds rise and fall due to local conditions, which may not be in sync with the U.S. market, thus offering diversification. If the EM bond is denominated in local currency, there is a potential for additional appreciation due to currency fluctuations. Of course, depreciation is also a possibility (which has happened recently). Since many EM bonds are thinly traded and are available only on local exchanges, it is difficult for individual investors to purchase these bonds individually. The easiest way to invest in this asset class is to buy funds. Exchange Traded Funds (ETFs) are the most popular vehicle with some ETFs trading over 700,000 shares per day. However, Closed End Funds (CEFs) are an alternative choice. The closed nature of these CEFs makes it easier for the manager to invest and hold limited liquidity assets without having to worry about cash inflows and outflows. However, the downside of CEFs is that the price is based on market action, which can wreak havoc when the asset falls from favor. This has been demonstrated with a vengeance since the second quarter of 2013 when talk of the Fed increasing rates led to a collapse of prices of these CEFs. As prices deteriorated, the discounts of these CEFs widened to historical large levels, many over 18%. This is evidenced by a large negative Z-score, a statistic popularized by Morningstar to measure how far a discount (or premium) is from the average discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A Z-score lower (more negative) than minus 2 is a relatively rare event, occurring less than 2.25% of the time. However, in today’s environment, most of the EM CEFs have a one year Z-score of negative 2 or lower, which illustrates the current lack of demand for these CEFs. There are several reasons that investor lost confidence in emerging markets: The dollar has been in a bull market, which means that emerging markets currencies are becoming weaker versus the dollar. The Fed may finally begin to tighten in the near future, which will again strengthen the dollar. Commodities are in a bear market and many emerging market economies depend on the sale of commodities. When commodities swoon, so do these economies, putting pressure on their bonds. China is the largest emerging market and turmoil in China has crushed some of the lesser economies Has the rout in emerging markets gone too far? I believe in the wisdom of Warren Buffet when he opined: “Be greedy when others are fearful.” I am not clairvoyant and have no idea how long it will take the EM bonds to recover. Some bonds may default, but on a whole I believe a diversified basket of EM bonds will be a smart investment. If you decide to invest in this type of bond, the question is: what are the “best” funds to purchase? There are many ways to define “best.” Some investors may use total return as a metric but as a retiree, risk is as important to me as return. Therefore, I define “best” as the asset that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”; I am just saying that this is the definition that works for me. This article will compare the risks and rewards of EM bond CEFs. I will use a 5-year time frame and require that the selected funds trade an average of 50,000 shares or more per day. Based on these criteria, I included the following CEFs for my analysis: MS Emerging Markets Domestic (NYSE: EDD ). This CEF invests in emerging market domestic debt and sells for a discount of 18%, which is a much larger discount than the 5 year average discount of 10.1%. The one year Z-score is minus 2. This is the only leveraged fund that invests exclusively in local currency debt. The fund has 46 securities, almost all in sovereign debt. Even though the bonds are from emerging markets, about 67% are actually investment grade (BBB or higher). The fund invests in a wide range of countries including Brazil (16%), Mexico (16%), South Africa (16%), Malaysia (15%), Poland (14%) and Turkey (14%). The fund utilizes 31% leverage and has an expense ratio of 2.2%. The distribution rate is 12.5 %, which is funded by income with some Return of Capital (NYSE: ROC ) in one quarter over the past year. The Undistributed Net Investment Income (UNII) is negative and is large when compared to the distribution, which is a concern. MS Emerging Markets Debt (NYSE: MSD ). This CEF sells for a discount of 18.5%, which is a larger discount than the 5 year average discount of 10.8%. The one year Z-score is minus 2.6. The fund has 115 holdings, with about 51% in sovereign debt and 46% in corporate bonds. Virtually all the bonds are denominated in U.S. dollars. Geographically, the holdings are distributed among a large number of countries including Mexico (13%), Indonesia (11%), Venezuela (7%), and Turkey (7%). About 41% of the bonds are investment grade. MSD uses 8% leverage and has an expense ratio of 1.2%. The distribution is 6.6% with no ROC. Western Asset Emerging Markets Debt (NYSE: ESD ). This CEF sells at a discount of 18.3%, which is a larger discount than the 5 year average discount of 8.6%. It has 240 holdings with 51% in sovereign debt and 42% in corporate bonds. The assets are distributed among several countries including Mexico (13%), Indonesia (11%), Turkey (7%), and Venezuela (7%). About 69% of the portfolio is investment grade. The fund uses 16% leverage and has an expense ratio of 1.2%. The distribution is 9.1%, consisting primarily of income and some ROC (about 10% of the distribution). UNII is negative but is less than one month distribution. Western Asset Emerging Markets Income (NYSE: EMD ). This CEF sells for a discount of 18.5%, which is a larger discount than the 5 year average discount of 8.6%. The one year Z-score is minus 2.2. The fund has 235 holdings with 53% in sovereign debt and 42% in corporate bonds. About 73% of the holdings are investment quality. The assets are distributed among several countries including Mexico (12%), Indonesia (9%), Turkey (9%), Netherlands (6%), and Peru (5%). The fund utilizes 14% leverage and has an expense ratio of 1.3%. The distribution is 8.5%, consisting primarily of income with about 30% ROC but the UNII is positive. Global High Income Fund (NYSE: GHI ). This CEF sells for a discount of 13.6%, which is a larger discount than the 5 year average discount of 7.3%. The one year Z-score is only minus 0.1. The fund has 308 holdings, with 66% in sovereign debt and 26% in corporate bonds. All the holdings are denominated in U.S. dollars. The holdings are distributed among a large number of countries including Brazil (11%), Turkey (7%), Indonesia (8%), Mexico (6%), and Russia (5%). About 38% of the holdings are investment grade. This fund does not use leverage and has an expense ratio of 1.4%. The distribution is 10.9%, consisting primarily of income and ROC. The ROC occurred in about 60% of the months over the last year and comprised about 30% of the distribution. The UNII is positive. Templeton Emerging Markets Income (NYSE: TEI ). This CEF sells at a discount of 17%, which is a larger discount than the 5 year average discount of 1.5%. The one year Z-score is minus 2.4. This fund has 119 holdings with 56% invested in sovereign debt, 24% in corporate bonds, and 13% in short term debt. The securities are distributed across many countries including Iraq (11%), Indonesia (11%), Zambia (10%), Hungary 990%), and UAE (8%). The fund does not utilize leverage and the expense ratio is 1.1%. The distribution is 8.1%, consisting of income with no ROC. For comparison, I will also include the following ETF: iShares J.P. Morgan USD Emerging Markets Bond (NYSEARCA: EMB ). This ETF is a passive fund that tracks an index made up of U.S. dollar denominated emerging market bonds. The country allocations are rebalanced monthly, based on the amount of outstanding debt. The fund has 287 holdings with 78% in sovereign debt and 21% in corporate bonds. About 62% of the portfolio is investment grade. The holdings are spread across a large range of countries including Russia (6%), Philippines (6%), Turkey (5%), Indonesia (5%) and Mexico (6%). Overall, 28 countries are represented. The fund has an expense ratio of 0.40% and yields 4.5%. To assess the performance of the selected CEFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds over the past 5 years. The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 1. Note that the rate of return is based on price, not Net Asset Value (NYSE: NAV ). (click to enlarge) Figure 1. Risk versus reward over the past 5 years. The plot illustrates that the CEFs have booked a wide range of returns and volatilities over the past 5 years. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with EMB. If an asset is above the line, it has a higher Sharpe Ratio than EMB. Conversely, if an asset is below the line, the reward-to-risk is worse than EMB. Note also that Sharpe Ratios are not meaningful if a stock has a negative return. Some interesting observations are evident from Figure 1. The CEFs were substantially more volatile than the ETF. This was expected since CEFs are actively managed, may use leverage, and may sell at discounts or premiums. All of these attributes tend to increase volatility. The EM CEFs did not have great performance over the period. EM bonds have been in a bear market since 2013 and the prices associated with CEFs decreased faster than Net Asset Value . Since EMB is an ETF that does not sell at a discount, EMB has much better risk-adjusted performance than any of the CEFs. Looking only at the CEFs, MSD had the best performance followed by ESD and EMD. The other three CEFs were underwater for the period. Next I wanted to see if the diversification promised by these emerging markets bonds lived up to expectation. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the selected funds. The results are provided in Figure 2. As is evident from the figure, these CEFs provided relatively good diversification with correlations in the 50% to 60% range. Thus, these CEFs did provide good portfolio diversification. (click to enlarge) Figure 2. Correlation over past 5 years. The 5 year look-back data shows how these funds have performed in the past. However, the real question is how they will perform in the future when the bull market in EM debt returns. Of course, no one knows, but we can obtain some insight by looking at the most recent bull market period from March 2009 to January, 2013. Figure 3 plots the risk-versus-reward for the funds over this bull market time frame. (click to enlarge) Figure 3. Risk versus reward during a bull market As expected, all the funds had excellent performance over this bull market period. The CEFs all had higher absolute returns than EMB but were also significantly more volatile. When volatility was taken into account, EMB was still a leader in risk-adjusted performance. However, during the bull market, EMD matched EMB in risk-adjusted performance and ESD, TEI, and MSD were not far behind. EDD and GHI continued to lag the other funds. Bottom Line If you are a risk-adverse investor who wants to diversify into emerging market bonds, EMB would be your best bet. However, if you want to take advantage of the wide discounts associated with CEFs, I would recommend ESD, EMD and MSD. These three CEFs had good performance over the entire 5 year period plus will likely excel if the bull returns. When this asset class returns to favor, I would expect the discounts to revert back to the mean and this would provide some capital gains to go along with attractive distributions. But beware, emerging markets CEFs are not for the faint hearted. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ESD,EMD, MSD over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.