Robert Arnott on Emerging Markets

Bob Arnott well know figure and creator of Fundamental Indexing had this to say about emerging markets in an interview with indexuniverse.com

IU.com: Interesting. Any other thoughts you might want to share that I've not even come close to touching upon?

Arnott: Well one thing that I think is fascinating is we’re in a business where customer demand evaporates as soon as there's a bargain.

What's going on with emerging markets, you’ve got emerging markets trading at a Shiller PE ratio of 13 when U.S. stocks are at 24. Back in 2007, emerging crested at 37 Shiller PE at a time when U.S. was at 26. So it's been a complete about-face, from an 11 points higher price to 11 points lower price. And now people are scared of putting money into emerging markets. To me, this is a wonderful-—this is the closest thing to low-hanging fruit I've seen in the global stock market since February 2009.

IU.com: Right. It’s all about expected returns. And they sure outsize there in the emerging markets, is what you're saying, right?

Arnott: Exactly. And most investors simply extrapolate from the past. Emerging markets have been pretty disappointing for three years. And they’ve been downright awful for six months, and downright scary for two months. So people look at that and say, “I didn’t sign up for this. I'm outta here.”

The correct response should be, “These are interesting prices—unless I want to postulate that a China slowdown turns into a China meltdown, and conflict in Syria and Egypt turns into a Middle East conflagration; are those things possible?” Of course they are. That’s why we’ve got bargains. Are they likely? Maybe not. Are they likely to have an effect that spans the whole emerging economy of the world? Absolutely not. But it’s affecting pricing all over the world.

Now, add to that the fact that growth has beat value in emerging markets by upwards of 1,000 basis points this year to date, and a Fundamental Index is looking really cheap. Fundamental Indexing for emerging markets is currently priced at a 9 Shiller PE ratio.

IU.com: And are the numbers apples to apples when you look at the Shiller PEs? Or do they have a different scale altogether?

Arnott: Well, a Fundamental Index clearly has a value tilt. So the presumptive growth rate is going to be slower. But the valuation multiple is one-third off of a market that’s already nearly half off relative to the U.S. To me, that’s a really easy investment choice. It’s not a comfortable one, but you don’t get rewarded for comfort.
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On the other hand investors seem to be moving their international investments away from emerging and into developed markets

The two largest emerging markets ETFs—the Vanguard FTSE Emerging Markets ETF (NYSEArca: VWO) and the iShares MCSI Emerging Markets ETF (NYSEArca: EEM)—have lost more than $11 billion in assets in 2013.

On the other hand, the Vanguard FTSE Developed Markets ETF (NYSEArca: VEA), the PowerShares QQQ Trust (NasdaqGM: QQQ), the SPDR S&P 500 ETF (NYSEArca: SPY) and the iShares MSCI EAFE ETF (NYSEArca: EFA) have collectively seen more than $13 billion in inflows over the first seven-plus months of the year.

Investors (Finally) Moving to Short Term High Yield

I have written many times about moving high yield exposure to the shorter term instruments...seems some people are making the move albeit a bit late

From ETF Trends

Investors looking for a balance between yield and protection from rising interest rates have been moving into ETFs tracking speculative-grade corporate bonds with shorter durations.

PIMCO 0-5 Year High Yield Corporate Bond Index (HYS) andSPDR Barclays Short-Term High-Yield Bond ETF (SJNK) have gathered $602 million and $318 million, respectively, since the beginning of May, according to WSJ.com’s MoneyBeat blog.[These High-Yield Bond ETFs Protect Against Rising Rates]

The largest junk bond ETFs, iShares iBoxx High Yield Corporate Bond (HYG) and SPDR Barclays High Yield Bond (JNK), together have seen more than $3 billion move out the door over the same period as Treasury yields climbed. [High-Yield Bond ETFs Recovering from Taper Tantrum]

In the shorter duration junk bond ETFs, HYS has an SEC 30-day yield of 4% and an effective duration of 2 years, according to PIMCO. SJNK has a yield of 5.1% and a modified adjusted duration of about 2.3 years, according to State Street Global Advisors.

“Shorter-term junk bonds are lower volatility, so in a downdraft there’s a lot less downside than regular junk bonds,” said Chun Wang, co-portfolio manager at Leuthold Weeden Capital Management, in the MoneyBeat post.

The article doesn't mention HYLD which now has a yield over 8% and a duration of a bit over 3 years. A combination of HYS and HYLD might offer a nice balance of risk/return in terms of interest rate risk.

Below are  ytd returns and volatility measures for sjnk , hys and Hyld as well as the intermediate term HYG and JNK

German Stocks…Time to catch up….Again?

The WSJ writes here 

of the prospects for German corporations to replace the decline in exports to China with sales into the US market.

 Last year German stocks as measured by EWG outperformed the US market. A strong rally in the second half of 2012 spurred the outperformance (Germany in blue) By the end of the year EWG outperformed VTI by 32.5 vs. 16%.

Here is a one year chart note the US outperformance during the worst (so far) of the European crisis last year and then the German outperformance as concerns were lowered. There hasn't been a big change in the European situation since then so perhaps the Chinese slowdown is the explanation for the recent performance. Given the latest trend in German exports(see below) one may ask if it is justified.

And here is a 10 year chart note the German outperformance during the US financial crisis and the US outperformance during the peak of the european crisis.

Prospects for Improved Exports

As noted in the WSJ article prospects for German exports out of Germany seem up beat as seen in this table

The weaker Euro is likely to continue as the European Central Bank has indicated a continued policy of low interest rates, while the US interest rates trend higher. This makes German exports more competitive. With the stock market higher, housing on a comeback particularly in higher end markets and a weaker dollar it isn’t surprising for this outlook from Daimler Benz:,

U.S. sales ofDaimler AG's DAI.XE -1.19% Mercedes-Benz luxury automobiles rose sharply in the first half of 2013 from the previous year, putting them on track to exceed 300,000 cars this year.

U.S. demand has been "great," Daimler Chief Executive Dieter Zetsche told reporters last week in Canada, "and it seems the momentum will sustain." In contrast, Mercedes' China sales were flat, though they improved in the second quarter after a soft start to the year.

Valuation

In the past year both Germany and the US have had p/e expansion . However thelarge P/E expansion for the US has been far grearer(rather than growth in earnings) and has been behind the US market rally... The S+P 500 P/E has increased 25% over the last 12 months while the total return is a bit over 28%...in other words virtually all the increase in the S+P 500 over the last 12 months comes from P/E expansion and is over 25% over its long term average.

 The DAX (German) P/E has expanded quite a bit recently but is still well below its long term average .Germany trades at a P/E discount of over 35% vs. the US

The price/book for the DAX top ten holdings is 1.45 vs. 2.1 for the sp 500 and price to cash flow ratios are...67 and 1.39 respectively.

Looking at all of this it seems a strong case can be made for at least a partial repeat of last year’s pattern of a strong performance for German stocks in the second half of the year, particularly if the export numbers give a rationale for rethinking the impact  of the Chinese slowdown on German companies. And it doesn’t require German stock returns even equal to those of the US for the year to mean significant gains for ETFEWG for the rest of the year.

If price eventually reverts to value or close to it we may see a repeat of last year’s strong performance by German stocks in the second half of his year.

Here are some more interesting charts

DAX P/E

S+P 500 P/E

DAX P/E And Dow P/E

Individual Investors Buying High and Selling Low...Again ?

Bloomberg July 3, 2013

Bond Funds Losing $60 Billion Foreshadow Risk of Fed Exit

Investors have pulled about $60 billion from U.S. bond funds since Federal Reserve ChairmanBen S. Bernanke rattled markets by outlining his plan to end the central bank’s unprecedented asset purchases.....

Retail investors, who fled volatile stock markets to pour about $1 trillion into the perceived safety of bond funds since the beginning of 2009, reversed that pattern in the past month in anticipation of rising rates.

WSJ MARKETSJuly 10, 2013, 7:55 p.m. ET

Bond-Fund Exodus Continues Amid Broad Drawdown

Long-term mutual funds fell by $4.89 billion in the latest week as bond-fund levels continued to decline, according to the Investment Company Institute.

Bond funds have posted outflows for five consecutive weeks amid a run-up in interest rates since late April.

For the week ended July 2, bond funds had outflows of $5.97 billion, compared with prior-week outflows of $28.23 billion. Taxable bond funds slipped by $5.05 billion while municipal bond funds were down by $920 million.

And note that most of the money did not go from bonds to stocks

Equity funds had inflows of $228 million, up from inflows of $45 million in the previous week. Domestic equity funds fell by $2.08 billion, while foreign equity funds gained $2.31 billion.

Bloomberg July 11,2013

Treasury 10-year notes rose for a fourth day, the longest rally since February, after Federal Reserve Chairman Ben S. Bernanke called for maintaining stimulus amid division among policy makers on when to slow bond buying.

More From the It Was An Accident Waiting to Happen Club

wsj March 6,2013

Advisers Find Income Alternatives in Mortgage REITs

As stock real estate funds strive for a fifth-straight year of gains, a hybrid type of investment offering plumper dividends is off to an even better start.

Real estate investment trusts that buy mortgage-backed securities rather than buildings or land are posting double-digit returns and attracting strong investment flows.

The $1.1 billion iShares Mortgage REIT Capped (REM) exchange-traded fund enters Wednesday ahead by 12.5% so far in 2013. In the past 12 months, the ETF has attracted nearly $727 million in net inflows through last week, estimates New York market researcher XTF Global.

Wsj May 29, 2013

Mortgage REITs Hit 52-Week Lows on Rate Fears

Mortgage REITs borrow money using short-term debt and use the funds to buy longer-term mortgage securities, earning the spread between the rates. They also use leverage to boost their returns. The low interest- rate environment greatly reduced their borrowing costs and enabled them to make more money off their bond portfolio. In addition, the low rates drove investors into REITs that promise high returns......

The mortgage declines were part of a broader rate-induced selloff as REITs underperformed the broader market. The closely followed MSCI US REIT Index was down 3.1% while the S&P 500 slid nearly 1%......

David Toti, an analyst at Cantor Fitzgerald, said REITs have long benefitted as an alternative to bonds because of their higher yields. The low interest-rate environment has also been instrumental in helping REITs raise inexpensive capital to repay debt and build war chests for acquisitions.

“Guess what? REITs don’t like the higher cost of debt,” Toti said.

But over at seeking alpha hope springs eternal

Mortgage REITs: Use The Sell-Off To Buy Yield And Stability

In this article, I will be focusing on agency mREIT preferreds and my top selections in the agency space. Hybrids will be addressed in another article and investors are encouraged to blend the two as part of an income focused portfolio (as they are often influenced by some differing factors). The specific agency mortgage REITs I will look at are the larger in the space as they are more likely to have preferred stock. Specifically, they are:

• Annaly Capital Management ,
• American Capital Agency Corp. (AGNC),
• Armour Residential REIT (ARR), and
• Hatteras Financial Corp. (HTS)

A Sobering Investment Outlook

From the ever perceptive John Authers of the FT

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oth equities and bonds look expensive compared with their own history (dramatically so in the case of bonds). Put the two together and the plight of pension funds with fixed liabilities to meet appears impossible. Cliff Asness, a former academic who now runs AQR Capital Management in New York, says the prospective return over the next decade from a portfolio invested 60 per cent in US equities and 40 per cent in bonds is 2.4 per cent per year. This is the worst predicted return in 112 years.

An alternative forecast by Elroy Dimson, Paul Marsh and Mike Staunton, financial historians at the London Business School, points to the extreme low real interest rates and shows that these have been associated over history with low subsequent returns for both equities and stocks.

They suggest that the returns in the late 20th century were driven by unrepeatable positive factors such as the postwar booms in Germany and Japan, and the fall of the iron curtain. Now, global demographics give institutions no room for manoeuvre. As the “baby boom” cohort retires, the balance shifts from those contributing to pensions to those receiving payouts.....

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long cycles of “bull” and “bear” markets are defined by how expensive stocks are at the outset. In a bear market, valuations steadily become cheaper until stocks are unambiguously attractive once more.

The commodities supercycle is over. But we can’t yet say we’ve entered a new secular bull market in equities

How to measure cheapness? Cyclically adjusted price/earnings (Cape) multiples, where share prices are compared with average earnings over the previous 10 years to account for changes in the business cycle, have been a good guide to long-run returns.

In 2000, when the bear market first broke out, the Cape on the S&P stood at 44, by far the highest in history. Even the Great Crash in 1929, which was followed by the Great Recession and a savage bear market, began with a Cape of only 32.5.

Now Cape stands at 23.5 – far above its historical average, although not at an extreme. Historically, as the chart shows, investors can expect equities to gain less than 1 per cent in a decade if they start with Cape at this kind of level. Generally, bull markets only start when it has hit single figures.

Ed Easterling, an expert in secular market trends at Crestmont Research in Oregon, says: “In 1996, we got to the normal high but then went into bubble mode. We’ve spent the last 13 years going from the bubble zone to the overpriced zone. We can’t start a secular bull market from here because we don’t have valuation levels low enough to give us above-average returns in future.”

They're Using One of My Favorite Phrases

From Investment News

State subpoenas 15 brokerages over sales of alternatives

Regulators in Massachusetts want info on products sold to seniors; 'accidents waiting to happen'

WSJ on Fundamental Indexing

Long term investors recognize that a "value tilt' to a portfolio makes sense...and the RAFI PRF methodology seems to have done quite well vs the more traditional cap weighted Russell 1000 index.

WSJ on the subject

...."Because they are weighted differently, the alternative indexes create more of a tilt toward smaller-cap stocks or value-oriented shares, or both. The long-term tendency of these types of stocks to outperform large-cap stocks and the so-called growth stocks of rapidly expanding companies is so persistent that it has its own name: the Fama-French model, named after the University of Chicago academics who first documented the effect....
Another option is to use low-cost market-cap-weighted funds and tilt your portfolio consciously toward value and small-cap stocks. This, however, only captures part of the outperformance of the alternative indexes, because the holdings within those funds are still weighted by market capitalization. For example, thePowerShares FTSE RAFI US 1000 PRF +0.61% has a five-year annualized return through June of 10.3%, beating the iShares Russell 1000 Value Index'sIWD +0.50% 6.5% and the small-cap iShares Russell 2000 Index's IWM +0.48%8.7%.

A more appropriate comparison would be matching the RAFI large cap ETF PRF against VTV based on the Russell 1000 Value. Here is a 5 year chart, the RAFI fundamental index large cap (black) has shown a consistent outperformance vs VTV /Russell 1000 value.

5 Years PRF (black line) vs VTV

A similar pattern can be seen in the small cap space with VBR representing the Russell 2000 value and PRFZ the small cap fundamental RAFI index (black line)

5 Year chart PRFZ (black line) vs VBR

No It's Not Really Different This Time

Interest rates of course have moved up sharply since May with the 10 year treasury yield going from a low of 1.59% to a high of 2.7% a massive short term move for the bond market.

Over the course of the move down to record low interest rates a trend that accelerated since 2008 investors have rushed to "alternative investments" in the "search for yield". It certainly proved to be a profitable strategy as rates were low.

But...finance 101 tells us that the present value of any cashflow is calculated by discounting it as the risk free rate. A good proxy for that risk free rate for a long term cashflow would be the ten year treasury yield. So simply put the value of a future stream of payments is worth less as interest rates go down.

So just as a long term bond bought with a yield of 1.5% is worth much less than par when market rates are at 2.7%, so too for bond equivalents. And if the "new consensus" of interest rate forecasts is correct or even close to correct and rates move towards 4% over the next year or two, there is no reason to expect this not to continue. In any event one would argue that there is minimal likelihood for any return to the market lows in interest rates.

The impact of the higher interest rates can be seen in bonds and several "bond equivalents"

Here is a one year chart of  TLH the 7 -10 year treasury bond ETF

And here are the charts for some popular "bond alternative" ETFs

Reits :

Preferred Stock

Utility Stocks

Some may argue that there may be some great "values" among the REITS, Utility stocks, and Preferred stocks as the group has been sold off as a whole. I am skeptical to any arguments that is a "stock pickers" market. This is particularly the case when the basic math of these instruments' value in a rising rate environment is inescapable.

So despite the recent sharp declines in price even for those that still hold these positions perhaps it is time to say "thank you" for the nice performance of these asset classes in the falling rate environment and move on to safer places such as short duration bonds more appropriate in a rising interest rate environment.

Looks Like The Father of the Random Walk Down Wall Street Isn't Much of A Sector Picker

From indexuniverse.com

Malkiel: Dividend & EM Bond ETFs Place To Be 
By Olly Ludwig | March 21, 2013

Related ETFs: PEK

IU.com: And can you speak to some of the other additions—TIPS, munis and emerging market bonds?

Malkiel: Well, munis are still relatively cheap compared with Treasurys, and they do have a rate of return larger than the inflation rate, and probably larger than even a 3 percent inflation rate.

The other asset class which I think is important is emerging market bonds. That's again an asset class that, when you think about history, was risky, and bonds defaulted. Actually, investors ought to start to believe and think that that might not be the case in the future, because if you’re worried about defaults, I’m more worried about Italy than I am about some of the emerging markets. Emerging markets now tend to have low debt-to-GDP ratios; they tend to have a much better fiscal balance—by which I mean the government deficits are small or there are even government surpluses.

IU.com: You’re painting with a broad brushstroke there. You’re not parsing emerging markets and isolating, say, Brazil or China, are you?

Malkiel: No. You know me; I’m an indexer. And that’s of course what we are doing with these portfolios; we’re talking about a very broad brush where we’re using a broad emerging market fund. And we’re always looking for the emerging market fund that is the most cost-effective—we’re going to see this year a Vanguard emerging market fund which I expect will have a lower expense ratio than the ones on the market today.

I wrote about emerging markets for the  first time in Feb 2012 :

Emerging Market Bonds Not Worth The Risk; Watch The Spreads

Feb 21 2012, 18:49  | 12 comments  |  includes: ELD, EMB, HYG, PCY, VCIT

EMLC (local currency em bonds) and EMB ($ denominated) returns top volatility bottom last 3 months.

A New Accident That Will Be Waiting to Happen

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WSJ:

Regulators Set to Lift Ad Ban on Hedge Funds

SEC Plans to Make It Easier to Solicit Investments in Private Offerings

24/7 Wall Street website:

The world of hedge funds and active management is on the verge of a serious change as far as Joe Public is concerned. The U.S. Securities and Exchange Commission is on the verge of allowing hedge funds to start advertising to the public, but this is after the hedge fund industry’s returns have had lackluster returns against the broader markets. After a recent round was raised by Goldman Sachs for a variation of hedge funds for retail investors, it now seems as though many investment banking firms are preparing to launch similar funds that would be hedge funds for retail investors.

Read more: A Flood Hedge Funds for Individual Investors on the Way - 24/7 Wall St. http://247wallst.com/2013/07/02/more-on-hedge-funds-for-individual-investors/#ixzz2Y4HeDohl

Here's what Simon Lack (Lack sat on JPMorgan's investment committee allocating over $1 billion to hedge fund managers and founded the JPMorgan Incubator Funds, two private equity vehicles that take economic stakes in emerging hedge fund managers/. says about hedge funds in his book  about hedge funds:

The dismal truth about hedge funds and how investors can get a greater share of the profits

Shocking but true: if all the money that's ever been invested in hedge funds had been in treasury bills, the results would have been twice as good.

Although hedge fund managers have earned some great fortunes, investors as a group have done quite poorly, particularly in recent years. Plagued by high fees, complex legal structures, poor disclosure, and return chasing, investors confront surprisingly meager results. Drawing on an insider's view of industry growth during the 1990s, a time when hedge fund investors did well in part because there were relatively few of them, The Hedge Fund Mirage chronicles the early days of hedge fund investing before institutions got into the game and goes on to describe the seeding business, a specialized area in which investors provide venture capital-type funding to promising but undiscovered hedge funds. Today's investors need to do better, and this book highlights the many subtle and not-so-subtle ways that the returns and risks are biased in favor of the hedge fund manager, and how investors and allocators can redress the imbalance.

• The surprising frequency of fraud, highlighted with several examples that the author was able to avoid through solid due diligence, industry contacts, and some luck
• Why new and emerging hedge fund managers are where generally better returns are to be found, because most capital invested is steered towards apparently safer but less profitable large, established funds rather than smaller managers that evoke the more profitable 1990s

Hedge fund investors have had it hard in recent years, but The Hedge Fund Mirage is here to change that, by turning the tables on conventional wisdom and putting the hedge fund investor back on top.

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Some recent news on probably the world's largest hedge fund manager:

Reuters) - A $70 billion portfolio managed by hedge fund titan Ray Dalio's Bridgewater Associates and widely held by many pension funds to survive stormy markets is emerging as a big loser in the recent selloff in global markets.

The Bridgewater All Weather Fund is down roughly 6 percent through this month and down 8 percent for the year, said two people familiar with the fund's performance.

The All Weather Fund is one of two big portfolios managed by Bridgewater and uses a so-called "risk parity" strategy that is supposed to make money for investors if bonds or stocks sell off, though not simultaneously.

It is a popular investment option for many pension funds and has been marketed by Bridgewater and Wall Street banks as way to hedge market turmoil

I never did understand that "risk parity strategy" at least as it was/is practiced by Bridgewater and others  it always seemed to me just a fancy term for taking a leveraged position in bonds...in other words an accident waiting to happen
Why would you want to do this:(from the article below)
"The basic idea of the strategy is that by equally distributing risks among stocks, bonds and commodities,.." ..

When finance 101 teaches the virtues of combining a mix of bonds and stocks to control the risk of a portfolio because bonds are less risky than stocks

WSJ

• MUTUAL FUNDS
• June 27, 2013, 8:44 p.m. ET
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Fashionable 'Risk Parity Funds Hit Hard'

Strategy, Using Leverage to Boost Returns, Hurt by Market Tumult

Investors who piled into "risk parity" funds, which follow a popular strategy that promises to make money in most environments, are being hit hard by the current market turmoil.

The losses are touching a broad swath of investors, ranging from hedge-fund firms Bridgewater Associates LP and AQR Capital Management LLC, to mutual funds and local pension funds.

Risk-parity funds use leverage to try to increase returns on bond investments so they more closely resemble returns of stocks. The basic idea of the strategy is that by equally distributing risks among stocks, bonds and commodities, the portfolio can weather huge price swings without sacrificing returns.

And of course there is the ongoing story of "top trader" Steve Cohen's and his hedge fund

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So getting back to the new SEC policy...does anyone seriously expect small individual investors to understand the risks in "fashionable" hedge fund strategies when the largest pension fund managers and wealthiest individuals in the world failed at doing so ? In fact will the retail brokers selling these funds (which will certainly give them higher payout than traditional mutual funds) understand them and actually make sure they are "suitable" investments for their clients ?

At least Registered Investment Advisors like me are at least obligated to make sure they are acting in the clients' best interest. Although the overwhelming evidence shows that it is not an investment that fits those criteria I am certain not all my colleagus will avoid them.

IMO Small Investors + Hedge Funds = accident waiting to happen