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Pursuing Smart Beta: Multi-Factored ETFs

Summary Both iShares and Global X have recently issued ETFs based on selecting holdings using complex systems of implementing “smart beta.” iShares’ “FactorSelect” funds use a complex system of factors to select high-quality holdings. Global X’s “Scientific Beta” funds use a complex weighting system to develop a portfolio that will perform optimally. In June, I wrote about the iShares FactorSelect MSCI International ETF (NYSEARCA: INTF ), an ETF with an inception date of April 28, 2015. 1 iShares introduced four other funds on that same date: the iShares FactorSelect MSCI Intl Small-Cap ETF (NYSEARCA: ISCF ), the iShares FactorSelect MSCI Global ETF (NYSEARCA: ACWF ), the iShares FactorSelect MSCI USA ETF (NYSEARCA: LRGF ) and the iShares FactorSelect MSCI USA Small-Cap ETF (NYSEARCA: SMLF ); as the names would suggest, all of the funds have something in common: they are based on the FactorSelect strategy. Shortly after the iShares releases (May 12, to be exact), Global X Funds issued four ETFs of its own: the Global X Scientific Beta U.S. ETF (NYSEARCA: SCIU ), the Global X Scientific Beta Europe ETF (NYSEARCA: SCID ), the Global X Scientific Beta Asia ex-Japan ETF (NYSEARCA: SCIX ), and the Global X Scientific Beta Japan ETF (NYSEARCA: SCIJ ). Again, as the names suggest, all four ETFs are based on the same ( Scientific Beta ) strategy. Both series of funds represent efforts by their respective issuers to provide investors with a “bridge” between – or perhaps better: an alternative to – actively managed funds and purely passive funds. 2 I thought it might be interesting to take a look at the two sets of offerings and their underlying strategies; there are interesting similarities between the approaches, as well as some significant differences. FactorSelect BlackRock’s (NYSE: BLK ) approach to Smart Beta involves a (proprietary) model that selects companies for a given fund on the basis of four factors: 3 Value : a score is derived from a company’s valuation, using measures such as price/book value, forward share price to earnings, enterprise value to operating cash flow, etc. Quality : a score is computed using a company’s metrics (return on equity, debt/equity, earnings variability, etc.). Momentum : the score is a composite of the security’s relative performance against the global market (for two years), and against securities based in the same country (for six months and twelve months). Low Size : the score is a measure of a company’s market capitalization compared to companies based in the same country. The final score is a composite of the four factors, which are modified-capitalization weighted. The funds are rebalanced/reconstituted semi-annually. Scientific Beta As with BlackRock, Global scores its potential holdings on the basis of four factors, although each factor has a single definition, rather than being an aggregate of several “sub-factors.” 4 , 5 Thus: Value : Price to Book Size : Market Capitalization Low Volatility : 104-week historical volatility Momentum : last 52-week total return, excluding most recent month. Unlike BlackRock’s modified-cap-weighting scheme for its factors, Global employs a more complex weighting system incorporating five schemes: 6 Maximum Deconcentration : equal weights to minimize firm-specific risk. Maximum Decorrelation : minimizes volatility based on historical correlations between holdings. Diversified Risk Weighted : volatility and weight are inversely correlated (greater volatility gets lesser weight) Efficient Minimum Volatility : minimize portfolio volatility based on both correlations and volatilities. Efficient Maximum Sharpe Ratio : maximize risk-adjusted performance based on expected returns and volatilities. The funds are rebalanced/reconstituted quarterly. Comparison In essence, both sets of funds mimic an actively managed fund by introducing complex selection and weighting criteria. The use of complex criteria adds a discretionary element to holdings selection, while at the same time providing the same level of transparency that is typical of an index fund. The difference between the two sets of holdings is in the focus of the complexity they introduce, with iShares introducing the complexity in the scoring factors and Global using a complex weighting schema. I will argue that while their approaches are different, the results may – at least intuitively – be quite similar. 7 Factors Both sets of funds look at a company’s size , value and momentum . Where they differ, iShares factor involves data reflecting a company’s quality , while Global factors the volatility of a company’s stock. But even where the two series “agree,” the agreement is in name only. Global defines its factors very narrowly, choosing a single characteristic, ratio or formula for each factor, while the iShares funds’ factors are complex aggregates. The difference in factor composition is perhaps most starkly exhibited in terms of stock value . It is difficult to accept that one can determine the valuation of a company on a single metric, particularly price-to-book. 8 Finding a realistic way to combine a set of valuation data to arrive at a reasonable value seems more adequate. Both funds incorporate size in their factoring, where they seek to avoid selecting large companies. Statistically, smaller companies realize more growth than large companies do, so in the interest of maximizing portfolio growth potential both fund series place greater value on the smaller companies. It is with regard to size that both companies structure their portfolios differently. iShares divides its FactorSelect funds according to U.S., ex-U.S. Developed, and Global focuses, with the first two subdivided between large- and mid-cap portfolios on the one hand, and small cap portfolios on the other. Global structures its four portfolios to include all market caps in each. Momentum is an interesting case, with Global focusing on a company’s total returns over 52 weeks, while iShares considers a company’s performance in relation to ((a)) global stocks over two years, and ((b)) same-country companies over six- and 12- month periods. Thus, while Global is looking at each company individually, iShares evaluates companies in the context of global and national trends – a more dynamic picture of how well a company is doing. I must admit to a little dismay that Global does not take fundamentals into account. One of iShares’ factors (quality) is essentially a composite of a company’s fundamental data, and would seem to be (at least to my view) much more important in evaluating a company’s prospects than low volatility, which replaces fundamentals in the Global schema. Moreover, and as we will see next, volatility plays an important role in Global’s weighting schema – using it in two phases of its selection process would seem excessive to its overall importance. Weighting Comparison While iShares’ factors are complex aggregates, the series becomes somewhat one dimensional in terms of its weighting system, which is a “modified market-cap weighting,” the weight a holding receives being its capitalization influenced by its overall factor score. Global’s factors may be one dimensional, but its weighting system is decidedly not. Global’s five-element weighting process is designed to identify correlations and volatilities in its portfolio, adjusting the weighting of its holdings (from an initial equalized weighting) to compensate for intra-portfolio correlations and minimize overall portfolio volatility. Finally, weighting is adjusted according to the companies’ Sharpe Ratios. Assessment In general, the primary difference between the two sets of funds seems to be that the iShares FactorSelect funds have portfolios that are constituted very selectively, while the Global X Scientific Beta funds have portfolios that are balanced for optimal performance. It will be interesting to see which series fares better over time from this perspective, but I do not see enough significance in this difference to recommend one series over the other. 9 Both systems are crafted to produce a portfolio that should exhibit excellent growth patterns, although they accomplish that goal differently. What is significant is the focus of each fund in both series. Global has developed funds that are geographically specific – one for the U.S., one for Europe, one for Japan and one for “non-Japan” Asia. If the investor is interested in a nicely balanced portfolio for a specific region, the Scientific Beta series makes for an attractive option. The iShares funds, on the other hand, constitute very selective groups of companies that provide excellent growth potential – at least, in principle. The funds are differentiated according to the extent of that potential: the relative safety of mid- to large-capped holdings or the greater potential growth of small caps; they are further differentiated by whether the holdings are domestic or international. The investor is choosing an equity category only broadly differentiated regionally. As I mentioned in my article on INTF, I have been really reluctant to commit to an international ETF. INTF is the first fund that has appealed to me in terms of its selectiveness and the range of its holdings. The fund has enabled me to add solid international holdings to my portfolio while making me feel confident that the foreign holdings are high quality companies with good growth prospects. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company’s Prospectus, Statement of Additional Information, and fact sheets. Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. 1 ” INTF: An Ideal Basket Of International Equities ,” Seeking Alpha , June 9, 2015. 2 Both companies specify that their strategies are intended to provide viable alternatives to actively managed funds while outperforming the simple indexed funds. 3 These factors are described in detail in the prospectuses(under “Principal Investment Strategies”) for each of the funds. All five funds apply the same factors, each fund applying them to a specific regions/market capitalization. The calculations in the model are proprietary to MSCI, which develops the underlying index for the funds. 4 Global X Scientific Beta ETFs Family Guide , available here . 5 A detailed discussion of the construction of the indices used by Global X can be found in ERI Scientific Beta Equity Strategy Construction Rules , by the EDHEC-Risk Institute . 6 Scientific Beta ETFs Family Guide . 7 Similar, at least, in terms of ultimate approach, although not necessarily in terms of actual portfolio content. 8 I am a big fan of price-to-book value. It is a great indicator of value, and I regularly look at companies that have P/Bs less than 1 – these are companies where the value of the actual assets of the company exceed the value of the shares. In the event of a bankruptcy, shareholders of such a company would, in principle, receive more money for their shares than they paid. However, I would not rely on P/B as the determinant of a company’s overall value. 9 Actually, I do, but it is a matter of personal preference, rather than rigorous analysis. The FactorSelect process seems more comprehensive, indicating a greater level of sensitivity to the strength (both fundamental and displayed) of the companies of which the portfolio is comprised, while the Global X Scientific Beta system – while rich in its weighting system – seems rather sparse in selectiveness. The result of the latter system is a portfolio that may be well-balanced, but I am less confident in the components of that portfolio. Disclosure: I am/we are long INTF. (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.

SCHZ: A Remarkably Complete Bond Fund

Summary I’ve been looking for some medium to high quality fixed income investments. My preferred method of making the investments is buying ETFs. I want something with decent yields, excellent internal diversification, and reasonable or better levels of liquidity. I would accept some credit risk or some duration risk to increase yields, but expense ratios have to be low. SCHZ offers investors an incredibly diversified portfolio of fixed income investments and I may use it from time to time. Since the Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) is a Schwab ETF it is eligible for free trading in Schwab accounts. Since I want to be able to use my bond ETF as a place to park cash and earn some yield off of it, I want that free trading to move money in and out. With an expense ratio of only .05% (not a typo), I’m very impressed with this ETF. To be fair, the largest factor in my decision to open accounts with Schwab was the free trading on low fee ETFs. It shouldn’t be surprising that I like several of their funds since I picked them as a brokerage after I glanced at their ETF offerings. The Good The portfolio offers an absolutely remarkable diversification of fixed income investments. Investors are getting exposure to treasury securities, mortgage pass-thru securities, and corporate bonds. There are even small allocations to non-us corporate debt, municipal bonds, and other small sections of the market. For a fixed income investor looking for one stop shopping for a bond ETF, this is probably one of the best options on the market. The average volume is running around 170,000 shares per day which is enough liquidity to avoid any major concerns. The average yield to maturity is running 2.46%. Given the low interest rate environment we are facing at a macroeconomic level, this is pretty reasonable. All fixed income investors would love to see higher yields on their investments, but 2.46% is solid compared to any similar alternatives. The effective maturity is over 7.3 years and the effective duration just over 5.3 years. That level of duration risk is fairly reasonable for matching my risk tolerance. If yields were higher on a macroeconomic level, I would be willing to tolerate more duration risk. The Bad While the portfolio is a strong contender for one stop shopping, as an mREIT analyst I can’t stomach paying NAV for an investment containing MBS. I can acquire my MBS exposure at a substantial discount to NAV, though I must admit that when buying mREITs I am effectively paying a much higher expense ratio. Regardless, when mREITs trade at huge discounts to NAV, I don’t want my portfolio to include any exposure to MBS where I am paying NAV. I expect that within the next few years we will see fair values for MBS take a meaningful hit. I want that expectation priced into my investment. Overall, holding MBS is not a bad thing. If mREITs were trading at a premium to book value, I would happily be buying into an ETF that trades around NAV and holds the same securities. When mREIT share prices and book values align, I’ll be tempted to make SCHZ a portion of my investment portfolio. It is a solid ETF that is hampered only by the fact that investors have the opportunity to buy MBS exposure at a discount to NAV. The category for “Mortgage Pass-Thru” is currently weighted at 28.9% of the portfolio. This comes in second for weightings with U.S. Treasuries over 36%. The third category is U.S. Corporate with a weight just over 21%. Interesting Notes I tend to be a buy and hold investor with the exception of being willing to do some trading in microcap securities when I think a lack of coverage is allowing prices to deviate from intrinsic value. When it comes to a bond ETF, I want to be able to rapidly move money in and out and of the investment so it functions as a cash fund. I find it interesting that the portfolio turnover is 74% for the Schwab U.S. Aggregate Bond ETF. Frequently I see high portfolio turnovers with excessively high expense ratios, but here the expense ratio is incredibly low. I don’t mind the portfolio turnover since there is no high expense ratio. My problem is not an issue with frequent trading in an ETF; I simply don’t want to pay for it. If it is free, that is fine with me. Conclusion The Schwab U.S. Aggregate Bond ETF is an exceptional bond fund with a low expense ratio and great internal diversification. The only thing that keeps from selecting it as a fixed income investment is that I’m trying to avoid buying MBS at NAV when I cover mREITs and feel confident that I can select solid mREIT investment options on my own. I want to use the diversified low fee ETFs for everything else. When mREITs see share prices and NAVs align, SCHZ will be a very strong contender for use as a fixed income investment or for parking cash while I wait for other opportunities in equity investing. I feel the market is a little frothy and I’m looking to shift my portfolio to have slightly less risk to a downturn in the equity markets while still making enough money off yields to offset inflation. This ETF does both of those things, so the exposure to MBS is the only reason I’m not using it right now. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SCHZ over 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. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

The Beginner’s Guide To Volatility: ZIV

Summary We will cover the basics of ZIV. Examples of trading strategies for the mid-term futures. Current advice on ZIV. Welcome to the final part of The Beginners Guide to Volatility. I highly encourage you to view the two articles below, unless you have already read them. Some terms in this article were previously explained in the first two parts. Part One: The Beginner’s Guide To Volatility: VXX Part Two: The Beginner’s Guide To Volatility: XIV VelocityShares Daily Inverse VIX Medium-Term ETN (NASDAQ: ZIV ) This article will focus on the mid-term VIX futures. To be clear, these products are not the same as the short-term futures products we have discussed before. Some things are similar and others are very different. As a basis for discussion, we will use the inverse product ZIV. I really don’t recommend any other mid-term futures products. What are the mid-term futures? How would an inverse fund operate in the mid-term futures? See below: (click to enlarge) The mid-term futures span months four through seven. An inverse fund, which means in reverse order, sells short month seven’s contract. The fund will hold that contract (short) until selling it when it reaches month four. This process typically takes about 90 days depending on the month and expiration date of the VIX futures. As you may recall from the previous two articles, VIX futures are not the VIX Index and they trade independently of the market and level of stock prices. If you are on vixcentral.com, below the individual months you will see the month seven to four contango box. I have edited this into the above graphic. The first box represents the total percentage of contango or backwardation from month seven to four. For more on these terms, please view the first two articles in this series. The second box represents the estimated amount of contango or backwardation you could expect to profit/loss from during the next 30 days. It takes the first box and divides it by three. Again this is just an estimate. Contango/Backwardation in Mid-Term Futures Charts above and below made by Nathan Buehler using data from The Intelligent Investor Blog . Below, you will see an overlay of ZIV using the same time values to give you a clearer view of the data: Context It is important to view the above chart to put the mid-term futures into context. Although the data is back-tested, it is still relevant and useful. Had you viewed the current data alone (see below), it would appear mid-term future rarely go into backwardation. For the most part, this is true; however, you should be aware of negative economic events that would cause a deeper and more prolonged trek through backwardation. (click to enlarge) Why Consider Inverse Mid-Term Futures? Inverse mid-term futures provide a less volatile bet on decreasing volatility and/or sideways to rising markets. The best reward for your risk would be investing in these products after a dramatic and prolonged spike in the mid-term VIX futures. Historically, investing in mid-term futures now would give you a high risk and minimum reward scenario. See below for an example of a winning strategy: Winning Strategy: Let’s review two strategies that would work well. Buy ZIV once futures re-enter contango from backwardation. Risk of backwardation reappearing. Wait for backwardation and buy ZIV once 5% contango is reached. Visual (click to enlarge) Let’s go over the positives, negatives, and key takeaways with this strategy. Positives: Mid-term futures are already less volatile and less risky than short-term futures. This strategy, especially strategy two, is conservative in managing risk. Negatives: With strategy one, futures could reenter backwardation causing large losses. This opportunity will only occur once a year on average. Some periods may go longer without seeing backwardation present in the mid-term futures. It has been almost four years since the mid-term futures were in backwardation. Takeaways: Your focus on this decision should be in the strength of the U.S. economy and the ever more important global economic impact on the U.S. You need a positive economic outlook and improving or stable economic conditions for this to work as intended. Liquidity One thing you will notice about ZIV in comparison to short-term futures products is the drastically lower volumes. Average volume over the past three months is about 62,000, representing around $2.5-$3 million in transactions per day. As of writing, the fund has $123 million in assets under management (AUM). This represents about 2% of the fund being traded per day. When compared with the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ) that fund had about $342 million in AUM, and with its near-term average volume of 12 million shares, that represents around $360 million or over 100% of the assets in the fund being traded per day. ZIV will attract investors that are not looking for a day trade and have more of a buy-and-hold or longer-term view of the market. The low volume does not make this an illiquid investment. Conclusion The inverse mid-term VIX futures offer you another way to invest in volatility. It is a much slower pace than the short-term futures but also carries a more moderate level of risk if backwardation persists for a long period of time. Should things turn south, this product is much more forgiving in allowing you to exit a position. Short-term products often react much worse to immediate events. Now is not an opportune time to invest in the mid-term futures, but this article should have given you a good indication of what conditions would look like when the opportunity arises. I appreciate you reading this series, and I hope it continues to serves as a foundational education piece for volatility investors for years to come. My best advice is to fully educate yourself before investing in any VIX-related products. Knowledge is power and very important with this asset class. 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.