Investing in ‘Sin Stocks’
analysis, mutual fund

An article in the Wall Street Journal’s recent Wealth Report covers investing in the so-called “sin stocks,” i.e. shares of companies in the alcohol, tobacco, gambling and weapons industries. The article features the USA Mutuals Barrier Fund (with an apt ticker VICEX; Investor Class shares), which specializes in such investments. This $200 million fund has a 1.44% expense ratio and 78% turnover. According to the article

The fund saw a total return of minus 5.7% for the year ended Jan. 25 […] compared with a decline of 6.5% for S&P 500 Total Return Index. Over the past five years, the index is up about 10%, while VICEX has grown by around 11%.

The prospectus benchmark for the fund is the S&P 500® Index. One of the long-lived and low-cost implementations of this index is the iShares Core S&P 500 ETF (IVV). Alpholio™’s calculations show that since inception the fund returned more than the ETF in about 65% of all rolling 36-month periods, 71% of 24-month periods and 66% of 12-month periods. The median 36-month (non-annualized) outperformance was 6.4%.

While the comparison of periodic returns is instructive, it does not take the fund’s risk into account. To accomplish the latter, let’s employ Alpholio™ patented methodology. One variant of this methodology constructs a reference portfolio of ETFs with fixed membership but variable weights. This allows the portfolio to more closely track the fund’s return than if the weights were constant. Here is the resulting chart of cumulative RealAlpha™ for the USA Mutuals Barrier Fund from late 2004 through 2015:

Cumulative RealAlpha™ for USA Mutuals Barrier Fund (VICEX)

The fund produced 0.45% of the regular and minus 0.06% of the lag annualized discounted RealAlpha™ (to learn more about this performance measure, please visit our FAQ). In 2015, the lag cumulative RealAlpha™ curve was below the regular one, which indicates that not all new investment ideas in the fund performed as well as expected. At 15.1%, the fund’s standard deviation, a measure of volatility of returns, was about 2.4% higher than that of the reference ETF portfolio. The fund’s RealBeta™ was 0.84. The median rolling 36-month correlation of the fund’s returns to those of IVV was approximately 0.9.

The following chart illustrates changes of ETF weights in the reference portfolio for the fund over the same analysis period:

Reference Weights for USA Mutuals Barrier Fund (VICEX)

The fund had major equivalent positions in the Vanguard Consumer Staples ETF (VDC; average weight of 32.2%), Vanguard Consumer Discretionary ETF (VCR; 9.7%), iShares Select Dividend ETF (DVY; 9.2%), iShares MSCI Hong Kong ETF (EWH; 7.7%), iShares MSCI United Kingdom ETF (EWU; 7.6%), and PowerShares Dynamic Market Portfolio (PWC; 6.2%). The Other component in the chart collectively represents additional six ETFs with smaller average weights.

Overall, the USA Mutuals Barrier Fund added little value on a truly risk-adjusted basis. From the cumulative RealAlpha™ chart, it follows that, despite the “defensive” nature of its holdings, the fund may not always outperform during market downturns, such as in 2008-09. In addition, its significant exposure to particular industries can lead to a substantial underperformance, as was the case with gambling in Macau in 2014. Despite a relatively high turnover, in recent years the fund did not produce any capital gains, which made is suitable even for taxable accounts.

To learn more about the USA Mutuals Barrier and other mutual funds, please register on our website.

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Analysis of BlackRock Global Allocation Fund
analysis, mutual fund

A recent story in InvestmentNews covers the origins and performance of BlackRock Global Allocation Fund in the last 25 years:

Since the fund’s inception, it has recorded an annualized return of 10.63% through the end of last year, beating the benchmark portfolio of 60% global stocks and 40% global bonds by more than 250 basis points a year. A $100,000 investment in the fund at inception would have grown to just over $1.1 million today, $500,000 more than the benchmark portfolio. That outperformance has come with about one-third of the downside.

While this record under the guidance of a long-term main manager is certainly impressive, as usual it is worth taking a look at the most recent performance of the fund.

First, the fund has multiple share classes; for the purpose of this analysis, Investor A class shares (MDLOX) with a maximum sales charge of 5.25% and net expense ratio of 1.07% will be used.

Second, the fund has grown to $57.3 billion in AUM. This will make it more difficult for the fund to provide a 100% return over each future ten-year period, as its institutional share class did in the past.

Third, because the fund invests in both domestic and foreign stocks and bonds, it uses a custom reference benchmark that is a blend of four indices:

The reference benchmark consists of 36% S&P 500 Index, 24% FTSE World (ex. US), 24% BofA ML 5-year US Treasury Bond Index and 16% Citigroup Non-US Dollar World Govt. Bond Index.

With the sales charge, the fund failed to beat this benchmark in the one-, three- and five-year periods through 2013. Without the sales charge, the fund outperformed the benchmark last year, but not over three or five years. However, in both cases the fund returned more than the benchmark in the ten-year period. The fund issuer claims that

Since the Fund’s launch in 1989, investors have doubled their money every 10 years, no matter when they bought the fund… The fund has outperformed global equities with 1/3 less risk [based on annualized standard deviation of monthly returns for Institutional shares from 2/28/89 to 12/31/13, compared to the FTSE World Index].

Let’s take a look at the fund’s performance from Alpholio™’s perspective. Here is the cumulative RealAlpha™ chart for the fund (disregarding the sales charge):

Cumulative RealAlpha™ for MDLOX

From early 2005 to mid-2008, the fund generated a fair amount of RealAlpha™ but lost most of it in the second half of 2008. After a two-year recovery to the previous peak level, the cumulative RealAlpha™ for the fund stayed largely flat until it rebounded in 2013. Even though the fund suffered a smaller decline in 2008 than its peer world allocation funds did (-20.6 vs. -29% per Morningstar), it significantly declined against its reference portfolio of ETFs. In addition, the ETF reference portfolio had a much smaller volatility than that of the fund.

The following chart shows the weights of ETFs in the reference portfolio in the same analysis period:

Reference Weights for MDLOX

The fund’s equivalent position in cash and short-term investments was in the iShares 1-3 Year Treasury Bond ETF (SHY; average weight of 35.4%). Domestic large-cap stocks were represented by the iShares S&P 100 ETF (OEF; 16%). The fund’s foreign stock holdings were covered by the iShares MSCI Japan ETF (EWJ; 9.6%) and iShares MSCI EMU ETF (EZU; 6.5%). Finally, the fund’s domestic bond holdings were embodied by the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD; 5%) and iShares TIPS Bond ETF (TIP; 5%).

While the BlackRock Global Allocation Fund has added value for investors over its long history, its performance in 2008 shows that it may quickly lose a lot of that value in a market downturn. Despite a large number of holdings (about 700 global securities), the fund may find it hard to outperform in the future due to its size. Finally, in good past years the fund had significant distributions, which makes it more suitable for tax-exempt accounts.

To learn more about the BlackRock Global Allocation and other mutual funds, please register on our website.

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REIT Correlations with Stocks
alternatives, analysis, correlation, portfolio

Traditionally, real-estate investment trusts (REITs) provided a good diversification to other stocks in a portfolio. However, in the last several years, REIT returns have become highly correlated with returns of other equities. One theory, outlined in a Morningstar article, is that over the years REITs evolved from a small, illiquid and neglected to a mainstream and easility accessible asset class.

As an article in The Wall Street Journal indicates

From 1980 through 2006, stock performance of REITs moved in tandem with the broader market only 47% of the time, according to an analysis for The Wall Street Journal by Citi Private Bank in New York… Since then, as the bank’s research shows, REIT correlations have jumped to nearly 80%, erasing more than a quarter of a century in decoupling.

To illustrate that, Alpholio™ compiled the following chart of correlation between returns of the SPDR® S&P 500® ETF (SPY) and iShares U.S. Real Estate ETF (IYR):

SPY-IYR Correlation 3-4 Years

The chart shows rolling correlations in trailing three- and four-year periods using total monthly returns of both ETFs since mid-2000. (As expected, thanks to a larger number of data points the latter curve is a bit smoother but lags the former one.) Either curve is characterized by four distinct phases:

  • Through 2006, the correlation was indeed in the mid-40%
  • From 2007 through 2008, the correlation gradually increased to about 70% and abruptly jumped to over 80% at the onset of the financial crisis
  • From 2009 through mid-2013, the correlation stayed at about 85%
  • Afterwards, the correlation decreased started to decrease.

The last two phases were caused, at least in part, by the Federal Reserve’s interest rate policy: a strong coupling of rising returns stimulated by low rates, followed by an indication of decoupling when rates rose. A better economic outlook is also a factor:

Improving conditions in the broader economy usually lead to lower real-estate correlations… In fact, correlations between the S&P 500 and REITs have dropped by about 10% since late last year.

Let’s take a look at the last phase in more detail, this time using trailing 18- and 24-month returns:

SPY-IYR Correlation 18-24 Months

Here, thanks to shorter time windows the degree of decoupling in the last phase is more evident: the correlation reverted to about 50%. This would suggest that REITs might once again help with portfolio diversification. However, as the next chart shows, REIT returns are currently negatively correlated with the interest rate on a 10-year Treasury note:

IYR - 10-Year T-Note Rate Correlation

With the prospect of rising interest rates this year, REIT returns are likely to continue to be depressed. At the same time, many analysts forecast 5-10% returns of the overall equity market (for example, S&P just increased its 12-month target for the S&P 500® index from 1895 to 1940, which implies an approx. 7% total return). Therefore, until interest rates stabilize, it may be too early to declare a structural decrease in correlation of REIT returns to those of other stocks. A permanent return to pre-2007 correlation levels would certainly help with portfolio construction.

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High Stakes in Small Caps
market, valuation

A trio of articles covers high year-to-date returns, valuations and, consequently, increased risk of small-cap equities, especially those with growth characteristics and in the technology sector.

An article in Bloomberg indicates that the rise of small-cap stocks has historically signaled an economic improvement:

Shares of companies … in the Russell 2000 Index (RTY) have advanced 32 percent in 2013, compared with 19 percent for the Dow Jones Industrial Average. The spread is the widest for any year since 2003, according to data compiled by Bloomberg. Three of the last four times small-caps outperformed by this much, the economy grew faster the next year and stocks stayed in a bull market for another year or more, based on data from the past 34 years.

While small-cap earnings are growing fast, valuation of these stocks has also increased:

Russell 2000 companies are beating analyst earnings estimates by 11 percent, more than twice the rate for companies in the Dow, according to data compiled by Bloomberg.

The Russell 2000’s price-earnings ratio increased 52 percent this year to 27.5 times estimated operating earnings, compared with 14.7 for the Dow, according to data compiled by Bloomberg.

The first article of the two from The Wall Street Journal brings up an issue of high stakes in the technology sector in many small-cap growth mutual funds:

Fund Ticker Technology
Conestoga Small Cap CCASX 41.5%
Brown Capital Management Small Company BCSIX 66.8%
Wasatch Small Cap Growth WAAEX 27.4%
Artisan Small Cap ARTSX 41.2%
Buffalo Small Cap BUFSX 34.1%
Loomis Sayles Small Cap Growth LCGRX 29.0%
Category Average 23.6%

The second article in The Wall Street Journal worries about small-cap returns:

Small-capitalization growth funds are up an average of 33.1% in 2013 through October, according to Morningstar Inc. That compares with average gains of 28.7% for small-cap value funds and 26.3% for large-cap growth funds. Within the small-cap growth category, many funds have gains approaching, or even topping, 40%.

However, the article states several factors propelling small-cap stocks:

  • A more direct exposure to the U.S. economy compared to large-cap stocks (per the Bloomberg article, 84% of an average Russell 2000 company sales vs. only 55% of an average DJIA company are domestic)
  • A higher rate of organic earnings growth thanks to profit reinvestment
  • A continuing low interest rate policy of the Federal Reserve that encourages investors to seek higher returns in riskier assets.

So, have investors been compensated for the increased risk of small-cap stocks? One way to determine that is to compare historical Sharpe Ratios of small-cap ETFs to those of the S&P 500® ETF (all figures to October 31, 2013 from Morningstar):

ETF Ticker 3-Year SR 5-Year SR 10-Year SR
iShares S&P Small-Cap 600 Growth IJT 1.31 0.97 0.56
iShares Core S&P Small-Cap IJR 1.24 0.89 0.54
iShares S&P Small-Cap 600 Value IJS 1.16 0.81 0.50
iShares Core S&P 500 IVV 1.29 0.94 0.45

The above data show that small-cap growth stocks have indeed provided higher risk-adjusted returns than large-cap equities did. However, the same cannot be said about the broader small-cap sector or its value component in the last three- and five-year periods.

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Are Stocks Cheap Now?
equity risk premium

A recent post on Liberty Street Economics (a blog of the Federal Reserve Bank of New York) attempts to answer that question. The post focuses on statistical analysis of the equity risk premium (ERP). As the following chart illustrates, the ERP is recently at an all-time high of 5.4%, compared to the long-term average of about 3%:

Historical Equity Risk Premium

To arrive at this conclusion, the authors of the post analyzed 29 different ERP models and weighted them so that the cross-section R-squared was maximized. The authors further concluded that the high level of the ERP is currently driven no so much by dividends (roughly, at the historical average) or dividend growth (anticipated to be slightly above average), but rather by the exceptionally low Treasury yields that result from the Fed’s actions. In other words, while in the traditional CAPM

Re = Rf + β * ERP
where Re = expected return on equity
Rf = risk-free rate
β = beta coefficient, by definition equal to 1 for the equity market


ERP = f(Rf)
i.e. the equity risk premium is a function of the risk-free rate, so Re is doubly so.

By various accounts, a long-term average return of the equity market is just over 10%. Subtracting the average ERP of 3%, this would imply a risk-free rate of about 7%. In today’s low-rate environment, the risk-free rate is in the 0.03% to 2.8% range, depending on which Treasury instrument with a maturity from one month to 30 years is used (while many models use three-month T-bills, others may use T-notes or T-bonds depending on the duration of the analysis period).

The following chart shows that the currently expected ERP falls only slightly from the one-month ahead value of 5.4% when the forecast period is extended:

Equity Risk Premium Horizon

Let’s assume that the ERP in the next two years is expected to be about 5% and use a corresponding two-year Treasury note yield of 0.2% as a proxy for the risk-free rate. Adding the two, the expected annualized return of the equity market in that period is about 5.2%, which is significantly below the aforementioned historical average.

So, while the ERP rose to a historically high level, it is still insufficient to compensate for the decline in the risk-free rate. In addition, at 14.3-times estimated next-twelve-month earnings, the price-to-earnings ratio of the S&P 500® is only slightly below the historical average. Therefore, based on the ERP measure alone, one cannot conclude that stocks are cheap now.

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