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Just Sold Your Bond Funds? Consider QSPNX And Its Low Volatility Twin

Alternatives can provide superior risk-adjusted returns, less volatility, and proven downside protection. AQR Premia Style Alternative N Fund and AQR Premia Style Alternative Low Volatility N Fund. Integrating these two style premia alternative funds into your portfolio. Surfing beach near Tofino, B.C. Ⓒ Sandy Cliff Research Alternative funds come in many shapes and sizes these days. In the past six years, they have flooded the market. Why? Because, if structured properly, they can provide superior risk-adjusted returns and less volatility. As Vanguard pointed out in its August 2014 white paper Liquid alts: a better mousetrap? these new strategies “constitute a new industry with explosive growth. More than 70% of their cash flows and 68% of new product launches have come since 2009; 50% of these flows and products have come just in the three years through 2013.” For a detailed listing of alternative funds launched just last year, see DailyAlts.com New Funds listing . Long-short, market-neutral, style premia, managed futures, and multialternative are some examples of these offerings. Financial advisors are now recommending these types of investments to replace varying percentages of equities and bonds in a traditional portfolio. The AQR Style Premia Alternative Fund ( QSPNX ) and AQR Style Premia Alternative LV Fund ( QSLNX ): AQR Capital Management: AQR Funds started out as a hedge fund shop in 1998 and entered the mutual fund business in 2009 in order to make its strategies available to a wider range of investors. Quantitative research forms the basis for all of the firm’s strategies. The firm has an academic bent with many of its principals and associates holding Ph.Ds. Fund managers and associates continue to research and refine the methodologies used in their funds. Results of their findings are often published in academic journals and can be found at AQR.com . Additional information on the two Premia funds discussed below as well as other AQR funds can be found at funds.AQR.com Fund Classes and Purchase Information: The details offered for these two funds refer to the N share class. Both N and I share classes are available from Fidelity with a minimum purchase of $1,000,000 for the N class and a minimum of $5,000,000 for the I class. However, initial minimum investments of these funds into “group retirement accounts such as Fidelity Simplified Employee Pension-IRA, Keogh, Self-Employed 401(k), and Non-Fidelity Prototype Retirement accounts are $500 or higher. Additional investments into Regular, IRA, and Group accounts are $250 or higher.” I was able to buy both QSPNX and QSLNX for my Fidelity retirement IRA for a minimum purchase of $2,500. AQR funds, according to the Morningstar entry for each of these funds, can also be purchased at over a dozen U.S. other financial forms including Vanguard, Schwab, etc. Important note: All share classes of the AQR Style Premia Alternative Fund and the AQR Style Premia Alternative LV Fund will close to new investors effective at the close of business on January 29, 2016. In November 2015, AQR stated that these two funds were closing due to “capacity constraints associated with the investment strategy employed by these Funds.” However, prior to this announcement, AQR filed with the SEC for approval for a new AQR Style Premia Alternative Fund II. There is no word as yet on date launch, expenses or any details on whether a low volatility version of this will be launched as well. Investing Style: The Style Premia Alternative and the Style Premia Alternative LV invest long and short across six different asset groups: stocks of major developed markets – approximately fourteen hundred stocks (for QSLNX and up to 1800 stocks for QSPNX) across major markets equity indices – twenty-one equity indexes from developed and emerging markets fixed income – bond futures across six markets; short-term interest rate futures in four markets currencies – twenty-two currencies in developed and emerging markets commodities – eight commodity futures Management employs long-short strategies across all of these asset groups based on four investment styles: value – the tendency for relatively cheap assets to outperform relatively expensive ones momentum – the tendency for an asset’s recent relative performance to continue in the future carry – the tendency for higher-yielding assets to provide higher returns than lower-yielding assets defensive – the tendency for lower-risk and higher-quality assets to generate higher risk-adjusted returns Management since inception: Andrea Frazzini, Ph.D., M.S.; Jacques A. Friedman, M.S.; Ronen Israel, M.A.; Michael Katz, Ph.D., A.M. oversee both funds. Details specific to QSPNX: Opened on 10/31/13. 2015 Return: 11.08%. 2015 Return: 8.50%. Expenses: 1.75%. Annualized volatility target level: 10% (with a range of 8-12%). Fund size: $1.7 billion. The listed % of risk allocation is: Global Stock Selection 33.7% Equity Markets 18.8% Fixed Income 16.5% Commodities 16.2% Currencies 14.7% Number of long holdings 969; number of short holdings 732. Details specific to QSLNX: Opened on 9/17/14. Year 2015 Return: 3.85%. Expenses: 1.10%. Annualized volatility target level: 5% (similar to the historical volatility of intermediate-term government bonds; typical range between 3% and 7%). Fund size: $185.2 million. Percent of risk allocation is: Global Stock Selection 33.2% Equity Markets 20.3% Fixed Income 17.3% Currencies 15.9% Commodities 13.4% Number of long holdings 864; number of short holdings 659. Integrating These Two Style Premia Alternative Funds Into A Portfolio: The alternatives landscape is littered with suggestions for adding alternatives to a portfolio, but the deciding factors are simply the individual investor’s risk tolerance, including a risk of buying an alternative fund with a short track record, and the individual’s investment timeline. I view these two Style Premia funds as alternatives to bonds within my IRA retirement portfolio. Because of tax implications, they are best held in an IRA or similar account. I have also recently added a market neutral and an equity long-short fund to my allocation. The Vanguard Managed Payout Fund (MUTF: VPGDX ) makes use of stocks, bonds, alternatives, including the Vanguard Market Neutral Fund (MUTF: VMNFX ). It has a mix that is worth considering as a foundation if you are thinking about adding alternatives to your portfolio mix. Here is a listing of its current holdings: Vanguard Total Stock Market Index Fund 20.1% Vanguard Total International Stock Index Fund 19.7% Vanguard Global Minimum Volatility Fund 15.1% Vanguard Total Bond Market II Index Fund 12.0% Vanguard Alternative Strategies Fund 10.4% Vanguard Market Neutral Fund Investor Shares 7.0% Vanguard Total International Bond Index Fund 5.8% Commodities 5.0% Vanguard Emerging Markets Stock Index Fund 4.9 For further information on alternatives you might want to check out: Brian Haskin, “Retiring Baby Boomers to Continue Liquid Alts Boom?” at DailyAlts.com which gives a good summary of and access to the PDF of “Liquid Alternatives: The Next Wave in Asset Allocation” by Matthew Glaser, Managing Director and Portfolio Manager/Analyst at Lazard Asset Management.

Are You Ready For CEFL’s Year-End Rebalancing?

Summary The index for CEFL/YYY was last rebalanced in December 2014, and changes to the index were made public a few days before the event. Last year, heavy buying or selling pressure in particular index components forced CEFL/YYY to buy-high and sell-low, causing significant losses to CEFL/YYY unitholders. How will CEFL’s rebalancing be handled this year? Introduction The ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ) is a 2x leveraged ETN that tracks twice the monthly performance of the ISE High Income Index [symbol YLDA]. The YieldShares High Income ETF (NYSEARCA: YYY ) is an unleveraged version of CEFL. CEFL is popular among retail investors for its high income, which is paid out monthly. (Source: Pro Spring Team ) YLDA holds 30 closed-end funds [CEFs], and is rebalanced at the end of every calendar year. The changes were publicly announced on the ISE website on Dec. 24, 2014, or about five days prior to the rebalancing event. According to YYY’s prospectus (emphasis mine): Index constituents are reviewed for eligibility and the Index is reconstituted and rebalanced on an annual basis. The review is conducted in December of each year and constituent changes are made after the close of the last trading day in December and effective at the opening of the next trading day . As CEFL is an ETN, it is not forced to buy or sell the constituent ETFs, but one would imagine that the note issuer, UBS (NYSE: UBS ), would be inclined to do so to hedge its exposure of the note. Rebalancing shenanigans Unfortunately, CEFL/YYY unitholders were hurt by the rebalancing mechanism last year. I first noticed that something was wrong when CEFL fell -2.96% (and YYY -1.25%) on Jan. 2nd, 2015, a day where both stocks and bonds held relatively steady, and where the comparable PowerShares CEF Income Composite Portfolio ETF (NYSEARCA: PCEF ), an ETF-of-CEFs that tracks a different index, rose +0.21%. A bit of detective work on my part revealed that the CEFs that were to be added to the index received heavy buying pressure in the days between the index change announcement and rebalancing day, while the CEFs that were to be removed came under tremendous selling pressure. This caused the prices of the added CEFs to rise significantly during that period, which was topped off by an upwards price spike on rebalancing day, while the prices of the CEFs to be removed declined markedly in price, culminating in a downwards spike on rebalancing day. As a consequence, the index and hence YYY were forced to “buy high and sell low” on rebalancing day, causing about 1.3% of the net asset value [NAV] of YYY to be vaporized in an instant. This findings were presented in my Jan. 4th article ” Frontrunning Yield Shares High Income ETF YYY And ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN CEFL: Could You Have Profited ?” However, the pain was not over for CEFL/YYY holders. The upwards price spike of the CEFs to be added on rebalancing day occurred on top of the artificially-inflated prices caused by the buying pressure days before the actual event. After rebalancing, the added CEFs possessed premium/discount values dangerously above their historical averages, as I warned in ” Beware Reversion In YieldShares High Income ETF And ETRACS 2x Closed-End Fund ETN ,” leading to further losses as the premium/discount of those CEFs reverted back to their original levels. How much were CEFL/YYY investors hurt? How much were CEFL/YYY holders hurt by last year’s rebalancing mechanism? It is impossible to provide an exact number, but here is my estimate. The 10 added CEFs with the largest increases in allocation rose by 2.96% in one week, while the 10 with the largest decreases in allocation declined by -3.38% in one week (as presented in my Jan. 4th article). Assuming that CEFL is equally-weighted*, these events would have caused an overall 2.11% decline in asset value. Up to a further 1.25% was lost on rebalancing day due to price spikes. Moreover, the 10 CEFs that were added to the index declined by 1.26% two weeks after rebalancing as mean reversion possibly took place (as discussed in ” 2 Weeks Later: Did Mean Reversion Of CEFs Take Place? “), contributing a further 0.42% decline of the index, again assuming equal-weight. This sums to a 3.8% loss for YYY holders, or about a 7.6% loss for CEFL holders, not an insignificant amount. Note that this number is likely to be an underestimate because only the top 10 CEFs undergoing the highest increases and decreases in allocation were considered. In actuality, 19 funds were added, and 17 were removed. *(CEFL is actually not equal-weighted, but it is not entirely top-heavy either. See my Jan. 4th article linked above for details to the index weighting methodology). An alternative methodology for calculating the underperformance of CEFL/YYY is to simply compare the performance of YYY to PCEF, as both are ETFs-of-CEFs, but track different indexes. As analyzed in ” Has CEFL Done As Badly As It Looks? ” YYY underperformed PCEF by a total of 5.3% in the months of December and January, i.e. the months surrounding the rebalancing date. Although this approach is only approximate (as the exact composition of the two funds differ), it does produce a number that is on a similar order of magntitude as the 3.8% loss calculated with the first approach. Either way you cut it, a 4% or higher loss for the index/YYY (double that for CEFL, due to leverage) because of factors outside of “normal” market behavior hurts. Moreover, the fact that the index was forced to buy high and sell low necessarily results in a lower income for the fund going forward, as the fund would not have been able to purchase as many shares of the new CEFs than it “should” have been entitled to. Indeed, each share of CEFL paid out a total of only $4.03 in 2015, down from $4.40 in 2014, representing a 8.5% decrease in income paid for the year. I lost…so who won? So if CEFL/YYY unitholders were hurt during rebalancing, who profited? Most likely, it was the savvy investors who purchased the CEFs to be added to the index and shorted the CEFs to be removed as soon as the index changes became public. This could, in fact, include UBS themselves, who are free to adjust their hedges for CEFL anytime they like (because CEFL is an ETN rather than an ETF), and not only on rebalancing day. This creates an ironic situation in which the act of UBS adjusting their hedges at more favorable prices before rebalancing could have actually and directly hurt investors in their very fund. Why is this a problem for CEFL and not other funds? The main problem appears to be the lack of liquidity for CEFs, as well as the fact that arbitraging price differences for CEFs can be risky as they often trade at premium or discount values around their intrinsic NAV, meaning that it would be difficult for arbitrageurs to determine the “true” value of a CEF. An insightful comment from a reader in my previous article reveal that this has happened to other funds as well, and also illustrates a possible solution to this problem: [We] also had a FTSE 100 tracking fund run externally by a well known global indexing house. I recall at one index rebalance, said fund had a MOC order to buy one of the new index constituents, and ended up paying about 25% MORE than the prevailing market price was 1 minute before. All index tracking funds got completely shafted as guess what, the next day the stock was back down to the price it was before its index inclusion. … Some index managers get friendly brokers to ‘warehouse’ stocks (take them onto their own book) for a few days, buying them up ahead of inclusion in a particular index, the fund then takes an average price, and doesn’t get the shaft with a MOC order. It can lead to a bit of ‘tracking error’ mind you. This time it’s…different? As a CEFL unitholder and with the end of the year rolling around, I thought I would refresh myself on the rebalancing mechanism of the index YLDA to confirm exactly when the CEF changes would be announced, so that I could…uh…you know…get in on the frontrunning action and profit at the expense of fellow CEFL/YYY holders. Just kidding, I would have definitely shared this information with all my loyal readers! (Please do click the “follow” button next to my name if you haven’t done so already if you enjoy my ETF analysis.) So I fired up the YLDA methodology guide and looked for the rebalancing date… and looked, and looked…only it wasn’t there! I then checked the date of issue of the methodology guide: December 4th, 2015. So this couldn’t have been the guide I was reading when I was writing my earlier CEFL articles this year. Luckily, I had a version of the guide stashed in my downloads folder, and the relevant section (4.3) is dutifully reproduced below (emphasis mine): 4.3. Scheduled component changes and review ( OLD v1.2 ) The ISE High IncomeTM Index has an annual review in December of each year conducted by the index provider. Component changes are made after the close on the last trading day in December , and become effective at the opening on the next trading day. Changes are announced on ISE’s publicly available website at least five trading days prior to the effective date . How does this compare with the current version of the methodology (emphasis mine)? 4.3. Scheduled component changes and review ( NEW v1.3 ) The ISE High IncomeTM Index has an annual review in December of each year conducted by the index provider. The index employs a “rolling” rebalance schedule in that one third of component changes are implemented at the close of trading on each of the first, second and third trading days in January of the following year and each change becomes effective at the opening on the second, third and fourth trading day of the new year, respectively. No prizes for spotting the difference! Not only has the statement about the announcement of changes been removed, the rebalancing is now not performed all at once at the close of the last trading day in December, but is now equally spread through the first, second and third trading days of the following year. I then used the free PDF comparison tool ( DiffPDF ) to scan for any additional changes to the methodology between last and this year’s. Besides being nearly foiled by the addition of two blank pages in this year’s edition, the software showed that, besides the aforementioned change in Section 4.3, a similar statement to the above had been removed from the index description in Chapter 2: Chapter 2. Index Description ( bold sentence in OLD guide only ) Companies are added or removed by the ISE based on the methodology described herein. Whenever possible, ISE will publicly announce changes to the index on its website at least five trading days in advance of the actual change . No changes were made to the constitution or weighting mechanisms of the fund. Appendix B of the current document lists the entirety of the changes as “Rebalance revision (4.3).” What does this mean for investors? Analysis of the old and new methodology guide reveals two major changes: The changes to the index will not be public beforehand. Instead of rebalancing the components all at once, the rebalancing will be conducted in three equal parts spread across three days. What does this mean for investors? I believe that the first change is well-intended, but may ultimately prove fruitless. The methodology for index inclusion and weighting is relatively complex, but is publicly available (it’s found in the methodology document), and I have no doubt that professional investors will be able to determine the changes even before they happen. In fact they may be doing this right now as I am writing this, and also later, when you are reading this. The second change is, I believe, a positive one, but only if it means one of two possible ways that one could construe “one-third.” The guide states that ” one-third of component changes are implemented… on each of the first, second and third trading days in January .” So if 10 CEFs have to be added to the index, does it mean that 33.3% of the total dollar value of the 10 CEFs will be purchased on each of the three days? In this case, the liquidity situation will be improved because each CEF will be purchased over three days. This would decrease the likelihood of a price spike occurring upon rebalancing (presumably by YYY, the ETF), which ameliorates the buy-high sell-low situation faced by the index last year. If instead, it means that 4 CEFs will be 100% purchased on the first day, 3 on the second, and 3 on the third, then unfortunately I don’t think that the liquidity situation will improve, as the trading in each CEF is still going to be concentrated in a single day, despite the fact that different CEFs may be spread out on different days. What do readers think about how this sentence should be interpreted? So, it appears that this time may actually be different. However, personally, I’m not waiting around to find out. I’ve recently sold all but a single share of CEFL to keep my interest in the fund, and replaced it with several better-performing CEFs (such as the PIMCO Dynamic Income Fund (NYSE: PDI )), as recommended in Left Banker’s article here .

Learning From The Past, Part 6 [Hopefully Final, But It Won’t Be…]

This is the last article in this series … for now. The advantages of the modern era… I went back through my taxes over the last eleven years through a series of PDF files and pulled out all of the remaining companies where I lost more than half of the value of what I invested, 2004-2014. Here’s the list: Avon Products (NYSE: AVP ) Avnet (NYSE: AVT ) Charlotte Russe [Formerly CHIC – Bought out by Advent International] Cimarex Energy (NYSE: XEC ) Devon Energy (NYSE: DVN ) Deerfield Triarc [formerly DFR, now merged with Commercial Industrial Finance Corp] Jones Apparel Group [formerly JNY – Bought out by Sycamore Partners] Valero Energy (NYSE: VLO ) Vishay Intertechnology (NYSE: VSH ) YRC Worldwide (NASDAQ: YRCW ) The Collapse of Leverage Take a look of the last nine of those companies. My losses all happened during the financial crisis. Here I was, writing for RealMoney.com, starting this blog, focused on risk control, and talking often about rising financial leverage and overvalued housing. Well, goes to show you that I needed to take more of my own medicine. Doctor David, heal yourself? Sigh. My portfolios typically hold 30-40 stocks. You think you’ve screened out every weak balance sheet or too much operating leverage, but a few slip through… I mean, over the last 15 years running this strategy, I’ve owned over 200 stocks. The really bad collapses happen when there is too much debt and operations fall apart – Deerfield Triarc was the worst of the bunch. Too much debt and assets with poor quality and/or repayment terms that could be adjusted in a negative way. YRC Worldwide – collapsing freight rates into a slowing economy with too much debt. (An investment is not safe if it has already fallen 80%.) Energy prices fell at the same time as the economy slowed, and as debt came under pressure – thus the problems with Cimarex, Devon, and to a lesser extent Valero. Apparel concepts are fickle for women. Charlotte Russe and Jones Apparel executed badly in a bad stock market environment. That leaves Avnet and Vishay – too much debt, and falling business prospect along with the rest of the tech sector. Double trouble. Really messed up badly on each one of them, not realizing that a weak market environment reveals weaknesses in companies that would go unnoticed in good or moderate times. As such, if you are worried about a crushing market environment in the future, you will need to stress-test to a much higher degree than looking at financial leverage only. Look for companies where the pricing of the product or service can reprice down – commodity prices, things that people really don’t need in the short run, intermediate goods where purchases can be delayed for a while, and any place where high fixed investment needs strong volumes to keep costs per unit low. One final note – Avon calling! Ding-dong. This was a 2015 issue. Really felt that management would see the writing on the wall, and change its overall strategy. What seemed to have stopped falling had only caught its breath for the next dive. Again, an investment is not safe if it has already fallen 80%. There is something to remembering rule number 1 – Don’t lose money. And rule 2 reminds us – Don’t forget rule number 1. That said, I have some things to say on the positive side of all of this. The Bright Side A) I did have a diversified portfolio – I still do, and I had companies that did not do badly as well as the minority of big losers. I also had a decent amount of cash, no debt, and other investments that were not doing so badly. B) I used the tax losses to allow a greater degree of flexibility in investing. I don’t pay too much attention to tax consequences, but all concerns over taking gains went away until 2011. C) I reinvested in better companies, and made the losses back in reasonably short order, once again getting to pay some taxes in the process by 2011. Important to note: losses did not make me give up. I came back with vigor. D) I learned valuable lessons in the process, which you now get to absorb for free. We call it market tuition, but it is a lot cheaper to learn from the mistakes of others. Thus in closing – don’t give up. There will be losses. You will make mistakes, and you might kick yourself. Kick yourself a little, but only a little – it drives the lessons home, and then get up and try again, doing better. Full disclosure: Long VLO – made those losses back and then some.