About that Currency Market Timing

I blogged Friday about the WSJ article that noted

The U.S. dollar’s weakness this year has shown the downside of hedging currency exposure when investing in overseas stocks.

Investors are taking note, pulling money out of currency-hedged exchange-traded funds after heavy buying last year, as the funds proliferated.

The rush of money into the hedged funds—and the recent movement out—is evidence that investors were chasing performance, says Ben Johnson, director of global ETF research at Morningstar Inc.

Investors “have a near-zero chance of regularly and effectively timing currency movements,” Mr. Johnson says.

Bloomberg this morning

Just when investors thought they’d finally made a good call in the currency market, the dollar’s advance messed it up.

The U.S. currency on Friday capped its best week all year versus its major peers, shortly after hedge funds finally switched to betting on dollar declines, known as going short. That’s not the only wrong move foreign-exchange managers have made this year -- an index tracking their returns shows they’ve failed to turn a profit in 2016.

More Evidence of Performance Chasing This Time in Currency Hedging ..and Many "Professional Advisors" are no Better than Anyone Else

WSJ

The Downside of Hedging Currency Risk for Stock Investors

Investors are pulling money out of currency-hedged exchange-traded funds after heavy buying last year  

The U.S. dollar’s weakness this year has shown the downside of hedging currency exposure when investing in overseas stocks.

Investors are taking note, pulling money out of currency-hedged exchange-traded funds after heavy buying last year, as the funds proliferated.
The rush of money into the hedged funds—and the recent movement out—is evidence that investors were chasing performance, says Ben Johnson, director of global ETF research at Morningstar Inc. MORN 0.55 %
Investors “have a near-zero chance of regularly and effectively timing currency movements,” Mr. Johnson says....

The outflows from currency-hedged ETFs tracked by Morningstar began in September. After taking in nearly $41.8 billion from January through August of 2015, the funds experienced net outflows of $1.8 billion from September through December. Nearly $6.5 billion more flowed out in the first three months of this year, says Morningstar, which currently tracks 48 currency-hedged ETFs.
There is an argument to be made for consistently hedging currency exposure—to focus on the returns of the underlying securities—and one for accepting currency risk as another variable in a diversified portfolio. But shifting between hedged and unhedged investments is essentially another variation of market timing and tough to do successfully.
“People are chasing the performance of the U.S. dollar,” says Paul Bosse, a principal in the Vanguard Group’s investment strategy group. “Is that really a surprise? We’ve seen those sorts of chasings go throughout the years

He says the decision to hedge currency exposure should be “a long-term position; it’s not an on/off switch.”
Some advisers who moved into hedged international-stock funds in recent years sold as they became less bullish on international shares in general.
For example, Jeffrey Carbone, co-founder and senior partner at Cornerstone Financial Partners Inc. in Huntersville, N.C., began investing in a dollar-hedged European-stock ETF in December 2014. But seeing slow global growth and anticipating a weaker dollar, he sold a portion of that position last year and the remainder in January. Mr. Carbone says his portfolio is now overweight in U.S. stocks and underweight in international equities.

This is What is Known in The Investment Business as Talking Your Book

In my earlier post about Bond guru Bill Gross I mentioned Jeff Gundlach the new "Bond King" who is attracting billions in assets with his own unconstrained bond fund. Like Gross he takes large concentrated positions with weightings far different than the total bond market index.

One well know technique of thse gurus is to get on as much as the media as possible promoting positions which you have taken in your portfolio. Nothing like a little extra buying from the guru followers to help the short term postion of your portfolio. Of course you can be sure this manager will have sold out his position before he starts appearing all over the media announcing his changed views of the market.

Via Bloomberg
Gundlach’s $59 billion DoubleLine Total Return Bond Fund has returned about 2 percent in 2016, compared with a 3.5 percent gain by the Barclays U.S. Aggregate Bond Index, the main benchmark for the broader bond market. The fund beat 98 percent of peers over the past five years, according to data compiled by Bloomberg.
Gundlach also recommended shorting utilities stocks and buying mortgage real-estate investment trusts, both through exchange-traded funds. With one turn of leverage, the trade should rise by 35 percent, he said.
Last month Gundlach told investors that it would be a good time to buy mortgage-backed securities and sell corporate bonds

And here is the  breakdown of Gundlachs Doubleline Total Return'Bond Fund's holdings showing it with an 83% weighting in mortgage back securities vs. a category average of just under 30%.

Can Those Robo Advisors Meet the Fiduciary Standard of Always Working in The Clients' Best Interests ?

I have written several times including here and here  about the shortcomings of "robo advisors". I noted that these services are unlikely to offer a comprehensive investment management that best meets the needs of investors.


Because of the structure of these advisory services they seldom get an in depth knowledge of the investors financial life,tax situation or even a full picture of their investment assets. They create the portfolio based on a short questionnaire then implement an allocation chosen from a set of models that are "cookie cutter". There is no opportunity for personal interaction with the client to explain the portfolio allocation in depth or to learn about changes in the clients personal circumstances.

Since these services are licensed as registered investment advisors they are held to the fiduciarcy standard of always acting in the clients best interests. Although the services charge low management fees and make use of low cost ETFs, and use long term strategies with rebalancing and no short term trading--all important elements of a good investment strategy-- many are asking if that is sufficient to meet the fiduciary standard. 

Those raising this issue include regulators and legal experts as the NYT recently reported


Many of the points raised here are the same as those I raised in my posts

A robo-adviser does not ask about money held outside of its service, for example, which can provide a distorted picture of a customer’s financial standing. Others argue the robo-advisers try to wiggle out of too much responsibility in their customer agreements.The Massachusetts Securities Division recently put investors and the state-registered investment advisers it oversees — or those with less than $100 million in assets — on notice. In a paper issued this month, it bluntly stated that it did not believe an algorithm alone was capable of serving as a fiduciary, at least not the way robo-advisers are structured now.“I am not sure that many investors, in many cases, can be adequately taken care of by answering questions,” said William F. Galvin, Massachusetts secretary of the commonwealth, who likened the services to driverless cars. “You need a human that is responding to them.’’Arthur Laby, a professor at Rutgers Law School, said investment advisers, as fiduciaries, can limit the breadth of their relationship with clients. Still, he does not view robo-advisers as fiduciaries in the traditional sense because of their inability to address subtleties that may arise in conversation.“They are not able to provide the kind of personalized advice that a customer can get from a human on the phone or sitting across the desk, where the customer can say: ‘Oh, I have a new wrinkle. I might be inheriting assets in the next 12 months,’” he said. “Or: ‘I may need to care for a sick parent. How will that impact the cash I need?’.... last May, the S.E.C. and the Financial Industry Regulatory Authority, or Finra, jointly issued an investor alert on automated investment services that highlighted their risks and limitations. For example, these services may suggest a certain mix of investments, the regulators said, but not realize that the investor needs some of the money in a few years to buy a new home.

Others acknowledge the shortcomings of the" robos" while still arguing they can still meet the fiduciary standard:

Many robo-advisers say that they make their limits clear, noting that they are not in the business of providing full-scale financial planning. But often that kind of information is buried in the fine print.Being a “fiduciary is not about the types of service you offer, it’s about the quality of service,” said Adam Nash, chief executive of Wealthfront, a robo-adviser managing more than $3 billion. “There are financial planners helping you figure out what type of house you should buy. It’s not required that everyone do that.”

I am certainly no expert on the legal nuances of what constitutes adequate service to meet a fiduciary standard. It is clear --even in the view of the head of one of the largest robo advisors--that their service is far less comprehensive than what an investor would get from a personalized relationship with a human being.

With the internal management fees of many exchange traded funds now under .10% it might be worthwhile for investors to consider whether or not and advisory fee of .8 to 1% (remember that fees on this service are tax deductible) in exchange for personalized advice might make more economic sense than paying .25% to a "robo advisor". 

For example: a couple with assets split between taxable accounts, IRAs and 401ks simply working with an advisor that looks at all of those accounts comprehensively and is sure to allocate in one comprehensive tax sensitive investment strategy could easily offset the additional fees paid to the "non robot".

Continue reading the main story

Changes Are Coming to the Way Real Estate Investment Trusts (REITS) Will Be Treated in the Major Indexes....And it Could Have Some Interesting Consequences

Index reconstitutions may sound like an esoteric subject. But they can create market movements of interest, that might create profitable opportunities and which challenge the logic of “efficient market” theory.

Such is the case with regard to changes in the treatment of REITs in the major indices the S+P 500 and the MSCI total US stock market index . The changes in the S+P 500 take effect at the close of business Septermber 16, the MSCI changes around the same time

As the FT notes

From the end of August, real estate investment trusts (Reits) will no longer be classified as financial stocks by the mighty index providers S&P and MSCI. Instead, real estate will be designated as a sector of its own, ranking alongside financials, information technology, telecoms, utilities and six others under the Global Industry Classification Standard. The plan was announced last year and more details are due in the coming weeks.

REITs currently count as part of the financial sector so an active manager can own little or no REITs in their fund but still “match” the industry breakdown of the index through holdings in other financials. But once the change is made such a fund would be well underweight the new sector: REITs.

We know that many actively managed mutual funds are “closet indexers” sticking close to the industry weightings in the index they are measured against and some active fund managers have as part of their mandate restrictions on how much they can stray from their benchmark. Managers keep an eye on both their “tracking error” (deviation from the their benchmark index) in their holdings in addition to their performance.

 FT:

If this sounds like the sort of category reshuffle that only librarians could get excited about, think again. An additional $100bn or more could flow into the Reit sector from fund managers who have to hew closely to the sector weightings of the major indices. As these managers top up their holdings of Reit shares, investors who get in early should see an uplift in share prices.

Several firms have researched the issue and all have concluded that there is potential for significant demand for REIT shares as a result of these index changes

A study at Jeffriesbrokerage found that the average mutual fund manager in the US is underweight Reits by 3.3 percentage points relative to their market benchmarks, :

S&;P Dow Jones Indices on Aug. 31 will begin tracking real estate investment trusts, or REITs, separately from other financial stocks, increasing the number of sectors to 11 from 10. That could lead to purchases of REIT stocks by active mutual fund managers, who are “substantially underweight the sector,” according to Jefferies analysts Steven DeSanctis and Omotayo Okusanya.

“We estimate each increase of 1% weighting in the group represents $46.7 billion. Given the buying pressure by active managers along with retail investors’ thirst for yield, we think the sector will outperform despite being expensive on an absolute and relative basis,” DeSanctis and Okusanya said in a report on Monday.

Using data provided by Morningstar, the Jefferies analysts concluded: “Managers would need to add nearly $154 billion to REITs to move to an equal weight” for the new REIT sector. They expect “buying pressure” for REITs as Aug. 31 approaches.

An analyst at TimbercreeekAsset Management interview on bloomberg estimates increased demand of $105 billion

 A study by JP Morgan Chase estimates the demad created by the index change at $100 billion

Relative to the overall US stock market $100 billion is not a particularly large number. However the  REIT sector is tiny the total market capitalization of REIT stocks is $800 billion so the increased demand definitely has the potential to drive prices higher.

If this information is so readily accessible “efficient market theory” which argues that prices reflect all publicly available information would argue that prices already reflect this information and there is no possibility of “excess returns” as a result of purchasing REITs prior to the index change. There are reasons why this may not be the case with regards to changes in indices like this one.

Efficient market theory assumes that market prices reflect the choices of “profit maximizers” who would always act to take advantage of an event such as this anticipated increase in demand. But in fact many in the market are not strictly speaking “pure profit maximizers”. An active fund manager who is measured against an index and may even have a mandate limiting the extent to which he can stray from the index has many incentives not to hold a portfolio that significantly differs far from the benchmark index. We know that most active funds have a low “active share” and that most of their holdings closely match their benchmark. "Tracking error'--the divergence between the portfolios holdings and the benchmark-- is a very important input in the decision making of a portfolio manager.

In the case of an index change this can lead to a: “non efficient outcome” Even though a manager might be aware that there will be a change in the index that might create demand for REITs and might require him to buy REITs to get close to benchmark, he still may wait till the reconstitution date or close to it before making the purchase. Why would that be the case:? if he buys too soon before the reconstitution he will be straying far from the index weigthing from now to the reconstitution date.  

Buying the REITS well in advance of the reconstruction of the index increases his “tracking error” thus violating one of the mandates/strategies of his portfolio construction.

From the above comes the market anomaly: even though it is clear there will be demand due to the index reconstitution there is a significant incentive for those active managers that benchmark to the index to wait till the date of reconstitution to make the purchase. The "price pop" due to the index reconstitution may not occur until very close to the reconstrtuction date even though it is well known that there will be increased demand for the sector.

Does this create a “market failure” an instance where the efficient market theory doesn’t hold ? the proverbial $20 bill lying on the sidewalk which—according to the theory-- can’t possibly be there because someone would have already picked it up ?  

The FT writes:

The old stock market adage is that one should “sell in May and go away”, but there is one sector where investors might want to turn the recommendation on its head this year. When it comes to US property, investors who buy in the coming month could get a one-off boost that they can cash in when they return from holiday in the autumn.

 Time will tell

For those looking to take advantage of the move the most direct way to do this would be through one of the broad REIT ETFs such as VNQ(tied to the MSCI index which is being reconstituted) or RWR(tied to the S+P index).

Changes in the REIT Market in the Age of ETFs

The growth of interest in REITs and the growth of ETFs has had significant impact on the REIT market once a relatively obscure sector dominated by a few players. As a consequecene the opportunity for outperformance of active managers vs low cost passive ETFs diminishes further.

 As the WSJ reported

In REIT Industry Shift, Veteran Investors Lose Clout

Longtime funds see net outflows while assets grow in passive indexes

By 

LIAM PLEVEN

April 26, 2016 3:4

Asset managers who have shaped the world of real-estate investment trusts for years are losing influence as passive index funds attract more money and a wider array of investors pours money into the stocks, according to industry insiders.

Members of a core group of REIT investors once could alter the path of initial public offerings and affect decisions about how companies should be run, longtime executives and investors say. Many longtime REIT-focused asset managers still control large sums.

Meanwhile, index funds that own REITs held shares worth about 20% of the firms’ market value as of last year, up from 6% in 2006. This year, real-estate index funds have seen nearly $2 billion in net inflows, through March, according to investment-research firmMorningstar Inc., while actively managed real-estate funds have seen net outflows of roughly $1 billion.

“The growth of index funds and ETFs which now own a much larger share of the capitalization of all companies—not only REITs—has reduced the role of any investor whether that be an individual or a mutual fund,” Ken Heebner, portfolio manager of the CGM Realty Fund, which invests in REITs, said in a statement.

The shift means that longtime REIT investors don’t act as gatekeepers to the same degree they did in the 1990s, when the modern REIT era began

The Perils of Market Capitalization Weighting In Action

All of the most well know and largest indices (and their corresponding ETFs) are market capitalization weighted.

Simply put that means that the weighting of any stock in the index is set by multiplying the price of the stock times the number of shares outstanding.

A consequence of this weighting system is that it leads to a very high weighting of some stocks..and sectors...and the weighting increases as the stock price goes up. That means the indices become heavily weighted with stocks that have high valuations.

The phenomenal rise of Apple (AAPL) stock has made it the largest holding in market capitalization weighted indices...and the recent fall in the price of AAPL--16.5% in the last 2 weeks shows the consequences of market cap weighting.

Bloomberg posted a great report on this (text and video) which includes this table of the weightings of aapl in some of the largest ETFs and the impact on returns.Not only do the total stock market index,  the SP 500 and Nasdaq (QQQ) ETFs carry a high Apple weighting so do the large cap growth indices and the technology sector ETF,

This shortcoming of market capitalization weighting sometimes referred to as "bubble risk"is a major rationale behind making use of alternative weighting methodologies in passive strategies now referred to as "smart beta" and available through many low cost ETFs. The simplest of these is equal weight which puts the same weighting on all stocks in an index. For example an equal weight SP 500 ETF would hold 1/500 of its assets in each component of the SP 500 index.

While an equal weighting eliminates the defect in market cap weighting, other approaches may merit a closer look. Long term research shows that value stocks (in particular small cap value stocks)outperform growth stocks and market capitalization indices and also that there is a momentum factor that generates long term outperformance vs overall indices.

A long term "evidence based" investment strategy could incorporate both a valuation based strategy and a momentum based strategy through low cost ETFs. These two strategies often work well in tandem with momentum working well in strong up markets and valuation based strategies doing best in other market environments.

Most interesting is that momentum strategies are not the same as growth indices even though the holdings often overlap. The S+P 500 Growth index include the following criteria:

The growth factors include:
1. Five-year earnings per share growth rate
2. Five-year sales per share growth rate
3. Five-year internal growth rate

Since investors often extrapolate this performance as a forecast of future performance these stocks tend to trade at high valuations. This does lead to momentum stocks reaching high valuations. Howeve,r a simple decline in upward price momentum which can be caused by a change in market sentiment even if the above long term growth factors might still be in place. That can lead to a lower weighting of a growth stock in a momentum weighted ETF.

And of course a value weighted index such as the S+P 500 will by definition have a low weighting in highly valued stocks and a small cap value index a zero weigthing in a large cap growth stock--the type that get the highest weighting in the S+P 500 and total market stock indices.

Below are valuation measures and top ten holdings(click to enlarge) for the S+P 500 index (SPY),S+P 500 value index(IVW),S+P 500 growth index(IVE), and the momentum ETF(MTUM). A small cap value ETF like VBR would have a zero weighting in AAPL

And below is the performance( top ) and volatility of the S+P 500 and alternatively weighted ETFs since the AAPL earnings release of April 26. Since that date AAPL has fallen a bit less than 5%.it is down around 15% since April 1.

Performance (top) volatility below SPY (sp 500) IYW (SP 500 Growth,) IYE (SP 500 Value)
, MTUM (momentum) VBR (small cap value)

Of course no one would advocate building an investment strategy based on the short term performance of a single stock. But this is good evidence of the perils of market capitalization weighting and the benefits of adding ETFs weighted towards value and momentum in a portfolio.

The "Penny" (actually $ big check) Seems to Have Dropped: Expensive Hedge Funds Dont Make Sense

via Bloomberg also a very interesting interview with Cliff Asness of AQR linked to the article

Top investors took hedge fund fees to task at the Milken conference Monday, with participants saying managers return too little and face a wave of closures.

Chris Ailman, chief investment officer for the $187 billion California State Teachers’ Retirement System, told Bloomberg Television that the two-and-twenty fee model is "broken" and “off the table” for large institutional investors. Neil Chriss, founder of Hutchin Hill Capital, said investors will pull out of funds that aren’t giving them returns to justify the fees.

“Reducing your fees is your best return on capital,” Ailman said from the Milken Institute Global Conference. “So we focus very much on costs in every single asset class and we’re pounding on fees across the board.”

The comments came after Warren Buffett said that investors would be better off backing U.S. businesses through low-cost funds and ditching expensive money managers. Consultants steer investors to these managers who together have underperformed what you could get “sitting on your rear end” in index funds, he said on Saturday at the Berkshire Hathaway Inc. annual meeting.

The $2.9 trillion hedge fund industry is having its worst start to a year in terms of performance and client withdrawals since 2009, when global markets were reeling from the most severe financial crisis since the Great Depression. Last week, Dan Loeb’s Third Point said that investors are “in the first innings of a washout in hedge funds and certain strategies.”