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Considerations For Building A Currency Hedged Strategy

By Jane Leung It’s been nearly impossible to ignore the news about the dollar, especially for those of us who are taking advantage of the upcoming vacation season to travel overseas. The greenback’s movement also has implications for investors. One of the things I’m hearing most from colleagues and clients is that investors know they need to have a view on the dollar – whether it will go up or down – and also be very aware of their investing time horizon. Unfortunately, they’re still unsure of how to implement a currency hedged strategy in their portfolio. Of course, predicting exact currency movements is impossible, especially in today’s environment. On one hand, you have the Federal Reserve angling to boost interest rates, while on the other, central banks in Europe and Japan continue efforts to lower rates, thus weakening their respective currencies. So let’s focus on the variable that’s easier to measure: time horizon. Why Time Matters Investors seeking to limit the effects of currency risk on their portfolios have a number of hedging strategies to consider, but what to do depends on the investment horizon. A quick review of the numbers shows that there is a big difference in the risk/return ratio of hedged and unhedged strategies depending on how long you remain invested. The chart below shows developed market return/risk ratios and reveals that results vary significantly over time. Of course, it’s important to remember that currency returns are generally viewed, over the long term, as a zero-sum game. And, as we can see, over a 15-year period, hedged and unhedged strategies, as measured by MSCI (daily index returns from April 1, 2005 to March 31, 2015) produced nearly the same results. However, applying some form of currency hedged strategy may help reduce volatility. In the example below, at 10 years, there was a higher return/risk ratio for a hedged v. unhedged index. The differences keep becoming more pronounced as you look at shorter time periods. Over a 1-year time period, a 100 percent hedged portfolio would have resulted in a 0.8 risk/return ratio while 100 percent unhedged would have resulted in a -0.6 risk/return ratio. EAFE HEDGING How to Build a Hedged Strategy When deciding how much of your portfolio should be hedged for currency risk, a good rule of thumb is to think about developing an asset allocation and hedging “policy” at the same time. To clarify my point, I’m including a simple risk-and-return illustration. Low risk/low return investments such as cash and U.S. bonds reside in the left corner and the potentially high risk/high return investments such as unhedged international equities in the upper right corner. The orange dot is where a hypothetical investor may indicate her risk tolerance. HYPOTHETICAL RISK TOLERANCE Considerations for Investing Overseas When you think about international investing, it is also important to recognize the distinct characteristics of each country that makes up a foreign region. Some of these features may or may not be correlated with the U.S., and this can affect the decision of whether or not to hedge and, if so, how much. Take a look at the annualized volatility over 10 years for a variety of single countries and international regions, as represented by MSCI: ANNUALIZED VOLATILITY: 10 YEARS We can see from the graph above that the annualized volatility over 10 years was consistently higher for unhedged positions than hedged positions and that different countries and regions had different levels of volatility relative to each other. In short, your asset allocation should depend on how much risk you’re willing to take on any given investment. If you have a portfolio that is heavily weighted toward international investments, has high currency volatility or high correlation between the currency and the underlying assets, a higher proportion of currency hedged investments might be appropriate. If you are more risk averse, and your portfolio is more heavily weighted towards U.S.-based investments, has lower currency volatility, or low correlation between the currency and the underlying asset return, you may consider having a lower proportion of currency hedged investments. Whatever your risk tolerance, you may want to consider a currency hedge as a way to help minimize the effects of volatility over the long term, regardless of short-term dollar movement. This post originally appeared on the BlackRock Blog.

2015 Q3 Value Performance Update And How I Value Markets

Summary Proof that you shouldn’t follow “smart money”, as it’s herd mentality. A list of my 2015 Q3 value strategy performances. A look at how I value the market to know whether it’s expensive. The final quarter. The home stretch. If you took advantage of the small market correction, great job, because the market has “recovered” about 6% already. The last thing you should do is take advice from what you hear on TV or the radio, because that’s where the peak of herd mentality exists. The talking heads don’t provide any deep insight or outside views, as it’s their job to provide simple outer-layer analysis that any average Joe can understand. You actually come out smarter if you ignore everything they say. Here’s a look at what I mean. This is the performance of the top 20 stocks held by hedge funds, according to novus.com . (click to enlarge) How does this look in a chart? (click to enlarge) Not impressive. Especially when people running these funds are supposed to be Ivy League top 0.1% brains. It’s quite easy to avoid these “top 20” names. Ignore news and headlines. Ignore popular stocks. Ignore complicated stocks you don’t understand. Investing doesn’t have to be complicated. Most of the investments above have complicated stories. If you’re looking for a simple business and investment thesis to understand, don’t look at hedge fund holdings. This is GREAT news for people like us. After all, the advantage that small investors and fund managers have is that we don’t have to play by their rules. It’s perfectly within the rules to resist the steady drumbeat of calls to activity. So, how does it look on the value side? Value Investment Strategy Performances 2015 Q3 YTD Even though on I’m on the value side, it’s not easy. It’s not supposed to be easy. Anyone who finds it easy is stupid. – Charlie Munger At the end of each quarter, I take some time to see what’s working and what isn’t working with a list of predefined value stock screens I follow. Here’s how it looks at the end of Q3. These are YTD performances. A lot can happen in one quarter, as you can see in the following image. The tables are organized so that the best-performing screen is at the top of each quarter. (click to enlarge) Don’t Blindly Follow High-Performance Screeners Last quarter, I mentioned how you should ignore the NCAV (Net Current Asset Value) and NNWC (Net Net Working Capital) performances this year. On paper, the results are mind-blowing, given the conditions this year, but in reality, it’s not so great and shows how difficult net net investing can be in a bull market. What do I mean? NCAV and NNWC produced only 8 and 12 stocks in the results respectively. They both include VLTC, which has done this. The problem is that at the beginning of the year, you wouldn’t have been able to purchase enough of it in your real-world portfolio due to low liquidity. It’s only after a spike that volume increases as traders and momentum seekers join the party. Plus, holding only 8 or 12 net nets in a bull market is not a strategy I want to employ. The 2015 NNWC stocks look like this: Thanks to one stock, the NNWC stock performance is up 30%. You may say that it’s the outcome that’s important, but I call this one more luck than skill. Why Bother Tracking Net Nets Or Underperforming Screeners? So why do I bother tracking this or other underperforming screens? The easy answer is to say that that one year doesn’t signal long-term performance, and then show you this table of results. (click to enlarge) (Source: Old School Value Stock Screener Performances ) But the better answer is that it’s a very simple and effective way for me to track how expensive the market is. I don’t refer to market P/E or Market-to-GDP, as it only looks at the entire market. I’m only interested in finding pockets in the market that provide value – mainly on the value investing side – and this is how I try to track and find those pockets of opportunity. Here are some more observations. When Mr. Market falls, it doesn’t care who you are. In fact, Mr. Market will take quality, growth and value all down with him. Risk management should be at the top of your list day in and day out. Boring value stocks fall less hard, but also don’t rise as quickly. Net Nets Are Awesome Indicators Let me revisit another reason why I like net nets. Using the number of net nets available as an indicator is a great way to expand Graham’s “net net” concept into a market valuation idea. In 2013, I made the claim that Ben Graham was a closet market timer, and drew up the following chart and table. Even without a table or chart like this, it’s obvious when the market is cheap. But it’s also most scary, which is why you need a table or chart like this where the facts smack you in the face. I haven’t updated this table in a while, but 2014 and 2015 are similar to the 2011 levels. Summing Up Investing is hard. “It’s not supposed to be easy. Anyone who finds it easy is stupid.” – Charlie Munger Ignore herd mentality. Ignore what the top funds are holding. Don’t play by the same rules as the big boys. Make use of your advantage, like buying smaller stocks, illiquid stocks, out-of-favor stuff. Net nets are awesome indicators. Recommended Reading

Why Seeking Alpha Recommendations Outperform Mutual Funds And Brokerage Analysts

Summary Academic research indicates that, on average, Seeking Alpha recommendations outperform mutual funds and brokerage (sell-side) analysts by substantial margins. The SA coverage universe includes many small company stocks that are ignored by sell-side analysts, despite the longstanding and significant negative correlation between returns and market cap. SA contributors are far more likely than sell-side analysts to issue sell recommendations when circumstances warrant, thereby avoiding losses and exploiting opportunities to short. SA taps the “wisdom of crowds” via large numbers of highly trained contributors who are freer than brokerage analysts to develop and express individual stock ideas in great detail. Given the findings of academic studies at NYU and Purdue , there can be little doubt that Seeking Alpha (SA) recommendations, on average, actually do deliver substantial positive alpha. Nor can there be much doubt that actively managed equity mutual funds typically deliver negative alpha . With respect to sell-side analysts, a 2014 academic study of their performance found that only “about 50% of ‘buy’ recommendations issued by industry and market benchmarkers meet or beat their objective.” (Roughly as reliable, in other words, as basing one’s investment decisions on coin flips.) Fundamental Advantages of SA Research 1. Microcap and small cap stocks have a long history of outperforming large caps. As the NYU study noted, SA analysts often cover companies that are too small to attract coverage by brokerage analysts – or to be owned by mutual funds. When my Data Driven Investing co-author, Mitch Hardy, and I analyzed Compustat data for over 20,000 companies between 1951 and 2002, we found that an annually rebalanced portfolio of the 100 smallest stocks (with a minimum market cap of $10 million in 2002 dollars and assuming reinvestment of dividends at year end) would have grown from $1 to $4,418 ( 17.52% compounded annually ) during this 52-year period. This figure assumed that buys and sells were done for zero commission at year end closing prices, which is certainly an overly optimistic assumption. Nevertheless, it is a meaningful indicator of a powerful negative correlation between company size and investment returns when compared to the terminal values of $1 invested in similarly constructed portfolios with higher market cap minimums: $100 million minimum market cap – $1,293 terminal value (14.77% compounded annually) $250 million – $667 (13.32%) $500 million – $289 (11.51%) $1 billion – $303 (11.62%) S&P 500 – $254 (11.23%) 100 largest market caps – $148 (10.08%) From 1/1/03 through 10/2/15, this correlation has persisted. The Russell Mega Cap 50 has returned 139.9% (with dividends reinvested) vs. 199.9% for the Russell Microcap Index. 2. SA contributors are far more likely to issue sell recommendations when warranted than are sell-side analysts. Because brokerages have little to gain and much to lose from issuing negative reports, they make very few of them , thereby exposing their clients to avoidable losses, as well as causing clients to miss out on profitable short sale and put buying opportunities. Whereas almost all investors are potential buyers of the individual stocks that brokerage analysts recommend, relatively few are in a position to act upon sell recommendations. That is, unless an investor either owns a stock already or is inclined to short it (or buy puts), that investor will not act upon a sell recommendation. As a result, the potential commission revenue to be derived from making a negative call is relatively small. In addition, there are strong disincentives in play. Not only is the subject of a sell recommendation quite likely to look askance upon doing investment banking business with the brokerage that makes it, but it’s also possible for a single negative research piece to harm relationships with an entire industry . At the very least, going negative on a company can impede an analyst’s access to its management and the information needed to do his or her job. Moreover, these analysts have strong incentives to defend the stocks of companies that are either investment banking clients or prospects of their brokerages – even when short sellers put forth solid evidence of existential product liability problems and unsustainable business models. The next time Citron Research makes one of its “emperor has no clothes” calls, watch for one or more brokerage analysts to leap to the stock’s defense, however compelling the sell case might be. The more troubled the company, the more opportunity there may be to profitably pursue investment banking opportunities with it. Such companies may well be in the market for assistance from accommodative Wall Street firms in raising cash and/or dumping the stock owned by their managements upon unsuspecting investors. 3. SA contributors can focus far more attention than brokerage analysts on each opportunity they research. The SA posts of Citron provide us with prime examples of the thoroughness that brokerage analysts lack. (Click on the link in the preceding sentence to see what I mean.) The focus of sell-side analysts is necessarily diluted, due to the number of stocks they are assigned to cover, as well as their sales responsibilities. Academics have noted a negative correlation between analyst workload and accuracy (as well as a negative correlation between workload and research timeliness). Whereas it’s commonplace for a single sell-side analyst to have coverage responsibility for a dozen stocks or more (e.g. at Raymond James ), SA contributors have far more freedom to focus on developing one individual stock idea at a time. And when an important sell-side prospect or client needs handholding from an analyst, be it an institutional investor or investment banking-related, this may take precedence over research . 4. As the preeminent aggregator of crowdsourced investment research, SA is uniquely positioned to harness a large and growing pool of individuals with underutilized talent who are highly motivated to produce quality work. Many SA contributors (like yours truly , for instance) earn CFA designations with the hope of becoming an equity analyst or portfolio manager with an established firm. For those of us who will never realize this hope, SA provides an attractive means of pursuing our analytical passions, as well as a platform for sharing our analyses with, and receiving feedback from, thousands of viewers. Whether or not one has secured such a position, the rewards for writing insightful analyses can extend beyond the intellectual challenges, kudos from viewers, and penny per page view. There’s a reasonable chance that one’s audience will include someone impressed enough to make a suitable job offer or open a new account. The CFA charterholder population has roughly doubled during the past decade and now stands at over 123,000 – and there are more on the way, with more than 210,000 exam registrations received in 2014. Inevitably, this crop of CFA wannabees will ultimately yield a bounty of well-trained SA contributors. There are, of course, many highly competent SA contributors who do not hold CFA charters. Their numbers include underemployed MBAs, downsized financial services personnel, and those with no relevant formal training who have enough sense to know a good investment opportunity when they see one. In fact, when flooring contractors have something to say about Lumber Liquidators (NYSE: LL ), their observations carry more weight with me than whatever a desk-bound CFA/MBA type might have to offer. Whereas Wall Street firms offer no effective way for small investors to band together in challenging the assertions of their brokerage analysts, SA gives users the opportunity to publicly point out errors, unwarranted assumptions, and other shortcomings in the analyses submitted by its contributors. In addition, SA provides a convenient venue for critiquing the alleged wisdom of Wall Street. SA’s sharp-eyed editors constitute a first line of defense against the publication of factually incorrect or otherwise misleading submissions. And if significant deficiencies remain after publication, SA users’ multitude of eyeballs can generally be counted on to catch them. To the extent that the “wisdom of crowds” exists in the investment world – in contrast to the “madness of crowds” that is the Wall Street norm – it can be found at seekingalpha.com.