On the WIsdom of Those Forecasts By Wall Street "Experts"

WSJ

Strategists had barely changed their views through the middle of the year. It wasn’t until the S&P 500 sharply dove more than 10% in the middle of August that Wall Street started becoming less optimistic on the path for equities in 2015.

Since it is always hard to find a Wall Street Expert working at a brokerage firm who isnt optimitic, there isnt a single analyst surveyed in the article that doesnt see the market ending the year higher than current levels with the average of those surveyed with a year end targe of 2177 for the S+P 500 which is around 15% higher than the current 1884.

More on Trade Execution

In an earlier post I reviewed best practices related to trade execution that a good advisor would avoid and that robo advisors, human advisors, and individual investors may miss. The drag on performance may be well in excess of anything you might pay to a "more expensive" advisor that is more sophisticated in his trade execution.

The WSJ reviews another "bad practice" in trade execution: trading on the market open especially on a Monday morning.

Rising stock-market volatility is proving especially costly for retail investors who typically buy and sell stocks soon after the market opens—often the most perilous time of the trading day.

Buying and selling by individual investors is especially heavy in the minutes immediately after the market opens in the U.S. at 9:30 a.m. Eastern time, when the chances of getting the best price for a stock are lower and swings tend to be bigger, traders and other market observers said.

But within minutes, the gap between the price sellers want for a stock, known as the “ask” price, and what buyers are offering, the “bid,” shrinks sharply and continues to narrow up until the end of the trading session. This quirk in the market has been amplified in recent weeks amid the big market swings.

The smaller gap, or spread, is better for investors because they are less likely to overpay for a stock or sell below the prevailing price in the market. The wider the spread, the more exposed investors are to high costs, which can erode returns at a time when major stock indexes are down for the year.

Of course it doesnt matter whether the market is up or down for the year, these costs reduce the return on the portfolio.

Trades for individual investors tend to be executed in the morning, because they put in orders the previous evening through their online brokerage accounts or their financial advisers, often after they have been able to catch up on the news after work. About 15% of average daily trading volume is driven by individual investors, according to TABB Group, a research and consulting firm focused on financial markets....

And Mondays are even worse:

“Mondays are generally going to be some of your busiest market opens as well because you’re queuing up orders over the weekend,” said Gregg Murphy, senior vice president of retail brokerage at Fidelity. “A large percentage of trade activity takes place in the first 30 minutes of market open.”

Goldman Sachs Forecasts $20 Oil..You Be the Judge of How Reliable that forecast is

Goldman trims 2016 West Texas price forecast to $45 a barrel

• September 11, 2015
• Surplus seen persisting into next year 
• Goldman Sachs Group Inc. cut its oil price forecasts as it sees a global glut persisting into 2016 on further OPEC production growth that may force prices to drop as low as $20 a barrel.

  The bank trimmed its 2016 estimate for West Texas Intermediate to $45 a barrel, from a May
•  projection of $57, according to an e-mailed research note Friday. 
• Goldman also reduced its 2016 Brent crude prediction to $49.50 a barrel, from $62
• It wasnt hard to find this January 15, 2014

Over the last several weeks, crude has been whipsawed by conflicting expectations out of the Middle East: Iran is seen as potentially increasing exports as it reaches a deal that curbs its nuclear ambitions, but at the same time, instability in Iraq and Libya have knocked more than 1 million barrels per day (bpd) of oil offline.

Where to next? Forecasts for crude, gas, and natgas: Goldman

	3m	6m	12m
WTI Crude Oil	$99	$96	$90
Brent Crude Oil	$108	$105	$100
RBOB Gasoline	$3	$3	$2
NYMEX Heating	$3	$3	$3
NYMEX Nat. Gas	$4	$4	$4
UK NBP Nat. Gas	$71	$72	$78

Source: Goldman Sachs Global Investment Research

• Brent crude ended 2014 at a bit under $60

Does that Higher Advisor Fee from the Human Always Mean Worse Returns than The Super Low Fee "Robot"....Do More Advisor Assets Management Cause Lower Potential Returns ?

I am a big believer that investors should keep a sharp eye out for the costs related to their investments. That is the reason I recommend portfolios composed of low cost ETFs.

But a closer look shows that this claims by robo advisors about the improved investment results because of their low fees may not actually be accurate upon closer inspection. Here is how Wealthfront presents its comparison to an advisor charging 1%

They estimate that a wealthfront advisor would benefit from the full impact of the difference between and advisors 1% fee and their fee of .25% every year over the life of the clients account.

 Betterment makes a similar claim calculating an investors savings of  over $55,000 on a $100,000 initial investment over 20 years.

Those claims are extremely simplistic and the market activity of the last few weeks is a case study in why.

Execution matters

The always insightful Jason Zweig of the WSJ  Presented some basic rules for readjusting portfolios and trading. These are particularly important in the volatile markets we are seeing as of late:

 trade seldom — but, when you do, trade smart. Check in advance to see how late in the day you can buy a mutual fund and still get that day’s price. Avoid buying individual stocks or exchange-traded funds during the first hour (9:30 to 10:30 a.m. Eastern time) or last half hour (3:30 to 4 p.m.) of trading, when prices can be especially prone to big swings.

And always use “limit orders” stipulating the highest price at which you will buy (or the lowest at which you would sell

If you have an advisor ask about his trade execution.

Unfortunately simply using an advisor doesn’t guarantee proper execution as the article notes:

On Aug. 24, the day the Dow dropped 1,000 points, it materialized that some financial advisers don’t use limit orders when trading ETFs. “There are still a lot of advisers who built their practice on mutual funds and have never really been through the wringer on trading ETFs,” says Dave Nadig, director of exchange-traded funds at FactSet. “This volatile market is unforgiving for people who don’t know what they’re doing” — and their clients.

 Those who ran into trouble would be those who had orders in place to sell an ETF that fell by a certain percentage. Such orders may have been executed at a price much lower than even where the order kicked in as shares fell quickly, he says.

TDAmeritrade Institutional, TDAmeritrade Inc.’s unit supporting independent registered investment advisers, said it has heard from some advisers who had ETF stop orders execute at the market open Monday. Advisers were not asking for the firm to reverse trades and the firm has no plans to do so at this time, a spokeswoman said in an email.

“Advisors we’re hearing from understand our responsibility is to make sure the mechanics of the stop-loss orders work as they are designed, which they did,” she said in the email. “Once a stop order is triggered, the order is turned into a market order to trade at the next available price. Extraordinary market volatility at the open played a huge part in pricing swings of some ETFS.”

Not surprisingly Zweig advises

So, if you use an adviser, make sure he always uses limit orders when trading ETFs. He can’t bottom-fish for you if he doesn’t know how to use the equipment.

In fact in many cases you don’t even have to ask your advisor. Many advisor managed accounts are separately managed for each account and you should be able to see the details of your trade executions in the information your broker provides

About Execution by Those Robo Advisors

The trade execution at a robo advisor is not at all transparent. It is impossible to know what time of day the trades are executed and how they are entered are they market orders or limit orders. How often does the account trade. We already know that Betterment proudly declares that it trades on a daily basis for “optimal tax management”. But does all that tax management trading actually increase the performance of the portfolio pre and after tax ?

If Jason Zweig recommends trading seldom what happens to a wealthfront portfolio when as they themselves state part of their strategy is to trade as frequently as daily or even several times a day.

Critics of actively traded mutual funds have pointed out the potential costs of market impact the slippage between the market price when a mutual fund begins to execute a trade and the final price of its transaction. A large trade “moves the market against the trader” as the price moves up as the large investor executes its buys (or the opposite for sells)

Most robo advisors trade ETFs but Wealthfront with its strategy executes trades in hundreds if not thousands of individual stocks increases the potential for market impact. John Bogle the pioneer of index funds estimates the cost of market impact at .50% 

With robo advisors growing rapidly in assets –Wealthfront is already over $2 billion the potential costs due to market impact is extremely high…and remember Wealthfront is trading stocks not ETFs.

The more assets in the investment advisory firm the more likely for unseen costs because of execution. Investment firms are required to enter trades as block orders” all accounts buying or selling a security must have their trades aggregated in an order. The larger the assets the greater the potential for market impact or for the trades executed in a mechanical manner.all trades entered at a particular time of day regardless of market conditions for example.

A smaller more sophisticated advisor might be able to “fine tune” the execution to take account of trading and market conditions.

The real question to ask about the “cost” of those higher fees or perhaps more accurately in the case of robo advisors the cost of those lower fees and automated activity.

All of the calculations and assumptions and marketing material related to robo (and probably many other advisors) are based on the portfolios performing exactly as the underlying indices and ETFs performed…based on closing prices.

But in reality there is absolutely no guarantee of that …and probably no way to even check .certainly not with a robo advisor and with extreme difficulty if at all with other investment advisors.

The hidden costs of execution particularly when comparing a large robo advisor executing trades in the $100s of millions compared to an advisor that executes taking into account trading technigwues an advisor that in Zweig’s terminology “knows how to use the equipment”.

What if you do it yourself ?

Many individuals choose to manage their portfolios on their own often persuaded by the argument that if an advisor “just manages a stable allocation of ETFs” the fee is a needless cost.

Zweig notes some important guidelines for executing transactions such as not trading in the first or last hour of trading and using limit orders. There are many other techniques involved in improving execution. Do many investors have the time and skill to execute their transactions in the optimal manner ?

The difference in performance because of execution can easily exceed advisor fees, not to mention added value through rebalancing and tax management. While there is no reason not to expect a full range of services from your investment advisor..proper execution alone is an important factor.

How are Those Alternative Asset Classes Working Out

So called "alternative asset classes" have gained increasing popularity over the last few years. In fact they are in included in the portfolios of "robo advisors" aimed at inexperienced small investors.

These instruments are touted as providing returns uncorrelated wit standard asset classes thus giving additional diversification. Another benefit that is marketed is as an income producer in an environment of low interest rates.

I think it was Warren Buffett who stated that when the tide goes out we can see who is naked. A review of some of the major "alternative asset classes' shows that in many cases they simply added risk often unanticipated to portfolios.

First off here are the major asset classes for comparison

ACWI total world equity  -4.9% ytd       -8% one month

VTI total US equities  -3.8% ytd            -6.8% one month

AGG total US bonds +.4% ytd                -.3% one month

Master Limited Partnerships
These have been seen as attractive due to their relatively high yield. But they also are concentrated in the energy sector. The price of oil has declined causing the same for the MLPs. Additionally as is the case in many of these assets they are all interest rate sensitive ad prospects of lower rates hurts their performance.

AMLP  -13.4% ytd  -3.2% one month

REITs  This is again seen as a good source of income stream and a diversifier to stocks. As s the case of  MLPs they are also highly interest rate sensitive

VNQ   -8% ytd  -7.7% one month

Commodities: This too has been touted as a diversfier away from stocks, It has generally been touted as an inflation hedge although the data on that is far from conclusive. A far better inflation hedge is inflation protected bonds. The increased exposure to commodities has not diversified portfolios from the recent market decline it has exacerbated it. The stock market selloff around the world began with China and the slower economic growth in China has driven commodity prices lower well before the stock selloff.In fact commodities have fallen so much earlier in the year that they actually have declined less than the world stock markets in the pas month.

DBC

-17.1% ytd -2.1% one month

Emerging market bonds: This has been a major target fro investment by those seeking higher yields than those available in US $ bonds. I have written numerous times that the modest pickup in yield is outweighed by the additional currency and other risks. The currency movements in emerging markets has hit this asset class hard.

EBND
-12.4% ytd  One month -4.6%

"Smart Beta"

"Smart Beta" has been a buzzword in investment industry over the last few years. Most of these are variants of value investing and these types of passive funds and etfs have existed for a long time.

Value strategies have suffered during the market rally which has been driven by momentum/growth stocks and have actually fallen more than the overall market last month. But these results should not be surprising value strategies are for patient investors and gain their long term performance during recoveries from market selloffs

VTV Large Value -6.9% one month  -6.4%

VBR Small Value  -5.9% one month      -5.4%


Dividend and Dividend Growth strategies: These have gained a tremendous following. Apparently there is a large group of investor either through mutual funds, stock picking or ETFs that have flocked to higher dividend stocks and those with a record or rising dividends. Many of these investors argue that as long as the portfolio throws off attractive dividends, the price fluctuations don't matter.I find this argument illogical but it is not the place to "debate" that here.

Such portfolios tend to be highly correlated with interest rate moves higher rates drives down prices. Also the great interest in these stocks has led to high valuations with sectors like utilities often reaching above market average p/es.

SDY dividend champions
-6.9% ytd   -6.4% one month


Momentum and Minimum Value

Two "smart beta" strategies that are relatively new to the ETF marketplace do offer something different and are based on some rigorous academic research. While there is never any guaranteed that what has worked in past markets will work in the future the results have been interesting.

These two seem to have in fact given exposure to factors different than"value" or "growth"

Momentum strategies have performed as advertised: stronger than market performance in strong up markets and potentially worse markets during selloffs and higher than market volatility. There is considerable overlap between momentum and "growth stocks" but there performances have differed.

MTUM  +2.5% ytd  -6.4% one month

Minimum Variance strategies are designed to be less volatile than the overall markets thus outperforming in down markets and underperforming in strong up markets and net providing better risk adjusted returns than the market. Although there is overlap with value indices they are distinctive enought to produce different returns

USMV     -1.1 ytd                -5.6% one month


Many researchers have argue that combing momentum and minimum volatility indices in a portfolio offers potential for better risk adjusted returns than the overall market. Time will tell the "live" data set when these instruments have traded is too short.

How Did Those Robo Advisors Do Last Week...We Will Likely Never Now

Robo advisors are to a large extent a black box. While the client can know his allocation he really has no idea how the transactions are executed in the markets. The past week trading was very erratic with many trading halts and large discrepancies between the trading prices of ETFs and the "intrinsic value" (value of the underlying securities) and wide swings in individual stock prices many transactions executed through any automated basis had a high likelihood at being executed at unattractive prices that didn’t represent "fair value" and were soon reversed.

August 24 was the most notable example with multiple trading halts and wide swings of ETF values. Any human being (like me) could look at a screen and know something was very wrong creating a trading environment that was best avoided. For example several of the dividend ETFs were trading at prices far lower than the drop in the S+P 500 Etf even though there was a large overlap in the holdings of the two. The dividend etf price simply couldn't represent fair value. And many stocks traded down close to 10% at the open and quickly recovered a significant part of those losses.

Investors should have learned long ago not to place stop loss" orders in the market as they are likely to be executed during "flash crash" type events when markets take unusual short term moves. A more sophisticated investor would also know that with the exception of a few of the largest ETFs it is bad trading practice or place market as opposed to limit orders. And in market conditions that prevailed most of the day on August 24 and at other times during the past week, the volatility and numerous trading halts for stocks made it best practice to simply refrain from trading.

Many of the algorithmic traders and high frequency traders that provide liquidity in normal markets simply did the same. Turning off their computers or placing very wide bid ask spreads. Market makers in ETFs unable to execute trades in many of the underlying stocks did the same. All of this further complicated market conditions and left those with market or stop loss orders literally paying the consequences.

It will be impossible to know how the robo advisors performed in these markets. At some point a researcher far more capable than me will measure the actual performance of the ETF portfolios of the "robos" vs the performance of the ETFs in their allocations based on market closing values. That would give some measure of any "value added" or "slippage" because of the transactions of these robo advisors.

The most interesting/complex test case of the impact of robo advisors execution is the case of Wealthfront.

Unlike other robo advisors which make use of ETFs. Wealthfront uses what it calls a" third generation tax loss harvesting strategy" which makes daily transactions which according to their description optimizes tax savings.

Wealthfront makes use of what it calls a unique tax optimizing strategy. There is a well-known strategy of tax loss harvesting of replacing one etf with a short term loss with another essentially identical ETF (for example two total US stock market ETFs) to realize a tax deductible loss without changing strategy. This is a widely used tax management tactic used by many individual investors and "non robo: advisors. 

In order to avoid "slippage" a loss in performance due to the trades in tax harvesting it is best to do this with tow essentially identical ETFs in quiet markets .An example would be a sale of a position in the Vanguard total stock market  Etf when there was an imbedded loss and when the ETF was down .5% for the day immediately executing the buy part of the tax harvesting with a purchase of the ishares total stock market etf when it is also down .5%. That would create the tax loss with no impact on portfolio performance. Any slippage between the two trades would affect portfolio performance. For instance in a volatile market the sale might be done with the one ETF down .5% and the purchase made when the other ETF in the trade was down only .2% the net "slippage" of .3% on the trade was the difference between the sell price and the buy price.

Wealthfront claims it is unique in two ways. Not only do they execute tax harvesting transactions on a daily basis they also do it with their own portfolios of individual stocks rather than with listed ETFs, generating individual stock trades. They call this "direct indexing"

 As Wealthfront explains it:

Instead of using a single ETF or Index Fund to invest in U.S. stocks, Wealth front’s Tax-Optimized Direct Indexing directly purchases up to 1,001 individual securities on your behalf — up to 1,000 stocks from the S&;P 500® and S&;P 1500® Indices and an ETF of much smaller companies.
This allows us to take advantage of the countless opportunities for tax-loss harvesting presented by the movement of individual stocks, to further improve your investment performance. Combined with our Daily Tax-Loss Harvesting service, we believe this could add as much as 2.03% to your annual investment performance.

Wealthfront uses a similar strategy in which it replicates the total stock market index with a smaller number of individual stocks.

Wealthfront does these transactions on a daily basis. The assumption is that this generates greater tax savings than for instance doing the tax loss harvesting periodically based on the status of the individual account simply swapping between two ETFs.

I am sure this "optimized" strategy works in back testing on a computer, although Wealthfront claim of a single number for client tax savings is questionable given the different tax status of individual clients. Wealthfront notes http://www.quora.com/What-are-the-main-differences-between-Wealthfront-and-Betterment-3

But two other major questions remain:

There can be two drags on performance:

Does Wealthfront's replication strategy work? Since Wealthfront doesn’t actually buy the ETF does its replication match that of the corresponding ETF?

While the tax harvesting may create tax losses what is the impact on portfolio performance?

The large number of transactions increases the possibilities of slippage. The buys and sells in the accounts may not be executed at zero cost. The transactions may not be executed such that the net result of the buys and sells does not create an outcome lower than the movement in the S+P 500. So the tax savings may potentially be higher...but the large number of tax harvesting strategies may actually be a negative for portfolio performance.

 Wealthfront uses this strategy on accounts with balances as low as $10, 0000 meaning daily tax harvesting numbering possibly several hundred trades a year of tiny size.  Is it necessarily true that the net result of 100 individual stock trades generating $1000 a year in tax losses in a $10,000 account (a high number since it would be 10% of the account value) in tax harvesting losses produces a better outcome than one trade between ETFs generating that same $1000 in tax losses And of course the more trades particularly since they entail purchases and sales of individual stocks. The more opportunity for slippage. In fact with that number of trades the cumulative impact of the bid ask spread could add up significantly. And as Wealthfront grows. In assets its tax harvesting trades will have greater impact on the market, making it even more difficult to avoid slippage

Did the strategy that worked in computer research work in highly volatile markets? The history of markets is full or automated strategies that worked on research based on years of data. Until the markets hit a highly volatile period. When these strategies run into illiquid markets. Those outcomes predicted by computer modelling disappear. A notable example was "portfolio insurance" in 1987. As noted many algorithmic traders and high frequency traders have their own "circuit breakers" when markets get too volatile and/or valuations across securities seem to be far away from fair value they turn off the computers and watch the market chaos. Humans both professional and some nonprofessionals have learned the same thing: to sit back and wait under such market conditions.

But Wealthfront was active in the markets on August 24.

Wealthfront CEO   proudly told Bloomberg that Wealthfront's tax loss harvesting did over $200 million of trades on August 24...the most volatile trading day in years.

And this anecdotal article reports on a client notes

The account had been easy enough to set up—skim a few questions, assess a few options, and voilà—all within a few minutes from the comfort of our couch. But, on Monday, as the Dow tumbled more than 1000 points, he watched as the service rapidly rearranged his account on the fly. “I’ve been constantly refreshing,” he texted, “and it’s a roller coaster.”

He was startled, concerned, and a little bit confused. But the service was doing exactly what it was supposed to do. Betterment, Wealthfront, and FutureAdvisor say their services not only take the headache out of investing, but offer real opportunities when the market dips. The question is how well this will work—and how well the services can retain their clients—in the long-term, especially when the market takes a turn for the worst, or, one day, heads into a recession.

Wealthfront may have generated tax losses and as seen in the above quote rapidly adjusted portfolios (with account size as small as $10,000).but was what the impact on the performance. Wealthfront’s tax strategy entails buying and selling individual stocks. For the strategy to work there should be minimal "slippage" the down movement on the stock should be equal to the decline on the stock purchased. If not the net gain or loss will cause the portfolio return to differ significantly from the index performance.

Call me skeptical that Wealthfront was able to execute its tax loss harvesting strategy which involves buying and selling individual securities without significant slippage and thus drags on performance. On August 24 over 1200 stocks and ETFs had trading halts which are put in place when there are swings of 5% or more in the stock. Numerous stocks had volatile swings particularly at the open of trading. How did Wealthfront's optimized tax harvesting manage in these markets executing $200 million worth of trades ?

It certainly wouldn’t have been easy given the market environment. To give just two examples of the market environment on August 24 that would have been faced by Wealthfront's direct indexing consider he performance of two widely traded SP 500 stocks. Citigroup opened trading on August 24 at 48 traded 6% higher an hour later the spread between high and low for GE was even larger trading at the open at 19.87 before recovering to 23.87.

As Wealthfront actively traded on August 24 it isn’t hard to imagine that their trading got them caught taking "tax losses" at extreme lows and buying back other stocks that didn’t have similar losses. Buying a stock down 10% and replacing it with one that had fallen only 8% would result in a loss vs the index far in excess of any tax savings.

August 27 was another roller coaster as the Dow opened 200 points higher dropped 300 points mid-day and recovered 300 points at the close. It is reasonable to assume that Wealthfront’s tax harvesting trading was active throughout and also found it difficult to avoid slippage.

Analyzing Wealthfront’s tax management trading and its impact on performance vs the index it is trying to replicate would be extremely difficult if not impossible.. Most likely Wealthfront will keep that information proprietary and it will be difficult to ever discover.

But it is clear that tax harvesting strategy through replication is not as simple as it sounds. And in fact may produce little if any benefit compared to a far more simple strategy of periodically swapping between ETFs when there are "harvestable" tax losses that are significant. And to wait until markets are orderly to execute the trades. 

Emerging Markets...This May Surprise You

The headlines of the past two months have been all about the "bursting of the bubble" in the Chinese stock market and more recently the impact of the Chinese currency devaluation announced this week.

I have written on a number of occasions that the term emerging markets has little usefulness since the countries that fall withing that category (and indices) are so diverse. China obviously has its own dynamic and in my view actually falls into a category of its own since it is an economy that can have great impact on emerging markets but the impact of those other emerging markets on China is limited.

Additionally the Asian non China emerging market countries have far different economies than those of Latin American countries, most of whom are dependent on commodity exports.

So looking around the emerging markets this year it is the Latin American emerging markets that have performed most poorly even worse than the Chinese A shares the epicenter of the Chinese stock market bubble bust.

Below are year to date  returns (growth of $100,000 top) returns and standard deviation bottom For emerging markets (VWO), Latin America (ILF),Emerging Asia (GMF) and China A shares (ASHR).I think many would be surprised that even after the bursting of the bubble. ASHR is not only the only one showing a positive return,.it's return is 7.4% almost 3 x as large as the S+P 500's 2.6%

Growth of $100,000 Year to Date

ASHR (gold) ILF (blue) VWO (black) GMF (green)

Total Return (top) Voaltility (bottom)

And here is the same data for the last 3 months even during this period of a 16.7% drop in the Chinese A Shares (ASHR), the Latin America fall was more severe -18.7%

.