Tag Archives: marius-bausys

What Can Russia Offer To Your Portfolio?

Summary RSX is down over 50% since the beginning of 2011, suggesting attractive expected returns. Russian equities offer diversification benefit to U.S. investors. However, high volatility of such an investment means that the actual portfolio risk contribution will be 2.5-3 times higher than its portfolio weight. I was recently browsing Research Affiliates Asset Allocation website and one chart that drew my attention was the forecast real 10-year expected return. As can be seen from the histogram below, projected returns by Research Affiliates models for various countries and regions differ widely with Russia comfortably offering the highest expected reward: (click to enlarge) This prompted me to explore how a modest allocation to Russian equities affects a typical portfolio held by a U.S. investor. For the purpose of this article, I use the 60/40 portfolio as a proxy for a “standard” allocation (even though I still think it is flawed ), with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) representing equities and the Vanguard Total Bond Market ETF (NYSEARCA: BND ) – fixed income. While ETFdb lists 6 Russian equity ETFs available in the U.S., the Market Vectors Russia ETF (NYSEARCA: RSX ) is the obvious choice given that its $2 billion of assets under management is almost 4 times more than the remaining funds have combined. Portfolio impact To start with, assume that we allocate 5% of the equities portion in the 60/40 portfolio to RSX. Analyzing 5 years of historical data, risk parameters of such a portfolio look as follows: (click to enlarge) Source: InvestSpy Retrospectively, such an investment would have been a real drag in a portfolio that otherwise had a stellar performance. RSX has lost 45% of its value over the last 5 years and experienced a whopping 65% drawdown. Furthermore, its annualized volatility stood at 34%, which was more than twice that of SPY. This lead to a significant risk contribution of 14% to the overall portfolio risk despite the allocation of only 5%. On the bright side, further inspection of the correlation matrix suggests that RSX has the potential to offer diversification benefits. Its correlations were 0.67 with SPY and negative 0.21 with BND (see the table below). In fact, the correlation coefficient with SPY was even lower at 0.47 over the last 12 months. Source: InvestSpy As demonstrated in this whitepaper by Salient Partners, a diversifier with high volatility is among the most powerful tools an investors has. And RSX definitely ticks the high volatility box. At the same time, it is highly unlikely that a U.S. investor would want to have 10%+ of their portfolio risk come from Russia. An investment in any Russian ETF will have 2.5-3 times higher risk contribution than its portfolio weight, thus I would not suggest a higher allocation than 2-3% of your portfolio to RSX or a related fund. One also has to bear in mind that Russian stocks will typically be included in most emerging markets ETFs and mutual funds, thus you may already have some exposure to this country. Under the hood Comparing the sector breakdown of RSX and SPY, it becomes apparent that Russian and American markets have completely different composition: RSX is largely dominated by the energy sector (43%), whilst oil & gas stocks account for only 7% of S&P 500. RSX is also heavily loaded with Materials (19%) but lacks more significant presence of companies operating in IT, health care, consumer discretionary or industrials sectors. Given that Russian stock market is so dependent on the energy sector, I have also checked how correlated to the oil price it is. Using t he United States Oil ETF, LP (NYSEARCA: USO ) as a proxy for the oil market, it turns out that over the last 5 years RSX had correlation with USO of 0.53. Although this reading does not seem exceptionally high at a first glance, I have previously shown that a coefficient above 0.5 comfortably puts RSX among top 5 single country ETFs to benefit from oil price recovery. Conclusion Russian stocks have been in a downward spiral since 2011, currently offering attractive valuations compared with other countries. RSX regained 10% in the last month and is a primary target to benefit from a potential reversal in the oil market. If the actual performance of Russian equities comes anywhere close to the returns forecast by Research Affiliates, RSX may very well be a welcome addition to your portfolio.

Comparing The Build Of BRIC ETFs

Summary BRIC ETFs have been around since 2006. Although returns tend to differ due to varying country weightings, risk profiles of BRIC ETFs are almost identical. There appear to be more efficient instruments to gain exposure to emerging markets rather than BRIC funds. The BRIC acronym has become a staple in the investment community. It was coined back in 2001 by Jim O’Neill from Goldman Sachs and refers to four countries: Brazil, Russia, India and China. These states are at the forefront of emerging markets although every single one of them has been going through its own struggles. Five years after the term BRIC came to existence, the first ETF targeting specifically this group of countries was launched. There are currently 3 main ETFs in this space and I would like to review and compare their risk characteristics and potential fit into investor’s portfolio. The largest BRIC ETF is the iShares MSCI BRIC ETF (NYSEARCA: BKF ), which was launched in 2007 and has over $200m in assets under management (‘AUM’). Its expense ratio stands at 0.68%. The second one by size is the Guggenheim BRIC ETF (NYSEARCA: EEB ) with $85m of AUM. EEB was the first BRIC ETF, launched in 2006, and comes with a net expense ratio of 0.64%. Despite its lowest expense ratio of 0.49%, the SPDR S&P BRIC 40 (NYSEARCA: BIK ) trails its competitors in terms of AUM with $82m. This fund came to existence in 2007. I would like to split the analysis into two parts: returns and risk. Returns Although all three ETFs posted negative substantially negative returns over the recent 5 year period, the extent of the decline was different. Whilst BIK declined 14.8% with 33.9% drawdown, EEB posted a whooping loss of 35.2% with 46.5% maximum drawdown. BKF stood somewhere in the middle with a 26.6% loss and 38.6% drawdown. This discrepancy between BRIC ETFs performance is easy to explain as each fund has distinctly different country weightings: Weightings as of October 9, 2015 Looking at single country ETFs in the same period, it is obvious that any fund that overweighed Brazil or Russia would have suffered most: This is exactly what happened in the case of EEB, which had by far the largest share of AUM invested in these two countries. Meanwhile, BIK was the least diversified in terms of country exposure but its focus on China delivered superior returns. It is important to note that the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) appreciated 61.5% in the same period, thus the performance of BRIC ETFs can be called dismal. However, one positive takeaway is that diversification across different regions appears to be working even when global stock markets are so closely linked together. Risk Even though the three BRIC ETFs were on different return trajectories, all of them had a strikingly similar risk profile. For the purpose of this analysis, I have used a simple online tool InvestSpy . Utilizing 5 years of historical data, the results are as follows: (click to enlarge) The two columns I would like to draw reader’s attention to are ‘Annualized Volatility’ and ‘Beta’. It is rather surprising to see that all three ETFs had almost identical volatilities and beta coefficients vs. SPY. Furthermore, they all had pretty much identical correlation to SPY: This illustrates that from the overall portfolio risk perspective, all three ETFs would have had the same impact to an average portfolio in terms of risk contribution, i.e. none of them was more or less risky. Alternatives Finally, given fairly high expense ratios for BRIC ETFs, I would like to explore potential alternatives. Utilizing the correlation tool on InvestSpy , it appears that there are 3 ETFs that have a correlation coefficient of at least 0.95 with BRICs: The Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ), the Schwab Emerging Markets Equity ETF (NYSEARCA: SCHE ) and the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ). Considering the fact that, for example, VWO is much more liquid, more widely diversified and significantly cheaper, it hard to make the case for investing in any of the BRIC ETFs.

Revisiting Asset Allocation Strategies

Summary Allocation between different classes is one of the most important decisions. 9 asset allocation strategies designed by famous investors provide a good starting point. Whilst returns are volatile, portfolio risk contributions tend to remain stable. One of the most important decisions for investors is their approach towards asset allocation. With a number of different asset classes and subclasses available, this task can easily become overwhelming. In an article published just over two years ago, I analyzed from the risk perspective 9 popular asset allocation strategies designed by famous investors. This time I would like to review the same strategies and compare how they have performed since my previous publication. Portfolio specifications come from Meb Faber’s website and they have been replicated using ETFs that most closely match the defined categories. All the statistics have been obtained from a publicly available analytical tool InvestSpy utilizing historical data for the last 2 years. 60/40 A “classical” portfolio consisting of 60% stocks and 40% bonds. Often considered as a simple benchmark for a balanced asset allocation and tends to be difficult to outperform over long time periods. (click to enlarge) Swensen Portfolio David Swensen has been the Chief Investment Officer at Yale University since 1985, where he is responsible for managing the university’s endowment fund and has a spectacular track record. This portfolio consists of 70% equities and 30% fixed income, split between several sub-classes. (click to enlarge) El-Erian Portfolio This portfolio is modelled on an allocation suggested in El-Erian’s book When Markets Collide and managed to outperform equities only portfolio over the last 40+ years. It is More aggressive than some others, this had 51 per cent in various classes of stocks, 17 per cent in bonds, and the remainder distributed between index-linked bonds, commodities and real estate. This portfolio is 60% invested in various sub-classes of equities, 29% in fixed income and 11% in commodities. (click to enlarge) Arnott Portfolio Rob Arnott is the founder and chairman of Research Affiliates and a portfolio manager at PIMCO. Bg proponent of fundamental indexing and smart beta, he has once suggested that the “ultimate” portfolio should consist of equal parts in a range of sub-asset classes. They add up to 30% equities, 60% fixed income and 10% commodities. (click to enlarge) Permanent Portfolio Created by the late Harry Browne in the 1980s, the Permanent Portfolio divides holdings into four equal pieces of stocks, long-term U.S. treasuries, cash, and gold. Simple as it looks, the Permanent Portfolio had only 3 down years over the last 30 years! (click to enlarge) Andrew Tobias Portfolio Andrew Tobias is a well-known author who proposes a “lazy” portfolio with only three equally sized holdings: US stocks, international stocks and US bonds. (click to enlarge) William Bernstein Portfolio William Bernstein is an investment advisor and best-selling author with a strong focus on efficient asset allocation. The portfolio below tries to replicate his suggestion in the book The Intelligent Asset Allocator . 75% are invested in bonds and the remainder in fixed income. (click to enlarge) Ivy Portfolio The Ivy Portfolio has been proposed by Meb Faber, who is a co-founder and the chief investment officer of Cambria Investment Management as well as a popular author. His proposed portfolio consists of equally weighted 5 components: bonds, US stocks, international stocks, real estate and commodities. This effectively equates to 60% stocks, 20% bonds and 20% commodities. (click to enlarge) Risk Parity Portfolio Risk parity is an approach to investment portfolio management which focuses on allocation of risk, usually defined as volatility, rather than allocation of capital. There are countless versions of implementation and this particular one has 20% invested in equities, 70% in fixed income and 10% in commodities. (click to enlarge) Conclusion Analysing the tables above, there are a few interesting observations: The best performer in terms of absolute returns was the simplest portfolio – 60/40, which gained 15.0% over the last two years. Swensen portfolio was second with a 10.4% return. The superior performance of these two portfolios was largely due to their substantial allocations to US equities as well as limited or non-existent exposures to commodities and emerging markets. The only two portfolios to post a negative return in the specified period were El-Erian (-2.4%) and Ivy (-0.8%). Both of these portfolios suffered badly from underperformance of commodities and turbulence in emerging markets. All 9 portfolios experienced a massive decline in annualized volatility, which in most cases more than halved. This comes as no big surprise though as the reference period covered August 2008 – August 2013 that included the peak of the financial crisis. Finally, and probably most importantly, risk contributions in portfolios remained very close to the levels seen two years ago, with the only exception being the Risk Parity portfolio. This is a great illustration that even though portfolio returns are volatile, the risk sources tend to be stable. And it is a good reason why analysis of risk metrics should always be a part of the investment decision making process.