Garth Friesen

Garth Friesen is the CEO at III Capital, a hedge fund management company specializing in fixed-income and credit. He is also the author of "Bite the Ass Off a Bear, Getting In and Standing Out on a Hedge Fund Trading Floor."

[garthfriesen]

MLP Sector: Cheap vs. High Yield

There is not much love going around for the MLP sector these days. So far in 2017, the Alerian MLP Index (AMJ) has underperformed the S&P 500 by a whopping 27%. There are several potential reasons for the move:

* Large MLPs are projected to slow distribution growth in the coming years to focus on capital expenditures.

* The rise in crude oil is deemed to be fleeting and some are calling for peak shale production.

* Investors are focused on tax-loss selling as 2017 comes to a close.

Regardless of the reason for the drop in prices, the sector has become cheap relative to some standard benchmarks. Many analysts compare the yield of MLPs to the average yield in the junk bond market. The correlation is quite strong through the credit cycle as MLPs need to continually tap the market for new debt to fund expansion. As debt costs rise, growth prospects diminish. Also, many investors look to the MLP market for yield, so the sector is often compared to corporate bonds as an income alternative.

On this measure, the MLP sector is inexpensive. The Alerian MLP Infrastructure Index now yields 2.3% more than the Barclays High Yield Index- the most in the last 10 years.

MLPs were caught in the energy sector downdraft in 2015 as the price of oil plummeted and yields on energy-related issuers widened. However, the leverage in the sector has since declined and so have debt spreads. For example, the spread to US Treasuries on 10-year Kinder Morgan debt is now 114 bp, down from almost 500 bp at the end of 2015.

With the shortage of asset classes considered “cheap”, maybe it’s time to take another look at the MLP sector: crude prices have some upward momentum, the credit market is well-behaved for now, and valuations are compelling. Yes, there are risks, but the underperformance is not corroborated by the major macro factors. 

[garthfriesen]

Financial Conditions Are Easier Despite Higher Rates

Despite the first interest rate hike almost two years ago, financial conditions in the US are highly accommodative. According to the Bloomberg Financial Conditions Index, the market is showing few signs of restrictive monetary policy. 

The Index is equally weighted with inputs from the equity, bond and money markets.  There are very few signs of stress in the system: equity markets just hit a new high, corporate bond spreads are at the narrowest level in years, and interest rate and stock market volatility remain muted.

Why are financial conditions getting easier when monetary policy is getting tighter? Fed policy is still loose.  With annual CPI running at 2.2%, real interest rates are still negative. As long as investors are punished for holding cash, they will continue to seek out higher-yielding alternatives. The Fed is tightening policy, but it by no means should be considered tight.

[garthfriesen]

An Alternative to the 10,000 Hour Rule

Malcolm Gladwell sent ripples through the parenting community in his book, Outliers, with his presentation of the "10,000 Rule". His hypothesis proposed experts are made from out working and out practicing the competition, and true mastery of a skill would take 10,000 hours of dedication to the craft. Parents enrolled their children in all sorts of activities to start the clock and log practice hours to develop an expertise. But is this really the way to give your child a head start in his or her career?

I have to confess, the rule does make intuitive sense. It would be great if we were all the best in the world in something. It would make our career choices pretty easy, wouldn't it? There is, and always will be, demand for experts. The truth, however, is only a tiny percentage of people will gain mastery in anything by the time they start a career. Fortunately, future success is not limited to those who start off as experts.

This is a particularly relevant subject to me as my oldest daughter is heading off to college next week and the only activity to which she has possibly dedicated 10,000 hours is Snapchat. Similar to many students, she is entering college with little idea of what do with herself when she graduates. I’m sending her off with one piece of advice that I hope she remembers. It is my alternative to the 10,000 Rule. I call it the “Top 20 Percent Rule.”

The rule is not based on years of academic research. Rather, it was passed on to me from my father, based on his own experience, and has proven to be accurate in both my career and in the careers of others I have witnessed in almost 25 years in the asset management industry. Essentially, the rule dictates that to secure a job opportunity, you need to be considered in the top 20 percent of candidates in the applicant peer group when it comes to the relevant hard skills. After you have made the top 20 percent cut-off, other “soft skill” factors will be the primary determinant of success in the job hunt.

I can't help to wonder how the average person gets hired in the field of finance today. The caliber of individuals is truly outstanding. There are always more applicants for entry level professional positions such as analysts and trading assistants than there are available openings. The average person does not have a chance- only the exceptional ones do. So that begs the question, how does a new college grad demonstrate they are exceptional?

To start, they need to make it through an employer’s first round of cuts. In other words, a potential employer is, of course, going to be selective in whom they call for interviews. They won't interview every single person who submits a resume. A friend of mine who is looking to get into the private equity business recently told me about job opportunity on LinkedIn for an analyst position that gathered over 800 applications within the first couple hours of its posting. That's pretty stiff competition. In these cases, firms will quickly weed out the majority of applicants. They do this using the Top 20 Percent Rule.

The process is quite simple. Employers scan a resume and identify whether the person's observable “hard skills” fall in the top quintile (or something close to that) of the rest of the applicants. Hard skills can be readily quantified and compared. They look at such metrics as GPA, class ranking, the reputation of the school and the program, and coursework relevancy. If a resume fails to demonstrate a candidate has hard skills better than 80 percent of the peer group, it will most likely get tossed in the trash. The odds of making it through the initial filtration process are not good if you have a 2.5 GPA from a 3rd tier college and finish in the bottom half of your class.

Once the identification of candidates with the best hard skills is complete, another filter is applied to the remaining pool, this time looking for the right "soft skills" for the job. Soft skills are the qualitative traits most jobs require for long term success, such as communication capabilities, integrity, and work ethic. Specific jobs may necessitate other well-developed skills such as the ability to handle high levels of stress or capacity to make decisions very quickly. It's fair to say you should be considered in the top 20 percent of applicants in these categories as well to make it to the interview stage.  

After screening for the required soft skills, the remaining candidates look very similar: they are all smart, motivated and most are surely capable of performing the job. It all comes down to the interview. Those who successfully make it through through the interview stage, and secure an offer, all have some form of “X Factor.” In my experience of hiring dozens of people over the years, that X Factor is likability. When employers are evaluating several equally qualified candidates for a position, they will usually hire the one who is most likable. In other words, if you come across as a jerk or a know it all, regardless of your skill set, you are not going to get the job offer. People want to work with individuals they can get along with and trust. It’s that simple.

HARD SKILLS + SOFT SKILLS + LIKEABILITY = OPPORTUNITY

College grads who have the trifecta will have many doors open to them. They need both IQ and EQ. Those who have spent their time solely developing IQ will find it difficult to get their ideal job. So the advice I'm giving my daughter is to avoid excessive worrying about finishing at the top of her class. Hard skills are only part of the equation. She just needs to be in the top 20 percent. All doors will still be open. Investing time and energy in the development EQ and learning to be likable, however, is just as critical as anything she will learn in class. Hard skills will certainly open doors, but soft skills will get her through.

(For more tips on how to get a job in finance, check out my book: Bite the Ass Off a Bear, Getting In and Standing Out on a Hedge Fund Trading Floor)

[garthfriesen]

Did the Fed make a mistake when it raised rates?

Forecasting GDP in not easy. It involves multiple variables and inputs, many of which are subject to revision. If anybody could do it well, you would think it would be the Fed, right? They have an army of staffers who spend their entire working lives looking at every piece of economic data, trying to attach its significance to their projection. Immediately after the latest rate hike, market participants quickly pointed to the latest release of the Atlanta Fed’s GDPNow indicator, which is supposed to measure real-time projections for the GDP in the current quarter, as evidence the Fed made a mistake. Did they?

Let’s begin by looking at the GDPNow indicator itself. The forecast construction is quite detailed, but essentially it takes incoming economic data and estimates the impact on 13 subcomponents that comprise GDP. The subcomponents are then aggregated to provide a forward-looking GDP estimate. Official GDP figures are released with a substantial lag, reducing the usefulness to policy makers. The GDPNowcast is updated whenever there is new model data available. 

The current model forecast is for Q1, 2017 GDP to come in at 0.9%, significantly below private sector estimates, and materially lower than the 3.4% model forecast just 6 weeks ago. How can the Fed raise rates when its own model predicts such a sharp drop in economic activity? 

One reason is the FOMC members don’t seem to put much weight on the indicator, despite it is generated by one of the member banks. To complicate the issue, the Atlanta Fed isn’t the only one producing GDP forecasts. The New York Fed has its own model called GDPNowcast. The New York Fed model is predicting Q1, 2017 to be 3.2%, a whopping 2.3% higher than the Atlanta Fed forecast.

Something is obviously amiss. As Mike Shedlock points out in a recent blog post, the two models use different inputs. The Nowcast model takes into consideration data GDPNow doesn’t such as JOLTS job openings, permits, and regional manufacturing surveys. Even when they use the same inputs, it can have opposite effects on the direction of the forecast, which makes no intuitive sense whatsoever. That alone raises credibility issues.

Another concern with the model is its volatility. The GDPNow was forecast current quarter GDP to be 3.4% after the ISM and Construction Spending reports were released on Feb 1. Just six weeks later, it’s predicting 0.9%? Seems like a pretty massive adjustment to me, especially when the economic data, according to the Citibank Economic Surprise Index, has surprised to the upside over the same period.

The bottom line is that people who must make critical decisions on monetary policy know better than to rely on a single forecast, even if it is from a trusted source. Don’t listen to the pundits who present only one piece of evidence when arguing a point. The Fed made the right move.

[garthfriesen]

Your Investment Portfolio: Time To Play Defense?

They say “defense wins championships” when it comes to which side of the football is responsible for securing the win in the Superbowl. It’s impossible to lose if the other team can’t score. The same concept can be applied to investing. A defensive stance in investing- one which attempts to limit losses as opposed to always trying to maximize gains- is a more conservative way to build wealth. So it is time to de-risk your portfolio?

While there is no crystal ball to tell us when we need to be more conservative, the market sometimes provides warning signs which shouldn’t be ignored.  One sign is the divergence between economic policy uncertainty and the low level of implied volatility in the equity market. Uncertainty over taxes, trade, regulatory reform and geopolitics is at a 17 year high. Usually, this coincides with more risk priced into the equity market. But not today.

The above chart shows a large divergence between equity volatility, measured by the VIX Index, and global policy uncertainty, measured by an index created by professors at Northwestern University, Stanford and the University of Chicago. Historically, the relationship has been quite tight. Higher economic policy uncertainty is coupled with higher equity volatility. The two series began to diverge in the middle of last year and now provide mixed signals as to the outlook for risk in the market.

Taken by itself, this is not a reason to make a major adjustment to your portfolio. One needs to examine other indicators, like valuations and investor sentiment, to get a more complete understanding of the level of risk in the market. It turns out these indicators are also flashing warning signs.

If your portfolio is highly sensitive to a continuation of the strong equity market performance since the November elections, it might be a good time to rebalance to a more conservative allocation. There are three ways investors can adjust their portfolios to a more defensive posture.

The first is probably the most obvious: tweak the asset allocation mix in your portfolio by reducing equity exposure and increasing the position in cash or fixed income. Trying to de-risk by making adjustments within the equity market is not sufficient. Switching to defensive companies, sectors or investment factors does not reduce your equity risk- and many of these investments are already trading at premium valuations relative to history. Also, increasing the fixed-income component does not mean you necessarily have to load up your portfolio with 30-year bonds. Short -term investment grade municipal or corporate bonds will do the trick.

Diversification is another way to de-risk a portfolio. Increasing exposure to international equity and fixed income markets should lower the overall level of risk without reducing potential upside. International equity markets- both developed and emerging markets- have underperformed the US market over the last several years, We don’t know when this trend of US market outperformance will end, but we can be certain it won’t last forever. More importantly, from a risk perspective, adding exposure to different countries and regions tends to lower portfolio volatility. 

The third way investors can reduce portfolio risk is to add an alternatives bucket, which is missing in many investors asset mix. Alternatives can be long-short mutual funds, systematic trend following CTAs, or other strategies with a low correlation to the broad equity market. These strategies are often designed to have performance which is not dependent on the short-term direction of the equity market. It’s true many alternative investments have underperformed a buy and hold equity strategy, but it is unfair to compare returns between the two when the stock market has only gone in one direction, having just completed its 8th consecutive year of positive performance. 

As the great David Tepper says, “there is a time to make money and a time to not lose money.” In other words, there is a time to play offense and a time to play defense. Investors need to be able to play both sides. High levels of uncertainty can be good if it means buying or holding assets which are appropriately priced for downside risk. It’s not good when valuations are high, investor sentiment is overwhelmingly positive, market internals are diverging and the market only seems to care about what can go right and not what can go wrong. It’s time for the defense to take over.

[garthfriesen]

Why Blackrock will win the ETF fee war

As the ugly battle for the White House rages on, another war is taking place in the $2.4 trillion ETF market. Top ETF providers are in a fee-lowering race to win the title of the firm with the lowest cost core products. But one firm, Blackrock, has an edge.

Last week, Blackrock lowered the management fee on 15 iShares ETFs in its “Core” lineup between 2-5 bp. The iShares Core S&P 500 ETF, IVV, now has an expense ratio of just 4 bp, down from 7 bp before the reduction. That compares with State Street’s SPY at 9 bp and Vanguard’s VOO for virtually the same market exposure. Only Schwab has a lower cost S&P 500 ETF, SCHB, at 3 bp.

Source: ETF.com

Much of the downward pressure on fees can be attributed to the Department of Labor (DOL) Fiduciary Rule. This rule will make it much more difficult for brokers and investments advisors to steer investor money into high-fee financial products when there are lower cost alternatives available. The DOL rule should help keep the gates open for the flood of money leaving actively managed mutual funds to passive ETF products. The fee reductions are an attempt to maintain or gain market share as money continues to flow in response to the rule which is scheduled to take effect next year.

Blackrock and Vanguard are the two largest ETF providers, with a combined market share of almost 65%, and they are both involved in the fee war and attempting to capitalize on the shift in demand for ETFs. While the two giants have similar ETF lineups, they do differ in one major area.

Securities Lending. Blackrock, through an affiliate, BlackRock Institutional Trust Company (BTC), manages the securities lending for iShares ETFs whereas Vanguard outsources it to a third party. BTC keeps between 15% and 30% of the securities lending revenue while Vanguard passes the net proceeds to the investor after expenses are covered and a fee is paid to the third party. In other words, Blackrock has an additional revenue source from its ETFs. Vanguard does not.

So how much can this be worth? According to annual reports filed through March of 2016, BTC earned almost $20 million from just six of the larger ETFs in its Core lineup. That amount is the 15-30% share BTC is entitled to keep, not the total securities lending revenue. The other 70-85% is income for the ETFs.

$20 million is small potatoes for a firm the size of Blackrock, but as iShares head Mark Wiedman said in an interview with Erik Schatzker on Bloomberg after the announcement, he believes the total AUM in the iShares Core lineup could eventually reach $1 trillion- almost five times the current size. At $1 trillion, the securities lending revenue could provide more than $100mm in profit to Blackrock. And that does not include securities lending revenue from non-Core products. 

Vanguard, on the other hand, does not retain any revenue from securities lending activities. Vanguard’s philosophy is the fund shareholders bear all the lending risks and therefore should keep the after-cost returns- a view consistent with its shared ownership structure. 

Success in the ETF business requires the achievement of massive scale. Both Vanguard and Blackrock have that scale. However, securities lending could be the difference-maker when it comes to who can cut fees the most and still maintain profitability. Blackrock’s additional revenue source in a business with declining margins is a huge competitive advantage and one which may just win them the war. 

[garthfriesen]

US financial markets: Absolutely hideous, relatively gorgeous

Isn’t it strange two people can look at the exact same image and see completely different things? It is also strange two investors can analyze the same market data and come to completely different conclusions with respect to value.

Most pundits predict a near term correction, highlighting above average P/E ratios, stagnant earnings and slow revenue growth as measures of overvaluation. But US equity markets have just rebounded to their 52 week high.

Many investors also forecast higher bond yields, pointing to “anomalies” created from the extraordinary central bank policies pushing long term interest rates lower and lower. But US interest rates touched a new record low last week.

Clearly somebody is buying, but who?

Indeed, it is hard to make a case U.S financial markets are attractively valued from an absolute perspective. However, on a relative basis, both the equity and bond markets look attractive.

Domestic US investors see a 10 year government bond yields of 1.4% and make the determination they have a better opportunity to earn a positive inflation adjusted return in the equity markets, especially with a long term time horizon. The “risk premium”, or the difference between the earnings yield of the equity market as a whole and the 10 year bond yield, is still relatively attractive from a historical perspective.

The dramatic out-performance of sectors with a heavy tilt to low volatility and dividend factors highlight investor preference for so called “bond-proxies”. As long as US yields remain low or go lower, the domestic flow from high grade fixed income into equities is likely to continue. These investors are not looking at internal equity market valuation (otherwise they would not be paying 20x earnings for utility stocks!). They are looking at the relative after-tax valuation compared to bonds.

As for the internal valuation of the bond market, once again we find a market rich to historical norms. Real yields are negative out to 10 year maturities, nominal long term interest rates are hovering near their all time low and the Fed just raised the short-term rate. So where is all the demand coming from?

International investors. While interest rates appear low in the US, they are relatively high compared to similar maturities in Japan, Germany, UK, Canada and even Spain and Italy. According to JP Morgan, 36% of bonds in the BofAML Global Government Bond Index are trading with negative yields and 74% are below 1%

Global demand for income and duration created from Brexit concerns is only adding fuel to this flow. So while 30 year US Treasury rates of 2.1% are indeed low, they seem significantly more appealing than other global alternatives.

Some investors have the mandate and ability to operate purely in an world where they can go to cash in their portfolio and wait for absolute value to appear. Many investors, however, live in a world where their job is to find the cheapest assets on a relative basis. Right now the relative players are the marginal buyers and are driving markets.

Investors need to be aware of global relative valuations and not just focus on how rich or cheap US asset prices may be in isolation. US equity and bond markets are hideous to some, yet they can still be gorgeous to others.

[garthfriesen]

Reflections on the Fed from my 12 year old

Sometimes children can really put things in perspective. They have the luxury of naivete which can often cut right to the heart of issues that cause so much concern for the rest of us. Today’s Fed meeting is one of those issues, and the conversation I had with my 12 year old son this morning as I was driving him to school was very poignant.

 Me: “Son, I might be a little late picking you up this afternoon. There is very important meeting going on today at 2:00 pm and depending on what happens, I might have to stay late and deal with a few things.”

 My son: “What is the meeting about, Dad?”

 Me: “There is a meeting with a bunch of people from the Federal Reserve Bank in Washington and they are going to decide whether or not to raise interest rates.”

 My son: “Why is that so important?”

 Me: “Interest rates have been at 0% for 7 years, so people are a little freaked out about what will happen if they decide to move them higher.”

 My son: “How much would they raise the rate?”

 Me: “Probably 25 bps. That is just ¼ of 1%.”

 My son: “That does not sound like a lot.”

 Me: “It’s not.”

 My son: “So why would they do it in the first place?”

 Me: “It’s complicated, but basically raising interest rates makes it more expensive to borrow money. If it is more expensive to borrow money then people don’t take out as many loans to buy things like cars or houses. When people stop buying stuff, the economy slows.”

My son: “Why would they want to slow the economy?”

Me: “Well, they are not really trying to slow the economy, they just want to make sure that is does not grow too fast. If it does, it can cause inflation.”

 My son: “Is there a problem with inflation right now?”

 Me: “Not really. In fact, it has been falling and is lower than it is supposed to be.”

 My son: “So why would they raise rates then?”

 Me: “That’s a good point. I don’t have a good answer for you. But they seem pretty sure they want to do it today. And if they don’t do it today, they will most likely raise rates sometime in the next few months.”

 My son: “Does it make a huge difference if they do it today or in the next few months?”

 Me: “In the grand scheme of things, no, it probably doesn’t.”

 My son: “So what is the big deal then?”

 Me: “I don’t know. I guess it is just because there is so much uncertainty about what will happen. People can’t seem to stop talking about it at work and on the news.”

 My son: “I’m sure it will be fine, Dad.”

 Me: “You’re right. I’ll see you after school. Don’t worry, I’ll be there on time.”

[garthfriesen]

Is There Any Place to Hide from Market Turmoil?

It’s only a matter of days before August month-end brokerage statements will arrive in the mailboxes of millions of investors across the country. It’s fair to assume that most people are not looking forward that moment, assuming they have picked up a newspaper at all in the last month. The question many people will be asking themselves (or their financial advisors) is what adjustments they can make to their portfolios to avoid further market turmoil and still stay invested.

Despite what the financial press may tell you, there are still places to invest that provide positive expected returns without incurring a large amount of risk. One such place is in shorter maturity investment grade corporate bonds.

Short-dated bonds are not what most people talk about when it comes to investment opportunities, but they do have a place in most portfolios, especially during times with heightened macroeconomic uncertainty.  With the Fed about to raise interest rates, China slowing more rapidly than previously expected and commodity markets experiencing stresses not seen since 2008, the inclusion of defensive strategies in a portfolio could go a long way to preserve overall value and provide the confidence investors need to stay invested in other more aggressive investments.

An allocation to short-dated investment grade corporate bonds can provide several benefits to a portfolio:

Insulation from swings in interest rates due to a low overall average duration

Excess return compared to cash

Positive expected real return (return in excess of the inflation rate)

A low or negative correlation to equities

As you can see from the table above, CSJ has a yield of 1.59%, an effective duration of 1.93 years and a 30-day volatility of 1.1%. At first glance, if you looked only at the yield to maturity, you might conclude that there is little value in the sector compared to the others. However, looking at yield alone does not give you any insight into expected risk-adjusted returns. Yield should be evaluated in context of other factors, including interest rate sensitivity (duration), the volatility of the sector, and possible losses from default.

It is important to note that a bond’s yield to maturity is only one component of its total return. Other factors that influence a bond’s total return are defaults that may occur as well as the slope of the yield curve. While this article provides a more thorough explanation, essentially a normal yield curve provides additional return through what is known as “roll down.” Obviously, the steeper the slope of the yield curve, the more additional return will be generated through the roll down. One to three year investment grade corporate bonds, for example, currently roll down at a rate of approximately 50 bps per year. For a 2-year bond, this would translate into an additional 0.50% in return during the first year, assuming the shape of the yield curve remains constant.

Duration

Duration measures the sensitivity of a bond’s price to changes in its yield. The higher the duration, the more sensitive a particular bond, or bond portfolio, will be to movement in interest rates. One way to compare different sectors of the fixed income market is to look at expected yield relative to duration. In other words, how much yield is offered for every year of duration? Simply dividing the yield by the duration provides the following results:

When the yield is adjusted to reflect the shorter duration, CSJ compares favorably against all the other sectors. CSJ has a yield of 80 bps for every year of duration. The only sector that provides a higher yield per unit of duration is the high yield sector at 161 bps.

Volatility

For fixed income instruments, volatility is closely tied to duration. However, some segments of the fixed income market, like high yield corporate bonds, have additional volatility stemming from investors’ views on defaults, recovery in the event of a default, and liquidity. Higher default risk and lower liquidity are not captured in the duration, but are represented in the volatility of high yield bond prices. Using a similar methodology as above, we can risk-adjust for these factors by simply dividing the yield by the 30 day volatility.

Using this measure, you can see that CSJ provides the highest yield per unit of volatility. The high yield markets does not appear as attractive when volatility is taken into account.

Default risk

Moving from a risk free asset class (from a default perspective) like US Treasuries to corporate bonds must include an evaluation of default risk. The yield of a corporate bond portfolio should reflect this risk. Investment grade bonds have historically had very low default rates, especially when viewed over a one-year time period. Typical one-year default rates for investment grade corporate bonds range between 0.08% and 0.13%, depending on what period is used in the analysis. Studies form Moody’s and S&P provide consistent results. A default rate of 0.08% to 0.13% is very low, and should not have a meaningful impact on the portfolio yield.

Liquidity

One way to measure liquidity is in the size of the bid/ask spread to trade a particular instrument (in this case all of the instruments in question are ETFs). The graphs below illustrates the bid-ask spreads (as a percentage) for various ETF sectors along with the average dollar value traded every day over the last 3 months.

According to these measures, CSJ is slightly less liquid than most of the other sectors, but not significantly. CSJ’s average bid-ask spread is 0.019%, which translates to about 2 cents on the current price of CSJ at $105.09. As for the average daily value traded, while there is not sufficient liquidity for institutional investors to allocate large flows in and out of the sector every day, at $50 million in daily turnover, there should be plenty of liquidity for retail investors to get involved.

Correlation

A final factor to consider before making any portfolio allocation is to compare the correlation of the sector’s daily total returns to those of other sectors in the fixed income asset class as well as to other asset classes, such as equities. The graph below shows the daily correlation between CSJ and other ETFs over the last year.

While CSJ is loosely correlated to the other fixed income ETFs, it is negatively correlated to SPY, the S&P 500 ETF. A low negative correlation to SPY indicates that CSJ should not be adversely affected by the day-to-day swings in the equity market.

Conclusion

The recent market turmoil has forced many investors to re-examine their portfolios and assess whether they are taking the appropriate amount of risk for their given circumstances. There is a tendency for people to think about allocations in their simplest form: government bonds, equities and cash.

So IF you choose to open the brokerage statement from last month, and IF a more defensive allocation is required, recognize that cash or government bonds are not the only alternatives. Short-dated investment grade corporate bonds have many of the defensive features of government securities with an expected return that is meaningfully higher.

[garthfriesen]

Trading Volatility ETFs: Respect the Roll

The recent explosion in equity market volatility has left investors and traders stunned by the magnitude of the gyrations in virtually all segments of the market. One of the most violent movers has been the VIX Index and the corresponding ETFs that attempt to track its direction.

The most common pair of ETFs that track the VIX is VXX (long volatility) and XIV (short volatility). VXX has returned a spectacular +92% over the last month, while XIV has declined 54%. Much has been written about these products and many experts have highlighted how they do not track the VIX very well (they track VIX futures, not the VIX Index). One aspect that often gets overlooked, however, is the holding cost associated with the rolling of VIX future contracts that these ETFs need to buy and sell on a daily basis in order to maintain their target exposures.

I explored the dynamics of roll costs in a previous article, Crude awakening: Why a long oil position could ruin your portfolio. While that article focused on the crude oil market, the dynamics in play are virtually identical to those embedded in the volatility ETFs that gain exposure through futures contracts. In either case, the main point is that strategies that require daily rolling of futures contracts can have tremendous re-balancing costs, depending on the shape of the futures curve.

Below is a chart that shows the estimated historical monthly cost of rolling VIX futures. This cost is from the perspective of an investor who needs to roll long futures positions.

Source: Bloomberg, Metric Advisors

As illustrated above, the benefit of the monthly roll accrues to the short VIX position holders, as the upward sloping VIX futures curve for most of this year meant that long VIX futures players had to continually buy the 2nd contract at a higher price than the 1st contract, and experienced the bleed as the 2nd contract “rolled down the curve.”

The estimated positive roll for XIV averaged roughly 7.8% per month from early March through August 19th. During that 5.5 month period, XIV returned +42%, which can be explained almost entirely by the roll effect (VIX futures during that time period were mostly unchanged from the start of the period through the end).

Then things reversed. The extreme volatility last week resulted in a spike in the VIX and an inversion of the futures curve between the 1st and 2nd contract. At current prices, the tables have turned for the XIV holders: rather than getting the benefit of the roll, they are now being punished to the tune of 15% per month (assuming the level of inversion remains the same over the next month).

The longer this inversion lasts, the more XIV will suffer and the more VXX will gain. To get an idea of how long this relationship can persist, I looked back at the last period of sustained VIX futures inversion, which occurred when the VIX more than doubled during the second half of 2011 in the midst of the European debt crisis and concerns over a US credit rating downgrade. 

During that time period, the VIX futures curve was inverted for 76 consecutive trading days between August and November. It wasn’t until February, 2012, that the VIX finally returned to its starting level from that previous July- a full six months later.

Source: Bloomberg, Metric Advisors

During that 6 month roller coaster, XIV declined by 47% in value, after being down as much as 73% at one point. Interestingly, the peak in the VIX front contract was on Oct 3rd, but XIV did not bottom until Nov 25th, more than 7 weeks later. The turnaround for XIV did not really materialize until the roll cost disappeared and the futures curve resumed its “normal” upward slope on Nov 15th.

Source: Bloomberg, Metric Advisors

So what can we take away from this?

The VIX curve has been inverted for the last 8 trading days. Recent history suggests that the inversion could last quite a bit longer. Remember, it was inverted for 76 consecutive days in 2011. 

A current roll cost of 15% per month does not exactly reward buying XIV early and trying to time the peak in volatility. Patience is prudent.

A better buy signal for XIV may be when the shape of the futures curve returns to an upward slope rather than the peak in the VIX. Waiting for curve “normalization” worked not only in 2011, but in other periods when the VIX curve transitioned from inversion.

[garthfriesen]

Can anything go right for energy MLPs?

It is no secret that the energy sector has been under tremendous pressure over the last several months. It’s hard to imagine that the fundamentals could get much worse:

* The domestic supply overhang of crude oil has brought prices back down to their March lows. Crude oil futures are down nearly 30% over the last 6 weeks.

* Leading global economic indicators point to a further slowdown in Emerging Markets which will further dampen commodity demand.

* The deal with Iran, if approved, will just add to global supply worries.

These weak fundamentals are reflected in asset prices that are sensitive to the energy sector. For example, energy stocks that focus on oil and gas exploration and production are down 32% over the last year. Moreover, even the larger fully-integrated behemoths of the industry, while performing slightly better, have still posted negative returns to the tune of 27%. 

The credit market has also repriced risk for energy assets. The option-adjusted spread of high yield bonds in the energy sector to US treasuries for is now at a staggering 1000 basis points. Indeed, some of the smaller players in the industry have already sought bankruptcy protection as the credit markets have slammed shut on all but the most credit-worthy issuers.

Market re-pricings of this magnitude are often associated with opportunities to comb through the wreckage in an attempt to find securities or sub-sectors that have been unjustly punished. The MLP sector might be one of those sectors.

MLPs (Master Limited Partnerships) have been subject to significant selling pressure in the last three months. For example, the Alerian MLP Index, is down 24% since the beginning of May. The chart below shows the decline of AMJ, the MLP ETN that tracks the Alerian MLP Index:

The MLP sector is often described as the “toll road” for energy assets. Profitability for infrastructure MLPs is largely determined by the volume of oil and gas passing through the value chain rather than on the price of oil or gas. So why have these companies performed so poorly?

* The MLP sector has served as a bond substitute for some investors during the Fed’s zero interest rate policy that began in 2009. As investors gravitate away from fixed-income type securities, in anticipation of an end to this policy, the sector has fallen out of favor.

* The correlation between MLPs and the high yield market is quite strong. MLPs have historically done well when high yield spreads have contracted and relatively poorly when spreads have widened. High yield credit spreads have risen almost 100 bps over the last three months.

* The liquidity of the MLP sector compared to other energy stocks is poor, to say the least. The current environment is one in which liquidity premiums are rising. We are witnessing rising premiums across all asset classes, and the lack of liquidity in the MLP sector is accelerating the price slide.

* While operating as the “toll road” for the energy sector, the fundamentals for MLPs are also turning negative. One of the attractive attributes of the asset class has been the dividend growth rates that investors have enjoyed in the past. Dividend growth rates for the sector have typically been 6-8% per year. A reduction in the availability of credit to the energy sector, including MLPs, will likely lead to a slowdown in M&A activity and capital expenditures, both of which are drivers of MLPs’ ability to expand their operations.

With all of these negative drivers, what could possibly go right for the sector? Support can be found in two areas: selling capitulation from current owners and relatively cheap valuations that could attract long-term, value-oriented investors to the asset class.

On the first point, there are some signs that the longs are beginning to capitulate. After a 5% decline on Tuesday, on very heavy volume, AMJ opened down another 3% Wednesday morning on abnormally high volume. However, by the end of the day, AMJ had almost fully recovered in price. That price recovery held for the remainder of the week, despite pressure on the broader market. Last week’s price action is shown in the chart below:

Capitulation from the longs is a positive sign for the asset class. It is too early to tell whether or not last week’s activity fully exhausted the sellers, but it was certainly a step in the right direction.

The second pillar of support can be found in MLP valuations. The asset class is the cheapest it has been since the financial crisis. Below is a chart that shows the historical yield spread of the Alerian MLP Index relative to US Government 10 year notes:

The Alerian MLP index currently yields 530 bps more than US Government 10 year notes. This is 154 bps more than the average for the last 5 years.

Given the high correlation between MLP performance and the high yield debt market, it also makes sense to look at MLP yields relative to high yield spreads:

The Alerian MLP index currently yields 75 bps more than the Barclays HY Index. This is 135 bps more than the average for the last 5 years. 

The valuation of the sector is compelling, but valuation alone is not a reason to jump into the asset class. This appears to be a classic case where high levels of uncertainty, coupled with deteriorating fundamentals and a lack of liquidity, are creating a value opportunity for long-term investors. However, most investors have learned the hard way that catching the proverbial falling knife often leads to short-term pain until the forced sellers are finished. 

The MLP asset class, along with other assets in the energy sector, have not rewarded investors with anything but losses recently. Investors don’t get any stars for bravery, and most will chose to observe the carnage from the viewing gallery. Waiting for a bottom is a sound capital preservation strategy. But when that bottom does form, the MLP sector may be one of the sectors to rebound the quickest.

Disclosure: Metric Advisors has a long position in AMJ

[garthfriesen]

High Yield spreads: rich or cheap?

Carl Icahn recently made some comments at the CNBC Delivering Alpha conference about the High Yield market:

"More importantly, they are overpriced, because if you go down and look at the index — and now I could get into some arcane stuff, but what a lot of these guys do, including BlackRock and the others, is these things — high-yield bonds, as you know, if you trade them, are quite illiquid. And therefore, if somebody wants to buy them, they do what they call CDS. They sell insurance on them. So take the money they are given, buy five-year Treasurys, then they go and they buy insurance from a guy like me. As a result, I personally think the illiquidity increases. So these high yields are extremely illiquid and extremely overpriced."

Focus on his last sentence for the moment and forget about the fact that the rest of his statements don't make much sense at all (first he says buyers sell insurance via CDS, then he says they buy insurance...?)

Ichan says the HY market is illiquid and overpriced. I'm not going argue that liquidity is great, but then again, it has never been tremendous for individual bonds. The big question is whether or not the liquidity situation is already factored into the price. The average option-adjusted-spread for the HY market since 2012 is 440 bp (According to the Barclays HY Index). The current OAS is 553 bp, close to the high end of the range over that period. Depending on how far back you look, OAS spreads are not "overpriced" as Icahn states.

The real concern for HY credit is the Energy sector where we  are just beginning to see the ultimate impact of the repricing of crude. The energy sub-sector of the index trades at a spread of 975 bp. Whether that spread is sufficient cushion to absorb the upcoming defaults remains to be seen.

The most violent moves in a market tend to come when positions are crowded and investors get hit with some sort of negative surprise. The HY market has already re-priced to a large degree and the macro headwinds for the Energy sector are well known.

There is a saying in the bond market that "there is no such thing as bad bonds, just bad bond prices". And it doesn't look like prices are too bad right now.

[garthfriesen]

Waiting for money market funds to start paying interest? Think again.

If recent statements by Janet Yellen are any indication, it appears that the Fed is finally going to start raising interest rates in the next few months. That news is music to the ears of many investors who have had their assets parked in money market mutual funds generating a hefty 1 bp of return over the last few years (if they were lucky).

The zero rate policy established by the Federal Reserve in late 2008 has left all types of investors starved for yield. As the Fed removes this extraordinary policy, investors might be thinking that the days of earning nothing on their cash will finally come to an end. Unfortunately, that is not the case.

Why? After all, if the overnight interest rate increases to 25 bps, why shouldn’t investors start generating income again?

The answer is simple: fees.

Mutual fund operators can charge up to 1.0% in annual fees to manage money market portfolios. While that may seem high, this is what mutual funds have historically charged. Well, at least until the global financial crisis brought about the current zero interest rate policy.

Obviously, while short-term interest rates are zero, money market mutual funds can’t buy assets that generate a return. If assets held by the mutual funds aren’t generating returns, then mutual funds have no income from which to collect fees.

The result is a significant reduction in fees that mutual funds would have normally collected for the past six years, with mutual fund operators effectively subsidizing their funds to prevent investors from realizing negative returns. Mutual fund operators provide these subsidies because they want their investors to remain within the fund family or brokerage firm. They understand that if they were to remove these subsidies, investors would simply take their money out of the funds and put it in the bank where they can at least be floored at 0%. These mutual fund complexes and brokerage firms do not want to lose assets under management.

Therefore, instead of losing investors, mutual funds choose to bear the cost of the subsidy, hoping that over the long term they will be able to recoup it. Here is a table of some randomly selected money market mutual funds. The expense ratio is provided in the second column and the net expense ratio (after the subsidy) is shown in the third column. The last column displays the amount of the subsidy.

The cost of this subsidy can be substantial. While the exact amount of the subsidy varies by fund and by share class, many large funds have effectively guaranteed investors an annualized return of 0.01% through a combination of expense reductions, waivers, and deferrals, in some cases nearly forgoing 75-100 basis points in fees. In some cases the dollar figures are staggering. 

For example, Fidelity Cash Reserves, a fund with total assets of approximately $115 billion, provided expense reductions of over $149 million for one year alone, according to its latest annual report. These subsidies result in a direct hit to the mutual fund operator’s bottom line. Therefore, the subsidies will likely disappear as soon as the Fed begins to raise interest rates. 

So if a mutual fund normally charges a 0.50% management fee, money market rates would have to increase above 0.50% before investors begin to see any benefits from a higher interest rate environment.

Furthermore, some mutual funds reserve the right to claw back fees that have been waived over the last six years. Fidelity, for example, has capitalized the expenses on their balance sheet and have language in their prospectus that says these expenses may be charged at a later date. The exact language is as follows:

"From time to time, the Adviser or its affiliates may agree to reimburse or waive certain fund expenses while retaining the ability to be repaid."

If a fund plans to recoup fees, that means rates have to go even higher before investors will begin to see any return.

So what should you do? Get your hands on the fund prospectus and annual report and read the fine print. Take a look at the fund’s management fee as well as the expense reductions that are currently being provided. Determine whether or not the subsidized fees can be reclaimed.

If your money market mutual fund is charging a management fee that is higher than 25 bps, you might want to explore other available options as rates start to go up, including ETFs that purchase short-term instruments, CD’s or even traditional bank deposits. These instruments may charge lower or no fees and allow you to participate in the transition to higher rates more than your money market mutual fund.

The “normalization” of interest rates will be welcomed by savers worldwide. Earning absolutely nothing on your cash is something that nobody likes. However, don’t assume that the Fed’s rate increase will mean an immediate end to this problem. It just means that the benefit of higher rates will initially accrue to the money market fund operators, not the fund investors.

[garthfriesen]

Charts of the Week

As the saying goes, “a picture is worth a thousand words”. Here is a collection of some charts I found last week that were particularly interesting.

1. The strength of the Canadian housing market has been well publicized in the last few years. This chart highlights the strength compared to other major global cities (source: SCMP). 

2. Global bond yields soared last week. Stronger economic data, met with a lack of liquidity, contributed to the sell-off. European bond prices were particularly hard hit. Bond markets are bracing for a rate hike from the Fed, most likely coming later this year (source: Bloomberg).

3. The recent rise in interest rates has had an adverse effect on the Utilities sector. The total return for the sector is -10.5% year-to-date. The price/earnings ratio for the sector has declined from a high of 19 in January back to 16.2. The index is now trading at its average P/E ratio for the last three years (source: Bloomberg).

4. The volatility in the bond market spilled over into equities, with most markets having a pretty tough week. However, equities still look relatively attractive in comparison to bonds. With the exception of the US, the dividend yield in other major equity markets is higher than the government bond yield (source: Citigroup).

5. The American Association of Individual Investors (AAII) publishes weekly readings on investor sentiment. The indices reflect the sentiment of individual investors toward the stock market over the next 6 months. It is currently hovering around a 5 year low. Some market participants use this reading as a contrarian indicator. Markets have a bizarre tendency to rise when most people expect the opposite (source: Bloomberg).

[garthfriesen]

US Equity Market: Evaluation of Valuation

The US Equity market is at historically extreme valuations and a 40% correction is about to occur…

No. Wait. I meant to say that the US Equity market is fairly valued and should continue to deliver returns that are consistent with long-term averages…

Actually, no, the US Equity market is still relatively cheap and should provide the highest expected returns relative to other asset classes.

When it comes to valuing the US Equity market, there is clearly no shortage of opinion. How is it possible that different people can look at the exact same market and underlying data and come to such vastly different forecasts?

Valuation is in the eye of the beholder

There is more than one way to value the stock market. There are dozens of available metrics; some focus on short-term valuations while others are more appropriate for longer-term evaluations. Here are three of the more popular metrics used for long-term analysis:

·        Cyclically-Adjusted Price/Earnings Ratios

·        Price/Earnings Ratios

·        Earnings Yield Gap

Cyclically-Adjusted Price/Earnings Ratios

Source:Citi

The Cyclically-Adjusted Price/Earnings Ratios (CAPE Ratio, also known as the Shiller P/E Ratio) is based on average inflation-adjusted earnings from the previous 10 years. The CAPE Ratio is calculated using a 10-year average of earnings to smooth out the volatility of annual earnings over a business cycle. Looking at the above chart, the CAPE Ratio indicates that the S&P 500 valuation is well above 1 standard deviation from its long-term historical average. If you are looking for evidence for an impending bear market, this indicator would be a great one to use.

Price/Earnings Ratios

Source:Citi

One of the more widely-used measures to put valuations into perspective is a simple ratio of the current price to 1-year trailing earnings. This is the standard Price/Earnings Ratio. The above chart would indicate that at a ratio of 20, the MSCI USA index is marginally expensive from a historical perspective, but well within 1 standard deviation of historical norms. This metric would indicate a valuation for the broad US equity market that is reasonably fair.

Earnings Yield Gap

Source:Citi

The Earnings Yield Gap is the earnings yield (the inverse of the Price/Earnings Ratio) less the 10-year government bond yield. Earnings yield is another way of looking at equity market valuations because it converts the Price/Earnings Ratio to a yield for the equity market. That yield can then be compared to other yields, such as the 10-year government bond yield, to measure relative attractiveness of equities to a risk free asset class. Using this measure, the equity market appears relatively cheap. This is largely due to the very low level of 10-year government bond yields. If you are looking for metric to demonstrate that the equity market is in fact relatively cheap in terms of valuation, then the Earnings Yield Gap would be a great ratio to utilize.

Which measure to use?

Each of the above three metrics provide a different answer to the question of stock market valuation. The market appears rich using the CAPE Ratio, fair using the P/E Ratio, and cheap using the Earning Yield Gap. All are commonly used for long-term valuation of the stock market, yet all three provide inconsistent insights. If all three indicators were flashing warning signs, then it would be much easier to make a definitive assessment.

The best we can do in this situation is look at ALL available metrics and determine whether there is a discernible pattern. In addition to ones above, some other indicators to evaluate should include:

·        Tobin’s Q (ratio of total market value to total asset value)

·        Price/1-year forward earnings

·        Stock market capitalization as a percentage of GDP

·        Price/Sales ratio

·        Price/Book ratio

·        PEG ratio (price/earnings ratio compared to earnings growth)

There are clearly numerous ways to look at valuations of an equity market. Concentrating on just one measure may work as a tool to support your cognitive bias, but it is not the best way to improve your chances of a correct forecast. Not all indicators will align. Sometimes you will get one indicator flashing a green light, another indicator signaling yellow, and yet another flashing red.

The best advice an investor can follow is to avoid paying too much attention to the extreme statements made by anybody focused on just one measure. Look at them all. Look at them all over different periods of time. Don’t look at just the ones that confirm your bias. When you see a preponderance of indicators signaling overvaluation, then it makes sense to incorporate those measures into your asset allocation strategy. Otherwise, tune out the sensationalism.

[garthfriesen]

Silencing the Roar of the Bond Bear

The bond market bears are roaring again. The pundits are out in full force, announcing that the fixed income market has finally reversed direction and yields are going to start their inevitable march higher on a path to “normalization.” These predictions are often accompanied by advice to sell your bond portfolio before it melts down in value. Let’s put “melt down” into perspective.

A favorite tactic of the bears to scare you out of fixed income holdings is to quote the performance of the long bond (or an ETF that tracks that part of the curve, like TLT). For instance, they would highlight since the beginning of February, TLT has sold off roughly 14%, which is a huge amount compared to its paltry 3% yield. They would fail to tell you that other segments of the fixed income market such as high yield (HYG) and short-dated investment grade corporate bonds (CSJ) had positive returns during that period. HYG was up 2.1% and CSJ returned 0.4% during that same time period.

Using TLT as a barometer for fixed income is like using a 3x levered ETF on the Russell 2000 index to gauge stock market performance. The interest rate duration of TLT is 17.3 years, compared to 5.1 years for a broader representation of the bond market like the Barclays Aggregate Index (AGG). The duration of TLT is a whopping 3x that of AGG.

A duration of 5.1 years means that the expected impact of an instantaneous 100 bp increase in yield would result in a decline in portfolio value of 5.1%. However the yield on the portfolio would buffer that impact. For example, if the increase in rates took place over one year, and the yield on the portfolio was 2.1%, the net impact would be -3% (5.1% capital loss, with 2.1% added back). Not exactly what people are looking for out of their core bond allocation, but not a disaster either. It is certainly better than the expected loss of 14% that would occur under the same scenario for TLT.

So, just how typical are these types of drawdowns on a broad fixed income index like AGG?

I looked back over the last 25 years and calculated the quarterly returns for AGG (on a calendar basis, not on a rolling basis). The worst 10 quarterly returns are shown in the chart below, along with the returns of the S&P 500 index in those same quarters.

The worst quarter for a core bond portfolio was the 3-month period ending in March, 1994, when the Fed surprised the market with a series of rate hikes. During that period, bonds lost 2.9% and the S&P 500 was down 4.4%. In that quarter, both equities and bonds posted negative returns. It’s important to note equity market weakness during periods of losses in the bond market is not a given. In fact, equities had a positive return in 6 out of the 10 quarters when bonds had their worst returns.

Two things jump out in this analysis. First, 3% as the worst calendar loss in the last 25 years is not that horrific. Second, equity returns during those time periods were significantly more volatile. In other words, for a balanced portfolio, equity markets really drive overall performance.

Given that equities are the main driver, it would be interesting to examine bond market returns when EQUITIES are performing poorly. The chart below shows the 10 worst calendar quarters for equities since 1990, along with core bond market returns during those periods.

The worst quarterly return for equities in the last 25 years was Q4, 2008, when the S&P 500 lost 22.6%. During that quarter, AGG returned 4.6%. It is interesting to note that in every single one of the worst 10 quarterly equity drawdowns, bonds had a positive return. Simply put, history has shown that when equities are performing their worst, bonds are still providing positive returns. This negative correlation to equities is consistent during times of significant equity stress.

So before you get caught up in the hysteria about the recent bond market weakness, try to keep perspective about why you bought the bonds in the first place. If one of those reasons was to gain exposure to an asset class that has historically provided positive returns when equities are doing the opposite, then jettisoning your bond portfolio may not be the smartest idea. Not all segments of the fixed income market will perform poorly. Let the pundits panic.

[garthfriesen]

Factoring the Differences Between Quality and Value

When it comes to investing, most of us are familiar with the various “style boxes” popularized by Morningstar: Small, Medium and Large capitalizations paired up with Value, Blend and Growth equity attributes. There are a multitude of investment vehicles and options to provide investors exposure to any of the various different combinations. 

Two of the categories, Value and Small Cap, are also identified as investment factors. An investment factor is a characteristic of a group of stocks that explain their risk and return. Value and Small Size, through rigorous academic research, have shown to contain measurable risk premium that can be extracted over time. Other factors, outside of the Morningstar Style Box, that have been identified to provide investors a return premium are Low Volatility, High Dividend Yield, Momentum and Quality. Similar to Value and Size, there are numerous active fund managers and ETFs that aim to capture one or more of these lesser-known factors as part of their investment mandate.

Fortunately, there are observable indexes that track these factors. Market-cap weighted indexes like the S&P 500 derive their allocations solely based on the size of the company. Factor-weighted indexes calculate portfolio holdings based on weighting one or more factors. Factor indexes can be either a subset of a larger price weighted index, or include all the components of a broad index with a weighting methodology other that price.

Some of the characteristics that determine the various factors are easy to measure: market capitalization, volatility, momentum, and dividend yield are all relatively easy to calculate. The Quality and Value factor, however, are more subjective. So what is the difference between the Value and Quality and how do index providers go about weighting these factors?

MSCI, a leading index provider, constructs indexes according the following criteria:

In both cases, the factor indexes include all the securities in a broad, price-weighted index (US MSCI Investable Market Index), re-weighted according to the above criteria. After the re-weighting, you end up with portfolios with very different sector exposures. 

QUAL and VLUE are two ETFs that track the MSCI Quality and Value factors. The sector exposures for each ETF is shown in the table below:

The QUAL portfolio has a much higher weighting to the technology, consumer cyclical and health care sectors. These three sectors account for over 63% of all exposure in QUAL compared to 36% for VLUE. The financial and energy sectors dominate the VLUE allocation, accounting for 32.8% of the portfolio, compared to 11.8% in QUAL.

In summary, according to the value and quality factor screens performed by MSCI, high quality companies (those with low debt/equity ratios, high return on equity, and stable earnings) are mostly found in the technology, consumer cyclical and health care sectors. Companies that exhibit the most value (strong sales, high earnings, good cash flow and a low price to book ratio) are currently found in the financial services, technology and energy sectors. The value factor appears to be more equally distributed across the different sectors. In fact, QUAL does not have any companies at all in the real estate, utilities and communication services sectors, whereas VLUE has a combined weight in those sectors of 9.3%.

From a fundamental perspective, QUAL has a 5.76 Price/Book ratio compared to a 2.13 ratio for VLUE. The Price/Earnings ratio for QUAL is 20 versus 18.4 for VLUE. This makes intuitive sense given technology stocks (largest sector allocation in QUAL), generally trade at higher Price/Book ratios than financial companies (largest exposure in VLUE).

As you can see from the data, the Value and Quality factors are not similar at all. Re-weighting a broad index according to these factors provide very different results in terms of portfolio composition. Investors need to be aware of the sector tilts that are generated through over-weighting or under-weighting various factors. Using factors to gain exposure to a certain type of company can be an excellent way to diversify away from traditional market-cap weighted indexes, but you may be increasing your concentration and exposure to a narrower group of industries and sectors. Expressing a view on a factor may come with other undesirable risks.