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Wednesday, April 16, 2014

Seeking Alpha - 6 Traits Of Successful ETF Investors



6 Traits Of Successful ETF Investors

Sun, Apr 13 | by David Fabian 

Summary

  • Many successful ETF investors share common traits that lead to prosperous outcomes.
  • ETFs allow you to immediately access nearly any global investment theme across a broad range of asset classes.
  • These tools can help lower your fees and enhance your returns by providing complete transparency and liquidity.

Millions of investors have successfully integrated ETFs into their portfolios over the last two decades as these innovative vehicles have surpassed more than $1.6 trillion in global assets. They are used by both retail and institutional accounts as a method of gaining instant exposure to a specific asset class with the click of a button.

Through my conversations with clients, readers, and industry peers, I have recognized several common traits that prosperous ETF investors share.

1. Liquid - Investors who enjoy instant liquidity are certainly drawn to ETFs in the same way as an individual stock. Because you can buy or sell an ETF at any time during the trading day, you have maximum flexibility to make changes whenever you desire. This is especially true for active traders or portfolio managers who are concerned about volatile markets. You never have to worry about surrender or redemption fees that would hinder your investment decision to exit a position once it's established.

2. Global - ETF investors are also drawn to the variety of global opportunities that exist. These investment vehicles offer single country, regional, or broad-based exposure to a variety of asset classes that span the globe. This allows you to pinpoint an opportunity almost anywhere in the world or take advantage of specific emerging macro themes. The WisdomTree Japan Hedged ETF (DXJ) won numerous awards last year for its unique index approach to combining equity and currency related holdings. This is just one example of a global strategy that many investors were previously unable to access.

3. Risk adverse - One of the advantages that ETFs offer over mutual funds is the ability to place automatic stop losses to manage downside risk. Many investors prefer this method of risk management, because they don't have to worry about being stuck in a position that is heading south quickly. In addition, you have the flexibility to set limit orders to execute a trade at a price that is desirable, both on the buy and sell side. Furthermore, the inherent diversification qualities of an ETF mitigate the business risk of investing in a single company.

4. Creative - ETFs allow you to construct a portfolio of creative holdings across a variety of asset classes. Many investors I come into contact with have broadened their horizons to include commodities, real estate, currencies, and a host of other unique ideas. ETFs allow you to be extremely diversified and offers access to previously hard to reach areas like frontier markets, niche industries, volatility indexes, leverage, and hedging strategies. Websites like ETF.com allow you to hone in on specific options that match your needs and provide excellent detailed information on each fund.

5. Fee conscious - Experts have drilled into you for years that fees matter and ETF investors are very tuned in to this concept. They abhor large trading commissions, surrender fees, and outsized annual management fees. They are also focused on the disparities in expense ratios and trading commissions between individual ETFs and brokerages. One noted example of this dichotomy is the Vanguard REIT ETF (VNQ), which charges an expense ratio of just 0.10% and the iShares Real Estate ETF (IYR), which charges an ongoing fee of 0.45%. That may not seem like a big difference, but paying excess fees can hinder performance over time.

6. Knowledgeable - Another tremendousadvantage of owning an ETF is that you know exactly what you own every single day. The ETF sponsors have done an excellent job in disclosing positions via their websites and other outlets so that you are informed about what the underlying portfolio looks like. Hedge funds, mutual funds, and other private label investments often make it difficult to discern exactly what their current holdings are. Even when you do get this information, it is often many months behind the present day asset allocation.

Each of these traits plays an important role in the investment process for both professional and novice participants. Knowing both what you own and why you own it is a crucial component to a successful outcome with your investing endeavors. I believe that ETFs continue to be on the forefront of innovation in terms of their ability to simplify your life and enhance your returns. That is why they are my preferred vehicle of choice when I am building portfolios for myself and clients.


Disclosure: I am long IYR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.


Disclaimer: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold.



Comments(7)
  • FleetUSA3226
    Apr 13 12:49 PM
    Isn't there a 7th trait of ETFs? They produce lower or no capital gains distributions the way they are constructed compared to mutual funds. I've read this several times on the web.
  • GM Trader
    Apr 14 05:21 AM
    Index ETFs are also cheaper than mutual funds if all you want is an index tracker.
  • DUMB
    Apr 14 08:54 AM
    i think that if you do not mix with options, trading etfs is a risky business, unless you have some special edge, which most of, simple we the people don't have.
  • Charles Cohen
    Apr 14 01:50 PM
    Do you have any statistical evidence that _any_ of these "traits" is more common among "successful" ETF investors, than among "unsuccessful" ETF investors?

    Or is this strictly "personal opinion", based on conversations ?

    Thanks --

    . Charles
  • Vincent1966
    Apr 14 05:50 PM
    There are 3 golden rules of successful investing:

    1) Diversify
    2) Keep investment costs low
    3) Take a long term approach

    ETF's make the first two very easy. John Bogle is worthy of mention with respect to this article. He is one of the greatest men that ever lived, as far as I'm concerned. He changed the world, bringing low cost & diversified investing ETF's to the masses.
  • ChinHoKelly
    Apr 14 11:29 PM
    Bogle "ever lived"? I just saw him on TV last week.
  • yep, he ever lived as much as I or my dead grandpa, and he lives now, Bogle Bogle Bogle ... u get the idea!


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Seeking Alpha - It's Bubble Time: A Study Of Peak PE For The S&P 500



It's Bubble Time: A Study Of Peak PE For The S&P 500

Fri, Apr 11 | by James A. Kostohryz Includes: spy

Summary

  • In this article I present one possible methodology for identifying a peak PE during a bull market cycle.
  • Detailed comparative analysis suggests that on the basis of forward PE ratios, S&P 500 valuations have rarely been higher than they are currently.
  • Only during the 1998-2000 bubble were forward PEs much higher than they are now. By contrast, once PEs peak, there is significant risk of PE contraction and/or major declines.
  • Unless you expect a stock market bubble to inflate, further market gains via PE expansion may be constrained. Risk/reward unfavorable for most investors.

Since May of 2013, I have been consistently saying the following: The valuations observed in broad market indices such as the S&P 500 (SPY) and the Dow Jones Industrial Average (DIA) are not yet indicative of a systemically significant bubble. However due to a confluence of factors, including excess liquidity and declining liquidity preferences, I believe that a systemically significant stock market bubble is likely to form.

What is the dividing line between a stock market that is merely expensive by historical standards, and one that exhibits characteristics of a systemically important bubble? In the coming weeks and months, I am going to be analyzing this issue in detail in my newsletter. In the present article, I am going to preview an approach to this question that is somewhat different from the manner in which most analysts approach it.

The Problem With Historical PE Ratios

Most analysts approach the problem of valuation by looking at average historical PE ratios (or other metrics) and comparing the current trailing or forward PE to the historical average. This approach is deeply flawed.

The most important reason why such simplistic analyses are flawed is because an average PE ratio averages in a great deal of data points that are absolutely irrelevant. The "garbage" data points can often skew the averages significantly.

Let me give you just one example of how a garbage data point can skew the averages, so that you can understand the principle. In March of 2009 when the S&P 500 reached its low of 667, the trailing PE of the S&P 500 was 97.23! Taken in isolation, this extraordinarily high PE ratio would tend to indicate gross overvaluation of the stock market. But, in fact, we know that exactly the opposite was the case: The S&P made a generational low and was grossly undervalued at the time. The problem is that this particular garbage data point from March of 2009 skews the historical average valuation upward, when by any rational valuation metric, the average valuation levelshould be getting pulled downward by the extreme undervaluation of stock prices at the time.

While the above data point is an extreme example, it is not at all an isolated case. The fact of the matter is that in the historical data series, the trailing PE of the S&P 500 tends to be at its highest during times when the S&P 500 is in the midst of a bear market and valuations are cheap. This PE distortion happens because bear markets often occur during recessions when earnings are temporarily depressed (i.e. are not representative of the true earnings power of the S&P 500). During bear markets associated with recessions, the "E" typically falls by more than the "P" and therefore the PE ratio becomes inflated, giving the false appearance of expensive valuations.

The entire historical data series is "polluted" by enormous amounts of garbage data points like this and any estimate of "fair value" that emerges from an average of so many garbage data points is simply not reliable. And no, folks, you can't average garbage data with garbage data to get an empirically derived gem.

The data problem described above is especially true of trailing 12-month PE data. But it is true of forward 12-month PE data as well.

Shiller's PE10 represents a marginal improvement in terms of historical valuation methodology since it is based on an average of 10 years of inflation-adjusted earnings per share and is therefore less likely to be affected by earnings distortions that are short-lived. However, for reasons that I will describe more fully in a future report to be published in my newsletter, Shiller's PE10 suffers from the same type of problem described above. There is so much garbage data in some 10-year intervals of time that the resulting PE is entirely unreliable. This is exactly what is happening right now: Shiller's PE10 is based on an estimate of "E10" that most likely grossly underestimates the true earnings power of companies in the S&P 500. Amongst other reasons, this is occurring because the E10 is currently averaging in lots of garbage earnings numbers from the period during and right after the financial crisis and Great Recession. This is dramatically skewing the "E10" downward in a way that is most likely not representative of the normalized future earnings power of the S&P 500. For reference, Shiller's methodology currently estimates "normalized" S&P 500 EPS to be $74.03, while trailing 12-month GAAP earnings are at about $105 and forward 12-month GAAP earnings are probably at around $115.

I will discuss the problems with Shiller's PE10 in more detail in the future. Suffice it to say for now that any valuation method that inputs so much garbage historical data will only provide a reasonable estimate of normalized earnings by pure coincidence, or dumb statistical luck - i.e. distortions from bad data being offset by other bad data that distort the averages back to a level that by chance happens to be reasonable.

A Systematic Approach: Comparing Apples To Apples

If you want to determine at what point the trailing or forward PE ratio might peak during the current bull market, it makes sense to narrow your comparative historical analysis to PEs observed during other bull markets. It would also make sense to further narrow your search to factor in only PEs during a stage of the economic cycle that is similar to the one we are in currently - mid-cycle. By contrast, it makes little sense to compare today's forward or trailing PE to historical PEs during early or late-cycle phases. It makes even less sense to compare today's forward or trailing PEs to historical PEs during recessionary periods. Right now, based on metrics such as potential GDP, capacity utilization, unemployment and inflation, it is most likely that the US economic expansion is in "mid-cycle," and if we are trying to estimate what a peak PE might look like at the present time, it makes most sense to look at peak PEs during previous mid-cycle periods.

With this basic idea in mind, I performed a study of peak mid-cycle PEs since 1958. There have been a total of eight economic expansions since 1958. I excluded the 1975-1980 expansion due to the high inflation during that period which render the data incompatible. I also excluded the 1980-1982 expansion due to both the high inflation and the fact that there was no "mid-cycle" period during this exceedingly short economic recovery. Finally, I have excluded as anomalous, the extraordinary bubble PEs from 1998, 1999 and 2000.

Having properly selected and sorted the data, there are six mid-cycle peaks in PE ratios since 1958 that we can plausibly use to derive an estimate of a mid-cycle peak PE for the current cycle. I performed the analysis on both trailing and forward PEs, but I will only include the results of the forward PE analysis here as I believe that forward PEs yield more accurate comparable estimates for reasons that I explain in my report: "The PE Peak: Historical Analysis of Trailing Versus Forward PE Ratios."

Note that I did not say that forward PEs are necessarily more accurate measures of valuation. I said that peak forward PEs provide a more accurate basis for comparison of peak valuations across time.It is important to understand this distinction.

_______________________________________________________

Figure 1: Comparable Peak Mid-Cycle Forward PE Ratios Since 1958

Peak PE Table

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As can be seen above, the current forward PE ratio of 15.6 is lower than the peak PE observed in four of the comparable cycles, while it is higher than in two of the historical instances. The range of historical outcomes since 1958 is reasonably narrow, which suggests that the methodology may indeed be useful in identifying a range of PE ratios which historically have signaled a valuation constraint on stock prices in mid-cycle.

Using an average of the six peaks would suggest an average mid-cycle peak forward PE valuation of 16.1. This represents potential upside of only 3.2% to be derived from prospective PE expansion. Targeting the upper end of the sample range would suggest a peak PE of around 17.7, or about 13.6% upside from current levels in terms of prospective PE expansion. PE expansion beyond that could probably only be expected in a bubble scenario.

It's Close To Bubble Time: What to Do?

The above analysis shows that since 1958, forward mid-cycle PEs have only been substantially higher than the above sample of historical peaks on only one occasion: The 1998-2000 bubble period.

What this means is that unless you are expecting a bubble to form, you probably have very relatively little to gain from further prospective PE expansion and much to lose from prospective PE contraction. Historically, it is important to note that PE ratios and/or stock prices tend to contract rather rapidly after PE ratios have peaked in a bull market.

In my case, I am expecting a systemically significant bubble to form for reasons that I have been expounding upon for almost a year.

So, what should a person do in this situation? If you are a skilled momentum trader with a high tolerance for risk you may consider riding the prospective bubble on upward. If you are an average investor, you should probably start to take profits in your equity positions. It might be painful watching the market continue to go up. But it is better to suck up that discomfort than to absorb the losses that could come quite suddenly if a bubble indeed forms and eventually explodes.

Better long-term opportunities for investment lay ahead for long-term investors, and my suggestion to most people would be to be patient and not get caught up in any bubble if, in fact, it continues to form. Indeed the greater the bubble, the more likely it is that tremendously attractive valuations will eventually present themselves.

Having said that, if you are risk-tolerant and/or you feel that you absolutely must own stocks in order to meet your professional and personal goals, I will provide some specific suggestions in my upcoming 2014 Investment Outlook.

To be absolutely clear, my thesis is that the S&P 500 will continue to make significant new highs during 2014. However, with only a few specific exceptions, I believe the reward/risk ratio of equities is not favorable at this point in time for most long-term investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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