I'm Still Confused by Wealthfront's Direct Indexing and Tax Harvesting

Robo advisor Wealthfront makes much of its strategy of direct indexing" purchasing individual stocks instead of broad ETFs which in turn allows more opportunities for tax loss harvesting as individual stocks fall..rather than only making exchanges between broad ETFs that have essentially the same index (total stock market ETFs ITOT and VTI for example).

As Wealthfront describes the strategy:(my bold)

Wealthfront 100 (WF100), Wealthfront 500 (WF500), and the Wealthfront 1000 (WF1000)

We call the up to 100 individual stocks owned as part of our Direct Indexing service the Wealthfront 100. When Direct Indexing employs 500 or 1,000 individual stocks, we refer to that collection of stocks as the Wealthfront 500or the Wealthfront 1000 respectively.

The individual stocks we buy are always selected to minimize tracking error with Vanguard’s Total Stock Market ETF, VTI, not based on their fundamentals or any perspective on whether they are fairly valued by the market. We harvest losses on individual stocks based on a threshold and use the proceeds to purchase other highly correlated stocks within the appropriate US stock index.

In some cases, we may purchase more of an existing holding. For example, if Coca-Cola misses an earnings estimate and drops precipitously in value we would sell Coke and use the proceeds to buy more PepsiCo to maintain the correlation with VTI in the absence of Coca-Cola.

The above may sound nice in theory but I am confused about how it would be implemented even in the case of Coca Cola and Pepsi other than that they make some competing soft drinks they are quite different companies with a large part of Pepsi's earnings from snack foods.

But that is trivial compared to week the one the market had last week. Facebook, the second  largest holding in the total stock market index

Here is Facebook stock over the last week (a 14% fall). It's hard to imagine how a strategy of direct indexing and daily (or even intraday) would work with Facebook. Which stock would reliably be chosen that had the same correlation with Facebook ?

No 2017 Was Not a Stock (or Bond) Pickers Market

Standard and Poors quarterly publishes their SPIVA report comparing the performance of actively managed funds vs their indices. And despite the fact that the active managers eash year proclaim "it's a stock pickers' market..the numbers show otherwise.

From Investment News

The S&P Indices Versus Active (SPIVA) report for 2017 shows growth fund managers improved markedly compared to their performance six months earlier. Over the one-year period, 63.08% of large-cap managers, 44.41% of mid-cap managers, and 47.70% of small-cap managers underperformed the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600, respectively.

That's the good news.

Over the past five years and the past 15 years, no more than 16% of managers in any category of actively managed U.S. mutual funds beat their respective benchmarks. In the longer term, the best records went to large-company value managers, who had a 29.56% success rate against their benchmark over the past 10 years and a 14.29% success rate in besting their bogies over the past 15 years.

As for international stock funds:

Only small-cap international funds beat their benchmarks over the past 12 months. The majority of managers in large-cap international funds and emerging markets funds lagged their benchmarks. And for any period longer than three years, most international funds lagged their indexes.

The SPIVA website is here with much more data.

Interestingly composing a "smart beta" porfolio did perform well compared to the overal market. A portfolio equal weighted to momentum (mtum), quality (QUAL) minimum volatility (USMV) and value VLUE outperformed the S+P 500 25.2% vs 21.7% for the S+P 500.

4 factor portfolio (green) S+P 500 Blue

4 factor portfolio (green) S+P 500 Blue (total return top volatility bottom)

Over a 3 year period  2014 - 2017 the 4 factor portfolio outperformed the S+P 500 64.4% to 58.1%

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Bond managers did not perform much better last year. The passive Barclay’s US Government/Credit Long index outperformed nearly 97 percent of active investment-grade long funds in 2017

Momentum ETF (MTUM) is not Full of FAANG (Facebook,Apple,Amazon, Netflix and Google)

Because of its name many may assume that the momentum ETF from Ishares (ticker) is top heavy with technology stocks and in particular the FAANG stocks (Facebook,Apple,Amazon,Netflix and Google.

In fact tht is not the case. The methodology setting the components takes into account volatility as well as upward price momentum. That is in contrast to cap weighted indices like the S+P 500 (SPY), Nasdaq (QQQ) and Technology indices (XLK) Although its largest sector is technology(36%)  It only includes one stock: Apple which has the lowest p/e of the group.

Here are the top 20 holdings in Mtum:

Name	Weight (%)	Sector
JPMORGAN CHASE & CO	5.2	Financials
MICROSOFT CORP	5.2	Information Technology
APPLE INC	4.75	Information Technology
NVIDIA CORP	4.32	Information Technology
BANK OF AMERICA CORP	4.15	Financials
BOEING	4.05	Industrials
VISA INC CLASS A	3.59	Information Technology
UNITEDHEALTH GROUP INC	3.59	Health Care
MASTERCARD INC CLASS A	3.17	Information Technology
ABBVIE INC	2.91	Health Care
CITIGROUP INC	2.74	Financials
MCDONALDS CORP	2.38	Consumer Discretionary
HOME DEPOT INC	2.28	Consumer Discretionary
3M	2.27	Industrials
ADOBE SYSTEM INC	2.07	Information Technology
PAYPAL HOLDINGS INC	1.99	Information Technology
ABBOTT LABORATORIES	1.63	Health Care
CATERPILLAR INC	1.55	Industrials
TEXAS INSTRUMENT INC	1.44	Information Technology
MICRON TECHNOLOGY INC	1.33	Information Technology

In fact that is not the case. The methodology setting the components takes into account volatility as well as upward price momentum Although its largest sector is technology(36%)  It only includes one stock of the FAANG among its top twenty holdings: Apple which has the lowest p/e of the group.

Mtum actually includes a far smaller % of its holdings in the FAANG stocks than the S+P 500 whose top holdings are below

And not at all surprisingly the Nasdaq has an even higher weighting of FAANG stocks which make up 37% of QQQ (Nasdaq 100 etf)

The technology ETF (XLK) has  31% of its holdings in FAANG  ( and this despite the fact that Amazon and Netflix are in consumer discretionary not technology).

Because of this differential MTUM is far less sensitive to moves in the FAANG stocks..or to any single stock that loses price momentum.

Mtum also puts a sell discipline on investors. As a stock loses upward price momentum it automatically comes out of the MTUM portfoilio
On the other hand whether or not to sell one's exposure to the technology sector either by selling SPY and diversifying into other "smart beta" ETFs, or selling QQQ or XLK leaves the investor with a timing decision. And we know all the behavior pitfalls in market timing and buy/sell decisions. In fact MTUM is "on the opposite side" of the panic sellers since it automatically adjusts and rebalances to reduce holdings of stocks without positive price momentum

As Facebook took its major drop of 7% on March 19 here is what MTUM,SPY,QQQ, and XLK have looked like since March 12 total return chart and bar chart of same data

SPY(green) MTUM(Black), QQQ(gold) XLK (blue)
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Total Return (top) Volatility (Bottom)

SPY(green) MTUM(Black), QQQ(gold) XLK (blue)

Watch Your Duration..Update

I wrote a little more than a month ago about the impact of duration on the traditional 60/40 stock bond allocation which often includes a total bond index like ETF BND as its bond allocation. With its 7 year duration it has a high price sensitivity to rising interest rates.

Alternatives to shorten the duration would include the Vanguard short term blend ETF(government and corporate bonds symbol BSV) or the ishares floating rate note ETF (ticker Flot)

Year to date returns might give a picture of how a 60/40 portfolio will perform with rising rates. All charts below compare the portfolios to 100% S+P 500

Returns YTD :

60/40 S+P 500/BND:+.3%

100% S+P 500 (blue) 60% BND 40% S+P 500 (green)

60/40 S+P 500/BSV  +1.0%:

100% S+P 500 (Blue) 60% S+P 500/40% BSV (Green)

60/40 S+P 500/FLOT  + 1.5%:

100% S+P 500 (blue) 60% S+P 500/40% FLOT (Green)

Apparently market participants have been making adjustments. Here is data for FLRN the State Street (SPDR) floating rate ETF which has $2.3 bln under management compared to the Ishares equivalent FLOT whch has $7.6 bln in assets

NFLX = Shooting Star Stock ?

I have written several times about "shooting star' stocks. They usually produce a product that is well known to consumers ("everyone is buying it"), trades at a very high p/e which reflects extreme optimism for the future, and--because it has strong upward price movement--develops momentum which in turn creates further purchases. One small decline in the fast pace of earnings growth and the stock can fall to earth.

Most often these are small cap stocks making small growth stocks a particularly poor market sector in terms of risk return.

But it seems to me Netflix falls into this category. It is certainly a ubiquitous product and still has many international markets to join...and I am a member. But it seems its offerings of studio films is declining as they expand their "original content". Producing that original content" is expensive..and also extremely difficult to produce good content. And Netflix is going head to head with Amazon already. Disney is beginning its own streaming content..and Apple which already has movies for rent on itunes is eyeing this market.

Thוs Netflix with no particular comparative advantage in content,no unique technology and no huge base of consumers to cross sell its streaming service to . And Apple and Amazon have far deeper pockets than Netflix. Ironically the huge runup in Netflix market cap makes the prospect of acquisition by Apple or Amazon less likely than it might have been a year ago.

Here is a chart of Netflix vs Apple and the S+P 500 Netflix price gain  of around 130% over the last 52 weeks. The netflix gain is so large it obscures the large outperformance of Apple vs the S+P 500. Nflx p/e is 225.8

Netflix (black) Apple (blue) S+P 500 (gold)

I certainly won,t mention a prediction of the future of Netflix stock. I would say that among the oft cited FANG stocks (Facebook, Apple,Netflix and Google) it has the least unique technology or dominance in its product sector.

Yet Apple trades at a p/e of 19, google at a p/e of 65(as noted above for netflix it is 225.8). Only Amazon is above netflix in valuation at 261. But of course Amazon is dominant in many business sectors and awash in cash. It can offer its streaming service for nothing as part of amazon prime because it drives so much business to its other products. Once you are on prime you order more,are more likely to buy an alexa or kindle etc.

Easy to see the risk in this shooting star falling back to earth. Although it has led market gains its market cap is sill small enough relative to the other fang stocks (and even less so after adding in stocks like Microsoft and a few others) the impact would likely not be extreme for the market.

Some opinions on NFLX in the WSJ here 

Netflix’s Massive Rally Draws Attention of Skeptics

It's A Momentum Market

3 Year total return:
Momentum (MTUM) 68.8%
S+P 500 (SPY) 44.8%
S+P 500 Equal Weighted (RSP)36.2%

Total Return MTUM (Green),SPY (blue),RSP (gold)

          Total Return (top ) Volatility (bottom)

What to Do About Currency Fluctuations and Your Portfolio ? Best Answer: Nothing

The WSJ recently had a recent  article on investors and how they should react to currency fluctuations. The WSJ articles explains several ETFs that  hedge portfolios against a weakening dollar but their core conclusion hits the right note:

The dollar’s recent drop to a three-year low against other major currencies raises a natural question: How should investors in mutual funds and exchange-traded funds handle currency fluctuations?

There are many options, including funds that allow investors to speculate on currencies’ short-term direction. But analysts say investors are best off with a plain-vanilla approach—having some exposure to foreign currencies through international stock and bond funds and just leaving it at that.

Having worked in the currency markets over a dozen years I can testify that currency movements are impossible to forecast. One of my responsibilities was to routinely take media calls asking to "explain" the market moves of the day. Of course they weren't looking for an answer that the movements of the day were pretty much random and there always was some "reason" an economic release or central bank announcement somewhere in the world, movements in other commodity or financial markets. But all of those factors could have been used to "explain" movements in the opposite direction.

 I am reminded of a colleague who came home from work one day and her spouse asked her about the direction of the dollar. :"It's definitely going up,,she replied". Her husband responded" but two days ago you said it was definitely going down"..to which she answered"I changed my mind".

Given that currency movements are unpredictable and that unlike stocks in the long term: one cant count on the dollar to go up (or down) vs foreign currencies the best strategy is to take the positive diversification to both foreign economies and currencies by simply purchasing a foreign stock fund.
As for the currency diversification..you get that in both a stock and bond fund,

Note that I wrote foreign stock fund..not foreign stock and bond fund. A  foreign stock fund offers currency and stock exposure and the characteristics of stocks--long term unlimited upside and limited downside risk.

 A bond offers limited upside--interest rates cant fall below zero so capital gain on bonds is limited-- but potential losses are far higher since interest rates could move up in double digits creating double digit losses. As we know from duration 3 percent rate increase on an international bond fund with a 7 year duration is a 21% decline in price. So one would need a 21% favorable currency movement to make up for the price decline of the bond in local currency terms...a huge move even in the volatile world of currency markets.

Furthermore, the bond allocation of a portfolio is supposed to offer the stable anchor..international bonds add more stability. Emerging market bonds add even more risk.

Although making market calls is fraught with pitfalls it does seem to me that purchasing etf IAGG an aggregate bond etf which has a duration of 7.3 years and a yield of  .99% has a pretty more risk/return characteristics in terms of the prices of the bonds in the portfolio, As for currency risk..that can be taken through a foreign stock allocation.

Watching Duration An Interesting Chart

From Blackrock

The steady increase in shorter-maturity bond yields provides a thicker cushion against concerns around further rises in interest rates. The light green line in the chart above shows interest rates would need to jump more than one percentage point to wipe out a year of income in the two-year Treasury note. This is nearly double the cushion on offer two years ago – and far larger than the thin insulation provided by longer-term bonds today. We believe the short end offers relatively compelling income along with a healthy buffer against the prospects of further increases in yields.