Exchanged traded funds have enjoyed great popularity recently, raising concerns in some quarters that they may be introducing froth to equities markets. But not everyone is convinced. With other asset classes seeing upticks in inflows, bulls argue there is a lot more room for ETFs to run, boding well for ETF providers.
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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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.
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.
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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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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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.”
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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PRESS RELEASE FOR IMMEDIATE RELEASE
December 8, 2016 – Oak Brook, IL – The advisors at Dashboard Wealth Advisors (“Dashboard”) announced today that it has expanded its investment management capabilities by engaging with Tidal Growth Consultants (“Tidal”), a consulting firm headquartered in Manhattan, NY, providing Outsourced CIO services to financial advisors.
The Dashboard Team strives to continue improving its outstanding wealth advisory services to its clients by adding Tidal’s investment process rigor and a system of checks and balances to its portfolio management process.
Through Tidal’s outsourced CIO services, Dashboard is significantly growing the depth of its investment research and portfolio management capabilities, adding discipline and oversight to their team’s investment and wealth management process, and formalizing a structure of benchmarks and performance measurement.
“At Dashboard we use our experience and expertise to help ensure that our client’s life goals are met through our comprehensive financial planning process” said Scott Schuster, CFP®, CPA, Managing Director at Dashboard. “In Tidal Growth Consultants we saw a key ally to propel the expansion of our investment management capabilities to provide our clients with the best practices and strategies in the market and help them reach their financial goals.”
“Dashboard is in a unique position to help its clients with their financial and investment goals” said Guillermo Trias, CEO of Tidal. “They are a breath of fresh air in the highly commoditized financial advisory industry, providing high level personalized advice to their clients in a challenging and continuously evolving market environment.”
Dashboard is an independent Firm headquartered in Oak Brook, IL with a team who specializes on providing highly custom and personalized wealth advisory services for investors, with a laser focus on financial planning. Its “dashboard” planning process allows their clients to focus on the entirety of their financial picture throughout their lifetime.
About Tidal Growth Consultants
Tidal Growth Consultants, a dba of Toroso Investments, LLC, is a group of finance thought leaders helping Financial Advisors seeking best practices in their investment process so they can adapt to the fast evolving needs of their clients and the ever changing landscape of market regulations”.
Dashboard Wealth Advisors
Scott Schuster, Managing Partner
1520 Kensington Road (Suite 107)
Oak Brook, IL 60523
Tel: + 1 630-203-3105
Bid the lovely summer calm adieu. Most ETF investors watched their portfolios coast along for roughly two months until the financial markets sank and volatility spiked, all over again.
Stocks, bonds and even traditional safe havens came under selling pressure from an enigmatic Fed in recent trading sessions. As the Federal Reserve kept the market guessing about its next move on interest rates, portfolios hit a squall.
SPDR S&P 500 (SPY), a proxy for the broad U.S. market, ended 2.4% lower in the month ended Sept. 13 while setting fresh all-time highs along the way. The largest ETFs that invest in foreign-developed and emerging markets posted losses of 1.7% and 3.6% over the same period, respectively.
And the shine came right off PureFunds ISE Junior Silver (SILJ), whose 210.7% gain year to date is unrivaled among nonleveraged exchange traded funds. It crumbled 17.9% in the past month, a laggard among ETFs.
A tough month held a few ETF market winners too. Among them were bank, energy and internet-focused funds, which advanced as much as 4%.
SPDR S&P Bank (KBE) pulled off a 3.4% gain in the month through Sept. 13, rising and sinking along with policymakers’ back-and forth remarks on a hike in short-term interest rates.
In this environment, managing risk is key, writes Richard Turnill, BlackRock’s global chief investment strategist. He sees certain crowded trades sending short-term danger signals.
“We advocate reducing popular positions where prices have moved beyond fundamentals,” he cautioned, naming gilts, or U.K. government bonds, and bond proxies, such as utility stocks, as examples. He likes dividend growers and quality stocks — found in ETFs such as iShares Core Dividend Growth (DGRO) and Vanguard Dividend Appreciation (VIG) — in a shaky market.
The specter of volatility looms, too, in the minds of two money managers who spoke to IBD about their best ideas for successfully investing in ETFs in the final quarter. While braced for more potential pain, they are focused on finding pockets of growth in tomorrow’s markets. Here’s what they had to say:
Rob Lutts is chief investment officer at Cabot Wealth Management in Salem, Mass. As fee-only financial advisors, the Cabot team provides investment management services to typically high-net-worth individuals, as well as institutions. The firm focuses on growth-oriented investments and uses ETFs extensively in its strategies. Assets under management: about $565 million.
We expect generally favorable but volatile stock market performance in the fourth quarter. Low interest rates and a stronger economy will generate real earnings growth in the S&P 500 for first time in many quarters. We believe the S&P 500 could trade at 2,350 by year-end.
VanEck Vectors Gold Miners (GDX) invests in global companies involved in gold mining activity. The price of gold had a nearly 50% corrective phase over the past five years. Central banks globally have created more than $12 trillion in fiat money over the last six years that will eventually stimulate a new phase of currency debasement and inflation. Gold is the only currency that cannot be debased by central bankers. Gold prices should rise as demand rises due to currency debasement. Mining companies will have high profits under this scenario.
WisdomTree India Earnings Fund (EPI) offers exposure to a country we like. The Indian stock market, as measured by the Sensex index, has appreciated an average of 17% annually from 1981 to 2015, including 1.5% in dividends. This is 50% better than the 11.4% annual growth seen in the S&P 500 index over the same time period, including dividends.
Prime Minister Narendra Modi has instituted structural changes to the country’s legal and regulatory environment that should allow a higher level of growth. We expect annual India GDP growth to increase to 8% or even 9% in the coming years. And we like this fund’s focus on earnings and sector exposure (oil and gas is 16%, banks 13% and diversified financial services 13%). We favor financial services, which may be the top sector in India. This fund has the highest weighting in this area.
KraneShares CSI China Internet Fund (KWEB) invests in the expansion of the Chinese middle class via companies in the online technology sector, like Alibaba (BABA), Tencent Holdings(TCEHY), NetEase (NTES) and Ctrip.com (CTRP). The 1.3 billion people of China love to use the internet, and these companies are making it happen. Ignore much of the negative hype around China — this fund holds some great growth companies. We don’t see the fund’s high concentration of assets in the top stock holdings as a big issue — these are top companies in the internet sector.
Michael Venuto is chief investment officer of Toroso Investments in New York City. The firm describes ETFs as the specialty of its three core business units — wealth advisory, asset management and consulting. AUM: $86.8 million.
We have maintained the position that without further monetary stimulus, U.S. markets are likely to be volatile and provide flat-to-negative returns. That said, we do see opportunities for returns in specific characteristics and unique market niches.
QuantShares U.S. Market Neutral Anti-Beta Fund(BTAL) provides a form of portfolio insurance without the decay and cost associated with many inverse and/or VIX futures-based products. The index behind BTAL is short the high-beta names in the S&P 500, while being long low-beta names. The position provided substantial protection during market downturns, and we continue to build the allocation, as further insurance is needed.
Direxion All Cap Insider Sentiment Shares (KNOW) combines a defensive screen with an alpha-producing characteristic. The index that this ETF tracks screens the S&P 1500 for aggressive accounting and other governance-based metrics in order to avoid future permanent losses of capital like Lehman Brothers or Fannie Mae. Then, it seeks potential alpha through concentrated overweights to securities with substantial insider buying. The ETF has a high active share vs. the S&P 500 and has provided stellar performance.
Emerging Markets Internet & Ecommerce (EMQQ) invests in companies that represent one the greatest growth stories of our generation, at over 35% annualized return on equity. Despite our general negative outlook on U.S. markets, one area where we see potential growth is the emerging market consumer. The beauty of this ETF is that it focuses on the Amazons (AMZN) (e-commerce) of the emerging markets rather than the Wal-Marts (WMT) (brick-and-mortars). The ETF has provided positive returns since inception while the broad-based MSCI Emerging Markets index has been negative.
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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