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Tech ETFs With Global Footprints At Risk

The U.S. dollar continues to appreciate against other overseas currencies. Large-cap companies with heavy overseas exposure could see revenue slow due to currency risks. Tech sector at risk of overseas exposure. As foreign central banks enact loose monetary policies, a strong U.S. dollar will negatively affect prominent technology stocks, along with related-sector exchange traded funds, that have significant overseas exposure. The Technology Select Sector SPDR ETF (NYSEARCA: XLK ) has been outperforming the broader markets, but a strong dollar could crimp the sector’s performance. XLK has declined 1.5% year-to-date and increased 16.0% over the past year. Meanwhile, the S&P 500 has dipped 1.7% year-to-date and risen 12.3% over the past year. A “strong dollar is negative for any company with significant overseas business,” James Kelleher, director of research at Argus, said in a CNBC article. “Companies like IBM and HP can’t totally avoid a currency headwind at the cost of being a global company.” According to Kensho quantitative analytic data, when the U.S. dollar appreciated 5% or more over 60 trading days on 10 separate occasions since January 1, 2005, tech companies were among the worst performers over the following three months. For instance, Hewlett-Packard (NYSE: HPQ ) traded in the red 70% of the time, with a negative median return of 4.51%. Intel (NASDAQ: INTC ) traded negative 70% of the time, with a median return of 2.97%. Adobe (NASDAQ: ADBE ) was negative 60% of the time, with a median negative return of 5.19%. IBM Corp. (NYSE: IBM ) also blamed the strong currency Tuesday for erasing any chance of a revenue increase this year, following its earnings report. XLK includes a 3.8% tilt toward INTC, 3.7% in IBM, 1.5% in HPQ and 0.9% in ADBE. Semiconductor ETFs, like the Market Vectors Semiconductor ETF (NYSEARCA: SMH ) and iShares PHLX SOX Semiconductor Sector Index ETF (NASDAQ: SOXX ) , also have significant exposure to INTC, which makes up 19.8% of SMH and 8.0% of SOXX. Additionally, the increasingly popular tech dividend ETF, First Trust NASDAQ Technology Dividend Index ETF (NASDAQ: TDIV ) , holds large positions in these large and stable tech names, including INTC 8.0%, IBM 8.0% and HPQ 3.0%. FX headwinds were “really the difference between growing pretax income and not growing pretax income in the fourth quarter for us,” CFO Martin J. Schroeter said. “Now, in this currency environment, and with the divestitures we’ve completed, our total revenue as reported will not grow in 2015.” An appreciating U.S. dollar makes U.S. products relatively more expensive in overseas markets. Sales in foreign currencies will translate to a lower U.S. dollar-denominated return in a strong U.S. dollar, or weak overseas currency, environment. Fueling the continued strength in the U.S. dollar, major central banks have been implementing loose monetary policies and enacting quantitative easing. For instance, all eyes were on the eurozone as the European Central Bank contemplated a Federal Reserve-styled bond purchasing program. “Policy diversion is driving this rally,” Win Thin, global head of emerging markets at Brown Brothers Harriman, said in the CNBC article. “The divergence is U.S. raising rates and the ECB, BOJ expected to do more easing, which typically weighs on a currency. Everyone’s very bullish on the dollar. The fundamental backdrop still favors the dollar.”

Why Indexing And ‘Smart Beta’ Are So Popular

By Jack Vogel, Ph.D. Asset Manager Contracts and Equilibrium Prices Abstract: We study the joint determination of fund managers’ contracts and equilibrium asset prices. Because of agency frictions, investors make managers’ fees more sensitive to performance and benchmark performance against a market index. This makes managers unwilling to deviate from the index and exacerbates price distortions. Because trading against overvaluation exposes managers to greater risk of deviating from the index than trading against undervaluation, agency frictions bias the aggregate market upwards. They can also generate a negative relationship between risk and return because they raise the volatility of overvalued assets. Socially optimal contracts provide steeper performance incentives and cause larger pricing distortions than privately optimal contracts. Core Idea: This is a theoretical paper, so proceed with caution! However, the paper does a good job discussing the Principal/Agent Problem . Briefly stated, the “principal/agent problem” relates to how the interests of agents, who act on behalf of principals, can conflict with those of the principals. In investing, when an asset manager’s performance (or fees) is measured or benchmarked relative to an index, the potential friction (of losing fees and possibly their job) causes the manager to track closer to the index. Here is a quote from the paper: Benchmarking, however, only incentivizes the manager to take risk that correlates closely with the index, and discourages deviations from that benchmark. Thus, the manager becomes less willing to overweight assets in low demand by buy-and-hold investors, and to underweight assets in high demand. The former assets become more undervalued in equilibrium, and the latter assets become more overvalued. Within this theoretical framework, how are asset prices affected? In the graphs below, the blue solid line represents assets in large supply, and the red dashed line assets in small supply. Notice in the graph, that the more expensive asset has lower supply, while the less expensive asset has higher supply! Not surprisingly, the expected return is inverted, where the asset with less supply and is more expensive has lower expected returns, while the asset with high supply and lower price has higher expected returns. Additionally, these assets with higher (lower) supply have lower (higher) volatility. See the paper for details on why this may be so. Note, however, that if an expensive (overvalued) asset with higher volatility has a positive shock to expected cash flows, it would account for a larger portion of market movement. For this reason, managers are reluctant not to hold it, and instead will buy it, since they fear that failing to buy it may cause them to deviate from the benchmark. The main conclusion is that in this theoretical world, asset managers tend to hug the index, as their fees are tied to the index, and thus they are loath to do things that might cause them to depart from it. In the real world, this makes sense as well. Imagine the following two investment strategies that an institutional money manger must pick from: With 98% certainty, you are going to beat the index by 5% over the next 10 years. The other 2% of the time, you will lose to the index by 1%. However, you know that 3 of the years you may lose by as much as 8%! So while the long run expected returns are quite high, the return path to get there is very noisy and volatile. With 50% certainty, you are going to beat the index by 1% over the next 10 years. The other 50% of the time, you will lose to the index by 0.50%. In any given year, you will be +/- 0.25% relative to the index. Here, the long run expected returns are comparatively lower, but the return path is stable. Now, from a mathematical and economist perspective, there is an easy solution — calculate the expected value. Expected Value = beat index by (0.98%)(5%) + (2%)(-1%) = beat index by 4.88% Expected Value = beat index by (0.50%)(1%) + (50%)(-0.5%) = beat index by 0.50 % Any economist would pick option 1! It’s a slam dunk. However, the asset manager knows that picking option 1 is risky to him as an agent, as he might lose his job if the principal (owner of money) loses faith in his strategy. Ever wonder why smart beta products run rampant in the marketplace? It’s because smart beta has low tracking error versus the index. Although expected returns are modest, the manager will remain withing hailing distance of the benchmark, and a principal can’t complain too much about that, right? Unfortunately, this may not necessarily be in the principal’s best interests. Original Post

A Weak Start To 2015 For MLP ETFs: Buy On The Dip?

Despite hailing from the energy space, MLPs put up a great fight last year against the oil price slump thanks to their low correlation with the underlying commodity and the U.S. shale oil boom. However, the winning streak reached the verge of a reversal as MLPs entered the New Year. The largest MLP ETF Alerian MLP ETF (NYSEARCA: AMLP ) , which added about 0.3% in the last one year against a 50% decline in oil prices, has lost about 3.2% so far this year (as of January 16, 2015). All energy MLP ETFs/ETNs are deep in the red this year with some products hitting an acute 12.5% loss in such a short span of time. Now, with the no signs of end to the oil price slouch and analysts turning more bearish on this liquid commodity, MLPs might find it tough to stay afloat. Going by a recent article by Bernstein , MLPs had a free cash flow yield of 5% in 2009 while at present these have a free cash flow yield of negative 5%. As you may know, MLPs often operate pipelines or similar energy infrastructures that make it an interest-rate sensitive sector. This group catches an investor’s eye as these do not pay taxes at the entity level and hence must pay out most of their income (more than 90%) in the form of dividends. Investors looking for higher income levels outside the traditional bond sources generally bet on these products. Investors should note that the rate scenario has been subdued since last year with yields on 30-year Treasury notes touching the all-time low in January. While this should brighten the appeal for MLP investing, a six-year low oil price comes in the way of outperformance. Strength & Weakness in the MLP Space Speculations are rife that the U.S. stockpiles will remain high in the coming days. So no matter how bad the oil price situation is, the need for mid-stream MLPs involved in the processing and transportation of energy commodities such as natural gas, crude oil and refined products, under long-term contracts, will always remain due to the energy production boom in the U.S. This is because MLP revenues depend on the volumes flowing through the pipes and not on the commodity price. On the other hand, upstream exploration MLP companies earn from every barrel of oil and are being thrashed by the endless weakness in oil prices. Still, investors’ fears pertaining to oil have hurt the MLP sector as a whole to start the year despite its allure for dividend income. Buy on the Dip Given the fundamentals discussed above, investors might consider the recent dip as an entry point to the mid-stream or energy infrastructure ETFs. Below are three such MLP ETFs for investors. AMLP in Focus It is the most popular product with an asset base of $8.62 billion and average trading volume of more than $6 million shares. The fund’s expense ratio is high at 8.56%. The product tracks the Alerian MLP Infrastructure Index and has exposure to the mid-stream securities like Williams Partners L.P. (NYSE: WPZ ), Energy Transfer Partners, L.P. (NYSE: ETP ), MarkWest Energy Partners, L.P. (NYSE: MWE ) and Magellan Midstream Partners LP (NYSE: MMP ). The fund has lost only 0.5% in the last five trading sessions and 3.2% in the year-to-date frame. AMLP pays out 6.9% in annual yields (as of January 16, 2015). Global X MLP ETF (NYSEARCA: MLPA ) The fund looks to track the Solactive MLP Composite Index. The Index is comprised of MLPs engaged in the transportation, storage, processing, refining, marketing, exploration, production, and mining of natural resources. The fund charges 45 bps in fees. The fund has garnered about $150 million in assets. This ETF too has considerable exposure to Energy Transfer Partners (6.72%), Magellan Midstream (6%) and Buckeye Partners, L.P. (NYSE: BPL ) (5.98%). The fund was off 0.6% last week and has shed about 2.6% so far this year. MLPA has a dividend yield of 6.13% (as of January 16, 2015). Credit Suisse Equal Weight MLP Index ETN (NYSEARCA: MLPN ) The ETN is equally weighted in nature. It is designed for investors seeking exposure to the Cushing 30 MLP Index. The Index tracks the performance of 30 firms which hold mid-stream energy infrastructure assets in North America. MLPN has amassed about $735 million in assets. The fund charges 85 bps in fees. MLPN lost about 0.7% last week and 4% so far this year (as of January 16, 2015). Bottom Line With oil prices falling fast on the 24 -year low Chinese GDP data in 2014 and rocketing volatility in the Euro zone, MLPs seem to be the best bet. Though the space succumbed to a slowdown to start 2015, it pared losses considerably in the middle of the month. Moreover, global growth worries kept the yields at substantial low levels and spurred the appeal for dividends. Apart from the strong return, these MLPs are acting as strong income engines reinforcing its scope for outperformance in the days ahead.