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Shield Fund Earns Its Name

Summary Hedged Exposure to S&P 500 currently protecting investors’ capital. Delta approaches zero as market drops. New investors in with a -8.33% floor and a 18.95% cap. The recent volatility in the equity markets was a fun test for an investment I introduced upon its launch last April, which is the Exceed Structured Shield Fund (MUTF: SHIEX ). The fund has indeed shielded investor capital as the market plummeted. A detailed description of the mechanics of this fund can be found in my previous article , but as a refresher of the highlights: Passive, synthetic exposure to the S&P 500 via OCC cleared options 1:1 up and down, i.e. no leverage Protection level of -12.5%, or better if market execution allows Ceiling of approximately +15% The fund opened for business on 16 April 2015 and marked at $10 on close of market that day. For several months we were in a relatively sideways market, with SHIEX closely tracking the SPDR S&P 500 ETF Trust ETF (NYSEARCA: SPY ), so there were not any real opportunities to begin to highlight the performance success of an options-based hedge. We were able to observe the success of the 1-to-1 tracking, as SHIEX paralleled SPY. The following chart is the first four months of SHIEX, which is right before the market started cratering. (click to enlarge) At the lowest point, SPY was only down -2.79%. You can see that SHIEX was preserving capital at that point, since it was only down -1.89%. As measured from inception to that low-point, SHIEX had a 0.68 downside capture ratio. That means that for every $1 that SPY lost, SHIEX lost only $0.68. You can also see that SHIEX lagged slightly when SPY turned positive. I wanted to show you the mundane first, in order to set the stage for a stressed, falling market. Let us extend our view to include the most recent market activity. (click to enlarge) As the S&P 500 heads further south, we can see more clearly the impact of the hedge I call a “floor.” Recall that Exceed achieves this by being long (owning) a Put that is out of the money (OTM) by -12.5% or better. For small losses one can hardly notice the effect of this Put. But as the underlying security approaches being at the money (ATM), the delta decreases, approaching 0, and you can see that reflected in the pricing of the fund. The following table will help demonstrate that. The “change” column for both SHIEX and SPY relates to the launch date of 16 April 2015. The second row demonstrates that slight lag I mentioned earlier. The third row, 8/24/2015, is demonstrating the effect of the hedge starting to come into play. While the market has -9.92%, SHIEX has only captured 72.6% of that drop, with a -7.2% drop. But, as the market tanks for a second day, pushing SHIEX closer to its floor, the downside capture ratio shrinks to 66.5%. You can see that clearly in the bottom row. Imagine it like the “ground effect” in aviation. As one gets closer to the ground, the ground (floor) starts “pushing” back. SPY lost -1.18% in the next day of the sell-off, but SHIEX only shed -0.11%. In other words, as the floor was approached, the downside capture ratio sank to 9.3%. That means SHIEX only lost less than a dime for every dollar SPY dropped. Indeed, if SPY continues to drop, you will see the downside capture ratio also continue to drop. The chart for SHIEX will likely look like an invisible Atlas is supporting the fund price. There is nothing mythical about the mechanics, though. This is merely a hedge doing exactly what it is supposed to do: saving investor capital. If the markets continue to correct down, will we see a point where SHIEX will absolutely stop and drop no further? I can’t answer that forward statement, because there are too many variables at play. Recall that there are four, consecutive, 1-year collars being employed at every moment in the fund. Each one expires within a different quarter of the year. The 12.5% floor is set on each collar at a different strike point. The collar that initiated when the S&P 500 was at its lowest will also have the lowest floor, so that will be the critical path to reaching the bottom. But options do not price merely on Delta. Other factors such as volatility, time to expiration, and interest rates also weigh on the value of this synthetic exposure. Also remember that there is a large fixed-income portfolio of investment grade bonds collateralizing the fund, which will have a small impact on the pricing. But, as we have seen demonstrated, the downside capture ratio will continue to shrink towards zero (i.e. an absolute floor)as the long Put approaches being at-the-money. All the historical test data, and mathematical proofs, support this: NASDAQ Exceed Structured Protection Index (EXPROT). Further, they indicate that as the lowest Put goes in-the-money, the hedge will hold solid. (click to enlarge) For every one of the four collars that expires while the market is below the -12.5% or worse, the floor is absolute. The reason is Delta is at 0 (zero). Where is the Fund at this time? Exceed sent out an update on the current state of their collars as of 8/24/2015. This is an average of all four collars currently at-work in the fund: Floor: -8.33% Cap: 18.95% These are the levels that an investor would realize if they invested at the close yesterday. I noted in my introduction piece that the -12.5% floor was a minimum requirement. As you can see, they have exceeded the minimum requirement, and are executing a superior hedge. Further, for those concerned about missing a runaway bull-market, the cap has increased to +18.95%. That is the defined-outcome range of SHIEX as of the most recent, quarterly collar-roll. In this market, by most subjective projections, that is a highly desirable range of outcomes. Unfortunately, the fund has only managed to raise around $7MM assets, which I find disappointing. Disappointing, that is, for all the investors that are losing billions of dollars in this down market with their unhedged, long, domestic, passive and active, large cap investments. I attribute this to a few factors: Lack of awareness of this solution, which I hope to address with articles like this. Misinformation about bundled option strategies propagated by for-profit competitors. Reticence to trust a theoretical strategy; instead preferring to see if it really does work. The numbers are in, and the strategy is working as engineered. Only Schwab and Pershing clients have been able to take advantage of this fund’s strategy. The fund is not yet approved on the TD Ameritrade and Fidelity platforms, but it is my understanding that TD and Fidelity clients will have access within a month. I see little reason to have unhedged exposure to the S&P 500 when this solution is available. The Exceed Structured Shield Index Strategy Fund was just put the test, and it scored. Disclosure: I am/we are long SHIEX. (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.

Smart Beta, Dumb Money And EMH

Someone asked me about Smart Beta in the forum the other day and I got to thinking about this. Indexers are all basically chasing some form of beta. But some indexers chase beta in stupid ways and some indexers chase beta in smart ways. An increasingly common example of this is the many forms of factor investing that have become popular in recent years (in case you haven’t noticed, I don’t like factor investing – see here and here ). I am generalizing, but I tend to believe that factor investing is just a new clever way to get people to pay higher fees for owning index funds. Now, this particular reader asked about the profit factor so I went exploring. It turns out that there are more than a few ETFs that track this profit factor. The largest one is the WisdomTree MidCap Earnings ETF ( EZM), which has 770 million in assets and “seeks to track the investment results of earnings-generating mid-cap companies in the U.S. equity market.” So, I go and compare this fund to the Russell Mid-Cap Index. It actually appears to be beating the index since inception, but it has a 99% correlation. Something doesn’t smell right about that. So, I look under the hood and find that it actually deviates from the Mid-Cap Index quite a bit. While the Mid-Cap Index has an average market cap of 10.5B this fund has a market cap of just 4.2B. Ah, so there’s the outperformance. It’s not profits, it’s just higher risk smaller cap stocks. And if you layer on the Russell 2,000 Small Cap Index, whose market cap is 1.5B, you get a near perfect replica of EZM. This is precisely what I expected given that I’ve run some version of this experiment almost every day for the last few years when assessing people’s portfolios. The kicker is, this fund isn’t “smart” at all. The only thing that’s smart about it is that it deviates from the Russell Mid-Cap Index giving it the appearance of better performance. And so what we have here is a sort of sad case of dumb money chasing market inefficiency and proving that the only thing inefficient here is their factor chasing charade. And in doing so they’re paying 0.38% per year for a fund that costs as low as 0.07% elsewhere. That’s almost $2.5 million in annual fees being flushed down the drain there. And that’s just one fund out of a growing list of hundreds and maybe thousands. I’d laugh if it didn’t make me sad. Share this article with a colleague

The Hidden Danger Of Index Funds

Summary Index funds have grown fantastically in popularity, and in 2014 received over half of inflows to equity funds. Data suggests that index funds outperform during bull markets, but not during bear markets. Index funds have become extremely popular, perhaps a bit too popular for both the health of your portfolio during current market conditions and the long-term implications to the stock market. The recent return of volatility to the market – multiple days where the major averages gained or lost several percent – has revealed a lot about the stock market that years of slow, grinding gains managed to camouflage. Index funds have become the “new religion” of the stock market, but they may not be the panacea that many think. In particular, they may pose a danger to the value of your investments under current market conditions. The Growth of Index Funds Index funds have been around for decades. Vanguard introduced its Vanguard Five Hundred Index Fund (MUTF: VFINX ) in 1976. Enthusiasm for indexing remained muted for years, but in 1992 the Amex went a step further and created the S&P Depository Receipts Trust Series 1, or “SPDRs.” These proved extremely popular, and many other Exchange Traded Funds (“ETFs”) soon followed. The allure of ETFs that mirror an index is obvious. They remove human error and, more importantly, the expense of active management. The real benefit, though, is the fact that securities linked to an index provide an “average” performance that beats that of the majority of active managers. The media loves to tout that passive investing beats active investing up to 85% of the time. Warren Buffett famously advises non-professionals to dump their money into index funds. Even those arguing in favor of active management, such as Wealthfront Knowledge Center, must admit that during bull markets, index returns beat those of most active managers. So, this is not an attack on index funds. They have their place. However, there is more to the story than simply assuming that index funds will remove all investing concerns. Burton Malkiel, whose “A Random Walk Down Wall Street” is one of the classics of investing, studied why index funds are better investments. He concluded that the primary reason is simply the extra costs associated with active management. Otherwise, they offer similar performance. There are good reasons for passive investment. Many, if not most, investors, don’t have the time or inclination to ascend the steep learning curve required to become a successful investor. They have their own careers, own lives, and not everyone is entranced by the wonders of the stock market. While one might think that the growth of the Internet and extremely low commissions relative to the past would lead to individual investors becoming more active investors who take matters into their own hands, it seems that the opposite is taking place. Why this is happening is a complex problem. Perhaps the inundation of random facts and opinions about stocks now available on the Internet has the perverse (or perhaps salutary) effect of making amateur investors realize how little they (or their advisers) really know about how stocks will do. From its humble origins in the 1970s, index investing recently has mushroomed. As of year-end 2013, it accounted for 35% of equity funds and 17% of fixed income funds. In 2014, 55% of money invested in equity mutual funds went to index funds. Obviously, if the asset base of equity funds was 35% in index funds, but the marginal contributions constituted 55%, the popularity of index funds is growing quickly. One could almost call it a “bandwagon effect.” There is very good reason to be leery about something that provides such an attractive lure that seems to cure all investing problems. Why This Trend is Dangerous It is easy for investors to look at the research showing the out-performance of index funds, throw up their hands, and bypass active management. I myself like index-based funds. They make sense for good returns without too much effort, and the data supports that. The problem is that they make too much good sense. This was masked for several years due to the gradual rise of the U.S. markets since the 2008-2009 recession. Basically, the stock market during these past few years was a “one decision” project. If you bought during periods of market weakness, the market quickly sent the averages to new highs. We can argue about the reasons, but the slow, steady, unflinching march higher of the S&P 500 and other major indexes in recent years made active management basically superfluous. Why pay the additional costs of active management if everything is going up? While making perfect sense for the individual investor, for the investing class this seemingly ironclad line of reasoning could lead to poor results in the future for a couple of reasons. First, index funds do not perform well during bear markets. In fact, a study found that during bear markets, an S&P 500 index fund beat only 34% and 38% of its active management competitors. That means that the “cruise control” of index funds will send you into the ditch just at the wrong time. Second, index funds rely on the pricing of their components for their own pricing, but that pricing can be questionable at times. This may seem trivial, but it can hurt you in unexpected ways during illiquid markets. On Monday 24 August 2015, when the Dow Jones Industrials opened down over 1100 points, many stocks didn’t open until well after the open. Market makers basically had to “guess” at the prices of their stocks. Old-time market participants will recall the same thing happening during the 1987 market break, and during others. This type of volatility leads to “pricing havoc” of index ETFs, as happened on Monday. That may sound terrific if you wanted to buy an ETF at a weirdly low price, but not if you were selling. Third, the growth of index funds appears to be turning the market into a binary casino. Now, it is hardly new to disparage the market as a random casino, that has been going on for as long as stock markets have been around. However, decreasing the role of active managers means the market increasingly leans toward becoming an “all or nothing” bet. If people are selling, then everything sells off at once, and vice versa. Bob Pisani at CNBC noted that there were wild swings of “panic selling” and “panic buying” during the big Monday morning rout, something he had never seen before. He mentioned that there were “strange numbers” in the market, such as only two new highs and 1200 new lows, and 120 stocks advancing while 3100 were declining. Was this due to the influence of all-or-nothing indexing decisions? That could have been a contributing factor. If you were holding an index fund, that would have directly affected pricing of your holdings, quite possibly to your detriment if you had chosen that time to sell. A glance at the chart shows how bizarre some prices were that morning. Fourth, if you don’t have active managers and sufficient numbers of investors in individual stocks, on what exactly are the indexes going to be based in the future? This is more of a longer-term problem, but if you don’t have millions of individual decisions being made about individual securities every day, the market is only going to become more binary and treacherous. The only thing left to determine its course, really, will be economic government data at a macro level, with individual stock prices set basically by the index funds. The individuality of the market will lessen, and as things become more “standardized,” you can count on returns decreasing. Conclusion Index funds make good sense for the individual investor – too much good sense at times. I use them myself, as do many professional investors. However, hidden dangers lurk both in the short term – if the market suddenly stops rising year after year – and long term. They can be dangerous to your financial health during times of market volatility. There are many ways for the individual investor to shield themselves from these sorts of dangers, but ignoring them is not one of them. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.