How To Pick A Sector ETF

Sector investing is popular, and we’ve been hearing a lot about sector rotation opportunities in the face of changing correlations since President Trump’s victory last year. But as an investor, how do you know when it’s time to get in or out of a sector? How do you pick the best sector to be in?

Unfortunately, there’s no single recipe that works here. Different investors look at different metrics and go about it in different ways in their hunt for the best sector for maximum return and minimum risk—price momentum, historical relative performance, job market trends, changes in volatility, volume, GDP data, etc.

 

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Do ETFs Cause Bubbles?

As U.S. stock markets have reached all-time highs some people are pointing the finger at exchange-traded funds, arguing that ETFs have caused this run-up because they have become so popular so quickly, and in the process have created a bubble waiting to burst.

It is tempting to believe these bubble fears are true. After all, the growth of ETF assets under management has averaged almost 20 percent annually during the past 10 years. That’s spectacular growth, so it’s no surprise that recent headlines are warning investors to watch out for the trillion-dollar stock bubble being caused by ETFs and index funds.

So is there a bubble, and is that bubble being caused by ETFs?

Well, no—and yes. What we found is that there really isn’t an immediate, massive and dangerous bubble in the way suggested by the headlines. But bubbles might be forming in some less-liquid areas of the market.

Quantifying Ownership

We set out to find answers to this bubble question with hard data using “ownership software” we created at Toroso that measures whether ETFs are affecting valuations of individual stocks.

Our software takes the 500 ETFs focused on U.S. equities and compares them to all U.S. equities—essentially, the Russell 3000 Index. It tells us that right now, on average, ETFs own about 6.29 percent of the market value of every stock.

Again, that’s an average. Some stocks will have higher ETF ownership, meaning ETFs are more likely to affect valuations of underlying stocks, and some are going to have lower-than-average ETF ownership, meaning ETFs are less likely to affect valuations.

But that average is growing. The first time we used our software five years ago, ETFs owned an average of 2.67 percent of the market value of every stock, which makes concerns about the formation of a possible bubble more tangible. So, we looked more closely.

No Bubble For Large-Cap Stocks

We looked at Apple—one of the most widely held stocks—to get a better handle on this bubble question. Apple is 4.7 percent owned by ETFs. It represents 2.5 percent of our investable universe and only 2 percent of ETFs assets. In other words, it’s slightly under owned by ETFs.

I think it’s very hard to argue that Apple’s share price is being influenced by ETFs and that ETFs owning popular stocks like Apple are creating a bubble.

In other words, I would say what’s true about Apple is also true of just about all large-cap stocks in the S&P 500 Index or in the Russell 1000 Index. The data just does not support the argument that ETFs are causing the market to reach all-time highs. But ETFs are a convenient access point, and that’s about it. Below we list the average equity market-cap ownership by ETFs of major Indexes:

S&P 500: 4.7 percent

Russell 1000: 4.8 percent

S&P 1500: 4.9 percent

While we don’t believe there’s a broad-base bubble caused by ETFs, we do believe there are bubbles that ETFs have extended or expanded in specific sub-sectors of the stock market.

Bubble Risks In Sub-Sectors

Returning to Toroso’s ownership tool that clarified that Apple is definitely not over-owned, we noticed that the companies on our daily list of stocks that are over-owned by ETFs are frequently REITs or realty companies or property trusts.

In other words, the real estate sub-sector is a place where ETFs appear to be pushing up valuations. That’s a pretty good indication of what is quite likely a unique bubble in the ETF space.

Let’s look at one example: National Retail Properties, a well-known REIT. About 17 percent of its market cap is owned by ETFs. When you look at the various ETFs that own that stock, you find a big and varied list. It’s owned by the Vanguard REIT ETF (VNQ), the biggest fund in its category (the average ETF ownership of the stocks in its portfolio is 11.3 percent,) and it’s owned by dividend ETFs—neither of which is a surprise. It’s also owned by mid-cap and small-cap ETFs (National Retail Properties’ market cap of $6.3 billion typically places it in the mid-cap category, but some money managers define market-cap sizes differently), and even by style ETFs focused on both growth and value.

So the headlines may be right about a stock market bubble, or a bubble caused by ETFs. However, the data suggest:

1. ETFs have little to do with whether or not there is a bubble in the broader U.S. markets.

2. ETFs are likely perpetuating bubbles in certain sub-sectors.

Michael Venuto is chief investment officer at Toroso, a provider of ETF research and thought leadership.

Source: ETFA-MAG

What’s Next For 2 Other Bitcoin ETFs?

The Securities and Exchange Commission did not approve the first physical bitcoin ETF, the Winklevoss Bitcoin Trust (COIN), after more than three years since the filing first entered the regulatory pipeline. In a 38-page statement released Friday, regulators cited concerns over bitcoin’s unregulated status, and the difficulty of preventing manipulation and providing oversight in this type of market. For those reasons, they were saying no to the first proposed physical bitcoin ETF.

The ruling was a massive setback for COIN. But COIN isn’t the only physical bitcoin ETF awaiting approval, and the SEC will have to weigh in on each one of them. Mike Venuto, co-founder and chief investment officer of Toroso Investments, has been closely following the bitcoin space, and shared with us what he sees happening ahead. His firm owns exposure to bitcoins via Grayscale (GBTC) on behalf of its clients.

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Betting On Red: Building A Russian ETF Portfolio

Russia has been in the news in the past few years, and ETF investors owe it to themselves to take measure. We take a closer look at Russia—a big oil-producing country whose actions affect geopolitical stability, the price of oil and, if you believe it, even the 2016 U.S. presidential election.

Whether you’re long or short, to choose the right ETF for Russia exposure, you need to know what’s available. Let’s start by looking at ETF.com, which lists six ETFs that have exposure to Russia. In reality, only four of those require looking under the hood, because two of the six are triple-exposure funds built around the same index as the VanEck Vectors Russia ETF (RSX), the largest fund in the category.

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This figure helps explain why so many active ETF managers underperform

Are your active funds active enough?

Non-passive funds—where the components are chosen by a team or through a rules-based system, rather than simply tracking a benchmark—have fallen out of favor in recent years, with investors instead gravitating toward funds that are cheaper, easier to understand, and which never underperform.

Another factor keeping investors from embracing them? These active funds may, in fact, be too passive.

A key metric for evaluating mutual funds and exchange-traded funds underlines why active and “smart beta” products have seen far less adoption than their passive equivalents: active share, or the degree to which the holdings of a non-passive product overlap with its closest benchmark (for example, an active large-cap U.S. equity fund compared with the S&P 500 SPX, -0.20%

If an active or smart-beta fund has a low active share, either by holding the same securities or having similar allocations to its benchmark, then it will have a high correlation with that index. (For this reason, portfolio managers with low levels of active share are frequently referred to as “closet indexers.”) This limits the fund’s potential for outperformance, especially after fees are taken into account.

If investors are able to get similar performance for a cheaper fee, it’s hard for an adviser to advocate for a nonpassive product instead. In fact, data has shown that an overwhelming number of active funds underperform over the long term, as do smart-beta funds.

This could be a reason why active and smart-beta funds have seen comparably less interest. Thus far this year, $5.28 billion has flowed into active ETFs, according to Morningstar data, while $41.2 billion has gone into smart beta, which Morningstar refers to as “strategic beta.” More than $223 billion has gone into passive ETFs.

“There’s a bit of research that shows if you don’t have at least 80% active share, then it’s unlikely that you will outperform after fees,” said Andrew Slimmon, a managing director at Morgan Stanley Investment Management, where he is the lead senior portfolio manager on all long equity strategies for Applied Equity Advisors. Referring to the active managers who notably outperform, he said “the key issue is that they have more dispersion to the index.”

Passive strategies are particularly strong in periods of robust economic growth, when the market’s gains are broad based. Active managers tend to perform better in periods of volatility, as in the third quarter of this year, when 53% of active managers outperformed their benchmark, according to data from J.P. Morgan. That quarter was marked by post-Brexit volatility, as well as uncertainty going into the U.S. election. Because of events like that, Candace Browning, the head of BofA Merrill Lynch Global Research, recently wrote that “2017 could be the year of the active investor.”

Of course, high active share cuts both ways. Assuming a fund doesn’t frequently change its holdings en masse, it will go through periods when its strategy is in vogue, allowing it to outperform, as well as through periods where it is out of sync with the market cycle, leading to underperformance.

“Active share does not mean outperformance. What it means is the potential to outperform,” said Michael Venuto, chief investment officer at Toroso Investments. “No active share means no outperformance, guaranteed. If you have it, then you at least have the potential.”

Venuto uses active share calculations in researching prospective funds to invest in. As an example, he compared the PowerShares Exchange Traded Fund FTSE RAFI US 1000 Portfolio PRF, -0.25% —a large-cap equity fund—with the SPDR S&P 500 ETF Trust SPY, -0.22% which tracks the S&P 500. The two funds have an overlap of 70%, per his calculations, but while the PowerShares fund comes with an expense ratio of 0.39%, the SPDR fund has a fee of 0.09%.

“For that 70%, I should only spend what it costs to get the S&P,” he said. “Therefore, you’re basically paying 30 basis points for the remaining 30%—for the active share. That would be like paying 90 basis points for the fund overall, and I do not feel that there’s enough difference in the active share to justify that expense ratio. This isn’t the only thing I’d look at here, but this alone is definitely enough to deter me from the product.”

Venuto’s calculations were derived from software his firm developed. Invesco, which manages the PowerShares family of ETFs, didn’t immediately return requests for comment.

The average expense ratio for a U.S. smart-beta ETF is 0.356%, according to Morningstar. For a passive fund, it is 0.344%, although many of the most popular offer ratios below 0.1%, and analysts view the passive industry as being in a “race to zero.” Active ETFs that cover U.S. stocks have an average fee of 0.864%.

For a large-cap equity fund that justifies its expense ratio, Venuto cited the Direxion All Cap Insider Sentiment KNOW, -0.05% which has a fee of 0.65% but only a 14% overlap with the S&P 500. “The overlap is so low that the ‘smart’ portion of the portfolio is equal to the expense ratio. What you pay coincides with what you should actually pay.”

He added that in a case like this, he would also research the fund’s strategy, tradability, and spreads before investing.

The problem with active share is that it is difficult to calculate—especially for mutual funds, which don’t disclose their holdings daily, unlike ETFs.

Dave Nadig, the chief executive officer of ETF.com, an ETF research and analytics firm, said he was of “a mixed mind” about using active share as a guiding principle.

“I’m a skeptic for people leaning too hard on it, as it is challenging to calculate and because it doesn’t predict performance so much as increase the risk for a higher dispersion of performance,” he said. “That said, if you want outperformance, a high-fee low-active manager is not going to give you what you’re looking for. You’d basically be buying an expensive index.”

Source: marketwatch

ESG ETFs Help Investment Portfolio’s Conform to Investors’ Attitudes

As many seek to diversify their equity portfolios, consider a sustainable investing exchange traded fund strategy that locks on the potential benefits of environmental, social and governance, or ESG, principles.

On the recent webcast (CE Credit available on-demand), The Untapped Potential of ESG Investing, Sharon French, Head of Beta Solutions at OppenheimerFunds, explained that there is growing demand for ESG investments in response to rising standards for corporate business practices, demographic shifts and investing preferences, regulatory and policy developments, global sustainability challenges, and greater accessibility and proliferation of ESG data.

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ETFs that go up when markets go down 

The current market uncertainty and anxiety by investors is being fed by the elections, the interest rate and the knowledge that the Federal Reserve will not keep helping the economy for now. So what can we do with this uncertainty? Let’s talk about ETFs that can protect you on the downside.
PREMISE
2016 has been a year full of surprises
Uncertainty is still in investors’ minds.
FINDING ALTERNATIVES
ETFs that go up when the markets go down
Traditionally there are two: inverse ETFs and Volatility Tracking ETFs (VIX).
The trick? You have to know when to use each one.
OUR IDEA
BTAL: a traditional, yet protective bet
The index has done very well of giving you a return when the market goes down and can be used as a buy and hold vehicle. You are getting risk protection and not getting the exact difference on the other side.

KNOW Characteristics: Finding the Right Factors

In this paper we will explore the evolution of smart beta investing through the advent of academic factor investing and examine how the characteristics sought by the SBRQAM Index can potentially overweight and/or rotate through the most common factors contributing to competitive performance.

The Sabrient Multi-cap Inside/Analyst Quant-Weighted Index (SBRQAM), is an index that investors can obtain exposure to through the Direxion All Cap Insider Sentiment Shares ETF (ticker: KNOW). For the most recent quarter end performance of the Fund, please see the disclosure page.

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Portfolio X-Ray: Toroso’s Neutral Allocation Strategy

by Cinthia Murphy

There is no single recipe to building an ETF portfolio. But understanding how a portfolio is built is key to picking the right one. And choices certainly abound, with hundreds of ETF strategist portfolios commanding nearly $100 billion in combined assets today.

For that reason, we are setting out to better understand how ETF strategists go about creating these portfolios in a series of interviews that look under the hood of some of the ETF portfolios available to retail, institutional and advisor clients alike.

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