Saturday, July 19, 2014


Market Cap. There continues to be an uncanny relationship between a company’s market capitalization and year-to-date returns. The largest 500 stocks in the Russell 3000 are up an average of 8.5% this year, while the smallest 500 are down an average of -6.1%.
From the beginning of July, when the small cap Russell 2000 Index peaked, the differential has been stark, with the top 500 stocks only marginally lower while the bottom 500 are down over -5%.
What is driving this incredibly strong relationship between market cap and return?
It can be explained in part by a simple reversion to the mean as last year the smallest stocks (microcaps) widely outpaced the S&P 500 and we are seeing a complete reversal thus far in 2014.
But there is more to the story here. As I have been writing about since January, small caps had been outpacing large caps for over fifteen years. This incredible run has left their shares extremely stretched on both an absolute and relative valuation basis.
One could quite easily make the argument that small cap valuations are at/near their most extreme in history (See: “US Small Cap Rally Sends Valuation 26% Above 1990’s”). Indeed, one of the smartest minds in the investment business, Jeremy Grantham of GMO (with over $100 billion in AUM) is projecting U.S. small caps to have a negative real and absolute return over the next seven years.
This suggests that the underperformance in small caps this year may not be a short-term phenomenon and could very well continue for some time. It also suggests that small-cap effect that many have become accustomed to may be absent for a while, at least until valuations are normalized.
What does this mean for the broad markets? For now, market participants remain highly bullish and are largely ignoring the small cap weakness, focusing instead on the all-time highs in the Dow (DIA) and S&P 500 (SPY).
Many of these participants are pointing to March and April of this year when small declined in consecutive months while the large cap indices continued higher as a template for what will happen next.
While this is certainly possible, I would caution investors against assuming this is high probability and a normal market relationship. It is not. As I wrote back then, this was the first time in history that such a consistently wide divergence had occurred.
Also, if you believe that small caps are declining because of valuation concerns, wouldn’t it stand to reason that investors will soon become concerned with large cap valuations? After all, while large caps are cheaper on a relative basis, they are anything but cheap on an absolute basis, as evidenced by the negative real returns expected by Grantham over the next seven years.
I would also note that despite the daily headlines about all-time highs, the most defensive area of the market, long duration Treasuries (TLT), continues to widely outperform. We are also seeing other signs of classic late cycle behavior, as I wrote about recently in showing the troubling similarities to July 2007.
Overall, the rotation out of small and micro caps should not be ignored by market participants. It is a clear sign of defensive behavior and is likely to have ramifications on investor returns not only in the near-term but for years to come.

Tuesday, July 08, 2014

Thursday, June 19, 2014

The free portfolio is here....

  • Covestor said this week it is building portfolios of ETFs for free.

  • Look out, smalltime financial advisors!
The wall of investment-management fees has been crumbling for some time. Wealthfront, another firm offering basic, pre-set ETF portfolios, last year said it would manage up to $1 million for 501(c) nonprofit organizations for free. Fees after the first million: 0.25%. The firm recently surpassed $1 billion in assets under management.
These efforts turn the typical model of the financial-advice business on its head. Advice is a scale business. The wealthier you are, the lower your fees. But it’s arguably the smalltime investor who could benefit the most from being freed of high fees.
In that regard, advisors often charge 1% or more a year to manage your money, on the theory that you won’t do it yourself, they can’t do it for much less and you can’t get a better deal elsewhere.
But if, like me, you don’t expect more than 6% annual long-term gains from stocks, an advisor who puts you in expensive mutual funds after laying in his own fee is siphoning away perhaps a third of each year’s expected return. Of course, he takes none of the risk. That’s reserved for you.
Compound lost returns over 20 or 25 years to see why your advisor drives a Jaguar and you drive a Honda.
Covestor’s program entails no management fee, just the underlying ETF expense ratios, which are measured in fractions of a percentage point, and trading commissions, which the firm estimates to be $20 a year.
So what about the portfolios? They’re about as basic and low-cost as the ETF market offers.Covestor Core Balanced Portfolio, targeting the Dow Jones Moderate Indexis invested in four funds from Vanguard Group and one from BlackRock’s (BLKiShares.
That’s 33% in Vanguard Total Stock Market ETF (VTI), 24% in iShares Core U.S. Aggregate Bond ETF (AGG), 15% in Vanguard FTSE Emerging Markets (VWO), 13% in Vanguard FTSE Developed Markets ETF (VEA), and 5% in Vanguard REIT ETF (VNQ). Those ETFs’ combined weighted expense ratio is less than 0.08%. 
This is no threat to the high-end financial advisor. But I expect to be a threat to the ones who charge smalltime investors 1% or more.

Sunday, June 08, 2014

Warning, Warning: This could only be launched into boiling mkt froth

New Short Squeeze ETF Coming to Market

"From Dec through May; the Federal Reserve bought 73% of all new US Treasuries." Strategas

Why You Have Way Too Much Invested In U.S. Stocks

Japan’s stock market rose to account for nearly half of the world’s market cap. And if you believed in the efficient market, you would have invested half of your equity allocation in Japan.But  Japan returned approximately -2% per year from 1990-2010, including more than 20 years of negative returns. A value-driven approach works not just by investing in the cheapest markets, but also by avoiding the most expensive.

What is the biggest country in the world by market cap now? The U.S., with nearly half of global stock-market capitalization.
Figure 5 shows the cheapest and most expensive countries in the world. Notice that the U.S. is one of the most expensive countries in the world.

Figure 5 – Five Cheapest and Five Most Expensive Countries, May 2014

Five Cheapest and Five Most Expensive Countries
If you look at where we stand today with world valuations in the chart below, the U.S. is actually above the upper end of the range for expensive countries. This chart could be used to help guide when to allocate more to the U.S. versus the rest of the world. The U.S. was cheap relative to the rest of the world in the early 1980s, which also happened to be the start of the long bull market. The late 1990s saw the U.S. near the top of the range, which preceded the bear market that began in 2000. 
Will the current overvaluation signal another bear or perhaps a time to shift more assets to foreign markets? Time will tell.

Figure 6 – CAPE ratios of expensive, cheap, USA and all countries

CAPE ratios of expensive, cheap, USA and all countries
I examine how to form portfolios of the cheapest countries in a new book, Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market.
The bad news is the U.S. stocks are expensive, although not in bubble territory.  I expect U.S. stocks to return about 4% per annum for the next 10 years.  The good news is most of the rest of the world is quite cheap. Here are a few actions investors can take to improve the future returns of their equity portfolio:
  1. At a minimum, allocate your portfolio globally reflecting the global market-cap weightings. For a U.S.-based investor, that means allocating 50% of your portfolio abroad.
  2. To avoid market-cap-concentration risk, consider allocating along the weightings of global GDP. This would mean closer to 80% in foreign stocks.
  3. Ponder a value approach to your equity allocation. Consider overweighting the cheapest countries and avoiding the most expensive ones. Currently, this would mean a low or zero allocation to U.S. stocks. This does not mean simply picking one or two countries, but rather a basket of the cheapest countries – 10 is a reasonable number.
For U.S. investors, how many of your stocks are in the domestic market? Once you account for the fact that the U.S. is one of the more expensive markets around the globe, it could be a good time to rethink your stock allocation. 

Friday, May 30, 2014

Perspective on EM Rally

Emerging markets have been on quite a tear this year.  Just as pretty much everyone gave up on the asset class, the emerging markets ETF (EEM) made a low in December and has rallied by over 16% since.
The question now is whether or not the sector has reversed its multi-year downtrend relative to the United States.  The chart below shows the relative strength of emerging market equities compared to the S&P 500 using the ratio of ETFs EEM (emerging market ETF) and SPY (S&P 500 ETF) as a proxy.  When the line is rising, it indicates that emerging markets are outperforming the S&P 500 and vice versa when the line is falling.  In spite of the big run in emerging markets over the last four months, it barely registers when looking at a two-year chart of the sector's relative strength versus the S&P 500.  Additionally, the recent high in the ratio still has yet to clear the low in the ratio from 2013.  That being said, the downtrend from the late 2012 peak has indeed been broken.  While you should probably wait until the prior low in the ratio from late 2012 is cleared, if the turn for emerging markets is truly here, there is a lot of room for additional upside just to erase the relative weakness from 2013.

Thursday, May 29, 2014

Arden: The real reason hedge funds have been underperforming

Hedge funds have long been accused of clustering, or crowding into too many of the same trades -- whether their herding behavior is better or worse than that of other institutional investors is a matter of much debate. Another recent—and frequent—­­­­complaint has been that hedge funds underperform the broader market, with an average return one third that of the S&P 500 Index for 2013.
As the monthly numbers for May begin to come in, we will surely be hearing more about struggling hedge funds, but this misreads both how hedge funds work and recent events in the market.
First of all, when people talk about "hedge funds" in this case they are actually referring to long/short equity funds such as the one founded in 1949 by Alfred Winslow Jones, the sociologist and journalist (he wrote for Fortune) who popularized the term (and that particular strategy; there are now many different strategies that fall under the umbrella term "hedge fund" that perform differently from each other). The reason Jones—and a great many subsequent managers—embraced the long/short strategy is that it enables you to make money in good markets on your longs and in bad markets on your shorts. This is not to say that in all markets you will make money on both your longs and your shorts, rather that the combination of profits on longs in rising markets and shorts in falling markets will create an attractive, diversifying return over time.
Very rarely, however, the longs and the shorts both underperform the markets during the same month. According to our analysis based on data from Goldman Sachs, this dual underperformance has happened only 10 times—or 6.5% of the time—since Goldman began tracking hedge fund holdings and monthly performance in 2001. Yet it happened in March, and then it happened again in April, making two consecutive months of losses on both the long and short side for the first time ever. So while the S&P 500 has posted a 2% rise so far this year, equity long/short funds have declined by about the same amount.
You might think from looking at the S&P 500 that not much has happened during this two month period, but underneath that broad index there has been a substantial shift out of growth and momentum stocks—including many of the most popular and significant longs in hedge funds such as Google (GOOG) and Apple (AAPL) —and into the more defensive value stocks, which are currently under-owned by hedge funds. The reversal was fairly severe, with the technology and healthcare sectors hit hardest, in addition to some internet stocks that recently went public, which, prior to the sell-off, had unrealistic and aggressive forward growth estimates priced into the stock prices. The crowding into, and out of, those trades isn't a cause but a symptom of the narrowing of the market in general, where small changes in the supply/demand imbalance can have a dramatic impact on market prices (in this case, the catalyst for the sell-off was comments by the Fed's Janet Yellen in February that were perceived as hawkish).
This situation is unusual, but it can happen in the latter stages of a bull market (the industry's euphemism for it is "a period of consolidation"). Typically during this stage of the cycle, the weakest hands enter the market and chase what had worked for the preceding periods, in this case growth and momentum versus value. Then when the trades do not work out as planned, as has been the case in the last two months, the weak hands are first to unwind their positions, creating selling pressure on both sides of the portfolio, long and short.
There have been similar periods where large themes and crowded positions have moved against hedge fund managers, but historically, these periods have been short-lived. In the past, those managers who stayed the course usually discovered that these conditions are transitory and don't last.
The takeaway is not that hedge funds are laggards, or trades are too crowded, but more simply this: There are times when being long/short doesn't always work, but they are usually short-term. In the last few years, the long-only strategies have outperformed the more diversified, long/short strategies. Over the long term, however, the theory still holds true that diversification is the only free lunch in finance. That's the long and short of it.
Ian McDonald is chief investment officer of Arden Asset Management and Darren Wolf is director of research. This article represents the authors' viewpoint of the subject matter contained and is not intended as investment advice or recommendation for a specific subject. 

The Liquid Hedge Fund that Never Goes Up

Today we’re going to talk about the boom in hedge fund-like mutual funds .
I once looked at a “liquid alternative fund” from Natixis – liquid alts are products that purport to offer hedge fund strategies in a ’40 Act mutual fund wrapper – and I couldn’t understand a word of what the wholesaler was talking about.
It was early 2011 and they were pushing this Dr. Andrew Lo vehicle called ASG Diversifying Strategies Fund. The idea what that Dr. Lo, perhaps one of the most brilliant quantitative scientists and academicians in finance (MIT, Harvard, all kinds of awards, PhDs out the ass, etc), would be incorporating a variety of approaches to manage the fund using all asset classes, derivatives and trading methodologies that he and his team saw fit to apply. As the strategies were explained to me, I nodded as though I understood – but it was Greek, locked in a black box, dumped into a river, in the middle of the night, as far as I was concerned.
Regretfully, I declined to get myself involved. But I promised the nice man from the mutual fund company to watch it and perhaps feel foolish in hindsight.
But that’s not what ended up happening.
What actually did happen was this: Andy Lo, maybe one of the smartest men in the history of finance, managed to invent a product that literally cannot make money in any environment. It’s an extraordinarily rare accomplishment; I don’t think you could go out and invent something that always loses money if you were actually attempting to.
Since its inception in August of 2009 – weeks after the generational bottom – the ASG Div Strat Fund lost money during almost every quarter. It’s compounding at something like negative 7% a year since 2010. It managed to lose money in a bad market (2011, negative 2.75%), a good market (2012, return was negative 7.69%) and a raging bull market (2013, in which it lost another 8%, inexplicably). It’s hard to say that it’s meant as a bear market vehicle or a short fund, because it actually earned 8% in 2010 with the S&P up 15. So if you ask “What is the ideal environment for this strategy?” the answer is that there isn’t one.
By the way, it’s actually somehow down another .73% year-to-date – with stocks, commodities and bonds all higher so far in 2014. I have no idea what the hell is in this thing. I don’t think I’ve ever seen anything like it.
In the meantime, this fund – and other alternative funds like it – takes a net internal expense ratio of close to 2% of assets while the brokers who sold their clients the A shares have been paid 5.75% upon purchase.
In other words, if this is the “alternative”, the real thing probably ain’t all that bad in comparison. Actually, just for the hell of it, let’s look at the alternatives to the alternative since this fund’s start date:
We won’t even get into the turnover and tax consequences here…
And yes, this is an extreme example – but again, coming from an extremely well-pedigreed management team, perhaps the best you could find. You would write Dr. Lo a check ten seconds after seeing him speak somewhere, trust me.
So this is why you rarely see fiduciary advisors getting excited about black boxes and unorthodox strategies – even when wrapped inside a friendly mutual fund casing.
But brokers on the other hand…
Wall Street Journal:
In 2013, liquid-alternative funds made up half of the net sales at firms like Bank of America Corp.’s Merrill Lynch and Morgan Stanley that sell mutual funds to investors, up from 38% in 2011, according to a report from Dover Financial Research, a Boston-based consulting firm, on behalf of the Money Management Institute, a trade association.
But despite that growth, investor portfolios have less than 5% of assets in liquid-alternatives funds, compared with as much as 20% recommended by banks.
One of the reasons money managers like the funds is the same reason financial advisers don’t: high fees. Because they use more complicated trades, the average expense ratio for a liquid-alternative fund is 1.9%, compared with 1.3% for a typical mutual fund and 0.8% for an index fund, according to Morningstar. An investor would pay $190 for every $10,000 invested in a liquid-alternative fund, versus $80 for every $10,000 in an index fund.


Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.