Reuters Money
Can a short ETF work for average investors?
This piece originally appeared on Portfoliost.
John Del Vecchio’s new Active Bear Exchange Traded Fund (HDGE) is the opposite of what you’d expect: it’s relatively expensive in a category dominated by low-cost funds, it’s transparent in a field (shorting) that’s all about secrecy, and though it was only launched a month ago, it’s already collected $37.7 million in assets under management.
Exchange-traded funds (ETFs) have grown into a $1 trillion asset class largely because they’re a cheaper version of index mutual funds. But HDGE is part of a new breed of ETFs, funds that are not just passive plays on an index, but are instead actively managed, requiring expertise and research, and carrying higher fees.
Like their index-shadowing brethren, actively-managed ETFs trade throughout the day like any stock does, while mutual funds can only be bought and sold at the end of the day. ETFs also must list their holdings at the close of the day, unlike funds which disclose that information quarterly. That’s an especially interesting wrinkle for HDGE, given the secrecy in which shorting stocks is generally conducted.
Short sellers borrow stock, then sell the borrowed stock. They hope for it to go down in price, so that when they have to replace the borrowed stock, they can do that with cheaper shares and pocket the difference as profit. One of the reasons short sellers are generally so quiet is fear of something called a short squeeze, where other investors buy up a lightly traded company which many sellers are shorting. This drives up the price of the stock, which leaves shorts, who have to buy at those high prices to cover the shares they borrowed, deep in the red.
Del Vecchio says he avoids this issue by largely trading highly liquid stocks, many with a low level of short activity.
He also does not use leverage in his fund or derivatives, techniques which have gotten other ETFs into trouble.
Are equally-weighted indexes better for investors?
What’s at the core of your retirement portfolio? If it’s an inexpensive index fund or exchange-traded fund (ETF), you’re up on the latest in investment science – circa 1995. But now, science may be moving on, and a new way of looking at portfolio construction has emerged.
Stock index funds like the widely-held Vanguard 500 Index Fund give investors access to broad markets for pennies in trading and carrying costs. Boatloads of research have demonstrated that they typically beat most actively managed funds on an after-fee basis. So if you’re depending on a fund or ETF like that, you’re not doing too badly.
But just maybe, you could do better. At least according to some academically-inclined investment pros who have been taking a closer look at those indexes and think there’s a better way to construct them.
Traditional stock indexes are market-weighted. That means that the companies with the biggest market footprint, in terms of their market capitalization (their share price multiplied by the number of shares in circulation), play the biggest role in the index. So Exxon makes up more than three percent of the Standard & Poor’s 500-stock index all by itself. The 20 companies with the biggest market cap make up 30 percent of the concentration of the S&P 500, according to Lipper, a Thomson Reuters company.
And that’s where some see a problem. “Cap-weighted indexes weigh companies exactly as the marketplace weights companies – and that means ‘popularity’ weighting,” Robert Arnott, founder of Research Affiliates, a Newport Beach, California, investment management firm told the Journal of Financial Planning recently. “Now, why should we expect to earn a full equity risk premium from holding a portfolio that’s heavily tilted toward the most popular stocks?” Arnott, a leading investment researcher, continued: “Cap weighting tends to load up on the most expensive companies and shuns big companies trading at deep discounts.”
Arnott has developed alternative indexes which weigh companies based on a host of fundamental factors, such as their book value, cash flow and revenues. In the 11 years ending on January 1, 2010, the market weighted S&P 500 returned an annual average of 0.9 percent, according to research published in the Journal of Indexes recently. During that same period, an Arnott-style fundamental index did far better, returning 5.3 percent a year, on average.
But the equal-weighted index of S&P 500 stocks trumped those returns. The equal-weighted index — in which each company made up 0.2 percent of the index — delivered an annualized 5.7 percent a year during the same period. And that’s the space in which some investment firms are concentrating. Most visible may be Rydex SGI, a firm that has been steadily launching equal-weighted ETFs, and now has 16 of them.
The most important sentence in this excellent report is this: “It’s entirely possible…that a period in which large-cap stocks outperformed small companies would show very different results.” Who knows when that period will start?
Best ETFs in 2010: Some surprises
Other than gold- and silver-based exchange-traded funds (ETFs), which funds produced the best returns last year?
A reasonable guess would be that anything invested in precious metals did well in 2010. You’d be right, but less-glamorous ETFs investing in Peru, Thailand and Colombia also made the top 10 of ETF Trends’ top-performing list .
I know these countries are hardly on most investors’ radar screens. And I certainly don’t endorse you jumping into these funds now because you won’t get last year’s returns. A broad-based approach, though, will serve you well.
Peru and Colombia make a lot of sense to me and will continue to prosper. Both are resource rich and feature growing economies. That’s why the iShares MSCI Peru fund returned 57.2 percent last year and the Global X/InterBolsa FTSE Colombia fund rose 52.7 percent.
Tiny Peru has one of Latin America’s fastest-growing economies. At eight percent growth last year, it’s keeping pace with China. Colombia, along with Peru, is building a larger middle class and benefiting from resource wealth.
While these Andean countries have been devastated by civil wars and poverty throughout most of their history, they have stabilized politically. They also are in demand for their mined resources.
China, India and the rest of the developing world are paying top dollar for their copper, silver, gold and other commodities. Colombia features the largest coal reserves in Latin America and is also endowed with petroleum and natural gas.
Egypt: Mummy’s curse or economic boom?
Did the Egyptian rebellion open up a gold mine for civil reforms or a mummy’s tomb of economic perils?
I choose to think there are some robust opportunities presenting themselves as Egypt and other countries press their demands for freedom from oppression. On the political side, if you subscribe the “big wave” theory that Egypt’s mass protests will trigger similar revolts in other Arab states, then the resulting reforms — should they happen — may fuel prosperity and greater distribution of wealth.
The markets, of course, have a laser focus on Egypt and its ramifications. There’s a huge commodities rally going on; some of it is guided by fear and speculation but most of it is driven by demand.
I’m rooting for the Egyptians to get a better shake from their thuggish government. For a country of 83 million, most of Egypt’s wealth is concentrated at the top and little of its resource wealth is shared.
Compare the most populous country in Africa to the tiny oil-drenched Gulf State Qatar, which reported about $145,000 in GDP per capita and has one of the highest growth rates in the world at 19 percent. My source, by the way, is the U.S. Central Intelligence Agency, which apparently was behind the curve on unfolding events in the land of the Pharaohs. They weren’t watching Twitter closely enough.
As Jack Ablin, chief investment officer of Harris Private Bank, notes in his current market update, Egypt’s per-capita gross domestic product is $6,200, which even lags Tunisia’s $9,500 and most of the Arab world.
The most immediate reaction of the markets as the revolt unfolded was to sell stocks and buy U.S. Treasury Bonds, gold and energy stocks (and other commodities), which is typical. The widespread fear is that the Arab “street” will emulate Egypt and Tunisia and somehow curtail oil production in other oil-producing states. I don’t buy this idea — yet.
3 ways to manage political risk in your portfolio
If it’s not Tunisia, it’s Egypt; if it’s not Egypt, it’s Yemen.
Political turmoil abounds on our TV screens. But hands up: Who adjusted portfolio positions before the unrest in each country began?
Probably very few. You may or may not have been burned as a result, but one thing’s for sure: managing political risk in your portfolio is a must. Here’s a primer.
Use all tools available First: do your research before deciding where to invest. Find out as much as possible about the regions and countries you are interested in. If you’re investing in a mutual fund or exchange-traded fund (ETF), don’t just stop at the headline name.
For example, if you pick the Market Vectors-Africa Index ETF, you may assume the bulk of the assets will be located in more stable countries, such as South Africa. You always have to drill deeper. Among its largest holdings is Egypt’s Orascom, while its top holding is British oil and gas company Tullow Oil, which has major investments in Uganda.
So what’s the best way to assess your political risk? There is, unfortunately, no panacea. If you have invested in a fund, ask for as much information as possible. Often fund managers provide reports that give a good overview, though they are not always up-to-the minute.
Then there’s AON’s comprehensive political risk map, which color codes 211 countries from low to very high risk. The downside is that it, too, can be slow to turn with the times. Its map for 2011 shows Egypt as medium risk. Rating agencies provide ongoing updates and analysis, though not all are accessible for free online.
Pay less to the IRS with tax-managed mutual funds
Werner Renberg is a writer and author based in Chappaqua, N.Y. He is the author of four books, including All About Bond Funds: A Complete Guide for Today’s Investors. The opinions expressed are his own.
If you own equity or mixed-asset mutual funds in taxable accounts, one thing is certain: Whatever the top income tax rate on capital gains that President Barack Obama and Congress will agree on for 2013 and beyond, it will continue to hit you in two ways — and possibly even a third:
1. You, of course, will owe income tax when you sell mutual funds’ shares out of taxable accounts if your capital gains exceed your capital losses.
2. You also will owe income tax when funds sell securities and have net capital gains at year’s end, requiring them to credit you with your portions of the taxable distributions even if you didn’t sell one share — and even if your funds values dropped.
3. You would suffer a third strike if all your net capital gains and capital gains distributions lift your adjusted gross income (IRS Form 1040’s Line 37) enough to put you into a higher tax bracket.
Can you do anything to have more of your taxable retirement portfolio continue to work for you and pay less to the IRS? Perhaps. You could move money into one or more tax-managed equity or mixed-asset funds. Such funds tend to have two goals:
• Maximizing after-tax returns by (a) offsetting capital gains with capital losses to reduce, if not to avoid, long-term capital gains distributions and (b) using other tactics, such as keeping stocks targeted for sale for a year until they become long-term holdings to avoid highly taxed short-term capital gains distributions. For income, these funds prefer stocks that pay lower-taxed qualified dividends and may also invest in federally tax-free municipal bonds.
