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Monday, September 18, 2017

Betterment Joins Wealthfront In an About Face About Smart Beta

Betterment has joined its major Robo Advisor competitor Wealthfront in doing a 360 on the use of "smart beta" in its portfolio,

From their website in an article published in June of 2015
Market Capitalization: Still the Anchor
The starting point for any allocation model is a market capitalization-weighted portfolio.  By anchoring to market capitalizations, you free ride on the collective wisdom of millions of investors and traders globally. You also know how much you are diverging from market allocation; that divergence is the foundation for generating outperformance.
The same logic can also inform portfolio construction for clients who want to take on more or less risk. While the market holding of U.S. small caps, for instance, reflects the risk that investors on average are willing to bear, individual investors may be comfortable with more or less risk in their portfolio. It is up to the individual advisor to determine how to take on more or less risk while still maintaining a diversified portfolio.
The cleanest way to do this is to use the global market as a benchmark for determining asset allocation. Allocations should consider the market value of available assets; the implied expected returns from those assets should guide a proportional allocation to the different markets. This was the insight behind the pioneering work of Fischer Black and Bob Litterman in creating the Black-Litterman model for creating diversified portfolios at every risk level.

Based on that approach this is how their asset allocation is described on the website
Our U.S. exposure covers the total U.S. market with a slight tilt towards value and small-cap stocks. The value and small-cap tilt has tended to beat the market in the long term, based on research by Nobel-prize winner Eugene Fama and Kenneth French

Here is their list of  ETFs used in their" simple" portfolios using market cap weighted ETFs

An article on their website from 2016 entitled  How Active is Your ETF Index I


A new breed of ETFs is similar in name only to passive ETFs, but instead exhibits the characteristics of a traditional actively managed portfolio—particularly in fees and turnover, and for less than certain higher returns.
Examples are inverse (or “short”), leveraged, and smart-beta ETFs. Smart-beta funds may only confuse rather than help most investors.
According to a Wall Street Journal report, smart beta funds’ stocks are weighted “by rules or ‘factors’ other than their market value, such as their dividends, value or low volatility.”
While proponents say that these funds can outpace a straight index over extended periods—say, a full market cycle or two, “don’t expect outperformance every year,” said the report.
In fact, according to, “Actively managed ETFs by design are expected to deliver outperformance, but they often underperform their benchmarks.”

Investors should also be aware that smart-beta ETFs rely on the actions of fund managers who dictate the actual execution of the fund’s investment strategies

I would note that many of the smart beta ETFs specifically state that the readjustments are made quarterly to avoid transaction costs and many  are available with very low fees

That atttitude towards smart beta at Betterment was then...this is now:
In a September 2017 addition to its website Betterment announces

IIntroducing Our Smart Beta Portfolio Strategy by Goldman Sachs

Betterment will now offer a smart beta portfolio strategy developed by Goldman Sachs Asset Management. The strategy reflects the underlying principles of Betterment’s core portfolio strategy while seeking higher returns by deviating away from market capitalization in and across asset classes.
The website includes a nice explanation of smart beta for people like me and someone who has taken a few courses in finance with citations to other research. But how many of its clients will understand the strategy be able to make the judgement as to whether to use the strategy in their portfolio and to stick to the strategy.
The website notes
Why invest in a smart beta portfolio?
As we’ve explained above, we generally only advise using Betterment’s choice smart beta strategy if you wish to attempt to outperform a market-cap portfolio strategy in the long term despite potential periods of underperformance.
For investors who fall into such a scenario, our analysis, supported by academic and practitioner literature, shows that the four factors above can persistently drive higher returns than a portfolio that uses market weighting as its only factor. While each factor weighted in the smart beta portfolio strategy has specific associated risks, some of these risks have low or negative correlation, which allow for the portfolio design to offset constituent risks and control the overall portfolio risk.
Of course, these risks and correlations are based on historical analysis, and no advisor could guarantee their outlook for the future. An investor who elects the Goldman Sachs Smart Beta portfolio strategy should understand that the potential losses of this strategy can be greater than those of market benchmarks. In the year of the dot-com collapse of 2000, for example, when the S&P 500 dropped by 10%, the S&P 500 Momentum Index lost 21% 

That's a alot to absorb for the Betterment customer who was marketed a service that was supposed to simplify their investing (and the explanation of smart beta is likely to make the eyes of everyone but a finance geek glaze over ,...and those people are likely self directed investors in any case..
I would think that based on the description above few people would turn down the opportunity to outperform the market weighting in the long term and few people think they would abandon a strategy becase of short term underperformance. in the short term. No one thinks they will be the investor that will panic and sell everything...they have read that is the wrong thing to do...but obviously many people do it. And few would turn down the opportunity to outperform the market based on historical analysis and a portfolio created by Goldman Sachs based on state of the art academic research.
I also dont understand the example given above of how the momentum factor did during the dotcom crash of 2000 . It would seem to me anyone from Betterment explaining the Goldman Sachs strategy  to a client would explain that moementurm is only one of 4 factors used in the strategy. In fact pointing out the performance of the momentum factor is a good argument in favor of the Goldman Sachs approach.
We have been hearing from customers that different portfolio strategies would be better fit for different goals,” Dan Egan, director of behavioral finance and investments at the firm, told ThinkAdvisor. 
"Betterment has an increasingly diverse customer base; they all want to put their money to work, but not necessarily in the same way," said Betterment founder and CEO Jon Stein, in a statement announcing the new portfolio strategies.
The Goldman smart beta strategy is designed to deliver stronger risk-adjusted returns than traditional market-weighted index funds generate. “Clients are a bit uncomfortable with market-cap weighted systemic approach,” says Egan. Trademarked as ActiveBeta, the Goldman strategy is based on four drivers (factors) of performance: value, momentum, quality and low volatility

From the website this additional note about the portfolio allocation
It tends to have higher allocation to emerging markets and small-cap stocks in the U.S. and developed economies and includes REITs and high-yield bonds with longer duration. Its expense ratios range from 0.11% to 0.24%.

I am confused by the above Goldman Sachs Active Beta (available in its ETFs) has nothing to do with REITs and bonds.
It is really hard for me to imagine that clients of Betterment which at least initially was sold as a simple solution to investing were sophisticated enough to express the fact that they were uncomfortable with a market cap portfolio. There is enough debate around professionals and academics on this issue its hard to imagine many Betterment clients have reached conclusion on this. And did those investors sophisticated enough to want a non market cap weighing for their stocks also indicate they were comfortable getting it as part of a "package deal" with the REITS and long duration high yield bonds?
I have nothing against smart beta. I have been using it in client accounts through mutual funds of Dimensional Fund Advisors before there were ETFs in this category and when their form of smart beta was called a tilt to the factors of size and value. And I have incorporated smart beta ETFs into client portfolios.
I also think the Goldman Sachs product has potential to be an excellent addition to portfolios in addition to or in place of ETFs based on only one of the "smart beta? factors
But I do think it will be extremely difficult for investors to understand and choose between the "new Betterment portfolios and the "old ones". And it seems Betterment investors can only buy the "whole package"that goes with a smart beta ETF. I think if they truly understood the "new portfolios" they might opt for making use of smart beta but passing on the allocation to other elements of the portfolio. I have seen lots of research with evidence of the outcomes of use of the smart beta factors. I have never seen at research about benefits of adding REITs and High Yield Bonds to such a portfolio.
The Betterment website cites the research of Rick Ferri on the advantages of a low cost index portfolio. But Ferri also has written and article entitled

The Dark Side Of Smart Beta

and doesn't make use of the strategy in his client portfolios.

I am totally biased of course but I would argue that incorporating "smart beta " in a portfolio is a decision best made by a dedicated do it yourselfer or someone working with a personal advisor that doesn't present only two choices   "smart beta" and "non smart beta" portfolio which ultimately is one  (actually one of  two) size fits all and can clearly explain the strategy.

In the No Surprise Department

from marketwatch

Hedge fund closures still outnumbered launches in second quarter

Hedge fund performance continues to lag the overall market, as measured by the S&P 500 SPX, +0.15% The HFRI Fund Weighted Composite Index is up 5.4% thus far this year (through the end of August), a gain that is less than half the 11.9% rise of the S&P.
While hedge funds are designed to do more than simply provide exposure to a particular market—for example, they can employ more complex instruments, like derivatives and leverage—investors have lately shown far more interest in broad-market funds that simply track a major index.
Beyond the fact that the S&P has long outperformed the average hedge fund—winning Warren Buffett a $1 million bet in the process—such products can be purchased for significantly less money. The average hedge fund management fee was 1.46% of assets in the second quarter, with the incentive fee coming in at 17.2%. To compare, an exchange-traded fund that tracks the S&P 500 can be had for as little as 0.04% of assets. 

Friday, September 15, 2017

How Do You Spell Tulip ?

I never understood this thing:

Thursday, September 14, 2017

Wealthfront's Passive Plus: A Low Cost "Black Box " Quant fund ?

From Passive Investing to Quant fund.

Wealthfront has now debuted the next state of the art investment strategy called Passive Plus. It is described as the next generation of indexing .

The strategy makes use of what is called "smart beta" meaning weighting the portfolio differently than the more common market cap weighting used in total stock market like VTI among others.

Wealthfront has now gone beyond claiming it offers a strategy to maximize tax savings to what it contends is a  market beating strategy. In other words the firm that claims in big bold letters on their website that:

when it comes to long-term investing, you can't expect to outperform the market.

Now it presents a  strategy that claims to do exactly that...Confused... so am I.

They also perform some intellectual sleight of hand by citing Warren Buffett (who favors a simple stock portfolio of an S+P 500 index fund) and their Chief Investment Officer Burton Malkiel who in his classic Random Walk Down Wall Street  endorsed a cap weighted index as endorsing Wealthfront's approach which has strayed far away from those strategies (which is why they call it "Passive Plus")

I am not alone in noting the irony

The company said Advanced Indexing is “an improvement on a strategy commonly referred to as ‘Smart Beta,’” and in a separate statement, noted that it was conceived by a team led by Wealthfront Chief Investment Officer Burton Malkiel and Vice President of Research Jakub Jurek...

Just a year ago, Malkiel reiterated his disdain of smart beta to the Wall Street Journal, saying they are riskier than index funds and just a new way for managers to justify fees. In a 2016 update of his book, “A Random Walk Down Wall Street,” he devotes a chapter to arguing why smart beta isn’t good for individual investors.

The next step for Wealthfront Passive inexpensive quant fund.

Wealthfront's new strategy differs fundamentally from any kind of  traditional indexing strategy. It is a factor based strategy "optimized using backtesting with performance  presented based on using that backtested model on historical data. In plain English garbage in garbage out. While most of these factors have been shown to impact stock performance and in some cases increase return there is certainly no consensus on how to weight the factors

Here is their methoodology from their website:

Advanced Indexing blends five single-factor strategies (value, momentum, high dividend yield, low market beta, and low volatility) with the cap-weighted market index to generate a modified index. This index then serves as the benchmark for our stock-level tax loss harvesting algorithm (Direct Indexing), which seeks to maximize the quantity of harvested losses, while minimizing the tracking error from the supplied benchmark.

But we don't know the details of Weathfront's algorithm and unlike an ETF it doesn't have to disclose its holding.

The Passive Plus strategy is subject to the problems of data snooping/back testing and transaction costs and potentially difficulty in liquidating portfolios described my post on their tax harvesting strategy  Wealthfront says it uses a .20% estimate for transaction costs..a number that doesnt even come from backtesting..since the backtest is based on closing prices. Apparently the assumption is based on an academic paper but there is no full citation to track it down,

Investors with portfolios over $500,000 have the "privilege" of investing in this strategy. The strategy is untested in the real world.

Essentially Passive Plus is an optimized" strategy with a combination of stocks that make up a smart beta strategy. The strategy is presented as the single strategy that can be chosen for a portfolio of $500,000 or above.

 Is There A Better Way to Access The Smart Beta Factors ?

An alternative way to access the smart beta factor would be to use it in conjunction with a cap weighted total stock market ETF and separate allocations to the factor ETFS for Quality (Qual .15% management fee), Momentum (MTUM.15% mgmt fee )Dividend Growth (DGRO.08% mgmt fee) and Small Value (VBR .07% mgmt fee) Making use of this approach creates more transparency, has the potential to reduce transaction costs and the factors (although not necessarily the ETFs have a longer term data set that is publicly available (although the danger of data snooping still exists few of thse ETFs have been around more than 5 years. Additionally investors need not go all or nothing" they can create a portfolio combining a cap weighted index ETF with the factor ETFs

A strategy using the ETFs mentioned above might be to simply equal weight the factors or to use a reblancing strategy. Momentum tends to outperform in strong up markets value performs generally better in down markets. Portfolios looking for more income would put a higher weight on DGRO.

Another alternative might be to use funds from Dimensional Fund Advisors which has for many years been a pioneer in presenting passive funds designed to take advantage of the size and value premia and have recently added a quality screen, These funds are only available through a limited number of financial advisors (including me)and some 401k funds.

Goldman Sachs Asset Management offers a seruies of active beta ETFs which combine all of the factors in single ETF.

Finally is a new ETF that could be potentially interesting is a new one from Pimco: MFUS It makes uses of a number of factors of smart beta and holds them in equal measure but within those strategies constructs the holdings taking into account valuation.

With Wealthfront's passive plus the investor is presented with a single strategy for his entire portfolio with wealthfront. Combining it with other strategies would lead to the complication of opening a brokerage account aelsewhere and would require the investor to calculate appropriate tax management strategies.

Making use of factor ETs in addition to a total stock market index would create a portfolio with more transparency and personalization and the possibility of combining a cap weighted index with the other "factors". 

What is Wealthfront's Direct Indexing and Will It Deliver in The Real World ?

I have noticed that many of the personal finance sites' reviews of the robo advisors like this one  from Nerd Wallet focus on low fees and simplicity But they are not sophisticated enough to understand the pitfalls in many of their strategies

Nerd wallet gives w\Wealthfront "five stars" but simply takes all their promotional material at face value not delving into the details of the strategy. Low cost, simplicity and what seems to be a sophisticated strategy seem to impress many observers without the inclination or skills to drill down.

There are many issues with understanding the allocation of Robo Advisors using traded ETFs. Wealthfront's strategy is even more complicated than other Robo Adviors. In fact the differences are so complicated that it will take more than one article to cover and took someone with expertise (me)  several hours to understand it.

This article will cover their "simple" direct indexing strategy, The next article will cover their strategy which is the next generation of indexing which they call "passive plus:

What is "Direct Indexing"

The most important difference between Wealthfront and other portfolios using ETFs is that most of Wealthfront''s US stock  assets are invested in "direct indexing". The strategy purports to offer a better alternative by owning a portfolio of constituent stock in the total US stock market instead of the Vanguard total index fund. Their strategy avoids s the wash sale rule with little impact on the total return and they claim adds to after tax return. A simple strategy of swapping ETF (explained below) avoids the wash sale rule much more simple.

By owning individual stocks Wealthfront claims the benefit of avoiding the management fee of the Vanguard ETF  tottl market ETF(. which is 05% ) is saved that there are more opportunities for tax loss harvesting through buys and sells of individual stocks instead of a single ETF.

Wealthfront claimed their strategy would generate an after tax alpha of 1.55% in return over 3-5 years vs the total stock market index. You can read through the assumptions used here on their whitepaper but it assumes the most favorable conditions possible strategy in terms of tax brackets and compares their strategy to the "straw man" of an alternative portfolio that does no tax law harvesting. This a 2014 "improvement over the .90% claimed in 2012. Of course there is no actual data for these strategies.

But do other hidden costs outweigh any benefits that come from tax harvesting and are the numbers given by Weathfront about the gains from tax loss harvesting realistic.

I will concentrate on other pitfalls of the strategy and how the purported results are presented

Is the strategy really that simple ?

Substituting stocks in the direct indexing portfolio

The Direct Indexing  strategy incorporates individual stocks and not ETFs.  There was  quite a bit of computer and human power used to define the strategy..but lots of things that could go wrong in the real world that will make it unlikely it meets its expectations.

Here is how Wealthfront describes its Direct Indexing

The next evolution in index investing

Here is an example of a trade Wealthfront says it would execute in the direct indexing strategy:

stocks in the same industry tend to perform similarly over short periods of time. So if Coca-Cola misses its earnings guidance and trades down 10%, our Direct Indexing program will sell shares of the Coke and temporarily buy more shares of Pepsi to replace it. That way, our client would maintain exposure to the beverage industry, while still realizing tax losses and lowering her overall tax bill. After 30 days, the program would sell Pepsi and buy back Coke, but only if Pepsi doesn’t trade up because that would lead to a realized gain which would cause a tax liability

If this is how Wealthfront decides how to do its "paired trades it is in trouble even what seem to be similar stocks a close look shows how dissimilar they are Pepsi earns way over 305% of its income from non beverage products (Frito Lay) Coca Cola has only beverage products

Here is a chart of Pepsi (PEP) and Coca Cola . It's quite clear that even in the swap described moving between the stocks can be as much as a trade as it is a simple tax loss harvesting study.

PEP (Pepsico) Brown KO (Coca Cola) black
But this isn't how tax loss harvesting is generally done with ETFs. The more widely used strategy doesn't "hope" for two stocks in the same industry to move as described. It is designed to immediately realize losses in one etf and trade into one that is essentially the same without changing the long term investment strategy..and little need a scenario like the one described above. Swapping between ITOT and VTI would keep the investor's allocation in the total US market  while creating a tax loss.that could be deductible with the position purchased ultimately liquidated at the lower long term capital gains rate (although the bais on the position has gone down)It isn't dependent on one stock going down while the paired stock goes up..and then the paired stock recovering.

 The Wealthfront strategy has many flaws when Wealthfront uses it in Emerging Markets where it swaps between VWO to IEMG.

The difference in holdings between the two ETFS is quite significant  VWO has no holdings in South Korea IEMG has 15% of its holdings in South Korea

Following the links above you can find other significant differences in the portfolios

Not surprisingly there is a gap in performance. Below are the twelve month numbers:. Returns on top volatility below.

The gap in performance means that it is likely not to be able to do a tax swap : realizing a loss in IEMG and then purchasing VWO one is not purchasing identical portfolios so the swap will not be made without what is essentially a change in strategy (because of the allocation)

VWO green IEMG Blue Returns top volatility below

...based on both back testing our algorithms, as well as through detailed Monte Carlo simulations of thousands of possible market scenarios

Put in simple terms for the layman they tested against past data found the algorithm for that model combined it with a statistical model for future stock returns called a monte carlo simulation..which itself can be based on a wide variety of assumptions  and many flaws which I I won't go into here there are many sources on the web on the pitfalls of such simulations.

In developing their model they used a frequent (and flawed) technique: data snooping: They kept running calculations based on past data until they found one that optimized their objective and made that the model..they used in sample data. As Robert Arnott of Reserach Affikiates notes in the article below no one ever presents a backtested strategy that doesn't work.

Furthermore as their whitepaper shows virtually all the benefits from tax harvesting over 2000-2014 came during two periods 2000- 2003 and 2008 2009 both periods when the us market dropped around 50%. And this was the period used by Wealthfront design its tax loss harvesting strategy. The likelihood of a market pattern just like that is next  10 years is next to zero and the utility of using a time series with a monte carlo simulation with two 50% drops in 10 years followed by one of the greatest market recoveries in history just as problematic.

Wealthfron "Tax Alpha" by Year

S+P 500 index

Since 2014 the market has been basically straight up meaning the opportunities for tax loss havesting (large losses) would have been quite much for making a forward looking strategy based on past data.

Despite all the caveats raised in this article Wealthfront confidently presents its strategy is based on backtesting to produce the next generation of indexing. Any strategy based on backtesting is problematic be it a mix of ETFs or Wealthfronts direct indexing. But at least on the major asset classes upon which the broad category ETFs are based have a longer track record and there is a data series going back far before the ETF was created.

As Ben Carlson writes about backtesting in his great blog A Wealth of Common Sense:

How many bad backtests came before the good ones? I wonder how many millions of deceased backtests there right now are sitting in a recycle bin graveyard on computer desktops all across the globe? No one ever shows you a bad backtest because it’s much easier to date mine the past than the future.
Data availability at the time. The fact that we now have data that wasn’t available in the past changes the nature of that past data. There would have been ripple effects if investors knew then what we know now. Hindsight changes perception.
 What the frictions were. It’s almost impossible in a backtest to completely account for costs and frictions such as taxes, commissions, market impact from trading, market liquidity, etc. Sure, you can estimate these frictions, but you never truly understand how these things will affect your bottom line until you actually have to execute buy and sell orders.
What’s going to happen in the future. As my colleague, Michael Batnick, put it recently, “Unfortunately there is no such thing as a front-test.” Every market environment is different than the last so you have to be able to accept that the future will never look exactly like your time-tested strategy.
Finally: How Do You Get Money Out of Your Direct Indexing Portfolio ?

Wealthfront direct indexing portfolios have more in common with the seperately managed accounts (SMAs) offered by many brokerage firms..albeit at far lower cost. Those portfolios seldom hold more than a few dozen stocks (as opposed to the hundreds held by wealthfront)  and the amount of assets allocated to the strategy are far less than the assets under management.

Investors in individual stock portfolios can choose the method of sales they want to use to maximize tax savings their brokerage firm will have a record of their "tax lots " created by reinvesting dividends and buys and sells. The investor can give the brokerage firm standing instructions  average cost , last in first out, or first in first out  or highest or lowest cost or tax minimization at many brokerage firms.  The proper choice of designating tax lots to minimize taxes is complicated.However nowhere on their website is there an explanation of how Wealthfront accounts for tax lots when it sells shares when investors liquidate all or some of their portfolios.

Wealthfront may look simple and cheap to folk like those at nerd wallet and many of its customers. But a look under the hood shows a very complicated strategy based on questionable assumptions. It will likely be difficult for real world execution of their strategies will produce the resuts presented in their whitepaper.

Thursday, September 7, 2017

Do You Know What is In Your Robo Advisor Porfolio...and Why ?

More on the major differences in portfolios among the major Robo advisors something I have written about several times previously. from the WSJ

Your Robo Adviser Is More Active Than You Think

They’re supposed to be straightforward investments run by algorithms—not a manager. But there’s still a lot of human judgment involved

there’s a crucial step here that isn’t always obvious. Algorithms manage the portfolios, but they don’t choose what goes into the portfolios in the first place. People do. That means the robo advisers aren’t always passively mimicking the allocation of assets on the global market; human managers are often making active bets on certain sectors, and those bets can make products from different advisers sharply different from each other

Here is a graphic that shows the differences in allocations

Drilling down for the differences in the portfolios shows the following:

Around 40% of the Vanguard stock allocation is in international stocks, ,,,The foreign-bond exposure also falls short of the global asset portfolio.

Among the robo advisers, Betterment has the international-stock exposure that most closely matches the global market, 50% of its equity allocation. Betterment also puts 8.2% of its equity allocation into emerging markets, close to the emerging-markets share of the MSCI All Country World Index. On the bond side, Betterment had 45% of its allocation in international bonds—the highest of all the portfolios we examined

Wealthfront has the second-highest foreign-bond exposure, 38% of its debt allocation. It’s also noteworthy that all of Wealthfront’s allocation to foreign bonds is in emerging-markets bonds via the J.P. Morgan USD EM Bond ETF, which owns bonds denominated in U.S. dollars and doesn’t impose currency risk on its shareholders. That’s clearly an active bet on emerging-markets debt.
Real-estate holdings
The Wealthfront portfolio also stands out by having 17.7% of its stock allocation in emerging markets—the highest in our survey—and 13% of its assets in real-estate investment trusts, ... . The only other portfolio in our survey with dedicated REIT exposure (a more-modest 5%) was an offering from Charles Schwab ’s SCHW 0.41% Schwab Intelligent Portfolios.

Schwab had 44% of its equity holdings in international stocks, and 9.3% in emerging markets, the second-highest allocation among the portfolios we examined. In terms of debt, the Schwab offering had nearly 28% of its bondholdings overseas, with more than 10% in emerging-markets debt—both figures roughly the same as the Vanguard portfolio.
Finally, the Schwab portfolio was unique in our group for having 5% of its portfolio in commodities—precious metals, specifically—and 12% of its portfolio in cash.

Readers of this blog know that I am uncomfortable with many of the asset classes that show up sometimes to a large extent in these portfolios. Specifically I would avoid REITS,commodities and emerging market bonds fact all non US bonds...and I favor holding only Asian emerging markets

As the article concludes it is certainly clear that:

hiring a robo adviser isn’t as simple an investment solution as some might think. Even low-cost indexing can mean portfolios different enough that they need some investigation.

Tuesday, September 5, 2017

More on International and Emerging Market Investing

A nice article in the WSJ emphazig ETFs as the best vehicle for investing in foreign stocks includes the chart below illustrating the point I made in a previous post as to the differences among overall Emerging, Market Latin American and Asian Emerging Market stocks

Monday, September 4, 2017

Some Additional Information on Emerging Markets ...

From Pimco some more information reinforcing some of the themes I discussed in my posts on emerging markets stocks and on emerging markets bonds,

Emerging markets include commodity importers and exporters

Although some countries are heavily dependent on oil exports, across the wider emerging market universe – and specifically in South East Asia, Eastern Europe and the Caribbean – many countries are net importers rather than exporters. Even Mexico, commonly perceived as a significant exporter, imports oil and exports refined products.
Hence low commodity prices are not necessarily bad for emerging market

Emerging market fixed income is less concentrated than equities

Emerging markets debt and equity have many overlapping traits, but also differ in their exposure to countries and risks. The MSCI Emerging Markets Index contains 27 countries, with the five largest accounting for 70% of market value. Three countries in Asia - China, South Korea and Taiwan - comprise more than 50% of the index.
Compared to equities, the fixed income universe is more diverse. The JP Morgan EMBI Global Index, which includes dollar-denominated debt issued by emerging market countries, contains 66 countries. The largest five countries account for only 40% of market value, and the top three for 28%. Of the 66 countries in the emerging market fixed income benchmark, only 19 countries overlap with the equity universe.
"EM equity and debt are distinct asset classes. Investors should allocate between the two based on the risk profile desired

Emerging market crises have become more contained

In the early days of emerging markets investing, trouble in one country could quickly spill over to another. Events such as the Tequila crisis in 1994, the Asian crisis in 1997, and Russia's default in 1998, all contributed to the perception that emerging markets were prone to "contagion risk"....

EM has evolved a lot. Country specific events are more contained and markets less susceptible to panic."

Thursday, August 31, 2017

Do You Really Know What Your Mutual Fund is Worth ?

The trend of public mutual funds investing in non public companies has increased. Although regulations restrict the holdings to 15% of the total this is a disturbing trend and certainly means that in many cases the listed net asset value of a fund may not represent the true value of its holdings. It seems that in an effort to stem the tide of movement of funds into passive vehicles fund managers are willing to "swing for the fences" seeking triple digit returns with these investments in order to improve returns.

Investing in these companies is traditionally the work of venture capital funds which invest their own capital along with that of institutions and high net worth individuals in fact the latter must meet specific characteristics with regard to net worth and investing experience to meet the criteria of "qualified investor". Built into the business model of the venture capital firms is that for every Google there are 70 or more companies that go bankrupt and that valuation is more art than science. It might be based on revenue, profits (if there are any), valuations of similar companies, the most recent capital investments or many other categories.Venture capital firms  need only report valuations to investors.

Mutual funds must  publicly report the value of their pre IPO investments quarterly meaning that there can be large changes in valuation over a single day at quarter end. 
 The value is set by the board of the mutual fund This is despite the fact that they report net asset value of their funds on a daily basis.In fact different mutual funds can value the same company at very different valuations. Bottom line: the net asset value of a public mutual  fund with non public holdings fully never reflects the real value of the assets.
. V

 Additionally there is no allowance in the valuation of the fact that the money is basically locked in until the date that the company goes it does at all. If the prospects turn negative the valuation used in pricing for the mutual fund may be virtually useless...the holding cannot be sold.

The most recent notable markdown of a pre IPO holding is the case of Uber...Talk about inconsistency  in valuation !

As the WSJ reports (my bold/red)

Mutual Funds Mark Down Uber Investments by Up to 15%

Investors including Vanguard marked down their Uber stakes for the June 30 quarter, while Fidelity maintained its estimate

Four mutual-fund companies have marked down their investments in Uber Technologies Inc. by as much as 15%, the first such price cuts that suggest these investors are souring on the ride-hailing giant following a scandal-ridden year.
Vanguard Group, Principal and Hartford Funds all marked down their shares by 15% to $41.46 a share for the quarter ended June 30, according to the fund companies’ latest disclosure documents. T. Rowe Price Group Inc. TROW -0.25% cut the estimated price of its Uber shares by about 12% to $42.70 for the same period.
Uber’s shares don’t trade publicly, so the mutual-fund companies that hold them must estimate the shares’ worth each quarter. Seven mutual-fund companies had mostly maintained a $48.77 share price since the fourth quarter of 2015, when Uber first sold its shares to investors at that price.
Fidelity Investments held its estimate of $48.77 as of June 30. The one outlier isBlackRock Inc., BLK 0.50% which wrote up the shares slightly each of the past two quarters, settling at $53.88 as of June 30.
Uber which in the midst of scandals and board disputes, recently replaced its CEO. If this NYT analysis is correct it may prove to be the biggest loss ever taken by a mutual fund in a pre IPO company.
According to the author UBER has a fundamentally flawed business model and will quite possibly just run out of gas (money)

From the NYT
While Uber has become popular as a taxi company for the digital age, and has been valued at nearly $70 billion — more than Ford, G.M. or Tesla — the company has been losing money faster than any technology company ever. It lost nearly $3 billion in 2016 (plus another billion or two in China), and it has already lost over $1.3 billion in the first half of 2017.
The dirty little secret of Silicon Valley is that seven out of 10 venture-backed start-ups fail because they never become profitable. The company Mr. Khosrowshahi will take over is on track to becoming one of those failures.
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That’s in part because Uber has never figured out how to offer taxi service at a lower price and still earn a profit. Consequently, it has become stuck in a trap, using its venture capital funding to subsidize at least 50 percent of every ride to cut fares and try to gain a monopoly position that can drive the competition out of business. As a result, the more customers use Uber, the greater into debt it goes.
Uber can subsidize rides for only so long. At some point, investors want a return on their money. They want to get to the stage where they can profit from the company’s I.P.O., or they turn off the spigot. Uber is standing at that precipice. More than anything, that’s what the recent revolt by Uber board members has been about. Uber’s initial investors and board members were willing to look the other way as scandal after scandal erupted because the business model seemed to be on track. But now some investors are publicly saying Uber is worth far less than $70 billion, and the Uber board is offering shares to new investors at a discount.
A recent report states that some existing  investors willing to sell off shares at a discount to current valuation as reported in mid August--allowing those investors to lock in their profits effectively leaving others (like the mutual funds) holding the bag(shares) 
Furthermore Benchmark capital also in a news item this month questions Uber's current valuation. Benchmark is one of the earliest investors in Uber,holds a 13% stake, and has a pending lawsuit.

Reuters notes many funds have stakes in Uber most relatively small relative to assets but this one is striking:
The $4.5 billion fund cited Uber among top contributors to performance in its report for fiscal 2015, alongside Amazon (amzn, +1.07%) and Netflix (nflx, -0.31%). The ride-services company's valuation in the fund surged 156% to $82.5 million, Hartford disclosures show.

Its pre-IPO stakes accounted for nearly 6% of net assets while most of its peers have kept their exposure below 1 percent, fund holdings show. Hartford declined to comment.
And there is this comment from a fund manager about UBER

"Who doesn't think Uber has a great thing going?" said David Kudla, CEO of Mainstay Capital Management, which has $2 billion under management

Here is a list of mutual funds holding privately held funds as of mid 2015 obviously the list by now is far larger

And from Fortune via Reuters  in 2016:

These Mutual Funds Have Been Juicing Their Returns With Unicorn Stakes

A Reuters analysis of fund filings and other data shows, though, that some have taken a more aggressive approach, boosting the share of these companies to more than 5% of assets and awarding them rich valuations that in some cases have helped them beat their benchmarks and peers by a wider margin.
Mutual funds' involvement also helped boost the number of so-called unicorns—private companies valued at $1 billion or more.
These private investments come at a risk, though. Many are young companies that have yet to make a profit. They are also harder to price and to sell than publicly traded stocks.
That could hurt investors in a downturn because fund managers forced to meet investor redemptions may have to sell liquid public companies while marking down the unlisted ones, said Larry Swedroe, director of research at Buckingham Asset Management in St. Louis.