Tag Archives: united-states

What Can Russia Offer To Your Portfolio?

Summary RSX is down over 50% since the beginning of 2011, suggesting attractive expected returns. Russian equities offer diversification benefit to U.S. investors. However, high volatility of such an investment means that the actual portfolio risk contribution will be 2.5-3 times higher than its portfolio weight. I was recently browsing Research Affiliates Asset Allocation website and one chart that drew my attention was the forecast real 10-year expected return. As can be seen from the histogram below, projected returns by Research Affiliates models for various countries and regions differ widely with Russia comfortably offering the highest expected reward: (click to enlarge) This prompted me to explore how a modest allocation to Russian equities affects a typical portfolio held by a U.S. investor. For the purpose of this article, I use the 60/40 portfolio as a proxy for a “standard” allocation (even though I still think it is flawed ), with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) representing equities and the Vanguard Total Bond Market ETF (NYSEARCA: BND ) – fixed income. While ETFdb lists 6 Russian equity ETFs available in the U.S., the Market Vectors Russia ETF (NYSEARCA: RSX ) is the obvious choice given that its $2 billion of assets under management is almost 4 times more than the remaining funds have combined. Portfolio impact To start with, assume that we allocate 5% of the equities portion in the 60/40 portfolio to RSX. Analyzing 5 years of historical data, risk parameters of such a portfolio look as follows: (click to enlarge) Source: InvestSpy Retrospectively, such an investment would have been a real drag in a portfolio that otherwise had a stellar performance. RSX has lost 45% of its value over the last 5 years and experienced a whopping 65% drawdown. Furthermore, its annualized volatility stood at 34%, which was more than twice that of SPY. This lead to a significant risk contribution of 14% to the overall portfolio risk despite the allocation of only 5%. On the bright side, further inspection of the correlation matrix suggests that RSX has the potential to offer diversification benefits. Its correlations were 0.67 with SPY and negative 0.21 with BND (see the table below). In fact, the correlation coefficient with SPY was even lower at 0.47 over the last 12 months. Source: InvestSpy As demonstrated in this whitepaper by Salient Partners, a diversifier with high volatility is among the most powerful tools an investors has. And RSX definitely ticks the high volatility box. At the same time, it is highly unlikely that a U.S. investor would want to have 10%+ of their portfolio risk come from Russia. An investment in any Russian ETF will have 2.5-3 times higher risk contribution than its portfolio weight, thus I would not suggest a higher allocation than 2-3% of your portfolio to RSX or a related fund. One also has to bear in mind that Russian stocks will typically be included in most emerging markets ETFs and mutual funds, thus you may already have some exposure to this country. Under the hood Comparing the sector breakdown of RSX and SPY, it becomes apparent that Russian and American markets have completely different composition: RSX is largely dominated by the energy sector (43%), whilst oil & gas stocks account for only 7% of S&P 500. RSX is also heavily loaded with Materials (19%) but lacks more significant presence of companies operating in IT, health care, consumer discretionary or industrials sectors. Given that Russian stock market is so dependent on the energy sector, I have also checked how correlated to the oil price it is. Using t he United States Oil ETF, LP (NYSEARCA: USO ) as a proxy for the oil market, it turns out that over the last 5 years RSX had correlation with USO of 0.53. Although this reading does not seem exceptionally high at a first glance, I have previously shown that a coefficient above 0.5 comfortably puts RSX among top 5 single country ETFs to benefit from oil price recovery. Conclusion Russian stocks have been in a downward spiral since 2011, currently offering attractive valuations compared with other countries. RSX regained 10% in the last month and is a primary target to benefit from a potential reversal in the oil market. If the actual performance of Russian equities comes anywhere close to the returns forecast by Research Affiliates, RSX may very well be a welcome addition to your portfolio.

What Happened To Natural Gas ETFs In October?

This year has been bad for commodities, and natural gas is no exception. China-led global economic slowdown, supply glut and stronger dollar ahead of an impending Fed rate hike have been battering the performance of the energy sector. However, October was a balanced month for natural gas as it faced both the odds and advantages. Natural gas kicked off the month with an amazing performance. There were a number of factors that led to the bullish trend in their prices despite oversupply concerns. After hitting its three-year low, natural gas prices began to rise due to short covering and bottom fishing by traders. This was complemented by rebounding optimism in crude oil as many oil producing companies are also engaged in the production of natural gas. Oil price crossed its $50 per barrel mark on October 8 for the first time since July. The rally extended when consensus of a chilly winter across the eastern parts of the U.S. began to build up. Cold weather boosts demand for natural gas, which is used by around 50% of the U.S. households as the main source of heating fuel. November through March is generally considered as a peak season for natural gas when heating demand is at a high. This led natural gas futures for November contract to settle at the highest level of $2.535 per MMBtu (million British thermal units) on October 12 since September 29. However, natural gas prices retreated in the second half of October when forecast of a warmer-than-normal winter in the U.S., partly due to the El Niño phenomenon, became pronounced for the coming weeks. In the last week of the month, MDA Weather Services had predicted that heating degree days (measurement reflecting the demand for energy required to heat a building) will be 178 over the next two weeks in contrast to 199 in the same period last year. The lower heating degree days indicates warmer weather in the lower 48 states of the U.S.. The forecast of a mild weather pushed natural gas prices to its three-year low of $1.948 per MMBtu on October 27, their lowest since April 2012. This intensified concerns of a supply glut as a mild winter means lower demand for natural gas. However, the supply situation didn’t turn to be as bad as expected when the U.S. Energy Information Administration (“EIA”) released its October 29 update on natural gas inventories for the week ended October 23. The EIA report revealed a less-than-expected rise in natural gas inventories in storage, which increased 63 Bcf (billion cubic feet) to 3,877 Bcf compared to the expected rise of 69 Bcf. This led to some respite in the natural gas market as its price surged 11% from the previous day to $2.257 per MMBtu on October 29. However, concerns about a mild winter loomed yet again, beginning to dampen prices at the start of November. ETFs that follow the natural gas futures witnessed the same swings during October. Below we highlight three of them that were strongly influenced by the topsy-turvy movements of the natural gas futures during the month. United States Natural Gas Fund (NYSEARCA: UNG ) UNG tracks the movements of the price of natural gas as delivered at the Henry Hub, Louisiana. The ETF has been able to manage $487 million in its asset base and is actively traded with about 5.6 million shares per day. It charges 60 bps in annual fees and expenses. The product gained 1.3% in the first half of October but retreated 13.3% in the second half of the month. United States 12 Month Natural Gas Fund (NYSEARCA: UNL ) This fund is designed to track, in percentage terms, the movements of natural gas prices. It has garnered nearly $13 million in assets and trades in an average volume of 23,000 shares a day. It charges 75 bps in investor fees and returned 2.3% in the first half of October but lost 8.8% in the latter half of the month. iPath Dow Jones-UBS Natural Gas Subindex Total Return ETN (NYSEARCA: GAZ ) GAZ follows the Dow Jones-UBS Natural Gas Subindex Total Return Index, measuring the returns that are available through an investment in the futures contracts of the Henry Hub Natural Gas futures traded on the NYMEX as well as the rate of interest from an investment in U.S. Treasury Bills. The note is quite overlooked as it has amassed just about $7 million in its asset base while it sees average volume of roughly 27,000 shares a day. It has an expense ratio of 0.75% and returned 4.5% in the October first half but retreated as much as 25% in the latter. Original Post

Alpha Wounds: Passive Management Is Not Passive

By Jason Voss, CFA Alpha wounds are decisions made by the investment industry that hurt active investment managers. It is my belief that there is still plenty of alpha left to be harvested by discerning research analysts and portfolio managers. So far, I have discussed the deleterious effects of managing to, rather than from, a benchmark ; poor evaluative methodologies by investment industry adjuncts; and the poor diversification of the human resources portfolio at active management houses. This month I point out a fact hiding in plain sight: Passive management is not passive. One of the tremendous and rarely discussed ironies in the active vs. passive debate is that passive management is thought of as the opposite of active management. That is, it is perceived as a ship set adrift in an ocean with no compass heading and no crew. Passengers are on board and left to fend for themselves. I politely disagree. Passive management is not blind, deaf, or dumb. In fact, for every index and for every fund or exchange-traded fund (ETF) designed to track it, human choice is involved. As I have discussed before in an entirely different context, choices are actions , that is, activity. That is, we are talking about active investing. To be fair, passive investing is not exactly “active” investing. It is really more like “less active” investing. Given a) the consistent inability of active managers to beat benchmarks, and b) the fact that passive investing actually involves active choices, maybe it makes sense to see what the indices are doing, right? . . . Right? Case Study: The S&P 500 Let’s consider one very famous index, the Standard & Poor’s 500. I hope it is indisputable that the S&P 500 is among the best-known indices and hence a proxy for stock market activity in the United States. Is an index fund or ETF that tracks the storied S&P 500 truly passive? Absolutely not. Many do not realize that a small committee at Standard & Poor’s oversees and makes decisions about the index. Specifically: “S&P Dow Jones U.S. indices are maintained by the U.S. Index Committee. All committee members are full-time professional members of S&P Dow Jones Indices’ staff. The committee meets monthly. At each meeting, the Index Committee reviews pending corporate actions that may affect index constituents, statistics comparing the composition of the indices to the market, companies that are being considered as candidates for addition to an index, and any significant market events. In addition, the Index Committee may revise index policy covering rules for selecting companies, treatment of dividends, share counts or other matters.” To me this sounds very similar to a description of the activities of an investment committee at an actively managed mutual fund. Yes, there is certainly a demure, passive tone. No doubt. But there are decisions being made here. Which brings me to my next point. Perhaps active managers would be wise to examine the nature of the decision criteria made by this committee in order to improve their own results. This is especially true if, like many funds, the S&P 500 is their benchmark. Put another way: What is this committee doing so incredibly right so as to best a majority of those competing against it? Here are the criteria that the US Index Committee consider: Market capitalization Liquidity Domicile Public float Sector classification Financial viability Treatment of IPOs A list of eligible securities Additionally, there are criteria for deleting an issue. Some of the above may seem simple on the face of things, but let’s drill a little deeper. The Hidden Story Inside Market Capitalization Market capitalization is indicative of some unique characteristics of a business. For example, a large market capitalization is likely the result of a highly successful business with in-demand products, well-established markets, a strong competitive position, that is professionally managed, well capitalized financially, and for which all of these things have been true over a long period of time. Heck, it is also more likely than not that the business pays its shareholders back with share buybacks, or – gasp! – dividends. In other words, large market capitalization is a natural outcome of running a successful business. The Remedy for the Alpha Wound: Could “active” managers also consider such criteria in conducting fundamental analysis? Could active managers actually roll up their sleeves and engage in some good old-fashioned fundamental analysis? Low Turnover Like most indices, the components of the S&P 500 do not change very frequently . A review of the historical data from 2002 through November 2015 shows 69 additions (and, hence, deletions) from the index. That works out to a turnover ratio of just 1.06% [(69 changes ÷ 13 years = 5.31 changes per year on average) ÷ 500]. Compare that with the average turnover ratio of 124.6% in the United States in 2012 (the last year for which data is available), and an average of the major global equity markets of 89%. Is there any possibility of actually understanding the companies in which you have placed your investors’ cash in these circumstances? Said differently, US investors have 117.5 times the turnover of the S&P 500. Given that most of the trading is likely in S&P 500 stocks, that the turnover of the index is so low, and that active managers have underperformed, does it seem like a possible self-inflicted alpha wound? In the most positive light, this is a trading desk enrichment program. The Remedy for the Alpha Wound: Could an “active” manager perform better by reducing its turnover? Diversification Another possible lesson to be learned from looking at indices is that each of them represents a diversified portfolio within a given context. For the record, I am personally against what I and many others call “deworsification”. Forthcoming research from C. Thomas Howard, CIO of Athena Investment Management, and a brokerage firm I cannot mention quite yet, entitled Why Most Equity Mutual Funds Underperform and How to Identify Those That Outperform, demonstrates that most fund managers are horribly diversified – as in overly so. The researchers estimate that for every one-decile increase, that over-diversification subtracts 13.5 basis points (bps). Also, they estimate that for every one-decile increase in closet-indexing, that performance is negatively affected by a whopping 31.6 bps. So as managers r-squared relative to their benchmark increases, performance decreases. It is important to remember that originally indices were created not as investment vehicles, but as a way of summarizing the performance of an entire market in one number. No one is likely to have originated the idea of investing in 500 companies. One benefit of being fully invested in each component of the S&P 500 is you end up buying every winner. But you also end up buying every loser. One simple strategy, and I am surprised that it is not deployed more frequently, is to buy the S&P 500 but to conduct fundamental analysis of its components and identify the handful of firms you believe have the highest probability of performing poorly. Then either exclude these from your index-like fund or short them. The Remedy for the Alpha Wound: Could it be that active managers are hurting alpha by over-diversifying and closet-indexing? “Passive” Investing Free Passes Passive investing gets three massive free passes. First, frequently risk-adjusted returns are calculated relative to the benchmark. This means that because benchmarks are both the numerator and the denominator in such calculations, their risk is always cancelled out. This implies that benchmarks have no risk. Clearly this is bogus. What is needed is a neutral way of evaluating risk to which both the benchmark and the active manager are compared. Second, benchmark returns are always gross of fees. Yet, if you read through the S&P Dow Jones report I referenced above, you get the sense that there is a large team making these decisions. What is the expense of creating and maintaining these indices? Also, the expense of buying and selling the securities from the benchmark is excluded. Yes, the turnover is low, but for a true apples-to-apples comparison, shouldn’t these be included? As a proxy, many investment industry adjuncts evaluate index funds tracking a particular benchmark in order to estimate these expenses. This is clearly fairer to active managers. The third and likely largest of the free passes handed to passive investors is the massive momentum effects of their “buy lists.” Indices are effectively “buy” lists. For the larger indices this means that there are huge momentum effects embedded into the strategies. So passive investors benefit considerably from non-fundamental factors when their performance is evaluated. To my knowledge, there is no agreed-upon method for how to back these factors out. In conclusion, passive investing is not truly passive. It is more like less active management. Looked at in this way, it makes obvious certain innate characteristics of smart investing that “passive” investors take advantage of. Maybe active managers could learn a thing or two from these strategies. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.