Tag Archives: usmv

Best ETF Strategies To Survive Market Turmoil

This morning, US stocks are trending higher after indiscriminate and irrational selloff over the past few days. Even though things may calm down in the near term, investors are getting increasingly worried whether the 76 month long bull run is finally coming to an end. The selling was initially triggered by the surprise devaluation of the Chinese currency – which raised concerns that economic conditions in the world’s second-largest economy may be much worse than suggested by official numbers. Recent commodity rout and emerging markets slump have added to these concerns. Investors should remember that a healthy correction at times is a sign of a normal functioning market. This market had not seen a drop of 10% or more from a recent high in more than 46 months. While this sudden, steep selloff was driven more by fear than facts, it is possible that we may see more frequent declines as the Fed gets ready to raise rates for the first time in almost a decade while the economic recovery in most parts of the world remains fragile. At the same time, the US economy is growing steadily and stock valuations are not yet in the bubble territory. And while the rout started with worries over China’s economic malaise, exports to the emerging giant actually account for just 0.2% of US GDP. Amid wild rout that defies all logic, it is important for investors to stay focused on their long-term goals and not act rashly during times of panic. While it is difficult to predict whether the market has bottomed out, it is almost certain that we are likely to see more volatility ahead. Buy High Quality Assets for Longer Term Predicting stock market’s short-term moves accurately is almost impossible but stocks deliver superior returns over longer term. So, if you are an investor with a long-term horizon, then this selloff presents an excellent opportunity to buy some high-quality ETFs that are now available at deep discounts. While growth stocks outperformed till earlier this month, value stocks have delivered higher returns with lower volatility compared with growth stocks over the long term in almost all the markets studied. Ultra-cheap value ETFs like Schwab U.S. Large-Cap Value ETF (NYSEARCA: SCHV ) and Vanguard Value ETF (NYSEARCA: VTV ) are excellent choices for long-term focused portfolios. Also consider adding some low volatility ETFs – like SPDR S&P Low Volatility ETF (NYSEARCA: SPLV ) and iShares MSCI Minimum Volatility ETF (NYSEARCA: USMV ) – to the portfolio. These not only shine during highly volatile market environments but also deliver superior risk adjusted returns over longer term. Stay Diversified As stocks plunged, nervous investors piled into the so-called safe haven assets, particularly Treasury bonds, sending the yield on the benchmark 10-year Treasury note below 2% for the first time in about four months. Investors with well-diversified portfolios were obviously less impacted than those with all stocks holdings. Bonds still deserve a place in portfolios even as the Fed is on track to lift rates sometime in the coming months. Treasury bonds – in particular longer term – may continue to benefit from heavy buying by foreign investors, as long as interest rates remain ultra-low in Europe and Japan, the U.S. dollar continues to strengthen and long-term inflation expectations remain benign. Shorter-term yields may however rise in anticipation of Fed funds rate hike and thus the trend of yield curve flattening may continue this year. Take a look at iShares 10-20 Year Treasury Bond ETF (NYSEARCA: TLH ) or Vanguard Long-term Government Bond ETF (NASDAQ: VGLT ) or other cheap longer-term Treasury bond ETFs. Similarly, a mix of cyclical and defensive stocks is essential for a core portfolio. My favorite ETFs are low-cost sector ETFs – Vanguard Technology ETF [(NYSEARCA: VGT )- ETF report ] and iShares Healthcare Providers ETF (NYSEARCA: IHF ), among others. Things to Know before Investing in Inverse/Leveraged ETFs If your losses are making you very nervous during times of steep declines, then it may be a better idea to add some hedging to the portfolio rather than bailing out of stocks completely. Leveraged/Inverse ETFs-like ProShares Short S&P 500 ETF (NYSEARCA: SH ), ProShares UltraShort S&P500 ETF [(NYSEARCA: SDS ) – ETF report )] and ProShares UltraPro Short S&P500 [(NYSEARCA: SPXU ) – ETF report )] can be effectively used by investors for short-term market timing or hedging purpose during selloffs. However, investors should remember that “timing” the market is never easy and should be prepared to monitor their positions closely and exit their short positions in case the market goes up. Please note that these ETFs are typically designed to achieve their stated performance goal on a daily basis. The performance of leveraged ETFs, if held for longer than a day, is path dependent. That means not only the level of the index at the end of the holding period, but also how the index got there will determine the performance of these ETFs. In trending markets with low volatility, compounding works in investors’ favor and hence there should be no harm in holding these instruments for longer periods. However, if the underlying index sees high volatility, compounding will work against investors and eat into returns, producing high tracking errors. Further if the index tracks a limited number of entities and/or faces contango risks, then it is safer to hold these positions just for a few days. The Bottom Line Investors should remember that patience and diversification are keys to long-term investing success. And, while it is impossible to predict which way the market will turn in the next few days, the overall outlook for US-focused stocks remains favorable in the medium-term despite global concerns. It is important for investors to stay focused on their long-term goals rather than fixating over short-term market moves. Original Post

Top 5 Smart Beta FAQs

In the first half of 2015 we’ve seen many of our smart beta predictions fulfilled. In particular I’m glad to see that there is more consensus around the definition of smart beta, with investors growing more comfortable with the investment strategy that captures aspects of both traditional passive and active investing. However, we are far from the Smart Beta Promised Land. In the meantime, here are a handful of questions I get most often from investors-so I thought I’d share my answers with you. Why is smart beta the topic du jour? Given the prolific attention on smart beta (in the United States alone, the term “smart beta” was searched an average of 7,500 times per month in the past year on Google), you’d think that smart beta is the shiny new bike on the block. We’re the first to admit that many of the concepts behind smart beta are not new – the idea of seeking inexpensive companies (Value investing) or high quality balance sheets (Quality investing) have been part of the active management toolkit for ages. What’s getting everyone’s attention is the ability to capture these potential sources of return in a low cost and transparent form – and we all like the potential to get more for less. How should I choose a smart beta strategy? There are lots of types of smart beta available these days, so the strategy you choose should be driven by the outcome you are trying to achieve. The best forms of smart beta are deliberate and transparent in the exposures they deliver, making it easy for investors to determine what’s under the hood. However not all smart beta strategies deliver “pure” exposure, so being mindful of any unintended risks lurking in the portfolio is always a good idea. Skilled implementation is also critically important. Most smart beta strategies have a higher level of turnover than traditional market cap-weighted indexes, and a slightly less advantageous liquidity profile. Without a skilled portfolio management team in place, transaction costs and tracking error may quickly begin to erode the potential benefits of a smart beta strategy. Smart beta providers talk a lot about transparency. Why is that important? Transparency is a defining attribute of smart beta strategies. Like traditional index strategies, smart beta strategies follow pre-set rules to determine the process for security selection, portfolio construction and rebalancing. Often those rules are published by a third-party benchmark provider. That means investors should have full knowledge of construction rules and portfolio characteristics, enhancing their ability to make deliberate allocations and build more diversified portfolios. Smart beta ETFs have yet another layer of transparency in that daily holdings are publicly available. One thing to note: Those pre-set rules stay set. Those rules have no knowledge of and make no adjustments for changing market conditions. Where would I implement smart beta into my existing portfolio? Many investors struggle to think about how to add smart beta strategies to their existing portfolios. Conceptually it is really no different than blending traditional passive and active strategies. Many smart beta strategies are designed to seek incremental returns. Others provide the potential for less risk (some do both, but let’s start with the simple case). A return-seeking strategy like the iShares® FactorSelectTM MSCI USA ETF (NYSEARCA: LRGF ) can complement traditional active and passive investments as a potential source of incremental return. In contrast, a risk-mitigating strategy like the iShares MSCI USA Minimum Volitility ETF (NYSEARCA: USMV ) can complement your traditional investments as a way to seek potential downside risk protection. Quantifying your desired outcome, such as an after fee incremental return goal, or a certain decrease in max drawdown, can further refine the asset allocation decision. Is smart beta just equities? There are many forms of equity smart beta, but we can apply this way of thinking to any asset class. One of the things I’m most excited about is the work we are doing in fixed income smart beta. As I wrote in my previous post discussing the iShares U.S. Fixed Income Balanced Risk ETF (BATS: INC ), there are many opportunities for smart beta to re-write the rules of fixed income investing. Original Post

The Low Volatility Debate: SPLV Vs. USMV

Summary The Low Volatility Anomaly describes portfolios of lower volatility securities that have produced higher risk-adjusted returns than higher volatility securities historically. Two ETFs – SPLV and USMV – have amassed $5B apiece in assets under management seeking to capitalize on this anomaly. This article discusses the relative differences in how these funds are constructed and how these discrepancies can impact their respective risk-return profiles. I recently reprised my series on five buy-and-hold strategies that have historically produced better absolute and risk-adjusted returns than the broader market. The third of these five strategies was about the Low Volatility Anomaly, or why lower risk stocks have historically outperformed their higher risk counterparts. A reader in the comments section of the article asked why I preferred the Powershares S&P 500 Low Volatility ETF (NYSEARCA: SPLV ) over the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). Given the increasing popularity of low volatility strategies, I thought that this would make an excellent topic for Seeking Alpha Readers. (For readers looking for a primer on Low Volatility Strategies prior to delving into a review of the top two domestic fund choices, please reference the links in the article or read Making Buffett’s Alpha Your Own .) What are the differences in the strategies? Given that these are both passive funds seeking to replicate the returns of an index, the answer to this question will be driven by the differences between the two benchmarks. SPLV seeks to replicate the S&P 500 Low Volatility Index, which is constituted by the one-hundred least volatile stocks in the S&P 500 (NYSEARCA: SPY ) as measured by the standard deviation of the security’s daily price returns over the trailing year and rebalanced quarterly. In contrast, the MSCI USA Minimum Volatility Index is calculated by optimizing its parent index the MSCI USA Index for the lowest absolute risk subject to constraints to maintain replicability, investability, and to limit turnover and industry concentrations. What have the risk and return profiles of these indices been historically? Below is a cumulative return series of the two indices since the earliest dually available data points. You can see that the S&P Low Volatility Index has outperformed by 55bp per annum. (click to enlarge) Drilling down further into these index return series, I have tabled some summary risk and return statistics for the return profiles of these two indices. In addition to higher cumulative returns over the matched sample period, the S&P 500 Low Volatility Index had lower variability of returns and a smaller peak-to-trough drawdown. The underlying indices are of course uninvestable, with the exchange-traded funds seeking to replicate these index returns the best way for retail investors to follow these strategies. Respectively, the ETF tracking these indices have only been outstanding since May and October 2011. It is difficult to determine the efficacy of either strategy in a market characterized by such strong returns over the short life span of these funds. I have graphed the cumulative returns of these ETFs since USMV’s later inception below: (click to enlarge) While the index data is necessarily backcasted, I believe that the longer time series for the indices, which featured three economic recessions and two large stock market drawdowns, is more informative than the history of the exchange-traded funds, which have existed only during a historic bull market. I hope that this analysis is valuable to Seeking Alpha readers interested in low volatility strategies but who might not have access to the historical return data. How does the composition of these two funds differ today? Despite the very strong correlation noted in the historical return series above, the composition of the two indices is quite unique. I examined the industry concentrations, top holdings, and index fundamentals in this section. Industry Concentrations The MSCI USA Minimum Volatility Index constraint to keep sector weightings within 5% of the market-weighted index gives it a more diversified set of industry exposures than the S&P Low Volatility Index, which is industry agnostic and formed from the one-hundred stocks in the S&P 500 with the lowest realized volatility. Readers likely share my surprise that financials dominate the Low Volatility Index. Also of note, utilities, traditionally a defensive, low beta industry, are under-represented. When I wrote about Low Volatility Stocks in mid-2013 , utilities represented more than a quarter of the Low Volatility index. You can bet that the Low Volatility Index was relatively underweight financials prior to the financial crisis as rising return volatility would have seen these stocks excluded from the portfolio. An industry-agnostic tilt towards lower volatility stocks is likely what caused the relative outperformance of the Low Volatility Index relative to the Minimum Volatility Index through the stock market slump in 2008- early 2009. Top Holdings There is some decided overlap between the top holdings, but the interesting part of this chart is less about how they are similar but rather how they are different. Despite the USMV index having 64% more holdings (164 vs. 100), it is still slightly more concentrated in its top holdings. Because the index weights of SPLV are the inverse of their trailing one-year volatilities rebalanced quarterly, the fund is much more close to equal-weighted because stock volatilities are likely to be less divergent than a capitalization-weighting. Like low volatility strategies, equal weighting is also one of my five factor tilts that have historically produced higher risk-adjusted returns than the market . Readers should also note that Exxon Mobil (NYSE: XOM ) is in the top ten holdings of USMV whereas no Energy stocks are included in the one-hundred constituents in the S&P Low Volatility Index. Falling oil prices have led to more volatile returns in that space, excluding those stocks from the Low Volatility Index. USMV is required to maintain an Energy exposure to keep the index from deviating outside of its industry band with the parent index. Exxon and its fortress balance sheet represent a whopping 48% of the Energy sector weight for USMV. Index Fundamentals The average index fundamentals are relatively similar. Lower volatility stocks currently trade at incrementally higher multiples than the market, and their more steady business profiles lend to higher dividend yields. Multiples throughout the market are stretched, and investors should be asking whether the premium multiple in low volatility stocks is attractive given their higher downside protection. Some might counter that it is a valuable feature while others might contend that this downside protection is now priced too expensively. I remain in the former camp. As I wrote in my 10 Themes Shaping Markets in the Back Half of 2015 : “Stretched equity multiples domestically will necessitate that valuations be driven by changes in earnings, tempering further price gains. As equity prices rise, investors may look to opportunistically rotate into underperforming rate-sensitive assets and lower volatility assets.” Conclusion For me, the S&P Low Volatility Index’s construction is a simple and transparent way to access a low volatility bent. I am not seeking to minimize volatility, but generate higher risk-adjusted returns, which the S&P Low Volatility Index has done historically versus both the broader market and the MSCI USA Minimum Volatility Index. There are certainly cases to be made for USMV. The replicating ETF is lower cost (15bp to SPLV’s 25bp), and has more constituents and less industry concentration. This greater diversification has not led to lower risk however in the historical study. You want to be incrementally overweight more defensive industries as markets are correcting. In a great 2011 paper, ” Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly “, the authors concluded that behavioral biases towards high volatility stocks coupled with delegated investment management with fixed benchmarks without the use of leverage flattens the relationship between risk and return. If benchmarking is an impediment to capturing the Low Volatility Anomaly, why would I want my Low Volatility fund exposure to have more rigid industry constraints. Since the S&P Low Volatility Index is less constrained, its industry concentrations can swing meaningfully. I discussed previously the sharp reduction in utility exposure, which has likely been a function of that sector’s greater interest rate sensitivity and a pickup in interest rate volatility. Investors may look at the current higher allocation of utilities in USMV or lower allocation to financials and determine that industry mix is preferable to them. In analyzing the funds in this manner, they can be viewed more as complements than substitutes. Both of these funds have their merits, and I applaud the fund families’ efforts to provide low-cost solutions to retail investors seeking to capture the Low Volatility Anomaly. Hopefully, readers now better understand the differences in index construction and how that manifests into different risk-return profiles Author’s Postscript As an aside, this article was prompted by reader feedback. Intelligent discussion and debate is what transitions Seeking Alpha from a collection of articles into a community. Please share your thoughtful observations that you believe could further this research as we all try to “Seek Alpha” together. Disclaimer My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long SPLV, SPY. (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.