Another Reason Not To Chase Hot ETFs

Financial advisors should know better than to chase the latest hot investment, and a research report offers more evidence of why it’s a bad idea.

Equity-focused exchange-traded funds that saw big inflows as a percentage of assets under management over a short time period generally underperformed funds with average inflows, according to a research report titled “Shun ETFs With Largest Inflows” by Jun Zhu, co-portfolio manager for the Leuthold Core Investment Fund and a senior analyst at The Leuthold Group.

With more than 2,000 ETFs available, and many having multi-year histories, Zhu applied the backtesting methodology Leuthold commonly uses for stocks. Although ETFs debuted in the U.S. in 1993, they didn’t start attaining critical mass until about 2006 when the number of U.S.-listed ETFs first exceeded 200.

Zhu looked at fund flow data from April 2006 to April 2018 for all ETFs to assess the performance relationship, but the lion’s share of ETFs are equity (69 percent), followed by fixed income (16 percent), commodities (8 percent), alternatives and asset allocation (both 3 percent), and currency (2 percent).

She grouped ETFs into five quintiles using one-month, two-month, and three-month fund flows as a percentage of month-end assets under management, and calculated the equal-weighted returns of each basket. The first quintile saw the largest inflows, second quintile saw the second-largest inflows, etc. The last quintile saw the largest outflows.

The forward one-month return for ETFs with the highest one-month fund inflows underperformed ETFs in the other four quintiles. The highest inflow ETFs saw a negative 0.01 percent versus a range of positive 0.37 percent to 0.48 percent for the rest. Zhu says this pattern persisted in back tests based on two-month and three-month fund flow data.

She also looked at how the fund-flow effect and performance appeared over six-month, nine-month and 12-month periods, and this also showed funds with the biggest inflows underperformed over all return horizons. During the 12-month period, ETFs with the largest outflows slightly underperformed ETFs in the middle three quintiles—i.e., those with more average inflows.

Over the course of the 12-year study period, people who invested equally weighted in equity ETFs with the highest inflows saw an 8 percent loss. Meanwhile, an equal-weighted portfolio using the other four ETF baskets returned 72 percent during the same period.

While Zhu can’t say exactly why this happens, she has a hunch.

“We know equity investors, especially with retail investors, have the tendency to chase returns,” she says.

That herd behavior tends to swell the valuation of the underlying assets in the ETFs, but eventually that valuation will revert back to normal and the asset eventually underperforms.

The equity-ETFs pattern doesn’t replicate when looking at fixed-income ETFs, Zhu notes. With fixed-income ETFs, the pattern of high-inflow/fixed-income ETFs versus the other fixed-income quintiles was flat since 2009.

She suggested the general pessimism investors have had toward fixed-income, along with dumping fixed-income ETFs that didn’t perform well, may have something to do with the pattern.

“Fixed-income investors are more risk averse. They want to protect their principal or protect their investment. So instead of return chasing, when things are not going well they may overreact [and sell],” Zhu says.

Regarding ETFs that invest in commodities and currencies, Zhu says there aren’t enough ETFs to make a meaningful analysis. But data show commodity ETFs seem to follow the equity-ETF pattern, while currency ETFs show a reverse relationship. Over nine years (April 2009 through April 2018), the back test showed investing in currency ETFs with the highest fund inflows netted investors a 37 percent cumulative return during the period tested, versus a loss of 15 percent for those buying ETFs with the largest fund outflows.

Zhu says she’ll need to do further analysis to ascertain why equity ETFs with high inflows relative to AUM underperformed, but for now she says it’s another reminder to be thoughtful when investing.

“It’s just something that you want to keep in mind when you are trying to build your portfolio, to probably avoid certain ETFs which are really hot,” she says.

Debbie Carlson is a freelance writer for ETF Advisor magazine.

Four Places ETF Bears Have Made Money

With U.S. stocks still trading near all-time highs, it’s easy to assume investors with a bearish slant haven’t been profiting. In truth, there are several places in the global markets where it has paid to be a bear. Let’s examine these areas.


The high stakes trade battle between the U.S. and China has turned into a global spectacle. China unveiled another $60 billion in tariffs on U.S. goods effective September 24. The latest move is in response to the $200 billion in tariffs imposed by the U.S. If no agreement between the two nations is reached by the end of this year, the Trump administration has vowed even higher tariffs in 2019.

Thus far, trade tensions have taken a heavy toll on the Chinese stock market. The Deutsche XTrackers Harvest CSI 300 A-Shares ETF (ASHR) has fallen nearly 19 percent this year. A-shares, which track mainland Chinese stocks, are denominated in Renminbi and traded on the Shanghai and Shenzhen stock exchanges.

On the other side of that trade, the Direxion Daily CSI 300 China A Share Bear 1x Shares (CHAD) has jumped 16.6 percent. CHAD aims for 100 percent daily opposite exposure to mainland Chinese stocks and it’s been the perfect trade for China’s falling stock prices.

Emerging Markets

Aside from China, emerging-market countries as a group have struggled in 2018. And for bearish types, it’s been another great place to trade.

The Vanguard FTSE Emerging Markets ETF (VWO), which tracks a basket of stocks from 23 developing countries, has slid 8.3 percent year-to-date. Among this group, Brazil and Turkey have been the hardest hit. Currency turmoil and political instability, along with the global trade war, have pushed prices lower. The iShares MSCI Turkey ETF (TUR) has crashed 43 percent and the iShares MSCI Brazil Capped ETF (EWZ) has slumped 13.7 percent.

Bad news in emerging markets has been good news for ETFs designed to move in the opposite direction. The ProShares UltraShort MSCI Emerging Markets ETF (EEV) and the Direxion Daily MSCI Emerging Markets Bear 3x Shares (EDZ) have rallied 8.5 and 13.1 percent, respectively. EEV aims for double daily opposite performance to emerging market stocks. EDZ aims for the same goal, but with triple daily leverage.


Since 2016, the trend in U.S. interest rates has been up. Stoking this trend has been a series of rate hikes by the Federal Reserve. After a long period of rates near zero percent, the Fed is focused on the “normalization” of interest rates back to pre-financial crisis-era levels. What have been the aftereffects?

Bond prices, especially long-term Treasuries, have experienced a swift market decline. The iShares 20+ Year Treasury Bond ETF (TLT) has slid 5.7 percent year-to-date. Meanwhile, inverse ETFs like the ProShares UltraShort 20+ Year Treasury ETF (TBT) and the Direxion Daily 20+ Year Treasury Bear 3x Shares (TMV) have jumped 13.4 and 18 percent since the start of the year. TBT aims for double daily opposite performance to long-term Treasuries, while TMV aims for the same goal, but with triple daily leverage.


Rising mortgage rates has dampened the once happy mood in the U.S. housing market. One year ago, the rate on a 30-year fixed-rate mortgage was 3.83 percent. Today, it’s closer to 4.75 percent. The result has been slowing sales as the cost to finance home purchases rises.

The SPDR S&P Homebuilders ETF (XHB) has tumbled 12 percent this year while the SPDR S&P 500 ETF (SPY) has risen by 10.4 percent. Although there’s no inverse ETFs tied directly to homebuilders, tactical investors who have bought put options on XHB have been able to play the trend of declining stocks in the sector. As equity prices decrease, the value of underlying put options go up and can be sold for a profit.

In summary, the narrative that bears have suffered in 2018 because of rising U.S. stocks hasn’t been entirely true. Instead, selective bears in carefully chosen markets have been rewarded for their bets.

Ron DeLegge is founder and chief portfolio strategist at ETFguide.

ETF Investors Buy Treasuries, Dump Junk As Trade War Risk Rises

Investors are pouring cash into exchange-traded funds that provide protection against the stock market turning sour as interest rates are set to rise again and trade tensions between the U.S. and China escalate.

It’s been a banner month for the iShares 20+ Year Treasury Bond ETF, or TLT, which has taken in $2.1 billion in September, putting it on track for its second most monthly inflows ever. That includes a $350 million outflow on Monday. The fund holds longer-dated Treasuries and typically profits from higher interest rates.

“I’m not surprised to see stocks selling off and some money being put into bonds,” said Chris Zaccarelli, chief investment officer at Independent Advisor Alliance. “It sounds like a classic risk-off trade to me, and I think the escalation in the trade war is the catalyst.”

Bond trades aimed at limiting risk are becoming increasingly popular. Investors have yanked more than $2.4 billion from the iShares iBoxx High Yield Corporate Bond ETF, or HYG, in September, putting it on track for a record month of outflows.

There’s $45 billion wrapped up in ETFs that track high-yield bonds, according to research by Bloomberg Intelligence analysts Eric Balchunas and Athanasios Psarofagis.

Typically, that money exits as rates rise. Since 2013, average fund flows for high-yield bond ETFs were 88 percent lower in months when 10-year Treasury yields moved higher.

“High-yield can be much more linked to the performance of the broader economy, and even equity markets, than the Treasury curve or investment-grade,” said Jason Thomas, chief economist at AssetMark, which manages $47.5 billion.
Rate Risk

The Fed is expected to raise its benchmark interest rate for the third time this year following its policy meeting Wednesday, with a 2 percent to 2.25 percent target range widely anticipated. The yield on 10-year Treasuries hit 3.1 percent Tuesday, its highest since May.

Pouring money into TLT as interest rates rise is “counterintuitive,” said Todd Rosenbluth, director of ETF research at CFRA Research.

“TLT incurs more interest rate risk than nearly all other fixed-income ETFs, and as such has lost money in September,” he said. “Yet, investors concerned about stock market volatility may find comfort in the liquid exposure to Treasuries.”

The trade war between China and the U.S. intensified on Monday after the Trump administration imposed tariffs on $200 billion in Chinese goods, with Beijing vowing it would slap $60 billion in U.S. products in retaliation. And the tiff shows no signs of abating.

In a speech before the United Nations General Assembly Tuesday, President Donald Trump accused China of engaging in “relentless product dumping” and intellectual property theft that “ cannot be tolerated.” Meanwhile, China reduced tariffs on imports from trading partners, which could mean it’s digging in for a much longer trade fight, according to Zaccarelli.

That’s reason for caution, not a market rally, he said.

“I think the risks of a prolonged trade war are greater than ever,” Zaccarelli said.

This article was provided by Bloomberg News.

Bitcoin ETFs Delayed Again As SEC Seeks Comment On Fund Proposal

The wait for an exchange-traded fund that invests in bitcoin likely continues with U.S. regulator seeking comments on a listing request.

Despite already receiving more than 1,400 comment letters on a proposal to list an ETF from Van Eck Securities Corp. and SolidX Management, the Securities and Exchange Commission is inviting more feedback, the agency said Thursday in a filing. Those who wish to comment have 21 days after the SEC’s order is published in the Federal Register, while rebuttals have 35 days from that date.

The agency is seeking views on market manipulation — including whether bitcoin is less susceptible to manipulation than other commodities that back exchange-traded products — as well as surveillance.

A spokesperson for the SEC didn’t immediately reply to a request for comment.

This article was provided by Bloomberg News.

The Limits Of Correlation In Portfolio Construction

There are some strange correlations out there. For example, a recent article in the Financial Times cited data showing a correlation between share price and CEO manners. Those CEOs who said “please” and “thank you” more often saw their companies enjoy a higher share price. Another study done several years ago by a firm called InsideSales and cited in The Wall Street Journal found that over a nine-year period the average value of a sales deal closed during a new moon was twice that of a deal closed during a half moon and 43% higher than one closed during a full moon.

Big data and artificial intelligence have the ability to unearth ever deeper levels of correlation, but whether these relationships will have investment value remains to be seen. This is interesting to financial advisors and investors because, for those looking for exposure in alternative asset classes, the conversation inevitably anchors around a single data point: correlation.

In measuring correlation, analysts use a mathematical formula to understand return differences in a series of numbers. These return differences are combined with a measure of risk to arrive at single point number that defines the relationship between the two series. Two assets classes that are perfectly correlated have a value of “1”; if the asset classes are a perfect inverse correlation, the value is “-1”. No definable relationship between the asset classes is expressed as “0”.

Asset class relationships can exist anywhere along this spectrum, but note that these results say nothing about where the relationship is coming from, just that it is strong, weak, or non-existent. In fact, correlation provides no insight for end-result performance expectations. This is its first significant flaw.

Nonetheless, investors continue to seek out and invest in “non-correlated” assets, using correlation as a standalone proxy for diversification and risk management. With markets near all-time highs and everything that is going on in the world, there’s a natural desire to want to take some risk off the table, often through an investment in what are mathematically shown to be non-correlated or inversely correlated assets.

Hedging techniques—options contracts, futures, and short or swap exposure, for example—can be used to provide an exposure of -1 correlation. But these can be expensive, and what happens should the market continue to rise? The money spent on hedges is thrown out the window. Institutionally, the cost of carry can be whittled down through economies of scale, but for advisors and their clients, a more appropriate approach would be a portfolio-based hedge that provides returns, yet exhibits natural limitation of downside market participation through the diversification of risk premia. With a portfolio hedge, correlation becomes just one factor to consider, and the primary concern then shifts to another statistical measure of risk exposure: beta.

Beta is a measure of volatility relative to the market, with the market often defined as the S&P 500. A beta of less than 1 means a stock is in theory less volatile than the market; a beta of more than 1 means it’s more volatile. Unlike correlation, beta isn’t limited to +/- 1 so it can provide a more nuanced understanding of the relationship of the equity or asset class to the benchmark.

ETF investors know beta as the measure that is used for factor identification. For example, in a fund that uses a “quality” screen factor in its index, an equity with a higher beta relative to the quality metrics being used would result in that equity being included as a constituent in the fund; those with lower betas would be excluded. Beta is also the measure that is used in the Fama-French factor model, which provides for a market beta, size beta, value beta, etc. “Sensitivity” to the factor is more important going forward compared to the historic “relationship” that correlation would represent.

This brings us to a second flaw in depending on correlation alone for portfolio (or index) construction: correlation does not imply causation; rather, it identifies a historical relationship that may or may not persist and that may or may not have predictive value.

While they may think in terms of non-correlated assets, what investors in alternatives and alternative ETFs generally have in mind is replicating a hedge fund type of exposure, with the goal of generating mostly positive returns and avoiding substantial drawdowns. Multi-strategy funds and ETFs are one vehicle for this. These funds seek to navigate the various risk premia in the market, including systematic equity risk, providing a hedge fund-of-funds type of exposure. They may do this in part by incorporating both beta and correlation in the strategy or, in the case of an ETF, in the underlying rules for the index.

This is not to say that correlations can’t be useful. Consider an investment approach that employs multiple types of risk; one may be general market risk, another might be volatility, and yet another a long/short strategy. If many of the other risks do not provide return, or maybe even counteract each other, portfolio return would be a function of general market exposure – it would show high correlation to the market, as well as low beta. If the other return sources kicked in, the correlation to the broad market would naturally go down. Going forward, the market may provide negative returns, and the other strategies may counteract and provide positive returns, which could look like negative correlation, without changing the strategy—the goal of multi-strategy exposure.

The efficacy of this multi-strategy approach is evident during drawdown periods. While there have been no major bear markets in the nine plus years since the first multi-strategy ETF entered the market, there have been six market sell-offs of at least 5 percent since that fund was first introduced. (Full disclosure: my company, IndexIQ, was the sponsor of that ETF, the IQ Hedge Multi-Strategy Tracker ETF, ticker symbol QAI). In those instances, QAI experienced drawdowns that were 41.5 percent of the drawdown experienced by the S&P 500. Overall volatility was lower as well.

Investors love numbers, and new correlations surface all the time. Some will be useful, others not. (Wet sidewalks probably don’t cause rain, for example.). On the evidence to date, measuring correlation among asset classes alone is not sufficient for alternative asset investors to consistently achieve their risk management and diversification goals. Adding beta significantly improves the chances for success.

Dan Petersen is product manager at ETF provider IndexIQ.

Higher Interest Rates? There’s An ETF For That

The not so inside joke about the exchange-traded fund marketplace is that there’s an ETF for whatever financial concerns you or your clients may have. Joking aside, today’s climate of rising interest rates has many fixed-income investors on edge, putting rate-hedged funds into the spotlight.

While bond yields are high enough to offer a relatively attractive alternative to stocks, many investors are still avoiding bonds in anticipation of even higher interest rates in the future. Is there a way to capture current bond yields without suffering losses if rates continue heading up? Rate-hedged ETFs have an offer they hope you won’t refuse.

The general idea behind ETFs with rate-hedging strategies is to own a basket of corporate bonds while simultaneously short selling U.S. Treasuries with identical maturities. By design, any losses realized by the corporate bonds due to higher interest rates would be offset by gains from selling Treasuries short. Has it worked?

Let’s compare the recent performance of the iShares Interest Rate Hedged Corporate Bond ETF (LQDH) against its unhedged cousin, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). Beginning when 10-year Treasuries hit their low of 1.37 percent on July 8, 2016 up until the current yield now near 2.98 percent, the unhedged corporate bond ETF (LQD) has declined 0.45 percent. Meanwhile, the rate-hedged version (LQDH) has gained 11.20 percent during the same period. Not a bad return, especially after 10-year rates more than doubled.

A similar pattern of outperformance has been experienced in other segments within the broader bond market. Using the same July 8, 2016 starting point up until present, the ProShares High Yield—Interest Rate Hedged ETF (HYHG) has jumped 20.42 percent while the unhedged SPDR Bloomberg Barclays High Yield Bond ETF (JNK) has gained 13.76 percent.

Protecting against the threat of higher rates via ETFs is still a fairly new idea that didn’t exist five years ago. While these types of ETFs aim to mute the negative impact of higher rates, they aren’t a cure-all.

During periods of falling rates, for example, a rate-hedged strategy is likely to perform worse versus an unhedged strategy. The hedged LQDH fund, for example, lost 9.61 percent from its inception date on May 27, 2014 through mid-February 2016 as the yield on 10-year Treasuries sharply declined.

Also keep in mind that rate-hedged funds do not hedge against or eliminate credit risk because they still maintain constant exposure to a basket of bonds. So if bond issuers default or go bust, performance returns would likely suffer. This is particularly true of ETFs linked to high-yield or junk bonds that carry elevated credit risk.

Finally, there are other ways to hedge against the danger of higher interest rates. Laddering bonds with sequentially longer maturity dates is still a more commonplace strategy among fixed-income investors. If interest rates go up, investors are able to redeploy the money from maturing bonds into new ones with higher yields. This strategy can be accomplished with target-maturity bond ETFs that deliver an expected cash payout date while providing diversification across a spectrum of different bonds.

Like any investment, rate-hedged ETFs have caveats. Nevertheless, they’ve mostly delivered as advertised during their brief history. And for many bond investors seeking protection, an imperfect hedge is better than none.

Ron DeLegge is founder and chief portfolio strategist at ETFguide.

BlackRock Hits Back At SocGen Alarm Over ETF Market Fragility

Alarm bells over the perils of the ETF investing boom are ringing anew, with Societe Generale SA the latest to warn on brewing liquidity risks — provoking a rebuke from the world’s largest asset manager.

After stress-testing the fragility of 16,000 stocks, the French bank concludes small caps, dividend shares and gold miners are all acutely vulnerable in market downdrafts thanks to outsized ownership among passive investors.

In turn, those positions could prove more costly to exit. Given the Bank of Japan’s massive purchases, the Nikkei 225 Index is also, in theory, particularly fragile.

“Crowdedness exists but is limited to a few stocks and strategies,” SocGen analysts led by Sebastien Lemaire wrote in a report last week.

The conclusion provides some ammo for regulators and ETF detractors on Wall Street, who charge the post-crisis flood of passive money has marshalled an investing-herd mentality, dubbed crowding risk.

Small caps could be whipsawed by this dynamic since the same stocks in the sector make an appearance in multiple indexes tracked by ETFs, according to the report.

The world’s largest issuer of passive products, BlackRock Inc., dismisses the warnings.

“This research is underpinned by two assumptions that don’t reflect the historic behavior of investors or ETFs,” the firm said in an emailed statement.

“To assume that all investors behave the same way in times of market stress is not grounded in reality. Additionally, we have repeatedly seen ETF volumes grow dramatically during times of stress as investors utilize them as a tool for price discovery.”

Price Discovery

Regardless, SocGen’s critique is a familiar one on Wall Street.

The theory goes that in a tumbling market, secondary liquidity in the ETF would likely evaporate, forcing traders to shift to the primary venue, with the liquidity of assets underlying the passive instrument subject to increased selling pressure.

Gold miners stocks held by popular securities from the likes of VanEck are at risk, thanks to large ownership by these funds, according to SocGen strategists.

Weighting dynamics also increase crowding risks in dividend equities, with a clutch of gauges boosting exposures to shares with modest market capitalizations given their high yields. That, in turn, has led to heavy holdings by ETFs of stocks like Tanger Factory Outlet Centers Inc. and Meredith Corp.

That’s not to say ETF providers aren’t aware of the issue. The VanEck Vectors Junior Gold Miners ETF, for one, changed its index last year after ownership stakes in some companies rose above 10 percent.

And there’s good news from the French bank. Around 90 percent of world equities likely aren’t subject to heightened risk of a liquidity squeeze because they’re owned 10 percent or less by ETFs, it says.

Even in fragile emerging markets — an asset class riddled with hot money — passive funds appear to have passed this year’s stress test.

BlackRock points to action last month in its iShares MSCI Turkey ETF, ticker TUR, when the country’s assets were roiled by increasing tensions with the U.S. The ETF’s underlying index plummeted 16 percent on Aug. 10, but trading in the fund remained orderly, with no discernible impact on the underlying shares.

“TUR saw its highest amount of daily trading volume ever, with 13.3 million shares exchanging hands that day, compared to its previous average daily volume of 500K shares,” according to the statement.

Still, regulators continue to warn of liquidity challenges spurred by the ETF revolution.

Among the latest is the European Systemic Risk Board. In a report this month, it warned that market stress could “create first-mover advantages if, for instance, primary markets offer stale prices, while the underlying markets are turning illiquid.”

The result? “Investors may expect there to be greater liquidity than that available during times of stress,” the report concluded.

This article provided by Bloomberg News.

More Advisors Using Third-Party Asset Managers, Survey Says

Advisors are finding success by increasing their use of external asset managers, according to a new survey.

The survey by FlexShares, the ETF unit of Northern Trust Asset Management, found that despite the increased interest in third-party managers, “many respondents are hesitant to use external investment managers because investment research remains a core part of their firm’s value proposition,” FlexShares said in a press release.

These were among the online survey’s findings:

• Advisors are increasing the level of assets under management devoted to external investment managers, from an average of 53 percent in 2016 to 57 percent in 2018.

• Satisfaction rates among advisors with external managers have steadily increased, up from 92 percent in 2010 to 97 percent today. Sixty-two percent of advisors have grown their client base as a result of external management, and 30 percent have increased revenue.

• Advisors particularly sought out external help for more niche strategies, including alternative investments (65 percent), emerging/frontier markets (43 percent), ESG (17 percent) and factor-based or “smart beta” investments (14 percent).

• Many advisors are hesitant to use external investment managers because investment research remains a core part of their firms’ value proposition. However, the data shows that this attitude may be changing as the percentage of advisors that cite this reason has declined over time—to 32 percent in 2018, down from 45 percent in 2016 and 56 percent in 2014.

“As advisors adapt to a growing demand for financial planning services and rising pressures on their bottom line, they are increasingly looking to employ external investment management services and to focus on activities through which they can add the greatest value,” said Laura Gregg, director of client development at FlexShares. “As they dedicate more client assets to outsourcing, advisors are able to benefit by spending more focused time with clients as well as concentrating on business development activities.”

The online survey was based on responses received from 600 advisors in February and March.

ETF Investors Keep Buying As Wall Street Warns Pullback Coming

Despite warnings from Wall Street that stocks are poised for a selloff, money keeps flooding into equity exchange-traded funds as investors bet that the recent pullback in the S&P 500 Index is just another opportunity to buy the dip.

The three largest ETFs tracking the S&P 500 took in a combined $6.6 billion on Wednesday, the most since Feb. 12, according to an analysis of Bloomberg data. This week’s inflows into the SPDR S&P 500 Trust, iShares Core S&P 500 ETF, and Vanguard S&P 500 ETF — which also happen to be three of the four biggest overall ETFs in the world — are on track to be the most since September 2015, the data show.

The moves fly in the face of guidance from strategists at Goldman Sachs Group Inc. and Citigroup Inc., who urge caution as stock market valuations get stretched amid surging investor confidence.

“Sentiment is very, very bullish right now no matter what reading you look at,” said Paul Nolte, a portfolio manager at Kingsview Asset Management. “Obviously that has followed a nice rise in the market over the past couple months.”

The majority of Wednesday’s flows into three equity ETFs was driven by cash into the Vanguard fund, known by its ticker VOO, which took in a record $3.8 billion.

Peaking volume in buybacks, two consecutive quarters of 24 percent earnings growth and the fastest economic expansion in four years are fueling confidence in the bull market. Sentiment has climbed to levels that foreshadowed the year’s worst rout, prompting Citigroup to caution that a pullback may be in the offing.

And at Goldman Sachs, the firm’s bull/bear market indicator has risen to alarming highs because of soaring valuations and a tight labor market, which points to accelerating inflation.

“Flows tend to follow market moves as opposed to lead market moves,” Nolte said. “If something is doing well, then everybody looks at it and says, ‘Oh, we’ve got to have some of that,’ and piles into it.”

This article provided by Bloomberg News.

S&P Sector Switcheroo

Key Takeaways

• S&P 500 GICS sectors will undergo a significant shift later this month with a big revamp and expansion of the telecommunication services sector.

• Investors employing sector strategies should be aware of the changes, which will also alter the makeup of the consumer discretionary and technology sectors.

S&P GICS sectors to undergo a significant makeover later this month. Effective September 28, S&P Dow Jones Indices will make significant changes to its Global Industrial Classification Standard—referred to as GICS. Index provider MSCI will follow with its own updated indices in early December. Reclassifying companies into different sectors may not sound like a big deal, but this one will be quite meaningful—even more so than the addition two years ago this week of real estate as an S&P GICS sector. Here we discuss the implications of creating the new communication services sector and changes to the consumer discretionary and technology sectors.

What’s Happening

About three weeks from now, the telecommunication services sector will be greatly expanded and renamed “communication services.” The stocks that will be added to the expanded sector are mostly media and internet companies within the consumer discretionary and technology sectors, with a focus on digital advertising and social media. In fact, after the changes, three of the original four “FANG” stocks (Facebook, Amazon, Netflix, and Google) will be part of the new communication services sector. The information technology sector, which will be impacted most, will see about 5 percentage points trimmed from its current 26 percent weight in the S&P 500 Index. The haircut for consumer discretionary will be smaller at just under 3 points (from 12.8 percent to 10.1 percent), and is tempered by eBay’s move from technology to consumer discretionary. The end result is that the S&P 500 Index weighting for the telecom services sector—rebranded as communication services—will increase from 2.0 percent to 10.1 percent [Figure 1]. Given that more than 8 percent of the S&P 500 is being reclassified, these changes will have the biggest impact on the sector landscape in the history of the GICS.

Why Does This Matter?

For some, this may not be such a big deal. For those investing solely with active mutual funds in the traditional asset classes (small caps, large caps, growth/value, and international), this change may not affect you at all. But for those of you who invest by sector, including using sector exchange-traded funds (ETFs), we think this change may be significant for several reasons:

• We lose a defensive sector. Historically, telecom has been considered a defensive sector, meaning its prospects were less dependent on economic growth than the more cyclical, or economically sensitive, sectors. In a weakening economy, consumers tend to forego more discretionary purchases before they give up their cell phones. As a result, telecom stocks—along with consumer staples, real estate, and utilities—have tended to be less volatile than the broader market during sell-offs. The sector’s makeover will significantly increase its volatility because more stocks that are sensitive to the fluctuations in the economy and stock market are being added and overwhelming the more defensive dividend-paying stocks that made up most of the legacy telecommunication services sector. The sector will enjoy stronger growth prospects—the average consensus long-term earnings growth forecast is 13 percent for stocks (FactSet data) that will make up the communication services sector, well above the 3 percent growth rate for the legacy sector. Investors will have to pay up for that significantly enhanced growth outlook, however, as the sector’s next 12 month price-to-earnings ratio (PE) will increase from 10 to approximately 24 (FactSet data, as of August 29).

• Technology may be lower octane. Some of the digital advertising and social media stocks that are leaving the technology sector are high-fliers. Losing these historically faster growing technology leaders may dampen the growth prospects for the technology sector, but it also slightly reduces valuations. The five technology companies leaving the sector have an average consensus long-term growth rate of 17 percent, compared with 14 percent for the sector overall. But those stocks carry an average PE of 29, compared with 19 for the sector (FactSet data). Also keep in mind the smaller technology sector will be more concentrated in its largest holding: Apple.

• Potentially more demand for traditional telecom names. The traditional telecommunication services sector had been whittled down to just three stocks after years of consolidation and business model disruption. As a result, the sector drew little interest among sector investors. In fact, most sector strategies were unable to replicate the sector due to rules around concentrated investment products. The revamped communication services sector has become much more attractive to investors, in our view; this may lead to more demand for products tracking the sector and, therefore, some incremental buying in traditional telecom stocks.

These are meaningful changes. Peter Lynch, the famed portfolio manager, once said about stock portfolios, “Know what you own.” That advice holds here. For those who own telecom strategies in particular, but also those who use or are considering using consumer discretionary or technology sector strategies such as ETFs, these changes are important to keep in mind.


Nearly 10 percent of the S&P 500 will see a change in sector classifications on September 28, the biggest impact on the sector landscape in the history of the GICS sectors going back to the 1990s. While a company’s reclassification may not impact the holder of that particular stock, or its growth or return prospects, the change matters for those using sector equity strategies.

The revamped and rebranded telecom sector—to communication services—will look much different than its predecessor, with superior growth prospects and higher valuations, but also higher volatility. It will no longer be one of the so-called defensive sectors. At the same time, the consumer discretionary sector will have less emphasis on traditional media, while the technology sector will lose some of its Internet high-fliers and see its weight in the S&P 500 drop quite a bit. We believe these changes are important for investors to consider.

John Lynch is chief investment strategist at LPL Financial. Jeffrey Buchbinder, CFA, is an equity strategist at LPL Financial.

ETFs, Day Trading And You

Detractors of exchange-traded fund investing have long argued these products are one-dimensional trading tools that seduce people into hyperactive trading. Have ETFs turned people into day traders?

The 1990s were a major turning point in the public’s attitude and behavior toward investing. Back then the day-trading culture took off as online trading gained in popularity. People with non-financial backgrounds were suddenly piling into the stock market hoping to strike it rich. Were ETFs behind this sweeping shift? In retrospect, hyperactive trading was fueled by hot initial public offerings in the internet and technology sectors. Put another way, the argument that ETFs helped shape the day-trading culture wasn’t exactly true.

Likewise today, the suggestion that ETFs are being used as stand-alone trading vehicles with no other purpose but to encourage hyperactive trading simply isn’t true. In truth, ETFs have become an important tool in both portfolio construction and management.

Morningstar’s latest ETF Managed Portfolios Landscape Report shows that total assets in professionally managed ETF portfolios held steady during the first quarter of 2018, near $121.9 billion. Twelve of the 20 strategies with the largest quarter-over-quarter percentage increases in assets were plain vanilla stock/bond strategic asset allocation portfolios. Atop this list was Richard Bernstein Advisors, which had the greatest organic quarter-over-quarter growth as assets in its strategic portfolios jumped 24 percent versus the prior quarter, to $878 million.

What does this all mean? Asset flow trends are signaling an increasing preference by investors for managed solutions, with ETFs being used as the primary building blocks. And rather than converting the investing public into day traders, ETFs have helped them—along with financial advisors—to build portfolios that are more diversified, tax friendly, and cost efficient.

What about the common assertion that massive daily ETF volume proves that ETFs are being used to speculate? This claim was made by Vanguard Group founder John Bogle in a Barron’s interview in May. According to Bogle, the 100 largest ETFs have turnover of 785 percent compared to just 144 percent for the largest 100 stocks.

In reality, Bogle’s statistics provide little evidence that mom-and-pop retail investors have turned into ETF day traders.

It’s a well-known fact the bulk of ETF trading is done by large institutions, not retail investors. This has always been the case since the first U.S.-listed ETF launched in 1993. If Bogle has a bone to pick about hyperactive trading, it should be with institutional investors, not with the retail crowd.

Vanguard conducted its own examination of ETF trading activity in 2012, and the findings contradict Bogle’s entrenched arguments that ETF shareholders are short-term speculators.

The study titled “ETFs: For the Better or Bettor?” scrutinized more than 3.2 million transactions in more than 500,000 positions held in the mutual fund and ETF share classes of four different Vanguard funds from 2007 through 2011. By obtaining information from the transaction and account records of actual Vanguard clients, the company was able to get to the bottom-line truth of how investors are really using ETFs. What did the study find?

The study’s results showed that 99 percent of traditional mutual fund investments and 95 percent of ETF investments did not exceed a rate of four reversals or changes in investment direction per year. Furthermore, less than 1 percent of ETF positions averaged more than one investment reversal per month. That’s hardly a sign of ETF day trading!

Furthermore, the study revealed another promising trend: The majority of traditional mutual fund and ETF investments in Vanguard’s study were categorized as buy-and-hold investments (83 percent and 62 percent, respectively). “We found little evidence of speculative behavior in either share structure,” concluded the Vanguard report.

In summary, data does not support the narrative that ETFs are responsible for a massive conversion of the public to day trading. On the other hand, data does support the trend of ETFs being used more and more within a portfolio-building context.

Ron DeLegge is founder and chief portfolio strategist at ETFguide.

Bitcoin ETFs Won’t Be Coming Anytime Soon Thanks To The SEC

Don’t hold your breath for a U.S. exchange-traded fund that invests in Bitcoin.

Prospects for such a fund took a nosedive on Wednesday when the Securities and Exchange Commission rejected requests to list nine cryptocurrency funds, citing continuing concerns about manipulation and market surveillance.

While a blow to the hundreds of virtual-currency fans who’ve lobbied for an ETF, the ruling is hardly surprising. The SEC has repeatedly urged exchanges and wannabe issuers to address the risks that ordinary investors face from the manipulation of an unregulated market. That was a key concern in January — when the agency outlined five questions it wanted answered — and why it again denied a Bitcoin fund run by the Winklevoss twins last month.

“The markets are small and the volumes on some of these exchanges are low, which makes it such that manipulation is possible,” said Chris Matta, co-founder of Crescent Crypto Asset Management. “That’s their major concern and, without having any sort of regulatory body stepping in and policing people doing that, it’s always a possibility.” A Bitcoin ETF will not start trading this year, he said.

The stakes are high for the SEC’s trading and markets division. Stories are still emerging of retail investors — such as one Democrat lawmaker — who bought Bitcoin at the peak of its meteoric surge to around $20,000 last year, only to see it crash to around $6,000. On the other hand, at least one Commissioner favors approving a fund; Hester Peirce was outvoted on the Winklevoss proposal.

The agency noted that “its disapproval does not rest on an evaluation of whether Bitcoin, or blockchain technology more generally, has utility or value as an innovation or an investment” — a statement it also made when denying the Winklevoss ETF and a sop, perhaps, to both Peirce and those who want a fund.

Ryan White, a SEC spokesman, said the agency declined to comment beyond what was posted in Wednesday’s orders.

The nine ETFs denied this time around came from three sponsors: ProShare Capital Management, GraniteShares Advisors and Direxion Asset Management. All of these funds sought to use futures contracts to get exposure, with several planning to short Bitcoin. The regulator had a hard-deadline to deny or approve all of these products over the next month; their requests to list had been pending since December and January.

Investors’ hopes for a Bitcoin ETF now rest on just one fund from VanEck Associates Corp. and SolidX Partners Inc. The regulator this month pushed back a ruling on that product until at least September and could ultimately take through February to make up its mind.

The SEC’s strong stance on market integrity show the ETF issuers have a lot to prove. But, either way, it won’t be the product for the masses that investors (or issuers) really want. The VanEck fund plans to have a high minimum share price, explicitly to discourage retail use.

This article was provided by Bloomberg News.

ESG Issues Becoming Important For ETF Investors

Investors need to take a long-term approach when they are considering including environmental, social and governance (ESG) guidelines in their ETF portfolios, said Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors.

For instance, “look at how the energy sector has changed over the years. In the long-term, clean power has a return potential, but an investor may not see immediate returns,” Bartolini said Friday during a discussion about including ESG and socially responsible investing (SRI) guidelines in ETF portfolios, which was sponsored by Charles Schwab.

More than half (52 percent) of ETF investors say it is important to invest in socially responsible funds because they want their investments to align with their beliefs, and 40 percent said they would be interested in using ESG guidelines for all of their ETF investments, according to the 2018 ETF SRI report used as the basis for part of the discussion.

“Young people and women are flocking to ETF and SRI strategies,” Kari Droller, vice president of third-party platforms for mutual funds and ETFs at Charles Schwab, said during the conference call. Advisors also are becoming more interested in ETFs, with 68 percent of ETF flows now coming from RIAs compared to half one year ago.

When ETF investments that used SRI guidelines were introduced, the investments were mostly made by institutional investors, but the landscape is slowly switching to RIAs and retail investors, Bartolini said.

However, 84 percent of people with ETF investments still believe they have to sacrifice returns in order to use ESG and SRI guidelines, according to the study, which included 1,500 people with ETF investments.

Another problem is that “finding nuanced ETFs that are created with different ESG goals in mind is still difficult,” Bartolini added.

The top concern for those who consider SRI important is the environment (45 percent), followed by global sustainability, which includes poverty and health issues (44 percent), and corporate governance (38 percent), according to the study.

Bartolini said advisors should try to determine their clients’ goals and how important immediate returns are to them before advising them on including SRI guidelines in their ETF investments.

Hate ETFs? Quants Say They Found Anomaly To Profit On Flows

August 3, 2018

Stock managers sick of being steamrolled by the onslaught of passive funds may have a new weapon to wield, one that was born of the very success their enemies had in overrunning the market.

According to quant strategists at Deutsche Bank, investors can beat equity benchmarks by building portfolios out of stocks that get whipped around the most when exchange-traded funds rebalance.

Bet against the ones they buy, and buy the ones they sell, is what they recommend. If all you did was go long stocks with the most negative ETF flows over the last 12 years, you would’ve topped the Russell 3000 Index by 2 percentage points annually. Buying and shorting returned 7.2 percent a year, the firms says. That’s more than double the best-performer among 10 factors tracked by Bloomberg over the period.

So enamored are they with their findings that Deutsche Bank strategists led by Ronnie Shah are treating it as the discovery of a new investment anomaly, a systematic way of profiting from errors in investor thinking.

In this case, they say, the error is when traders sense price trends being created by ETF flows, jump in and make them bigger. Since buying and selling by ETFs doesn’t reflect any company-specific knowledge, the trends later reverse, the study holds.

“The proliferation of passive investments is causing distortions,” said Shah, the firm’s head of U.S. quantitative equity strategy. “It’s a new anomaly associated with ETF flows that active managers can take advantage of.”

His team is among a growing group of market watchers who seek an edge by studying ETF behavior at a time when indexes outnumber stocks and passive vehicles control more than one fifth of the market cap of the S&P 500 and Russell 2000 indexes.

While hedge funds and other speculators have devised any number of strategies to front-run and otherwise exploit passive flows, Shah is among the first to publish a model for doing so over time using rule-based inputs. The success of the strategy relies on the popularity of passive investing, he said.

Lots of trading systems generate big returns on paper and then fail to live up to their promise when let loose in the real world. Shah noted that his model didn’t turn a profit until 2009, when the active-to-passive rotation accelerated. That’s also when the bull market began, leading one analyst to question if it’s a coincidence.

“Seeing anything turn around in 2009, you have to wonder whether it’s just a good, up market strategy,” said Melissa Brown, head of applied research at Axioma Inc., a provider of tools for risk management and portfolio construction.

Returns such as those reported in the study reflect choices about time frames and trading rules that in any researcher’s hands could be tweaked to maximize output, noted Vincent Deluard, a strategist with INTL FCStone Financial. But Shah’s study looks like “a great paper” with little evidence of data snooping, he said.

“The fact that the results are not that amazing actually increases my confidence in their findings, it suggests little over-optimization,” Deluard said. “From what I can tell without replicating the work myself, it looks like they were quite diligent.”

A separate paper published this month by S&P Global’s market intelligence unit found evidence that stocks responded to price pressures created by ETF flows, mainly those created by buying and selling of ETFs in the open market. The effect “is transient and of only modest magnitude,” though might also enhance returns if included in a risk model, it said.

Unlike active funds where managers spend months researching fundamentals in the quest to pick winners, an ETF typically tracks an index and only buys and sells when the members change. Rebalancings, which happen on a regular basis, can trigger money flows with only the thinnest connection to a company’s fundamentals.

The source of inflows isn’t always intuitive. Often a stock’s demotion from a large-cap index can spur passive buying. It takes a bigger share of the small-cap pool than its old weight in large caps, and the downgrade forces ETFs to purchase it.

Such blind buying tends to push share prices beyond what’s justified by fundamentals, Deutsche Bank says. But the gains and losses later unwind. To exploit the pattern, the firm developed a quantitative model that tracks ETF flows for Russell 3000 companies, and each month it ranks stocks by their performance over the previous 12 months.

Signals from ETF flows have shown low correlation with traditional quantitative factors such as momentum or value, making them “an enhancement” to existing models, according to Deutsche Bank.

Keeping other factors static in a multi-factor model, the strategists found that incorporating ETF flows led to proportionate improvement in performance. The more ETF flows are considered, the better the returns.

“Whether or not it’s a factor is debatable,” Shah said. “But this is an anomaly that we found and it’s worth exploring further.”

This article was provided by Bloomberg News.

Can Precious Metals ETFs Regain Their Luster?

August 3, 2018

After a strong start to the year, precious metals have delivered disappointing results. Can they climb out of their rut?

The SPDR Gold Shares (GLD), the largest gold-focused ETF with $31.1 billion in assets, has slid more than 7 percent in value since the start of the year. Similarly, the $5 billion iShares Silver Trust (SLV) has fallen 9.8 percent.

During the first quarter, gold demand of 973.5 tons was the lowest first-quarter total since 2008. The main factor was decelerating investment demand for gold bars and gold-backed ETFs, according to the World Gold Council.

Despite lackluster results on the investment side, there are two positive trends in the gold market: high demand by central banks and the needs of the technology sector. 

Central banks added 116.5 tons to global official reserves during the first quarter. That impressive showing was the highest first-quarter total in four years and in line with long-term average quarterly purchases of 114.9 tons since first quarter 2010.

In the technology sector, year-over-year growth in the first quarter grew by 4 percent. Gold demand remained strong due to smartphones, gaming devices and security systems.

The ETFS Physical Precious Metals Basket Shares (GLTR), a broader measure of the precious metals group, is down 9.1 percent year-to-date. Aside from gold and silver exposure, GLTR also contains platinum and palladium.

Nonetheless, the choppy performance in precious metals hasn’t stopped ETF issuers from launching new products.

On June 26, State Street debuted the SPDR Gold MiniShares Trust (GLDM). GLDM’s per-share trading price is set at 1/100th of an ounce of gold, as represented by the LBMA Gold Price (priced in U.S. dollars). This new fund also has the lowest total expense ratio among all gold exchange-traded products, with a net and gross expense ratio of 0.18 percent. As with the other two gold-linked SPDR ETFs, GLDM is backed by physical gold.

On the equity side, gold miners are lagging performers relative to broader equity benchmarks. While the Schwab U.S. Broad Market ETF (SCHB) has gained 7 percent this year, the VanEck Vectors Gold Miners ETF (GDX) has dropped nearly 10 percent.

Within the S&P 500, exposure to miners is held inside the materials sector and the Materials Select Sector SPDR Fund (XLB). The result has been underperformance for XLB relative to other S&P 500 industry groups. XLB is down 2.2 percent this year.

The U.S. dollar’s strong rally has been another contributing factor to gold’s weakness. The primary cause for the rally has been a stronger domestic economy relative to international peers. This dynamic has resulted in better relative performance for the SPDR Long Dollar Gold Trust (GLDW) compared to other gold-related ETFs. GLDW was built for a strong dollar backdrop because it combines both a long position in physical gold and long dollar exposure against a basket of six non-U.S. currencies. The final result is simultaneous exposure to gold along with the U.S. dollar.

GLDW is down more than 3 percent year-to-date. Again, not good, but better than its peers.

Thus far, the best gains for gold speculators has been on the bearish side. 

Since the beginning of 2018, the ProShares UltraShort Gold ETF (GLL) has gained 17.4 percent while the Direxion Daily Gold Miners Bear 3x Shares (DUST) has jumped 21.9 percent. GLL aims for 200 percent daily opposite exposure to gold prices while DUST aims for 300 percent daily opposite exposure to gold mining stocks.

Can precious metals escape their seven-year slump? Identifying a definitive bottom is nearly impossible, but potential signs that a bottom is nigh are popping up. For example, Vanguard last week renamed its $2.3 billion Vanguard Precious Metals and Mining Fund (VGPMX) as the Vanguard Global Capital Cycles Fund, and also altered the fund’s investment strategy. According to the company, “while the fund will maintain meaningful exposure to precious metals and mining stocks, the capital cycles strategy encompasses a broader opportunity set from which to identify return potential.”

Sounds like Vanguard is throwing in the towel on the precious metals sector. A contrarian investor could interpret that as a sign that we’re nearing a bottom in the precious metals funk.

Aside from bottoming signs such as this, advisors who decide to allocate money to precious metals will need plenty of stomach and stamina.

Ron DeLegge is founder and chief portfolio strategist at ETFguide.

Time to Buy Defensive ETFs?

June 19, 2018
As widely expected, the Fed effected the second-rate hike of the year in its June meeting. The Fed raised the benchmark interest rates by a modest 25 bps to 1.75-2.00%. So should you adjust your portfolio based on the latest Fed activity and guidance?