Thursday, July 23, 2015

New-to-Market: OUSA

New-to-Market - This blog series highlights ETFs that have recently gone public and reflect those strategies currently most in demand by investors. While ETFs are not eligible for ETFG Risk Ratings until traded for 3 months and ETFG Reward Ratings for 12 months, our goal is to highlight the most cutting-edge investment strategies that have recently embraced the ETF structure – we hope you enjoy this special series of posts.

One thing that investors don’t lack in this brave new world of exchange traded products are options to express whatever investment whim they might have from the mundane sector funds to the far more sublime market neutral, anti-beta and volatility hedged.  And while investment advisors are overwhelmed with literature touting the benefits of the latest esoteric back-tested strategies, what is there for those investors who come to the market looking for a core fund to help them avoid becoming just another statistic in the annual Dalbar study?  Thanks to the host of ABC’s Shark Tank and a regular CNBC Contributor Kevin O’Leary, they might just have the answer they were looking for in the recently launched O’Shares FTSE U.S. Quality Dividend ETF (OUSA) which promises to unlock the same investment wisdom used by America’s wealthiest families for generations to help preserve and grow their wealth.

At first glance, OUSA looks like another product of the times where investors have become devoted to the art of factor investing and where the investment strategy of a fund is clearly spelt out in the name.  Some investors could see OUSA as just another dividend fund for retirees with a focus on providing income instead of capital gains while others will think it the latest offering trying to take advantage of the low volatility phenomenon.  But those who take the time to research the fund will discover a very different beast indeed and that the fund is perhaps easiest to define by telling you what it’s trying not to avoid.  Many of the exotically named ETF strategies being presented to investors these days have at their core a very simple investment strategy which can often times have very unintended consequences as many investors in funds focused on low volatility or high dividend yields have unfortunately discovered.

The PowerShares S&P 500 Low Volatility Portfolio (SPLV) and the Vanguard High Dividend Fund (VYM) have underperformed the S&P 500 by nearly 500 and 300 bps respectively on an annualized basis over the last three years for the much the same reason; by buying “seemingly” cheap stocks concentrated in the consumer staples, industrials and financial sectors, they fell into a value trap and were left behind by their faster-growing brethren.  And while SPLV might eventually outperform thanks to its 40% allocation to REIT’s and insurance stocks, investing in these two strategies requires investors and their advisors to be paying close attention to market developments to time their buys and sells.

OUSA was designed with a very specific clientele in mind, namely investors who want to invest like a family office but without having to hire their own staff of CFAs.  Benchmarked to a mouthful of an index, the FTSE U.S. Qual/Vol/Yield Factor 5% Capped Index, the manager screens their universe of large and mid-cap U.S. stocks around three different criteria to avoid buying any unintentional factor exposures.  The first criteria are earnings quality with a focus on low accruals and leverage matched with a high return on assets and asset turnover to help isolate fast growers relying on booking next quarter’s revenue today from more consistent growers.  To help avoid steeper drawdowns, the manage next screens for lower volatility using five years of weekly standard deviation of returns and then finally on the natural log of the trailing twelve month dividend yield to avoid buying into a “dividend trap” of seemingly high dividend yield stocks as investors abandon them due to declining business conditions.  No single stock is allowed to be more than 5% of the portfolio and the fund is reconstituted annually/rebalanced quarterly which is why the fund’s expense ratio of 48 bps is higher than the more streamlined strategies like VYM’s 10bps or SPLV’s 25.

What that three pronged approach gets you is a very diverse portfolio of 142 names with a distinctly megacap value focus and an average dividend yield above 3%.  No one sector currently makes up more than 20% of the portfolio and looking through the top holdings (only 38% of the portfolio) you can see the focus on earnings growth is more than a market slogan.  Names like Johnson & Johnson and Exxon Mobil don’t get the heart racing the in the same way as Netflix, but what they do have is a record of above average income growth, stronger margins and debt-to-equity ratio’s below their sector average.  OUSA isn’t some stealth utilities or REIT fund; healthcare names like Merck and Eli Lilly have a strong presence.  With only a full week of trading under its belt, it’s too soon to tell what with a long-term performance of the fund might be like, but the fund was designed to attract investors who believe that the only way to earn those high single digit returns is to stay invested with the market and not by timing it and cutting volatility is the key to keeping clients in the fund for the long haul.  For those willing to put their faith in back tested results, they might want to visit the FTSE/Russell website where their highlights show a strategy that can potentially deliver an attractive risk/reward tradeoff over the last ten years with nearly market performance at 80% of market volatility.

With domestic equities struggling in anticipation of the first rate hike later this year, now might be the time for investors to ask themselves where they want to want to place their trust.  On the one hand they can invest in the brave new world of smart beta or factor strategies or they can take choose a strategy that’s built with the wisdom that’s guided America’s wealthy for generations.  Only time will tell which has true staying power.  

Thank you for reading ETF Global Perspectives!

*Please note that ETFs are eligible for ETFG Red Diamond Risk Ratings following 3 months of trading and ETFG Green Diamond Reward Ratings following 12 months of trading.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors.  Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue.  Prices, values, or income from any securities or investments mentioned in this report may fall against the interests of the investor and the investor may get back less than the amount invested.  Where an investment is described as being likely to yield income, please note that the amount of income that the investor will receive from such an investment may fluctuate.  Where an investment or security is denominated in a different currency to the investor's currency of reference, changes in rates of exchange may have an adverse effect on the value, price or income of or from that investment to the investor.

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