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Friday, May 29, 2015

Market Timing ...The Crowd Makes It Impossible for The "Experts",,,Or Anyone Else

At the Research Affiliates blog they posted a great article entitled

Calling the Turns: Why Market Timing Is So Hard

My takeaway. "Expert " analysts have so little success in timing markets because market prices are controlled by investors (certainly not confined to individual investors( who make decisions based on factors other than financial analysis. What an expert would call an overvalued market is simply not a determinant of how most investors make decisions, and those "uninformed" investors make their decisions based on other factors. And the most important factor not surprisingly is recent market performance.

Academic research and simple market observation shows that such behavior creates a momentum factor. We know it exists but it is very difficult to profit from (by knowing when to buy or sell) in excess of buy and hold. Most technical analysis is based on momentum. And much to the chagrin of academic economists a simple 200 day moving average has a fairly good record for giving market buy/sell signals.

From the article

The Market in Theory
The standard model of investment management equips portfolio managers and traders reasonably well to determine if an individual stock is fairly valued. Most investment professionals use discounted cash flow (DCF) analysis to estimate a stock’s inherent worth,3 and so to judge whether it is mispriced. With a handle on a stock’s true value, an investment professional can also observe the extent to which the market may have mispriced it. Similarly, by comparing the market’s current cap-weighted price/earnings to the long-term average, analysts can judge whether, and by how much, the market as a whole is misvalued. 

But DCF analysis, P/E multiples, and other theoretically sound valuation measures cannot tell us how much more misvalued the market will get nor can they explain the wild swings we’ve experienced in the two equity market cycles in the last 15 years.4 As Figure 1 illustrates, the stock market seems to go too far in both directions—up and down—and the amplitude of these movements cannot be satisfactorily explained within the cool analytical framework of the standard model. 

Empirical research has established that sooner or later stock prices revert toward their long-term averages. There is also strong evidence that the value premium is mean reverting (Hsu, 2014). If the market rises or falls to an extreme level despite a natural tendency to self-correct, then countervailing forces must be at work. .....

What are those countervailing forces ? Some insights from two Nobel Prize Winners in economics Daniel Kahneman and Vernon Smith neither of them believers in the efficient market theory which would argue markets are always rational:

One hypothesis is that many market participants view mental effort as an avoidable transaction cost. Disinclined to gather and analyze solid information about the stocks that interest them, they are carried along by the crowd, trading on momentum and noise. 

In addition to this kind of indolence or inertia, Daniel Kahneman and others have described a number of cognitive biases and patterns of emotionally charged behavior that affect individuals’ choices under uncertainty—the selling and buying of securities being an excellent example of such an activity. They include overconfidence and the illusion of control,5 mental accounts, availability cascades, loss aversion, overreacting to news, and herding, among others
Smith, the experimental economist who shared the 2002 Nobel Prize in Economic Science with Kahneman, distinguishes between constructivist and ecological rationality. The former involves the intentional use of reason to analyze the given and to advocate a course of action. (The standard model of investment management is a sterling product of constructivist rationality.) Ecological rationality, in contrast, emerges in institutions, such as markets, through human interaction rather than by human design. 

“Predominantly,” Smith  writes, “both economists and psychologists are reluctant to allow that naïve and unsophisticated agents can achieve socially optimal ends without a comprehensive understanding of the whole, as well as their individual parts, implemented by deliberate action.” But in Smith’s account, personal exchanges gave rise to impersonal markets which serve to facilitate the specialization that creates wealth. Smith demonstrates that in a diverse set of circumstances, such as the airlines’ response to deregulation, FCC spectrum auctions, and a variety of trust games, the interaction

Is all lost for the rational knowledgeable investor ? The author indicates that some use of tilting towards owning low valuation stocks has potential for outperformance or at least better risk/return. And the evidence of long term outperformance of low valuation to high valuation stocks is strong. But it should be noted that the folk at Research Affiliates have developed such strategies for several mutual funds and ETFs,:

At this juncture, we must acknowledge that financial theory does not provide clear and timely trading signals. Calling the turns is hard because we don’t have a mechanics of mean reversion. Our best theories—including behavioral finance, neuroeconomics, experimental economics, and evolutionary psychology—do not enable us to foresee the sudden exogenous shock that will trigger a reversal, or to sense when a gradual change in investors’ attitudes will reach the tipping point. Not even the most skilled and experienced asset allocators can pinpoint in advance the onset of a reversal. Most of us are well advised not to attempt market timing. The soundest plan is to choose a strategy that suits our investment objectives and risk tolerance—potentially including a disciplined smart beta strategy that systematically rebalances over time—and to stick with that choice for the long term.   

More Performance Chasing ...This Time in the Hedged Europe ETF ?

Currency hedged ETFs such as HEDJ have been the hot investment of the past year even earning's "ETF of the Year" for 2014.

Not surprisingly much of the money flowing in is performance chasing. So I wasn't at all surprised to read this after the dollar reversed some of its gains in the early part of of May.


Asset inflows into the two most popular ETFs of 2015, the WisdomTree Europe Hedged Equity ETF (HEDJ | B-54) and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF | B-72), slowed to a trickle this month, due largely to unexpected softness in the dollar.

HEDJ has gathered only $2 million in fresh net assets so far this month, while DBEF has raked in $137 million. These flows have come after HEDJ added $13 billion in net assets in the first four months of the year and DBEF $9 billion

And as is often the case the timing seems terrible. HEDJ (chart belwo) is up 3.4% since May1 as the dollar has resumed its rally against the Euro

Thursday, May 28, 2015

Is the US Stock Market Expensive...and Emerging Markets Cheap ?

I have written many times about the Shiller CAPE ratio developed by Nobel Prize winning economist Robert Shiller. Although as Shiller himself acknowledges it is not a market timing vehicle..but as seen below high CAPE markets tend to have low future returns.

By CAPE the US market is at high valuations. Shiller has characterized it as high but not in "bubble territory". And since that CAPE has been above long term average for several years investors using it as a timing vehicle have missed quite a bit of the US market rally.

But given that high CAPE over the long term produces low returns and vice versa it is useful to look at relative CAPE around the world. Below is CAPE for the US and emerging markets. Emerging markets are well below long term average the US is currently  (as of May 28) at 27.3 which is 64.5% above its long term average. At gurufocus the Shiller P?E is updated daily.

This article is written by Burton Malkiel famous for the Random Walk on Wall Street classic. It includes  the graphs below and argues with this and other measures for a significant weighting in emerging market. The article appears from wavefront capital management and at the end advocates a quite complicated investment strategy using options....not something at all recommended in the book.

At the Research Affiliates website you can run CAPE ratios for a large number of countries.
Germany is slightly abover average CAPE . China, India, Japan are below long term average and Russia and Brazil at current CAPEs quite significantly below long term averages.

Those Go Anywhere Bond Funds...You REALLY Don't Know What You Own

I have written before that "go anywhere" or "unconstrained" bond funds are essetially bets on the "genius" manager. Bill Gross once manager of the (then) world's largest bond fund Pimco Total Return Fund ran into a period of poor returns which (predicatbly) let to outflows from the fund and his subsequent departure from the firm.

He landed at Janus Capital with a new fund. And he continued his style of making many bold statements which seemed to indicate how he was positioning his fund.

In April with the yield on 10 Year German Government Bonds (BUNDS) trading at the rock bottom yield of .10% Gross tweeted and spread the word all over the media that going short Bunds was the trade of a lifetime". Such a short would profit from a rise in German rates (fall in price). Sure enought rates on the bonds rose to .64% over the next month.

Following those pronouncements by Gross investors in his Janus Global Unconstrained Bond Fund would likely have been expecting the fund to rack up some nice gains as a "short position in the Bunds would have been quite profitable.

It didnt turn out that way. As Bloomberg reports

Bill Gross acknowledges doing a poor job of implementing his recommendation to bet against German government bonds.
“My famous (infamous?) ‘short of a lifetime’ trade on the German bund market was well-timed but not necessarily well-executed,” Gross wrote in his June investment outlook for Janus Capital Group Inc. “Still, it was a prime example of opportunities hatched by the excess of global monetary policy.”
Gross, who runs the $1.52 billion Janus Global Unconstrained Bond Fund, advised selling short the 10-year German bund on April 21, when it yielded about 10 basis points, or 0.1 percent. Over the next month, yields climbed to 64 basis points as prices fell, vindicating Gross’s prediction. Yet his Unconstrained fund lost 2.5 percent in that period as he wagered German bunds would trade in a narrow range instead of betting all-out against the debt, data posted on Janus’s website show.
Looking at the graph below one can only imagine the frustration of an investor who invested in the Janus fund based on faith in Gross' portfolio management skills. The public market call he made was nearly perfect...yet he didnt make money on the trade. "Poorly executed" is  perhaps an understatement
10 Year German Government Bond (Bund) Yield
Gross explains his trade and his view on the markets in an interview here

Performance Chasing in Emerging Markets ...Again ?

. Last week, EM equity exchange traded funds garnered $1.2 billion in investor assets.

Chart of IEMG Ishares emerging markets ETF:

Wednesday, May 27, 2015

Market Capitalization vs. "Economic Footprint"

Yesterday's blog entry on the larger weighting in the future for Chinese stocks points out one example of the disconnect between country weightings in the major indices and what I call the "economic footprint" of countries: their weight in the world economy.

China is the most extreme example of the disconnect between the capitalization weighting and economic footprint but there are others. Since the capital markets of emerging market countries are less developed the number of their companies that are publicly held and thus included in equity indices is small.

Here is an example here are the weights in the MSCI all world capitalization index

And here is the list of countries based on % of world GDP

United States
United Kingdom
Russian Federation
Korea, Rep.

And here is one estimate of what the world economy will look like in 2030

Looking at these numbers one would not be surprised in the future to see a growing share of the worlds market capitalization coming from China and India and other emerging markets and less for the developed markets of Europe as the world stock market weightings more closely match the "economic footprint" of countries.

I came across this chart which although a bit difficult to follow at first gives a very interesting perspective on past and possible future

Another Positive For Chinese Stocks for Overshore Investors

Should the strengthening trend of the Remimbi continue of accelerate any investments in Chinese stocks will gain in local currency value even if the stock market is unchanged or falls less than the exchange rate goes up. Such would be the case for US investors invested in a US Etf of Chinese stocks.


May 26, 2015 6:07 pm

China currency is ‘no longer undervalued’, say


The International Monetary Fund has declared that China’s currency is “no longer undervalued”, marking a significant shift after more than a decade of criticism of Beijing’s tight management of the renminbi.
The move amounts to a major vote of confidence in Beijing and the renminbi at a critical time. It also puts the IMF at odds with its biggest shareholder, the US, which insists that China continues to draw an unfair trade advantage from a renminbi that it considers “significantly undervalued”.

This a further step towards the Chinese currency becoming part of the IMFs SDR  giving it the status of a reserve currency, 
This article explains the implications in more detail.

A rough comparison in terms of market impact would be similar to the changes described in my earlier post on the changes in the weighting of Chinese stocks in major indices.....multiplied by hundreds of millions measured in $.

With the remimbi part of the SDR(think of it as an "index of reserve currencies" and its status as a reserve currency Central Banks around the world will need to hold Remimbi in their currency reserves ...reducing their weighting in Yen $ and Euros. It would be hard to see this as not increasing the value of the Remimbi. Another positive trend for foreign investors in Chinese stocks.

Tuesday, May 26, 2015

Major Changes Coming for Chinese stocks

I wrote in November about the major changes in the structure of the Chinese capital markets. The “stock connect” made Chinese onshore “A shares” more accessible to investors and opened up a new flow of demand.  Since then the ETF which invests in A shares ASHR has risen since then and Chinese stocks have had a huge rally this year.

 The A shares  ETF ASHR is up 83% since the initiating of stock connect last November (chart below) MCHI the ETF based on the current MSCI china index is up 26.6%

I have observed in the past that the “economic footprint” of many countries is far larger (% of world GDP) than their weight in market capitalization indices. This is because the indices reflect the number of publicly traded companies in those markets. China is currently 15.4% of world GDP but only 2.95% of the MSCI global stock index.

 Further complicating the weighting of Chines stocks in indices is the different classes of Chinese shares. Among them A shares which trade on the mainland (and became more widely available through stock connect.) H shares traded in Hong Kong and N shares traded in the US market (like the recently publicly issued Alibaba).

Up until now the most widely used indices for emerging markets the MSCI index and the FTSE Russell indicess have not included N or A shares.

The same is the case for ETF MCHI based on the MSCI China index.

This change can potentially produce significant increase in demand. The reconstruction of most indices impacts market prices although usually before the actual date when the reconstruction takes place.

One of the 2 major index providers FTSE Russell has just announced a transitional index to include Chinese A shares. which will make up 5% of the index 

As the article notes:
When and how to include China A shares - yuan-denominated shares listed on the Shanghai and Shenzhen stock markets - has been a major challenge facing global index providers. Inclusion in benchmark indexes could pour billions of dollars into China stocks over time.

Over time the impact of the changes in the index will be dramatic:
The indexes will be called FTSE Emerging inclusion indexes, and will have an initial weighting of 5 percent for China A shares. That will rise to 32 percent when the shares become fully available to international investors.

When taken together with other types of China shares including those listed in Hong Kong, Chinese shares would then account for 50 percent of the emerging markets index, FTSE Russelll said.

The much larger index provider.. MSCI is making changes in its treatment of Chinese stocks as well. Currently only Chinese shares traded in Hong Kong (H shares) are included in the index.

The inclusion of the N shares will take place in 2015. An announcement on the inclusion of A shares will take place on June 9 and would likely take place in 2016. Either of these changes will be implemented gradually to lessen the impact on trading.

The addition of A shares to the other categories of Chinese shares in the index will increase the China weighting in the emerging markets index from 19% to 28%. It will also impact the overall world and world ex US indices (to a lesser extent) and the Asia Pacific and Asia Pacific ex China (to greater extent ) compared to the emerging market overall index.

From an article that initially appeared in the Hong Kong Economic Journal May 18

MSCI index is a widely-used index for global money managers. More than 90 percent of global institutional asset managers use the index in North America and Asia. There are 5,719 funds tracking MSCI index, with total assets of US$3.7 trillion.
Given this situation, inclusion of A-shares will lead to substantial capital flow into Chinese stocks.
According to some analysts, the capital inflow effect will remain pronounced even if the A-shares inclusion takes place in 2016. By mid-2017, Chinese equities will account for 30 percent of MSCI Emerging Markets Index plus existing Chinese stocks in the US market. That would bring additional US$30 billion capital for Chinese equities, and US$17 billion capital inflow for A-shares.
The most conservative case would bring in over US$1 billion for A-shares. Capital flows could get a further boost as Dow Jones & Co. is also said to be mulling an inclusion of A-shares in some indexes.
In fact, many global institutional investors are seeking to adjust their portfolios, with some shifting from zero allocation to balanced allocation for Chinese stocks.
There is half chance for inclusion of A-shares this June, but the inclusion may actually take place next year. This is prompting global investors to take a fresh look at A-shares.
Of course there is no way to precisely gauge the future impact. But the change is significant and should affect markets for a considerable time in the future. For those that own international and particularly emerging markets ETFs it is definitely something important to monitor.
I have noted before that I don’t think emerging markets as an asset class make sense as a way to look at the financial markets and asset allocation. I have noted that in my view the prospects for emerging Asia look more positive than those for other countries in the index. This move will shift the country weightings in the overall emerging markets into the higher weighting in emerging Asia.

ASHR the Chinese A shares ETF is up over 9% since May 15 through May 22 and up another 4.5% as of mid morning May 26...could that be related to the news items cited above ?

I Always Find This One Interesting Stocks Get Far Less Risky as The Holding Period Increases

Although many academics use standard deviation as a measure of is pretty much useless for most investors. The first question they want answered is how much can I lose ? and the second far less important one is how much can I make ?

I run this graph periodically and it almost always surprises people. The risk of owning stocks based on historical data dramatically drops as the time frame lengthens as can be seen in the data below.
There has not been a 15 year period in which stocks generated a negative return and there has not been a ten year period in which a simple blend of 60% S+P 500 and 40% total US bond market has generated a negative return

Data below expressed in annualized return

Friday, May 22, 2015

Are BRICs an Asset Class...Do They Have Anything in Common ?

I have argued many times that BRICs (Brazil,Russia, India, China) is not a useful asset class for investment allocations due to the great diversity in their economies. I have argued the same for Emerging Markets overall as Latin American countries and Russia have little in coming with Emerging Asia particularly the largest countries in that group: India and China.

I cam across this first chart on growth forecasts from the they say pictures speak louder than words.

Interestingly Emerging Asia has significantly outperformed the overall emerging markets index since 2011 (second graph below)

Thursday, May 21, 2015

More On The Israeli Stock Market: Record Highs.....But A Market in Crisis ?

Despite reaching a new all time high, the Israeli stock market continues to have the issues described in my previous post on the subject.

The English Haaretz in a translation of an article in its partner Hebrew business newspaper the Marker noted the following with regard to the record high. Israeli stock market.

Five reasons Israeli stocks have surged to record highs

With bond yields tiny, global stock markets climbing and the Israeli economy solid, why wouldn’t shares shine?

1. Zero interest rates for bonds
2. Stock indexes don’t necessarily overlap with economic glitches:
Many companies on the TA-25 are tied to events in overseas markets, not in Israel. For example, the biggest gainer so far this year is drug and diagnostics firm Opko Health. The stock, a very volatile one, has surged 71% this year.....

As far as the companies I labelled "pure Israeli companies":

Shares with a closer link to the local economy — such as those for banks, food makers, retailers, supermarket chains and communications companies — have risen much more moderately this year.
The TA-75 index, probably a better representative of the Israeli economy, has risen only 8% this year, half the TA-25’s performance. In fact, over the past 12 months, the TA-75 is down 4%.
Some stocks have been gradually slipping in tandem with their companies’  profits, such as Israel’s largest supermarket chain Super-Sol, cellular providers Cellcom Israel and Partner Communications, and Alon Blue Square, which owns Israel’s second largest supermarket chain, Mega
3. The economy is solid
4. Investors smile on right-wing governments
5. Records on global stock markets
The Tel Aviv Stock Exchange is always influenced by what happens elsewhere around the world, and elsewhere around the world most stock markets are near record highs, or at least are rising nicely.
An article in the Hebrew the Marker pointed out that the record high was not much of a headline or a subject of conversation and in fact the Tel Aviv stock exchange is in a crisis. one that intensifies each years and shows no sign of reversing
Some of the reasons cited 
Despite the growth of pension money it will be difficult to invest the money estimated at NIS 70 billion (approximately 18 billion) each year from new contributions and maturing bonds. Interestingly the estimate is that the allocation is as follows 60% Israeli govt bonds 15% outside of outside of Israel and 35% in corporate bonds or stocks of Israeli companies. Interestingly this means out of the funds not invested in govt bonds 42% is outside Israel.
But the article notes it will be very difficult to invest that pension money because of the poor liquidity and lack of new issues on the Tel Aviv Market.

Reasons cited for the crisis in the Israeli market are noted below, All of these problems form a vicious cycle the more they accelerate the worse they get and each one is related to the other.

  • Complex regulations

  • Low Level of activity. While it may sound counterintuitive to some all markets need a significant number of short term traders to provide liquidity and thus ease of execution by long and short term participants. The decline in volume from domestic speculators is related to the boom in speculative activity in real estate.

There also has been a massive decline in institutional investors from abroad since 2009. At that time MSCI moved Israel from the emerging to developed markets indices which significant reduced the value of Israeli stocks present in global indices. This means both index instruments and investors benchmarked against an index would have less demand for Israeli stocks .From a Bloomberg article in 2013

Three years later, the reclassification is looking like a disaster. Before 2010, Israel accounted for 2.7 percent of the now $7 trillion MSCI Emerging Markets Index, giving it an outsized share of investor money allocated toward developing economies. Now, it makes up just 0.2 percent of the MSCI World Index, which has a cumulative market value of more than $33 trillion, according to data compiled by Bloomberg.
The change has forced Israeli companies to compete with those from the U.S., Europe, and Japan for fund managers’ attention and money. Since 2010, trading volume on the TASE is down about 45 percent. Initial public offerings have dried up, and big companies are choosing to delist or list elsewhere. “We went from a significant place in a market we wanted to move from to no-man’s land,”
Israeli companies want to raise money abroad: The small size of the market and lack of liquidity make the Israeli market less attractive to investors. As a consequence it is an unattractive market to raise capital. Israeli companies choose to go public in the large liquid markets in the US. The large multinational corporations most attractive to investors large and small are on the US exchange. This leaves the Tel Aviv market to what I call purely local Israeli companies such as local retail chains which are tiny in size and capitalization and unable to raise capital on the global equity market.

  • The trend of larger companies looking outside of Israel continues to intensify :67% of Israeli  companies raising capital between 2012 to 2014 (23 in total)did so outside of Israel raising   NIS 9 billion ($2.37 billion) while  the 5 companies raising funds inside Israel  companies raised  raised NIS  1.4 billion ($367 million)

Left chart number of companies issuing on Israeli capital markets (blue stocks grey bonds) center chart % if companies issuing securities outside Israel (gold) inside Israel (blue) right chart number of companies trading on Israeli market

The article's analysis doesn't see any reasons the above trends will reverse if anything they will likely grow. With the pension funds of Israelis constrained to invest in Israeli corporate bonds and stocks despite the problems described above, individual investors might be advised to review market conditions before deciding to add their non pension money to this market

Tuesday, May 19, 2015

The WSJ on the Future For the Euro

WSJ May 18

Euro’s Surge Tramples Parity Predictions

Investors see potential for further short-term gains

WSJ May 19:

Euro Slumps After Official Says ECB Will Front-Load Stimulus

European Central Bank could launch greater-than-expected stimulus in May and June

The euro fell hard against the U.S. dollar Tuesday, while European stocks and bonds surged on the prospect of the European Central Bank ramping up its asset-purchase program in May and June.
By late afternoon, the euro was down 1.6% against the buck on the day at just over $1.11, after the ECB published comments delivered by board member Benoît Coeuré saying the central bank would moderately front-load purchases in its bond-buying program in anticipation of less market liquidity in the summer.

Tuesday, May 12, 2015

I Live in Israel..Should I Own Only Israeli Stocks ?

The answer is a resounding no….which is the case for an investor in the Unites States, Germany. Hong Kong or Brazil if the issue is whether to invest only in home country stocks…but is even more the case for those living in Israel. Given the small size of the Israeli economy and domestic market and the fact that the most successful Israeli companies are global companies with their stocks largely traded on the US markets…the argument against holding a significant part of investment portfolio in Israeli stocks is even stronger. That is certainly the way insurance companies and other institutional investors set their stock allocation the number that invest 100% in their domestic market is quite small.

·         All investors should have global diversification(see wsj here). It is abundantly clear that we are in a global economy and investing in just a small part of it doesn’t make sense. Investors around the world suffer from a “home country bias” investing the overwhelming part of their portfolio in their home country and missing the benefits of global diversification. Even for US investors living in the home of the world’s largest economy and capital market experts recommend holding between 20 -30% of one’s portfolio outside of the US. And the US market represents just under 50% of the worlds market capitalization Israel represents .30% of the world's stock market capitalization. This means an investor invested 100% in the Israeli stock market holds only .30% of the stocks available for investment globally.

Now to the specific case of the Israeli investor where the case for the overwhelming amount of one’s stock holdings outside of Israel makes sense.In fact Israeli pension funds which hold 60% of their assets in Israeli government bonds invest over 40% of their non government bond assets outside of Israel.  

·         First off …what is a “truly Israeli company ?  Israeli is a tiny economy but home to many successful corporations. Many of these are world class corporations…but to call them what I would designate in this article as “truly Israeli companies” would be a misnomer. They are global companies some headquartered in Israel (and many not) with operations around the world. The overwhelming percentage of their sales and operations take place outside of Israel and their economic performance  is contingent on factors in the global economy and trends in their industry, not the Israeli economy.

In fact most of those companies are either not listed at all on the Tel Aviv stock exchange or are “dual listed” on one of the US exchanges as well as the Tel Aviv exchange. It is the US stock exchange where the trading takes place and the global stock price is established…and it is a price in dollars even if it appears in Israeli shekels on the Tel Aviv Stock Exchange.

A glance at the current financial news illustrates the point above. Two multinational Israel pharmaceutical companies Teva and Perrigo are in a battle over Mylan 
and there is absolutely nothing going on in the Israeli economy, financial markets or currency exchange rate that has any relevance to the prospective deal and its impact on the economics and future stock price of the two companies. Yet Perrigo and Teva both dual listed and are the 2 largest components of the Tel Aviv 25 stock index. Together they make up 20% of the index.
What are the other major companies on the Tel Aviv stock exchange ?

The Israeli stock index the Tel Aviv 25 has a very high weighting in multinational corporations. In addition to Teva and Perrigo, Nice systems and Elbit 2 world class corporations in the technology area make up another 10%. Again as in the case of Perrigo and Teva very little in the Israeli economy is important to the economic fate of these tow companies.

So what are the truly “Israeli” companies in the index? I would define a “truly Israeli company” as one having the vast majority of their business, revenues and earnings in Israel in local currency and local economic and political conditions in Israel a major factor affecting their economic fortunes. Looking at the rest of the index. one finds 25% in the financial sector, 8.5% in the real estate sector and 11% in energy.  The full weightings of the index can be found here:

And looking at these industries it is possible to identify some significant risk factors particularly because of local economic conditions and political conditions. The financial services industry is extremely concentrated and the incoming Finance Minister has set reform of the banking system to bring more competition into financial services as a top priority.

 The real estate markets fortunes are highly determinant on Government policies. Given the huge run up in real estate prices in the last 7 -10 years there is great financial pressure for government activity to slow or reverse the trends in real estate prices. Because of many complications in the nature of real estate in Israel government the government role is central.

And of course developments in the financial and real estate industries in all countries are intertwined.

As for the third major sector :The energy industry in Israel's future fortunes are highly dependent on development of the large offshore natural gas projects...and government policy has massive impact on that project.

Israel Chemicals (ICL) is a bit over 6% of the index and it too is highly dependent on changes in government regulations.

To illustrate the impact of changes in government regulation: Between Jan 1 2011 and  July 31,2012 Cellcom, which pre market liberalization was the dominant player in the the cellphone market which had been tightly regulated  lost 81% of its stock value. This was the period in which deregulation came to the cellphone market. At the time cellphone companies has a very high weighting in the Israeli stock indices. EIS, the Israel ETF lost 32.7% in 2011.

Added together the picture can be seen as follows: an Israeli stock market dominated by two large multinational companies and sectors that may be subject to the major impact of future government policy.

Looking at the above list it is hard to make a strong investment case for investing in Israeli companies particularly for those who already through their home ownership have a large exposure to the fate of Israeli real estate. Add in the risks related to possible changes in economic policy and the reality of being located in an unstable political/military environment and the rationale for holding a significant proportions of one’s equity holdings in specifically Israeli companies is very weak.

High tech Israel is not on the Israeli stocks exchange. Israel definitely has a high tech sector whose success is impressive far out of proportion to its position in the world economy. But that success creates high investment returns for venture capitalists who invest in Israeli start ups at their early stages and a small number of principals in the companies. Those two groups make their money when one of 2 things happen:1.the corporation is bought out by a major multinational company as was the case for be Waze which was purchased by Google in 2013 for a reported $1.3 billion.Or 2. When the company goes public on the US stock exchange  A recent example would be Mobileye (MBLY ) which went public on the US Nasdaq in 2014 and is not even listed on the Tel Aviv exchange.

In both of those cases the big profits are made well before investment is open to individual investor on the public market. Even when it becomes possible to invest in the company after it becomes publicly that point it is simply another tech stock. And of course its fate is determined by the global factors affecting other corporations in its industry….it is certainly not an “Israeli” company economically.

In sum the universe of “truly Israeli  companies” i.e. corporations  whose economic fate is primarily determined by the Israeli economy and market is a very small one. And the investment case for them does not appear to be particularly compelling.

An analyst from Barclays made the same point in this excellent article from 2012 explaining the sharp drop in volume on the Israeli stock exchanges.

Joseph Wolf of Barclays Capital: ...
A major issue is the fact that 50% of the new money invested in equities by (Israeli)institutions such as pension funds is going overseas.” Wolf does not necessarily blame the domestic institutions for turning their backs on their home market: “Key sectors of the Israeli market, such as telecoms, banks and oil companies, have all been made much less attractive to foreigners and domestic investors because of regulatory or legislative intervention over the last two years.”

The unusual rules affecting investments by dual US Israeli citizens creates a bit of a paradox. An investor interested in purchasing the Israeli stock index would be best off doing it with a US traded etf ticker symbol EIS and avoiding the PFIC problem related to taxing of non US mutual funds and ETFs. The holdings of this ETF are also highly concentrated. The index used for EIS differs from the Tel Aviv 25 has a 24% weighting in TEVA and a 36% weighting in financials. 

Since the holding of individual stocks does not trigger PFIC rules an investor interested in owning what are closer to “truly Israeli companies “such as Bank Leumi, real estate developer Azrielli and food giant Osem (all of whom also have significant foreign operations) could put together a portfolio of those individual stocks. I wouldn’t think this is an attractive alternative for most investors.

So what is a possible strategy for the long term Israeli investor:

A long term portfolio should be diversified producing long term returns from capital appreciation, interest and dividends with a mix of stocks and bonds.

The stocks are designated to produce the long term capital appreciation as the riskier part of the portfolio. The bonds producing mostly interest income are expected to provide the stability in the portfolio less return but less risk/volatiltiy.

There is a strong argument for a relatively small allocation to Israeli stocks in the equity portion of the portfolio based on the analysis. For US/Israeli dual citizens the easiest alternative for most investors is the Israel ETF traded on the US stock exchange The rest of the portfolio should be invested much the same as any other investor anywhere a globally diversified portfolio invested in low cost index funds/etfs

What about currency risk? Certainly holdings in non Israeli stocks (and stocks of Israeli global companies) exposes the Israeli shekel based investor to the variations in the value of the Israeli shekel. Just as in the case of global diversification in equities a strong positive case can be for gaining he currency diversification as well.

In the long run currency fluctuations probably balance out  over the long term. Furthermore the absence of truly “Israeli companies” means that virtually all Israeli companies are effectively dollar based.

There are Israeli mutual funds and etfs that hedge out currency risk. Unfortunately they have two large drawbacks.The first is the “dreaded PFIC problem” Israeli funds and ETFs create high taxes and reporting headaches for US investors. The second is that those hedged instruments don’t do a good job at executing the currency hedging.

Probably the best way to reduce the currency risk of the portfolio is to alter the mix of stocks and bonds in the portfolio.

Many Israeli investment analysts and advisors recommend holdings of non Shekel denominated bonds and even direct ownership of foreign currency. My view on the holding of foreign bonds for the Israeli investor is the same as my advice for the US based investor. The risk reward of such bonds is unattractive. Instead of reducing volatility through the bond allocation adding foreign bonds adds additional risk factors.

What is an alternative portfolio allocation strategy.?

Global stocks + domestic bonds.

Combining a global stock portfolio for long term capital appreciation could make up the equity portion of the portfolio. The bond allocation designed to provide steadier less volatile returns and reduce the volatility of the portfolio could be allocated exclusively to high quality Israeli shekel denominated bonds nominal or inflation protected. In order to avoid the PFIC issue individual bonds and not funds must be used.

A note on past performance. Although I would base my choice of allocation more on the arguments above than past performance, the Israeli ETF has underperfromed the US, world ex US, and World stock market indices since its inception in 2007. Charts below growth of 100% and performance and volatility. You can not the large decline in 2011 largely due to the collapse of prices of cellphone companies was the major cause of the underperformance.

Growth of $100,000 Jam.1.2011 to May 12,2015 US total market (gold) World ex US (green),
 total world market (blue) Israel (black)

Total Return (top) and volatility (bottom) Jam.1.2011 to May 12,2015 US total market (gold) World ex US (green),
 total world market (blue) Israel (black)

The excellent Israeli blog  makes many similar points in an article here and recommends teh core holding be an all world market ETF. Non hebrew readers could drop the article into google translate and probably get a serviceable translation.