As part of the "Alternative Investments e-Letter", subscribers will have an opportunity to ask Brad Zigler questions. A subscription is required to view this content. Click here to find out how to subscribe.
I’m confused by some of the portfolio statistics I see reported for the funds I follow, especially beta and alpha. Sometimes, they don’t seem to jibe with reality. Why would an extremely volatile fund -- one with a negative beta, in particular -- show a positive alpha?Posted by Chaz H. on July 10, 2013
Good question. Portfolio stats can befuddle investors and financial professionals alike.
There are a number of variables regularly reported by fund issuers or third party analytical outfits such as Morningstar or Lipper that attempt to describe the risks and the rewards earned by investment products. The most commonly reported stats are the r-squared, beta and alpha coefficients and the Sharpe ratio.
R-squared, quoted as a value between 0 and 100 (or, alternatively, .00 and 1.00) describes the level of “fit” between an investment and a benchmark representing the broader market. Typically, the S&P 500 Index is the default benchmark for equity products while broad-based domestic bond funds are often measured against the Barclays U.S. Aggregate Bond Index. A high degree of fit, represented by larger coefficients, tells you the investment’s price movements are greatly “explained” by the benchmark. An S&P 500 index fund, for example, is likely to have an r-squared value equal to or darn close to 100 (1.00), since the product’s purposely designed to track the index. A looser fit would be expected for actively managed products, with the ultimate degree of slack found in hedge funds.
Generally speaking, the tighter the fit between an investment and its benchmark the more reliable the beta and alpha coefficients are. The reported statistics for a technology fund, for example, might be benchmarked to the S&P 500, but a more appropriate way to really gauge the portfolio manager’s acumen in picking the right tech stocks might be to use the NYSE Arca Tech 100 Index.
Beta expresses the volatility of an investment relative to the benchmark. Beta can be positive or negative. A beta coefficient of 100 (1.00) indicates a direct correlation -- in both direction and degree -- between the fund’s price movements and the benchmark. In fact, that value is what you’d expect an index fund to exhibit. An inverse index fund, on the other hand, would likely report a -100 (-1.00) beta unless it was leveraged. Levered funds post betas in multiples, positive or negative, of 100 (1.00).
An investment with a negative beta, when added to a portfolio, would act as a hedge against market volatility, reducing overall systematic risk.
There’s a direct link between beta and alpha. Alpha is a measure of an investment’s outperformance (or underperformance). It’s derived by comparing a fund’s return to that of the risk- (beta-) adjusted benchmark. Multiplying the benchmark’s return by the fund’s beta simply makes the comparison valid. When positive alpha is exhibited for an investment with a negative beta, it’s an indication that the investment outdid the market by risk reduction. That may or may not correspond to a higher-than-market return.
If you have any doubts about the portfolio stats reported for an investment (e.g., the r-squared coefficient is quite low) you can always get a snapshot of the investment’s risk-adjusted return through the Sharpe ratio. The ratio’s calculated by taking a fund’s excess return -- that is, the fund’s percentage gain or loss versus a Treasury security -- and dividing it by the fund’s volatility. The higher (more positive) the ratio, the greater the degree of payback for undertaking the investment risk.Alternative InvestmentsPosted by Chaz H. on May 28, 2013
For this question, we enlisted Kurt Voldeng, the COO of AdvisorShares Investments LLC and Co-Manager of the firm’s QAM Equity Hedge ETF (NYSE Arca: QEH). AdvisorShares runs 18 actively managed exchange-traded funds from Bethesda, Maryland.
The obvious advantage of the approach is the ability to diversify risk by selecting highly skilled professional funds that can fit an investment objective. The selection process requires discipline to narrow down a global universe of very diverse funds into a portfolio, having the capital and human resources to accomplish the necessary due diligence and for the on-going monitoring, as well as meeting the liquidity/return needs of the investor base.
Because of the high hedge fund investment minimum, individual investors can’t diversify risk as well as the pooled assets approach that a fund of funds offers. Despite the fact that a fund of funds may be able to choose the highest ranking funds in a universe, over a long timeframe the average single long/short equity manager has consistently outperformed multi-manager funds of funds and long/short equity mutual funds.
Based on historical data, index replicators incorporate the all advantages of mutual funds (liquidity, transparency), fund of funds (diversification, less risk), and direct hedge funds (performance) while leaving out all the disadvantages I’ve mentioned. If a tracker could closely follow one of those indices on a monthly basis, then it has clear advantages over the fund of funds or direct hedge fund investing approach.Alternative Investments
What's the process behind long/short strategies that aim to isolate investment themes? How are market influences like beta hedged out? Don't all the transactions made to maintain dollar and sector neutrality add considerable costs?Posted by Chaz H. on May 28, 2013
We turn to Bill DeRoche, CEO and Portfolio Manager of QuantShares. Bill manages a stable of four market neutral exchange-traded funds for the Boston-based firm.
Isolating investment themes entails reducing unwanted influences while increasing exposure to the desired theme. For equity portfolios the largest risk comes from the equity market itself, followed by industry exposures. In our thematic ETFs, equity market exposure is reduced by building a portfolio of long and short positions of equal dollar value. The result is a market neutral portfolio that earns the spread return. The indices we track reduce industry exposure by holding equal dollar amounts long and short within each sector. Thus, the portfolio becomes sector neutral. To ensure sufficient exposure to the desired investment theme, the securities within the investable universe are ranked by pre-selected variables defining define the theme. The portfolios are then rebalanced periodically, to maintain theme exposure as well as keeping the portfolio market- and sector neutral.
Broad equity exposure can also be reduced by employing a beta neutral methodology. When we created our value fund which is long inexpensive securities and short more expensive securities, for example, we relied on the notion that cheap stocks typically have slightly higher betas than more expensive issues.
As to costs, our monthly rebalance methodology has a grandfathering mechanism that measures the need to restore the portfolio to a desired state against the costs. It allows a security that is already in portfolio to remain if its ranking hasn’t deteriorated beyond a pre-determined buffer.
Buffers reduce unnecessary turnover. The break points for the buffers are set through research that models performance (after transaction costs) versus turnover.Alternative Investments
I’ve been hearing a lot about “contango” affecting the returns of commodity ETPs (exchange-traded products). Can you explain how this condition impacts an investment in gold or oil? What’s the real cost of contango and what can be done to minimize it?Posted by Chaz H. on April 16, 2013
For this question, we turned to Brandon Riker, Director, Strategic Marketing and Analysis at Teucrium Trading LLC. Teucrium is an issuer of a half dozen single-commodity agricultural and energy exchange-traded funds.
Contango, simply stated, exists when the price of a commodity is higher in the future than in the spot [immediate delivery] month; backwardation is the opposite condition, that is, the commodity price is lower for future delivery than the spot month cost.
You can think about contango as the carrying cost from one month to another. Some commodities have a lower "cost to carry" the underlying good than others. One component of this carrying charge is the cost of storage. Futures contracts must be replaced, or rolled, before the delivery of the good required by the contract, otherwise the holder must actually take delivery of and arrange for storage of the commodity. Storage costs vary dramatically according to the type of commodity, so prices along the futures curve tend to reflect the impacts of these costs over time.
For example, the storage costs associated with gold are relatively insignificant, compared to many other commodities, because a bar of gold is easier to store than a barrel of oil or a bushel of corn. A bar of gold takes up very little space and does not need to be in a climate controlled environment; more importantly, gold is non-perishable with little or no ongoing transportation costs. For all these reasons, the futures curve on gold is impacted less by the economics of contango and backwardation than many other commodities.
Conversely, oil requires a relatively expensive and complex closed system of transportation and storage, and the price of this is often reflected dramatically along the futures curve. These costs can have a significant impact on the value of commodity-holding ETFs over time. In oil futures, for example, there are twelve contract months per year. If a fund only held futures in the front (spot) month, its managers would need to roll each month, resulting in a 1,200% annual portfolio turnover.
That creates a potentially large exposure to contango. [Editor’s Note: Rolling a long position forward in a contango entails selling the expiring (lower-priced) contract and buying the distant (higher-priced) futures; in essence, “selling low and buying high.” The methodology underlying some commodity ETFs mitigate the effect of contango by calling for the purchase of those distant contracts with smallest premiums to spot (less contango) or with biggest discounts to spot (more backwardation). Investors need to know how an ETF deals with contango and backwardation before committing their capital. Funds vary in their approach].Alternative Investments
Investments in commodity futures are subject to a unique, and sometimes unfathomable, tax treatment which gets passed through to fund investors. What are the rules for marking futures to the market at year-end? Does this result in more or less tax liability for fund holders compared to a non-commodity investment?Posted by Chaz H. on April 16, 2013
John Hyland, Chief Investment Officer of United States Commodity Funds LLC, steps in to field the next question. His outfit sponsors a dozen exchange-traded products, mostly single-commodity funds covering the energy sector.
Investments in commodity futures ETFs or funds are subject to a different tax treatment compared to stock or bond funds. Sometimes this may work in favor of an investor, sometimes not. One fundamental dissimilarity is that, at the end of each year, investors are taxed on the commodity fund's capital gains as if they had sold their shares (of course when they do sell there shares, they won’t pay taxes a second time on these gains).
That said, investors can also claim a capital loss in the current year without selling shares. Claiming capital gains or loses each year is known as "mark-to-market" accounting and it primarily impacts when one pays taxes and not so much how much one pays.
Additionally, as with any mutual fund, investors are taxed on any interest or ordinary income the fund earns during the year. They can also take as a deduction their share of the fund's expenses.
Funds organized as commodity pools issue K-1 tax forms rather than the 1099s produced by mutual funds. Starting in February each year, funds begin sending out K-1 forms. Owners of a commodity ETF will note that almost all of the boxes of the K-1 are blank, except for the four detailing their share of the fund’s long-term capital gain (or loss), short-term capital gain (or loss), income and expenses. As a result, the K-1 is not much more complicated than the 1099 sent by a mutual fund (by comparison, a K-1 from a real estate partnership will be very complicated).
One other notable difference between stock owning funds and futures funds is that with the commodity futures, all capital gains or losses are assumed to be 60% long term and 40% short-term, even if the fund held the futures positions for just a short time. An equity fund only claims as a long-term gain stocks held and sold after one year. All other trades get short-term treatment.
The "60-40" treatment might be better for investors or it might be worse. It really can’t be predicted, but largely depends on one’s tax bracket [Editor’s Note: For example, taxpayers at the highest marginal tax bracket -- 39.6% -- would face a nominal 24.8% tax liability on their year-end mark-to-market gains].