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If It Looks Like a Bear—Believe It, And Our Move to Equity ETFs

I’m about three weeks behind my intended publishing of this quarterly newsletter. Part of that delay was related to our main topic, as we’ve moved the core equity exposure in portfolios from actively managed equity funds to index-based ETFs (exchange-traded funds).

Before I delve into that, and all the context that goes with it, we’re going to begin with a brief update on markets.  We’ll be able to expand on that in our regular monthly email update likely right before Christmas.

Stocks Are Likely In a Bear Market

I suspect that many of us have had a friend or relative who looked fine on the outside, and then one day, you get a call and learn that they had a heart attack.  After the fact, you learn that there was deterioration going on under the surface, that no one could see.

For many months now, the headline level of the S&P 500 Index has been increasingly exaggerative of average stock market performance this year.  This past week, most stock indexes dropped from -3% to -5%, the worst since late September, and on the NYSE, 639 stocks made new weekly lows, with just 80 making new weekly highs.  In other words, a lot more stocks are going down than up.

Year-to-date, the NY Composite (all stocks on the NYSE) is down nearly 8%, the Russell 2000 (IWM) is off -5.48%, the Russell Mid Cap Index (IWR) is down -4.03%, and the Vanguard Total International Stock Fund (VGTSX) is off -6.5%.  The anomaly is the S&P 500, which due to its top-heavy cap weighting, is down just -0.4%, including dividends.

Since early November, our tactical equity exposure has ranged in the 35% to 45% range, where it remains today, which we consider to be low neutral.  Others would consider this to be quite bearish.  Our high yield bond model turned positive in late October, only to go negative just three weeks later.  Our real estate model went positive in early November, then reversed course just two weeks later, but then went back on a Buy again.  Finally, the risk model we use for the Loomis Sayles Bond Fund (LSBDX) has just turned negative.

With the Federal Reserve likely to increase interest rates this week for the first time in 10 years, we’re likely entering a period of more restrictive monetary policy, which historically is not as favorable for stocks.  Historically, stocks tend to rise during the last two weeks of December, but the overall evidence is suggesting that the stock market is at increasing risk of a heart attack as we enter 2016.

Our Move to Equity Index ETFs

In the past several years, there has been a number of studies and a growing body of evidence showing that the average equity mutual fund is typically lagging its respective index benchmark, up to 80% of the time over a variety of time periods.

As a result of a client’s urging for us to “go with the evidence,” we began a research project in this area, to compare our current process of selecting funds to using the same process, but with ETFs.  We couldn’t take the data back as far as we’d normally prefer, but we found consistently better results using index ETFs, yet still using our relative strength methodology to focus on owning the areas of the market which are leading.  The other advantages include lower annual expenses and much better tax efficiency (which are irrelevant to retirement accounts).

All in all, we’re trying to produce better outcomes over time, so if we can consistently add between 0.25% and 0.40% to the bottom line of clients’ accounts, due to a variety of factors in favor of ETFs, we’re all for it.  It’s also our job to point out where they don’t work and why we will use other funds for certain purposes, because trading in the real world has issues that many investors really don’t understand (and for that matter, many advisors).

For those of you who are interested in the details, read on.  If not, you may want to skip to the next topic.

What is an ETF (exchange traded fund)?

An ETF is an investment fund traded on stock exchanges, much like stocks, and they hold assets such as stocks, bonds, or commodities, and trades close to its net asset value over the course of the trading day.  Most ETFs track an index, such as a stock index or bond index.

In contrast, a mutual fund is priced once per day, and its net asset value is determined at the close of trading each day.  Even though ETFs can be bought and sold during the day, there are both advantages and disadvantages to this “liquidity,” depending on how it is used.


Because most ETFs are associated with indexes, their annual expenses tend to be significantly lower than actively managed funds.  Below are the annual expense ratios of eight of the funds in our leading funds matrix (six of which we owned until recently).

HWAAX   Hotchkis & Wiley Value Opportunities    1.21%

HFMDX   Hennessy Cornerstone Mid Cap 30           1.25

HDPSX     Hodges Small Cap Fund                              1.31

HWMAX   Hotchkis & Wiley Mid Cap Value              1.25

CAMAX     Cambiar Unconstrained Equity                 1.35

PTSGX       Touchstone Sands Capital Select Growth 1.08

PIXDX       PIMCO Fundamental Index Plus               1.19

ARGFX      Ariel Fund                                                       1.02

Now, contrast that with the top seven funds (out of 22) in our ETF matrix:

QQQ           PowerShares QQQ Trust                             0.20%

IJT              IShares S&P Smallcap 600 Growth           0.25

IJR             IShares S&P Smallcap 600 Index               0.12

IVW            IShares S&P 500 Growth                             0.18

RSP             Guggenheim S&P 500 Equal Weight        0.40

IJK              IShares S&P MidCap 400 Growth             0.25

IJH              IShares S&P MidCap 400 Index                0.12

The average expense of the 8 actively managed funds shown above is 1.207%, while the average of the ETFs is 0.217%.  The difference is nearly 1% annually, which very candidly, is a pretty big head start.  Currently, the core equity positions in TABR’s Moderate Risk portfolios account for about 21% of assets, so right there you have a savings of about 0.21% annually.

Tax Efficiency

As noted above, there is no advantage to being tax efficient inside of an IRA account or other type of retirement plan, but in trust accounts and other after-tax brokerage registrations, it is a different story.  Of the four ETFs we currently own, none have paid out any long or short term capital gains in the past three years, and that is not likely to change.  In contrast, just a few days ago, three of the core funds we formerly owned paid out from 12% to 15% of their assets in capital gain distributions, and some of them did this for the second year in a row because of large, realized gains.  ETFs have a big edge in this area.

Trading Costs

On the Fidelity platform (as is the case with Schwab and TD Ameritrade), mutual funds are broken down into NTF funds (no transaction fee) and TF funds (transaction fee).  The former come with higher expenses (see above) and shares must be held at least 60 days before selling them, or Fidelity imposes their own short term redemption fee.

ETFs are treated like stocks, and at Fidelity, depending on the ETF, an investor will pay nothing, $7.95, or $17.95 to buy and sell.  Fidelity, in partnership with IShares, has a fairly large list of ETFs that can be bought or sold with no commission.  We created our own custom matrix of broad equity ETFs from this list to cover all areas of the stock market, including large, midcap, small, growth, value, international and emerging markets.  However, out of 22 ETFs, we did include four which are not on the no-commission list, because they are important areas to represent.  Based on current rankings (and these go back for many months), two of the four core funds we own come with a commission (QQQ and RSP).

Additionally, the difference between paying $7.95 per trade and $17.95 is whether or not an investor has signed up for electronic delivery of documents.  If you have, you pay less.  Finally, if you have over $1 million in your household at Fidelity, you will pay $7.95 regardless of your mail preferences.

Spreads, Trading Execution & Liquidity

As they say, not all ETFs are created equal.  That is definitely the case when it comes to liquidity.  Two of the most popular ETFs, and which trade the most volume, are the QQQ representing the NASDAQ 100, and the SPY, which is the equivalent of the S&P 500.  One can be sure that when markets are relatively normal, you can safely use a market order and know that the bid/ask spread is likely only going to be a penny, such as 110.78 bid and 110.79 offered.

In times of stress, though, all kinds of dislocations can occur, such as on the morning of August 24, when the Dow Jones Industrials plunged 1000 points in a matter of minutes.  Those are times when you do not want to be trading, or at the least, better be using limit orders.

With our selection process of ranking the ETFs on a monthly basis against each other, we’ve found we have very little turnover in our core equity positions.  Had we been using this process for all of 2015, there would have been only two buys and sells, both with no commission funds.  When we do make these type of trades, we create a block trade and get the average weighted price of the day, which tends to minimize liquidity issues.

But, I want to point out a recent transaction, and the reasoning why when we increased exposure, we purchased the Pro Funds Small Cap Growth Fund (a mutual fund), which has an expense ratio of 1.54% annually.  Since we’re trying to focus on keeping expenses to a minimum, a very astute client wondered why we didn’t instead purchase the Vanguard Small Cap Growth ETF (VIOG), which has annual expenses of just 0.20%?

We use the Pro Funds family of mutual funds, along with Rydex, for both inverse funds to reduce exposure below 50%, and for additional long exposure up to 100%.  We can buy and sell their funds with no holding periods, which is critical for us when we are using multiple models to gradually increase or decrease exposure.  So, one has to pay more for the ability to be flexible and play defense or offense.

In the above example, had we purchased the Vanguard ETF, there are a couple of big negatives that come into play.  First, it is not on the no-commission list from Fidelity, which means every account we manage will pay at least $7.95 each way to buy or sell.  Second, this particular ETF does not have much of a following, and only averages daily trading volume of about 8000 shares.  As a result, during the day, the difference between the bid and ask can be anywhere from 10 to 12 cents (106.10 bid, 106.22 ask).

When we are increasing or decreasing exposure to equities, it is typically in 10% increments, which is about $4.4 million.  To buy this particular ETF, trading around 106 and change would require us to purchase about 39,000 shares.  That is over four times the average DAILY volume.  It doesn’t mean it can’t be done, but we’re likely not going to get good prices, and if one does this about 10 times a year, there is no longer any edge in expense ratios.

This, by the way, is one of the main reasons we have not turned to ETFs before, because if you have an active trading style, they are really not that cheap.  The process we’ve created is not an active trading style.

Relative Strength Selection Process

Even though we’ve changed from using actively managed equity funds to ETFs, what has not changed is the process of staying with leading funds.  As a reminder, a passive fully invested approach has diversification into all styles, and always includes exposure to international equities, regardless of the outlook.

In contrast, our on-going dynamic ranks will only own what is leading the market.  Currently, international funds occupy the bottom five places in our matrix, and have for many months.  The four core funds we do own include QQQ, RSP, IJT (Smallcap Growth) and IJK (MidCap Growth).  At some point, international funds may ascend to the top of the rankings and it will make sense to own them, perhaps in greater proportion to domestic U.S. funds, but that is not the case at present.

What About Bond ETFs?

Just so you know, we’re not entirely eliminating actively managed funds.  In the bond market, where our strategies have a strong over-weight to corporate high yield bond funds, we will continue to utilize several actively managed high yield funds in client portfolios, such as Blackrock High Yield (BRHYX), PIMCO High Yield (PHIYX), and several others.  These two funds have annual expenses of 0.51% and 0.55% annually for their institutional share classes.

The ETFs available for junk bonds are primarily HYG and JNK, with expenses of 0.50% and 0.40%.  So, there is virtually no edge in this area, but more importantly, these funds do not behave the same as open-end high yield bond mutual funds.  They are much more volatile, with inferior performance, a bad combination.  Though the ETFs come without trading restrictions, in our view, that “liquidity” comes at a very high cost.

Though this data is only for year-to-date 2015, it illustrates my point.  Through this past Friday, HYG was down -6.76% and JNK down -7.87%, including dividends, and both lost 2% in Friday’s trading.  In contrast, the Lipper High Yield Fund Index is down -4.27% for the same period, while Blackrock is down -2.76% and PIMCO is down -1.31%.

There are certain areas and strategies where owning bond ETFs can make sense, such as broad exposure using the IShares U.S. Aggregate Bond Fund (AGG) or the Vanguard Total Bond ETF (BND).  These funds have expense ratios of only 0.08% and 0.07% respectively, and could easily be used in a buy and hold passive portfolio.  In fact, we do use BND in our passive, index-based portfolio.  We believe, though, that over time, we can do better with the combination of our risk models applied to top-performing funds such as PIMCO GNMA and PIMCO Income Fund, which we are using in our bond strategies.

One type of bond ETF we have embraced is called a defined maturity ETF, developed by Guggenheim Funds and recently copied by IShares.  These funds own corporate bonds of varying quality (investment grade or high yield) where all the bonds in a fund mature in the same year.  This has made it possible to create a bond ladder, or simply to own bonds to meet a particular goal, without having to have $millions of dollars in your portfolio in order to properly diversify your holdings.

In our case, we’ve taken a position in the 2024 Guggenheim Bullet Shares Corporate Bond ETF (BSCO).  The plan is to simply hold the ETF until the early to middle part of 2024, reinvesting monthly dividends along the way, and then to swap it out for a similar fund farther out in maturity.  We recently purchased almost the entire position where the net yield to worst (after fund expenses of 0.24% annually) is about 3.60%.  This is an investment grade portfolio with 161 different bonds in the portfolio, and we’re not expecting any defaults, which of course is the biggest risk in bonds.

With the vast majority of our clients able to meet their spending goals with long-term nominal returns of 3.5% to 4%, we’re trying to create some certainty in a very uncertain world.  At present, we’re also considering the 2018 Guggenheim Bullet Shares High Yield Corporate ETF (BSJI), which has a yield-to-worst of nearly 7%, but it comes with much more risk, and investors are getting burned when reaching for yield.  It may offer an opportunity at lower prices, and then again, may be just fine buying and holding.  Unfortunately, these types of funds were not in existence back in 2005 and 2006, where one could see how they went through the 2008-09 decline.

TABR Strategies Year-To-Date

Though lower equity exposure in the third quarter was really helpful, that wasn’t the case with the sharp rebound in October.  Equity fund selection has detracted from the comparison versus indexes (see above), and for the first time in a long time, our overall bond strategies have been a drag.

Below is the performance, net of management fees, of TABR’s five different portfolios at present.  These represent a majority of the strategies we are using in client accounts, but not all.  The differences are mainly attributed to risk (example—moderate allocation versus conservative allocation or aggressive) and account size.  The numbers are for the nine months ending September 30, 2015 as well as the peak-to-peak cycle from September 2007 to September 30, 2015.

Type of Account/Strategy YTD Benchmark 09/07 to 09/15^ MaxDD
TABR Tactical Moderate -2.32% -2.84%* + 0.50% -25.06%
TABR Tactical Conservative -2.23 -1.81**    n/a
TABR Tactical Bond -1.28 +0.93*** +5.22 -19.73
TABR Dividend Stock -8.41 – 5.38****    n/a
TABR Fully Invested PBA -7.16 – 3.17    n/a
Vanguard Total Stock – 5.59 +5.40 -55.38
Vanguard Total IntlStock – 6.87 – 1.70 -60.60
Vanguard Total Bond +0.93 +4.50 -5.36

*consists of 40% Vanguard Total Stock Index, 15% Vanguard Total International Stock Index and 45% Vanguard Total Bond Index

**consists of 30% Vanguard Total Stock Index, 10% Vanguard Total International Stock Index and 60% Vanguard Total Bond Index

***Vanguard Total Bond Index

****Vanguard S&P 500 Index Fund from 12/31/14 to 09/30/2015

^  denotes annualized returns and actual period is 9/30/2007 to 09/30/2015

MaxDD stands for maximum drawdown, the worst loss from peak to trough in the period noted

Returns shown are net of management fees, and include reinvested dividends

In Closing

Next letter, we intend to delve into the topic of Universal Life Insurance policies, along with an update on our home solar panel installation, which will have about one year under its belt at that time.  Our goal is to get the letter out by the first week of February.

As noted above, the evidence suggests the stock market is in a precarious position as 2015 comes to a close.  I’m reminded of the folly of forecasts this weekend, as the latest issue of Barron’s had its annual forecast issue from various strategists, all of whom are bullish.  That is pretty typical, though.

Take that news as entertainment.  In life, I think optimism is the way to go.  But with markets, unbridled optimism is folly.   All of us at TABR are grateful for the trust and confidence you express in us daily.  Wishing you a Happy Hanukkah and a Merry Christmas.



Bob Kargenian, CMT

TABR Capital Management, LLC (“TABR”) is an SEC registered investment advisor with its principal place of business in the state of California.  TABR and its representatives are in compliance with the current notice filing and registration requirements imposed upon registered investment advisors by those states in which TABR maintains clients.  TABR may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements.

This newsletter is limited to the dissemination of general information pertaining to our investment advisory/management services.  Any subsequent, direct communication by TABR with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides.  For information pertaining to the registration status of TABR, please contact TABR or refer to the Investment Advisor Disclosure web site (www.adviserinfo.sec.gov.).

The TABR Model Portfolios are allocated in a range of investments according to TABR’s proprietary investment strategies. TABR’s proprietary investment strategies are allocated amongst individual stocks, bonds, mutual funds, ETFs and other instruments with a view towards income and/or capital appreciation depending on the specific allocation employed by each Model Portfolio. TABR tracks the performance of each Model Portfolio in an actual account that is charged TABR’s investment management fees in the exact manner as would an actual client account. Therefore the performance shown is net of TABR’s investment management fees, and also reflect the deduction of transaction and custodial charges, if any.

Comparison of the TABR Model Portfolios to the Vanguard Total Stock Index Fund, the Vanguard Total International Stock Fund and the Vanguard Total Bond Index Fund is for illustrative purposes only and the volatility of the indices used for comparison may be materially different from the volatility of the TABR Model Portfolios due to varying degrees of diversification and/or other factors.

Past performance of the TABR Model Portfolios may not be indicative of future results and the performance of a specific individual client account may vary substantially from the composite results above in part because client accounts may be allocated among several portfolios. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable.

The TABR Dividend Strategy presented herein represents back-tested performance results. TABR did not offer the Dividend Strategy as an investment strategy for actual client accounts until September/October 2014. Back-tested performance results are provided solely for informational purposes and are not to be considered investment advice. These figures are hypothetical, prepared with the benefit of hindsight, and have inherent limitations as to their use and relevance. For example, they ignore certain factors such as trade timing, security liquidity, and the fact that economic and market conditions in the future may differ significantly from those in the past. Back-tested performance results reflect prices that are fully adjusted for dividends and other such distributions. The strategy may involve above average portfolio turnover which could negatively impact upon the net after-tax gain experienced by an individual client. Past performance is no indication or guarantee of future results and there can be no assurance the strategy will achieve results similar to those depicted herein.

For additional information about TABR, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein.  Please read the disclosure statement carefully before you invest or send money.

A list of all recommendations made by TABR within the immediately preceding one year is available upon request at no charge. The sample client experiences described herein are included for illustrative purposes and there can be no assurance that TABR will be able to achieve similar results in comparable situations. No portion of this writing is to be interpreted as a testimonial or endorsement of TABR’s investment advisory services and it is not known whether the clients referenced approve of TABR or its services.









By Bob Kargenian | Quarterly Newsletter