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.

What is Smart Beta?

What is Smart Beta?
Any ETF that follows a non- traditional market cap index in an effort to produce superior risk adjusted returns.
Smart Cost of Smart Beta
At Toroso We have developed a proprietary software to evaluate the cost of Smart Beta in a fast, efficient way. It is a Four Step Process that you can learn here, in our ETF Prism Report.

STEP I
Set a Benchmark
With a high correlation.
STEP II
Determine the Overlap
Make sure you are producing something that is different to give you the possibility to outperform.
STEP III
Calculate the difference
Apply the difference in active share to the difference in expense ratio.
STEP IV
Compare and Contrast
Smart cost should be equal or less than the expense ratio.

 

 

 

Disclaimer

This presentation has been prepared solely for the intended recipient and contains highly confidential and proprietary information that are of independent, economic value to Tidal Growth Consultants (“TGC”). By viewing this presentation, you agree not to alter the contents of this presentation in any manner prior to re-distribution without the prior written consent of TGC. This presentation does not constitute investment advice and the fact that a security may be mentioned in this presentation does not mean it is recommended or is a suitable investment for any recipient or to be recommended by any recipient of this presentation.

Different types of investments involve varying degrees of risk.  Registered investment advisers, financial advisers, family offices and registered representatives should be aware that by using TGC’s services, the investment return and principal value of securities they may recommend to client will fluctuate based on a variety of factors, including, but not limited to, the type of investment, the amount and timing of the investment, changing market conditions, currency exchange rates, stability of financial and other markets, and diversification.  There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment.  No investment strategy can guarantee profit or protection against loss in periods of declining values.  No assurance can be given that capital market assumptions will prove to be correct, and the difference between assumptions and actual conditions could vary materially.  

When a financial planning representative recommends exchange-traded funds (“ETF’s”) and other investment companies, they should disclose that such funds will indirectly bear its proportionate share of any fees and expenses payable directly by the underlying ETF’s or other investment company. Therefore, that portfolio will incur higher expenses. In addition, ETF’s are also subject to the following risks (i) the market price of an ETF’s shares may trade above or below its net asset value; (ii) an active trading market for an ETF’s shares may not develop or be maintained; (iii) trading of an ETF’s shares may be halted if the listing exchange’s officials deem such action appropriate, the shares are de-listed from the exchange, or the activation of market-wide “circuit breakers” (which are tied to large decreases in stock prices) halts stock trading generally; or (iv) the ETF’s may fail to achieve close correlation with the index that it tracks due to a variety of factors, such as rounding of prices and changes to the index and/or regulatory policies, resulting in the deviating of the ETF’ s returns from that of the index.

Financial Planning representatives should disclose to clients and prospects, as TGC is disclosing herein, that past performance is no guarantee of future results and every investment may lose money. No guarantees or assurances are or can be made as to performance of any investment.

Registered investment advisers, financial advisers family offices and registered representatives should consider the investment objectives, risks, charges and expenses of an investment strategy before using TGC’s services and prior to recommending any such investment strategies to its clients and/or prospects.  A prospectus and/or other applicable offering documents contain this and other important information about the investment strategy.  Investors should read the prospectus and/or other applicable offering documents carefully before investing. 

Certain of the economic and market information contained in this presentation has been obtained from published sources and/or prepared by third parties. While such sources are believed to be reliable, neither TGC nor its respective affiliates, employees and representatives assume any responsibility for the accuracy of such information. 

ETF Prism Report

 

Disclaimer

This presentation has been prepared solely for the intended recipient and contains highly confidential and proprietary information that are of independent, economic value to Tidal Growth Consultants (“TGC”). By viewing this presentation, you agree not to alter the contents of this presentation in any manner prior to re-distribution without the prior written consent of TGC. This presentation does not constitute investment advice and the fact that a security may be mentioned in this presentation does not mean it is recommended or is a suitable investment for any recipient or to be recommended by any recipient of this presentation.

Different types of investments involve varying degrees of risk.  Registered investment advisers, financial advisers, family offices and registered representatives should be aware that by using TGC’s services, the investment return and principal value of securities they may recommend to client will fluctuate based on a variety of factors, including, but not limited to, the type of investment, the amount and timing of the investment, changing market conditions, currency exchange rates, stability of financial and other markets, and diversification.  There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment.  No investment strategy can guarantee profit or protection against loss in periods of declining values.  No assurance can be given that capital market assumptions will prove to be correct, and the difference between assumptions and actual conditions could vary materially.  

When a financial planning representative recommends exchange-traded funds (“ETF’s”) and other investment companies, they should disclose that such funds will indirectly bear its proportionate share of any fees and expenses payable directly by the underlying ETF’s or other investment company. Therefore, that portfolio will incur higher expenses. In addition, ETF’s are also subject to the following risks (i) the market price of an ETF’s shares may trade above or below its net asset value; (ii) an active trading market for an ETF’s shares may not develop or be maintained; (iii) trading of an ETF’s shares may be halted if the listing exchange’s officials deem such action appropriate, the shares are de-listed from the exchange, or the activation of market-wide “circuit breakers” (which are tied to large decreases in stock prices) halts stock trading generally; or (iv) the ETF’s may fail to achieve close correlation with the index that it tracks due to a variety of factors, such as rounding of prices and changes to the index and/or regulatory policies, resulting in the deviating of the ETF’ s returns from that of the index.

Financial Planning representatives should disclose to clients and prospects, as TGC is disclosing herein, that past performance is no guarantee of future results and every investment may lose money. No guarantees or assurances are or can be made as to performance of any investment.

Registered investment advisers, financial advisers family offices and registered representatives should consider the investment objectives, risks, charges and expenses of an investment strategy before using TGC’s services and prior to recommending any such investment strategies to its clients and/or prospects.  A prospectus and/or other applicable offering documents contain this and other important information about the investment strategy.  Investors should read the prospectus and/or other applicable offering documents carefully before investing. 

Certain of the economic and market information contained in this presentation has been obtained from published sources and/or prepared by third parties. While such sources are believed to be reliable, neither TGC nor its respective affiliates, employees and representatives assume any responsibility for the accuracy of such information. 

Are You Ready for This “BR-OLATILITY”?

So Brexit happened, or is happening, or will happen effectively very soon.

This is what the US equity markets are waking up to, and despite the massive flow of information, no one really knows what the effects will be of what is happening.

Markets respond negatively to surprises and lack of clarity with huge spikes and volatility that can eliminate six months of returns in a single day. Today, the Volatility Index is opening up about 20% on Brexit.

The question on all investor’s minds right now is “what do we do?”. We will answer that later, but I want to start with what we have done at Toroso to prepare for events like this in our portfolios.

Our planning process begins with what we consider to be the most important investment question: what are your goals, needs and priorities as a client and which Phase are you in life?

As you can see from the chart below, the Toroso investing glide path differs from traditional MPT risk based allocations in that we combine goals based portfolios of Growth, Wealth Preservation and Income to target a client’s true time horizon and risk tolerance.

unnamed0ZKZA6IY

Once we understand your goals, the immediate question arises: “How much of your assets need to be available in a time of distress?”

untitledWe allocate that “always available amount” to our core wealth preservation strategy, the Toroso Neutral Allocation Strategy, to preserve wealth and compound returns. All Toroso strategies are designed through a combination of alternative asset allocation and in-depth fundamental ETF security selection. More specifically, the asset allocation for the Toroso Neutral Allocation Strategy is based on Harry Browne’s permanent portfolio allocation, which has historically provided returns of about 8% with 1/3 of the volatility of US equities. The allocation is predicated on equal weighting of four asset classes (25% per asset class): Equities, Commodities and other alternatives, Cash equivalents and Bonds that independently thrive in one of four possible economic environments: prosperity, inflation, recession and deflation.

Next, we build our portfolio through a process of in-depth fundamental security selection. We exclusively use ETFs and attempt to find themes that will provide excess returns to the core benchmarks that represent each asset category. So far, the equity component is showing significant volatility to Brexit pressures. Fortunately the cash and bond positions appear to be holding value. Additionally, the commodity allocation is heavily weighted toward gold, which is rallying substantially in reaction as a safe haven investment.

After answering the first question, we ask investors is “Do you need current income from investments?” As you can see from the glide path chart above, we believe the Income Portfolio is usually appropriate for retirees in the distribution phase of their investing life cycle.

Our Target Income Strategy employs a barbell approach to balance two components: the portion of the strategy in higher yielding securities meant to drive the majority of the yield, and the low risk portion of conservative, cash equivalents which allows for the opportunity to tactically increase allocations to higher yielding securities when markets permit. Currently 5% Target Income model is 51% allocated to safety component with very little exposure to European bonds or dividend paying preferred stocks. We feel well positioned to mitigate the volatility expected in the high yield market from Brexit.

The third question we ask is “Do you prefer a moderate or aggressively diversified growth portfolio?” In our glide path above we allocate all assets not in wealth preservation or income to one of our two growth strategies: Sector Opportunity or Global Alpha.

The Sector Opportunity Strategy seeks to outperform the S&P 500 Index while maintaining lower volatility than the market. We strive to quantitatively select superior sectors – those better positioned to outperform the market using job figures, relative profitability, and GDP impact – for 80% of the portfolio, while allocating the remaining 20% to volatility based ETFs using historical and forward-looking market volatility trends. Through tactical rebalancing, this volatility component strives to opportunistically enhance up and down market capture, or collect the implied volatility premium during sideways markets.

Coming into the Brexit vote the volatility portion was positioned in a very conservative manor: one third cash, one third Wisdomtree CBOE Put Write ETF (PUTW), and one third Quantshares Anti Beta ETF (BTAL).
The three most important take a ways from our positioning are:

1. No current VIX short exposure (The VIX is opening up about 20% on Brexit)

2. BTAL is designed to provide positive returns when the market drops violently

3. We exited the Financial Equity sector ETF two months ago

Our other growth portfolio is the Global Alpha Strategy, which has the most exposure to Europe. It is an equity ETF portfolio that strives to outperform the MSCI All World Index (ACWI) while maintaining similar volatility. The portfolio maintains geographical diversification similar to ACWI, but employs smart beta and active strategies to encompass securities usually absent or underweighted in traditional indexing and is designed to produce a high level of active share.

In the last few weeks we have positioned this portfolio more conservatively. We exited, with substantial gains, our position in VanEck Vectors Morningstar Wide Moat ETF (MOAT) in search of more diversification and protection, which we believe we found in Rex Gold Hedged S&P 500 ETF (GHS). Gold can be an important part of a diversified investment portfolio because its price historically increases in response to events that cause the value of paper investments, such as stocks, bonds and fiat currencies, to depreciate. The REX Gold Hedged S&P 500 ETF (GHS) provides equal simultaneous exposure to many of the benefits inherent to gold and large US equities.

We did not anticipate a Brexit. We simply prepared for volatility in general, through a concise glide path combined with goals-based asset allocation and intelligent security selection.

We feel we were prepared, so now we can answer the question on everyone’s mind our way: “What do we do now?” We wait to buy. When positioned properly, panic is opportunity.

The Antidote for Volatile Times: Disciplined & Rigorous Security Selection

Now and Then…

With over one third of 2016 behind us, the markets have offered little to be excited about in terms of returns. We have seen some massive drawdowns in the US and Developed markets and some equally strong recoveries. In previous commentaries, we have proposed that the US equity market is fundamentally overvalued unless further government-sponsored stimulus is applied. It now appears that not only is future stimulus unlikely, but further monetary tightening is probable this summer. So with that realization, volatility is expected for the market.

Although this is exactly what we expected at the beginning of the year, the violent recoveries and low level of implied volatility have been a surprise. (Do you remember the phrase ©øirrational exuberance©÷?) We maintain our commitment to diversification and protection of wealth in what we believe will be an increasingly volatile environment. Additionally, we continue to seek fundamentally sound investments, through our rigorous security selection process, which will be the main subject of this commentary.

So How Have We Done?

In past commentaries we have noted that this year diversification is working. Asset class correlation has normalized and we are no longer in an environment where everything goes up and/or down together. This has substantially benefited our flagship wealth preservation strategy. The Toroso Neutral Portfolio was up 4.6% net of fees through April 30th, with limited volatility. Our income strategy has also navigated the choppy waters well; the Toroso Target 5% Income Portfolio was up 2.5% net of fees through April 30th, while maintaining a consistent annualized yield of 5.1%.

Unfortunately, our two growth strategies are underperforming year to date and have been negatively affected by the markets irrational optimism. The Toroso Sector Opportunity Portfolio was down -2.2% through April 30th, mainly because our volatility hedge detracted from returns during the rally in March. Often referred to as the price of insurance. The Toroso Global Alpha Portfolio was down -0.6% through April 30th, which can be attributed, again, to hedges imbedded in the ETFs we utilize. However, we remain confident that the portfolios are positioned well, for the volatile markets ahead, with fundamentally attractive securities.

What We Do

When we started Toroso in 2012, one of our main goals was to provide thoughtful ETF research and advice on ETF security selection that could be as comprehensive as what active managers commit to individual equities. Over the past few years we have developed software tools and processes to dig deeper into the key ETF behaviors and statistics; such as fundamentals, true cost, ownership or passive influence, premium or discount to NAV, performance ratios, risk metrics and index construction.

Our security selection process begins with the benchmarks embedded in our asset allocation, then we seek out themes and other qualitative concepts that may enhance the core benchmark exposure, and finally we refine those ideas through quantitative data using our proprietary software tools and processes. In this commentary we want to share two examples of how these qualitative and quantitative processes work.

Is this Porridge Too Hot?

We have continually discussed the current and anticipated volatility of the US equity markets this year. With that in mind, an obvious qualitative candidate for inclusion in our portfolios are ETFs focused on minimum volatility. Apparently, we are not alone in this desire to protect against volatility; the iShares MSCI USA Minimum Volatility ETF (USMV) has seen substantial inflows this year.

©øIn the year-to-date period through April 29, the iShares MSCI USA Minimum Volatility ETF (USMV | A-71) has taken in $4.7 billion in investor capital, second only to $6.2 billion for GLD, according to FactSet data. Š As the name suggests, the fund aims to minimize the volatility of its portfolio. It does this by holding a basket of stocks that together have low-volatility characteristics. Unlike the competing PowerShares S&P 500 Low Volatility ETF (SPLV | A-58)‹which simply holds the 100 least volatile stocks in the S&P 500‹ USMV considers the correlations between various stocks to come up with its optimized mix.©÷
ETF.com May 3, 2016

On its face, this ETF appears to be the perfect candidate to solve for the macro-economic problem we have been describing all year. We conducted our quantitative process to evaluate the position and, in our opinion, discovered it is not the right ETF to limit volatility. Sometimes a rigorous security selection process benefits a portfolio by avoiding a potentially disastrous investment rather than finding a superior one. That is the case with USMV and here are three concerns our research shows:

1.Fundamentally Overvalued ¡© Much of the market volatility stems from the belief that interest will rise; in a rising rate environment P/Es tend to contract. The P/E of USMV is 20.1 or at a higher level than the S&P 500 (SPY) at 17.8 and even more frightening higher than the US Growth (IVW) at 19.7. Put simply, can a fundamentally overvalued portfolio lower volatility when the market corrects?
2.The Herd Creates Bubbles – On average, ETFs own about 4.6% of every US public equity. On average, the names in USMV are 5.6% owned by ETFs. When passive ownership creeps above normal levels we have found this to indicate a brewing bubble. Similar metrics were present with REITs in 2013 and with MLPs in 2015. Also, the top position in the ETF is Newmont Mining (NEM), which is also a top position in the Gold Miners ETF (GDX). GDX and NEM are extremely volatile and many holdings like this appear counterintuitive for USMV.
3.Factor Contradiction ¡© The chart below compares USMV to other ETFs with the most overlap of holdings by weight. How is it possible that an ETF focused on Minimum Volatility can have so much overlap with an ETF focused on Quality Factors, an ETF focused on Momentum factors and a Mega Cap ETF, which is, essentially, a size factor? The answer lies in the ETF.com quote above; ©øUSMV uses optimizations and other constraints to build the portfolio and limit tracking error.©÷ Our fear is that the end result is a portfolio that appears minimum volatility in good markets but may not provide any protection in a true downturn.

This analysis of USMV shows how our security selection process can help avoid ETFs that qualitatively meet our investment objective but quantitatively are rejected.

This Porridge is Just Right

Now for an example of an ETF that meets both our qualitative and quantitative criteria. The Direxion Insider Sentiment ETF (KNOW) has been a core exposure in the Toroso Global Alpha portfolio for a few years. Our original thesis focused on the historical outperformance of companies that have elevated levels of disclosed insider buying. At time of initial purchase, the fundamentals were in line with the benchmark and the active-share generated versus the S&P 1500 was 89%, thereby meeting our quantitative requirements. (Active-share refers to the percentage of the ETF that is considered different than the benchmark to which it is compared.) KNOW has been a successful investment that we continue to evaluate and research.

That research has led us to evaluate another aspect of KNOW that is consistent with other Environment, Social and Governance (ESG) themes we are researching. The index behind KNOW does two characteristic based screens of the S&P 1500 universe. The first is a forensic accounting screen to help avoid fraud and other malfeasance, the second looks for companies where the insiders/management are personally investing in the company.

These two characteristics represent core concepts behind the G in ESG. Strong corporate governance has historically been an ESG factor that can benefit the performance of securities, but more importantly avoiding companies with accounting irregularities can help lower volatility during bear markets. Remember in 2008, many of the now bankrupts mega cap companies practiced creative accounting (There was a movie made about one!).

We have continued to add to our KNOW position as our attention has turned to more defensive positions to combat volatility. The fundamentals remain attractive with a P/E of 16.7 and an active-share that is now 90%.

Why We Do It

The well-known and often cited 1991 study by Gary Brinson, Brian Singer, and Gilbert Beebower titled Determinants of Portfolio Performance shows that asset allocation accounts for as much as 91% of the average investor©ös returns. This and other studies are based on replacing benchmarks with active managers and are somewhat antiquated to the ways investing with ETFs is done today. We believe that when it comes to building portfolios of ETFs, a rigorous security selection process can have a much more meaningful attribution for three reasons:

1.Passive ETFs, like KNOW, can provide superior returns, meaningful coverage of characteristics likely to limit downside volatility, and impactful ESG exposure.
2.The security selection process can force the discovery of bubbles like REITs, MLPS or Minimum Volatility. These quantitative revelations have helped us adjust our asset allocation away from irrationally valued assets.
3.The data and resources available to evaluate ETFs are still quite limited thereby generating inefficiencies in pricing and valuation. Our proprietary software was built to aid in uncovering these inefficiencies.

The ETF landscape continues to grow and offer new problems and solutions. Toroso remains committed to outcome oriented asset allocations enhanced by our disciplined research and rigorous security selection.

First Quarter 2016 – Lots of Pain, Little Gain

Despite the fact that the S&P 500 ended slightly positive for the first quarter, the experience for investors concentrated in US equities, so far this year has been quite tumultuous.

As of January 20th the S&P 500 was down 9% and then recovered. By February 11th the S&P 500 had again declined by more than 10% only to recover dramatically over the next 20 days and end the quarter up 0.81%. Thus, even though the end result has been meagerly positive, the roller coaster ride may have caused some investors to opt out and miss the recoveries.

Believe or not, this Time is Different

The seesaw returns of the first quarter 2016 seem quite reminiscent of the August 2015 decline and rapid recovery in October. However, the four most dangerous words in investing are “this time is different”.   Yet, we dare to say that this time is different for two reasons:

  1. The Federal Reserve will not provide any more stimulus; at best they can only temper the pace of rate increases.
  2. This time diversification worked; commodities like gold were inversely correlated to the market decline and maintained the gains during the equity market recovery.

The key here is that investors should not extrapolate the recovery in March as an indication of sanguine markets in 2016. Instead, the volatility that we anticipate for the remainder of the year highlights the need for diversification. We also believe that that a focus on fundamentals will be rewarded.

Procrastination is not Stimulus

Over the past few years the market has often rallied because the Federal Reserve signaled that they would not raise rates and delayed starting a period of quantitative tightening.

Clearly procrastination on tightening is not the same as providing fuel to the economy. Rate increases are intended to temper both growth and combat inflation; the delay is, at best, an acknowledgement of tepid growth, but not a way to promote economic expansion. We maintain our position that the economy is in decent shape but the US Equity market is overvalued. A dovish Federal Reserve will not be enough to mitigate future volatility.

For many, the market rally of this past March was due to a general sense of an oversold market. However, the more likely reason why it happened was the overall belief that current volatility would delay the next increase in rates.

Finally, diversification worked!

In previous commentaries, we have noted that diversification has detracted from returns during the past few years. Further, we have contended that the markets have been irrational and essentially drunk on artificial stimulus. Although the declines in the US Equity markets during the first six weeks of 2016 seem to support these statements, the rapid recovery in the following six weeks appear counterintuitive.

The major difference with the first quarter experience and the irrational returns of previous years is that this time diversification worked. Asset classes like commodities and fixed income provided protection during decline but did not substantially detract during the recovery.

For example, consider that as of April 15 the year-to-date return for the SPDR S&P 500 ETF (Ticker: SPY) was +2.47% and the 3-month return was 11.30%, meaning there was a -8.83% loss in the first 15 days of the year followed by the nice return. And then for SPDR Gold Shares (Ticker: GLD) was at +15.39% for the year and 12.08% for the 3-month period ending April 15, providing a +3.31% return in the first 15 days. Even though there is only 15 days’ difference in the time periods being measured, the return pattern confirms that GLD helped to minimize a portfolio loss during a severe equity market downturn during first part of the year and did not deteriorate when the equity market rebounded.

Why We Diversify

Diversification is the simplest form of volatility control. As noted in previous commentaries, volatility can erode returns even if the overall market trend is positive. Investing across various asset classes, geographies, market caps and even factors should provide superior returns over time. The key driver of successful diversification is having a portion of one’s portfolio maintaining the purchasing power of the portfolio in times of distress. Fixed income, for example, can provide a source of stable principal from which to reallocate and compound returns during a recovery.

The most common form of diversification is constructed on asset allocation models rooted in Modern Portfolio Theory (MPT). The core of MPT is based on blending the optimal risk and reward of multiple assets to create a portfolio consistent with one’s risk tolerance. The MPT process seeks to diversify assets to the ideal return per unit of risk, but many investors forget that this method generally assumes an extended time horizon of 30 to 40 years.

Goals-based diversification!!

A second and less discussed benefit of diversification is the client experience. Many studies show that investors tend to buy high and sell low, which is emotional reaction rather than a sound investment choice. Volatile markets foster emotional decisions to exit the markets at exactly the wrong time.

To counteract this tendency, we believe investors should diversify their time horizon as well. If all of one’s assets were allocated within a plan that takes 40 years to work, it is easy to see how in times of distress that investor’s faith would be tested.   A goals-based approach, which acknowledges an investor’s true time horizon is our preferred way to enhance the investor experience and ensure their participation in market returns.

We separate Goals Based Investing into three categories:

  • Wealth Preservation: Time Horizon 5 years +
  • Targeted Income 5%: Time Horizon 10 years +
  • Growth: Time Horizon 20 years +

These three outcomes can be combined to create a glide path through retirement as depicted in the chart below:

chart1CommentaryApril

Our process is intended to provide investors with a positive experience as they participate in the growth of the markets. We believe that investors with extended time horizons should focus on growth. Accumulated profits should, over time, build a base of wealth preservation as retirement age is achieved. Then, through retirement, the wealth preservation assets convert to income producing strategies. So, how was this experience in our goals-based strategies for the first quarter of 2016?

Wealth Preservation

The diversified asset allocation strategy behind our core wealth preservation strategy is based on the permanent portfolio philosophy.  This asset allocation philosophy has been around for 40 years and has produced average annualized returns around 8% with a third of the volatility of the S&P 500.   The portfolio employs four different asset classes, designed to offset the volatility of each other and compound the upside potential of each component: Equities, Bonds, Gold and Cash.  The portfolio is performing well in 2016; our core strategy is up 3.57% net of fees for the first quarter.   This year bonds and gold are helping to counteract the extreme volatility of equities.

Income

In our Target Income 5% strategy we combine high yielding ETFs with low risk cash alternatives ETFs.   This income “bar-bell” provides lower volatility than traditional bond laddering or blending. Our approach is significantly more diversified; we combine high income ETFs proportionally with low risk funds like the iShares Short-term Treasury ETF (SHY) to target a 5% distribution. Today, our Target Income strategy yields 5.1% while maintaining 48% in low risk ETFs and cash alternatives. The combination of diversification and high percentage of low risk ETFs is how we mitigate volatility. As of March 31st the total return for this strategy was 1.52% net of fees.

Growth

We manage two core growth strategies; the first is our Sector Opportunity portfolio, which combines an 80% allocation to US equity sectors with a volatility ETF overlay. In this portfolio we seek growth through the equity exposure but protect the assets with the volatility overlay. This strategy significantly outperformed the S&P 500 during January and February with substantially less volatility, but underperformed during the recovery in March because of the drag from the protective overlay. The return for the first quarter was -1.66% but since its inception in June of 2013 the strategy’s annualized return net of fees has been 12.3%.

In our second growth strategy, Global Alpha, we build a global portfolio focused on high active share. The intent is to not only diversify through geography and market, but also seek out factors and business characteristics that should enhance returns. Unfortunately, thus far the strategy has failed to provide alpha in an irrational market that has rewarded concentration and momentum rather than diversification and fundamentals. For the first quarter the Global Alpha Strategy returned -1.7% net of fees.

A Healthy Dose of Reality

The first quarter of 2016 began with a roar and ended with a whimper.

We urge investors not to become complacent and expect the good times to persist. Without artificial stimulus the US equity markets will likely experience extreme volatility this year.

The premise of our asset allocation process is to combine three outcomes: wealth preservation, growth, and income. We believe investors should allocate essential money only to wealth preservation strategies. Non-essential money should be allocated to growth strategies. Finally, investors should use income strategies in the distribution phase of their life. Through a diversified goals-based approach we seek to improve the investor experience and foster continuous participation in the potential future growth.

chart2CommentaryApril

The average of four stocks: Facebook (ticker: FB), Amazon (ticker: AMZN), Netflix (ticker: NFLX) and Google (ticker: GOOGL)
** The Toroso Neutral Index is comprised of four equal weighted ETFs; Vanguard Total Stock Market ETF (VTI), iShares Core US Aggregate Bond ETF (AGG), iShares 1-3 Year Treasury Bond ETF (SHY), and SPDR® Gold Shares (GLD).

Source: Morningstar Direct

 

 

 

 

 

 

Disclaimer — This commentary is distributed for informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. Nothing in this commentary constitutes an offer to sell or a solicitation of an offer to buy any security or service and any securities discussed are presented for illustration purposes only. It should not be assumed that any securities discussed herein were or will prove to be profitable, or that investment recommendations made by Toroso Investments, LLC will be profitable or will equal the investment performance of any securities discussed. Furthermore, investments or strategies discussed may not be suitable for all investors and nothing herein should be considered a recommendation to purchase or sell any particular security. Investors should make their own investment decisions based on their specific investment objectives and financial circumstances and are encouraged to seek professional advice before making any decisions. While Toroso Investments, LLC has gathered the information presented from sources that it believes to be reliable, Toroso cannot guarantee the accuracy or completeness of the information presented and the information presented should not be relied upon as such. Any opinions expressed in this commentary are Toroso’s current opinions and do not reflect the opinions of any affiliates. Furthermore, all opinions are current only as of the time made and are subject to change without notice. Toroso does not have any obligation to provide revised opinions in the event of changed circumstances. All investment strategies and investments involve risk of loss and nothing within this commentary should be construed as a guarantee of any specific outcome or profit. Securities discussed in this commentary and the accompanying chart, if any, were selected for presentation because they serve as relevant examples of the respective points being made throughout the commentary. Some, but not all, of the securities presented are currently or were previously held in advisory client accounts of Toroso and the securities presented do not represent all of the securities previously or currently purchased, sold or recommended to Toroso’s advisory clients. Upon request, Toroso will furnish a list of all recommendations made by Toroso within the immediately preceding period of one year.

 

 

 

Diversification in Context: Time to be Rational Again!!

Research compiled by Michael Venuto, CIO

For the past three years, large capitalization US equities have been consistently one of the best performing asset classes.  They have outpaced small caps, international equities, bonds and especially commodities. The consistent outperformance of US large cap stocks is somewhat unprecedented (see chart below).

In addition, these stellar returns were accompanied by a low volatility environment that made these returns quite resilient.  During this sanguine market, any form of diversification has detracted from returns.  Even worse, investing in asset classes other than the S&P 500 has added to volatility.    

In previous commentaries, I have noted that government stimulus was the primary reason for the US markets irrational, albeit good, behavior.  Despite the calming feeling evoked by the more subdued volatility in late February and early March, I recommend investors prepare for a more volatile market by committing capital to multiple asset classes through rational diversification.

Help is NOT on the Way

US economic indicators remain cautiously optimistic, which appears to be enough to keep the Federal Reserve paralyzed on rate policy.  Since the US market should anticipate no further stimulus, equity prices are expected to return to traditional metrics of evaluation.   A rational market considers fundamentals, like earnings and margins.

Although the volatility in the US markets in early 2016 has temporarily subsided, a rational investor will want to diversify. Lets start with the basics of diversification.

The following excerpt is from the Security and Exchange Commissions website (www.sec.gov):

Diversification 101: A diversified portfolio should be diversified at two levels: between asset categories and within asset categories. So in addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, you’ll also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions. 

In this commentary, I will discuss the benefits and implementation of the two levels of diversification described by the SEC.  Additionally, I will address a third level which has been enhanced by the advent of smart beta ETFs.  This third level is diversifying some factor exposures to mitigate the risk of traditional indexing which tends to overweight factors such as growth and momentum.

Does the Song Remain the Same?

The first form of diversification is to combine multiple asset classes. The simplest version of this form of diversification is a balanced portfolio of equities and bonds.  The consistent application of a balanced portfolio has historically mitigated volatility and provided reasonable returns for many years. The proliferation of ETFs allows investors to take diversification of asset classes to another level, providing access to bonds, commodities, currencies, options, futures and volatility. 

However, the opportunity generated by these ETFs has also changed the way some asset classes behave. For example, when bonds are packaged in an index, the end product loses two of the key covenants associated with bonds: maturity date and consistent coupon.  I believe that this may negatively impact the future returns of a traditional balanced portfolio especially in a rising rate environment.

At Toroso, we take asset class diversification a few steps further.  The asset allocation strategy behind our core wealth preservation strategy is based on the permanent portfolio philosophy.  The strategy employs four different asset classes, designed to offset the volatility of each other and compound the upside potential of each component: Prosperity, Deflation, Inflation and Recession.  Unlike the balanced approach which relies on how bonds used to behave the permanent approach looks to how assets should behave in the future depending on four specific macroeconomic environments.

Fine Tuning the Instruments

The second level of diversification is within asset classes.  This simply means owning both US small caps as well as US large caps.  Also within equities it requires owning different geographies.  Over the past few years, this form of diversification has also produced lackluster returns. 

The fundamentals and growth prospects of many equity markets is far superior to the S&P 500 and yet US large cap stocks have consistently outperformed.  I maintain that these other equities markets provide substantial relative value and the performance of the S&P 500, fueled by stimulus, has been irrational. 

In Toroso’s core wealth preservation strategy, we provide a strategic allocation to commodities like gold.  Gold has performed very well so far in 2016, but over the prior five years gold returns were negative.    Toroso utilizes the second level of diversification in our allocation to gold to help mitigate the negative effects of sideways or strong dollar environments.  One product we utilize is Credit Suisse Gold Buy-Write ETN (GLDI), which collects option premium on gold while maintaining the core exposure to gold.  This provides some return even if gold does not appreciate.  

Another diversifier is AdvisorShares Gartman Gold Euro Hedged ETF (GEUR), which allows Toroso to reduce the negative effect of a strong US dollar on the price of gold.   The key is that diversification within an asset class is an intelligent way to mitigate risk and fine-tune exposure.

Getting Precise with “Smart” Diversification

Now for the third level of diversification, those smart versions of categories in an asset class that mitigate the inherent idiosyncratic risk. 

Category or benchmark investing has been around for decades.  Historically, investors have turned to active mangers to improve upon benchmark investing.   Active managers are generally not constrained within a category, and therefore bring new risks and uncertainties that are difficult to evaluate to the process of intra-category diversification. 

Smart beta ETF investing acknowledges that traditional beta ETFs, by the nature of their index construction, can irrationally overweight factors like growth and momentum which can concentrate risk.  Smart beta seeks to diversify away these unintended, over-weighted factors by diminishing their concentrations and in-turn reducing overall risk.

Here is an example of how idiosyncratic risk in US large cap stocks looks.  In previous commentaries, I have referenced the FANG stocks (Facebook, Amazon, Netflix & Google).  These four fundamentally overvalued stocks were the primary reason the S&P 500 had a positive, albeit meager, return in 2015.  They are also one of the key sources of volatility in 2016 (see the Returns Table below).  At Toroso, we use smart beta ETFs to reduce exposure to risks such as the FANG Paradox (the fact that the overvalued FANG stocks drove returns 2015 but also the volatility in 2016) in all of our strategies.

Rational Diversification

In 2016, intelligent rational diversification appears to be working again, but over the last three years none of the diversification techniques described in this commentary would have enhanced returns.  Diversification generally works because the markets are fluid and constantly changing; no category, asset class or factor remains dominant forever.  Simply put, as illustrated in the chart at the beginning of this article, the US equity markets have been historically unusual for the last few years. Investors should not respond irrationally to this phenomenon by abandoning diversification.

Volatility in Context:  Let’s Have a Conversation

Markets Are Scaring Themselves

“You have probably noticed that U.S. stock prices have fared poorly of late—and the S&P 500 closed on Wednesday at 1859, down almost 13% from its July 2015 high. You have probably also noticed that the biggest daily drops seem to occur either on bad news from China or when oil prices slide further.”

Continue reading “Volatility in Context:  Let’s Have a Conversation”

Is This Lack of Fear Scary?

This lack of fear scares me.  Investors seem to believe that the Federal Reserve will save them, but that seems unlikely to me.  I believe the economy is generally in good shape and the low cost of oil acts like a stimulus to the consumer.  Additionally, employment and wages continue to improve so it is unlikely that government can artificially prop up the market.   Growth stocks are at astronomical valuations as represented by the FANG stocks (Facebook, Amazon, Netflix and Google).  Margins on the S&P 500 are over 10% and well above historical norms, which seems unsustainable.  I believe that the US equity market will continue to be volatile and the relatively low implied volatility or VIX means this will likely get worse before it gets better.

Continue reading “Is This Lack of Fear Scary?”

ETF Q&A by Mike Venuto

ETF Reference – Mike Venuto Provides ETF Q&A

The editorial team at ETF Reference surveyed 57 ETF investing experts, including Toroso’s Mike Venuto, in search of the best tips for exchange-traded fund investors. The response received was incredible. The panel of experts sent the editorial team hundreds of amazing tips! They winnowed that list down to 101, which can be accessed from Toroso’s Q&A interview. Whether you’re a beginner or a veteran ETF investor, there are likely dozens of valuable tips in there for you.

Toroso was humbled and excited to be a part of such an elite group of experts. Obviously, some of our contributions were cut in the editorial process to make room for ideas from the other professionals. However, we thought it would be nice to share all of our answers, so we have provided in the link above the written Q&A interview we contributed to ETF Reference on behalf of Toroso.