Asset Allocation for Twelve Sector Funds

Asset Allocation for Twelve Sector Funds

Issue:  Under an asset allocation investment strategy, an initial allocation is assigned to all assets in a portfolio and the portfolio is rebalanced from time to time to maintain the original composition of assets.   The rebalancing can be at scheduled dates or whenever the portfolio manager observes large changes in relative asset prices.

The original allocation of assets is maintained by selling assets that do well and buying assets that do poorly.   This approach can backfire.   A hedge fund manager who bought horse and buggy stocks and sold car stocks after the introduction of the car would not have done well.  However, asset allocators who sold internet firms prior to the tech bubble in the late 1990s did quite well.

Question:   Table one below has stock price information on 12 sector ETFs offered by Vanguard for three dates – 7/1/13, 7/1/16, and 6/29/18.

Using this price data, calculate the average annual return between 7/1/13 and 7/116 and the average annual return from 7/1/16 to 6/29/18 for the 12 funds.

What do these annualized return statistics suggest about the likelihood of success of an asset allocation strategy, which starts out with equal shares of the 12 ETFs on 7/1/2013 and rebalances on 7/1/2016.

Adjusted Close Stock Price for 12 Sector Funds
Symbol Fund Description 7/1/13 7/1/16 6/29/18
VDC Consumer Stables 93.55 133.53 134.27
VDE Energy 103.12 88.25 105.08
VFH Financials 38.12 47.48 67.45
VHT Health Care 86.84 133.78 159.14
VIS Industrials 79.06 106.53 135.81
VGT Information Tech 73.07 112.61 181.42
VAW Materials 82.52 104.33 131.56
VNQ Real Estate 56.70 84.58 81.46
VOX Communications Services 68.28 94.02 84.92
VPU Utilities 72.52 106.33 115.96
GLD Gold 127.96 128.98 118.65
SLV Silver 19.14 19.35 15.15

A note on calculations:   The return between two dates is obtained from the formula (APt/ APt-n(1/n)-1

The first period is three years and the second period is two years.   (n is 3 for first period and 2 for second period.)

The table below sorts the funds from least to highest annualized return during the first period.

Annualized Rate of Return for 12 Funds
Symbol Fund Description July 2013 to July 2016 July 2016 to July 2018 Diff.
VDE Energy -5.1% 9.1% 14.2%
GLD Gold 0.3% -4.1% -4.4%
SLV Silver 0.4% -11.5% -11.9%
VFH Financials 7.6% 19.2% 11.6%
VAW Materials 8.1% 12.3% 4.2%
VIS Industrials 10.5% 12.9% 2.5%
VOX Communications Services 11.3% -5.0% -16.2%
VDC Consumer Stables 12.6% 0.3% -12.3%
VPU Utilities 13.6% 4.4% -9.2%
VNQ Real Estate 14.3% -1.9% -16.1%
VHT Health Care 15.5% 9.1% -6.4%
VGT Information Tech 15.5% 26.9% 11.4%

Observations:

Information Technology, the best performing fund in the first period, was also the best performing fund in the second period.  This asset allocation strategy would have reduced holdings of an asset, which continued to out-perform all other assets in the portfolio.

Energy, the worst performing fund, in the first period, had a return 3 percentage points over average of the 12 ETF returns in the second period.

Four of the six worst-performing sectors in the first period realized improved returns in the second period.

Five of the six best-performing funds in the first period had worse returns in the second period.  (The only exception is the previously mentioned information technology fund.)

The median annualized return in first period was 10,9 percent.   Only four funds had annualized returns over this level in the second period.

Two sectors – financials and information tech – are positive outliers in the second period.  However, financials have underperformed in last few months.

Concluding Remarks:   Information Tech, the best performer in both time periods, did spectacularly in the second period.  Asset allocators sold the best fund.

Asset allocation strategies tend to work more consistently when the investor holds broader funds, including both the overall stock market and debt funds.  Subsequent research will look at situations where asset allocation provides better results.

Authors Note:  Interested in financial problems caused by student debt.   Take this quiz on student debt trends and proposed policy changes.

http://financememos.blogspot.com/2018/07/a-student-debt-quiz.html

Are Tech Stocks Overvalued?

Are Tech Stocks Overvalued?

Issue:   Professor Jeremy Siegel maintains that the stock market and tech stocks are still fairly value.

http://www.cnbc.com/2017/05/26/were-not-in-the-danger-zone-for-overheating-says-longtime-stock-bull-jeremy-siegel.html

He supports this argument with the observation that the PE ratio of Tech stocks in the S&P 500 is still under 20.

What are the limitations of using the PE ratio for a basket of stocks to measure the valuation of the portfolio when some stocks in the portfolio have negative earnings?

Does an analysis of the PE ratios of the stocks in the Vanguard Information Technology ETF support or contradict Professor Siegel’s view on the valuation of Tech stocks?

Is Professor Siegel correct in his assertion that tech stocks are valued correctly?

Discussion of ETF PE Ratios: 

Professor Siegel pointing to a PE ratio for a basket of tech stocks in the S&P 500 has argued that the sector is valued fairly.   My problem with this argument is that published statistics on ETF PE ratios often fail to accurately include information on firms with negative earnings.

Firms with negative earnings have negative PE ratios.  These firms often have a lot in common with high PE firms.   Often startups have negative or low earnings.   If earnings are negative the PE is negative.  If earnings are slightly positive the PE is large.

It would be incorrect to average negative PE firms with positive PE firm because the result would be to reduce the PE of the portfolio even though the negative PE firms have high valuations compared to their income.     Some web sites including yahoo finance report and include negative PE ratios.   Most analysts omit negative PE ratios from their calculation of the portfolio PE.   However, this procedure will also understate valuation relative to income because firms with negative PE ratios have high valuation compared to earnings.

PE ratios have no clear economic interpretation when earnings are negative.  When earnings are slightly below zero (a small loss) the PE ratio is a very large negative number.   When a company has a larger loss the PE ratio is a smaller negative number.

Why PE ratios make no sense for firms

 with negative earnings

Earnings per share

Price per share PE ratio

(0.10)

3.00 (30.00)
(5.50) 3.00

(0.55)

In short, PE ratios incorrectly rank firm valuation when earnings are negative.

It would be incorrect to average negative PE firms with positive PE firm because the result would be to reduce the PE of the portfolio even though the negative PE firms have high valuations compared to their income.     Some web sites including yahoo finance report and include negative PE ratios.

Most analysts omit negative PE ratios from their calculation of the portfolio PE.   However, this procedure will also understate valuation relative to income because the firm with a negative PE ratio has a high valuation compared to earnings.

I am not the first to write about the problem of measuring ETF PE ratios.  Here are some additional resources.

Why ETF Price/Earning Ratios Lie.

http://www.etf.com/sections/blog/23121-why-etf-priceearnings-ratios-lie.html?nopaging=1

Understanding Negative PE Ratios for ETFs

http://www.etf.com/sections/blog/21801-understanding-negative-pe-ratios-for-etfs.html/page/0/1?fullart=1&start=2

Data used in this study:

I obtained a list of stocks in the VGT mutual funds from Zachs guide at the link below.

https://www.zacks.com/funds/etf/VGT/holding

Vanguard Technology Fund VGT has a total of 356 firms.  This study examined the PE ratios of all firms where the equity investment was greater than or equal to 0.1 percent of the value of the VGT portfolio.     There were 109 such firms.

Results:   The frequency distribution of dollar share values invested and number of firms for five PE categories – less than zero, 0 to 15, 15 to 30, 30 to 40 and over 40 – are presented below.

 

   Shares of Firms in VGT by PE category

PE Category

Dollar Share Invested by PE Category

Percent of Companies

<0 6.31 17.43
0-15 5.74 6.42
15-30 36.19 34.86
30-40 31.16 12.84
40< 13.12 28.44
Total 92.52 100

Sample consists firms in VGT where the equity position was greater than or equal to 0.1 percent of the total value of the VGT portfolio.   There were 109 firms meeting this criterion.   These 109 firms represent 92.5 percent of the value of the VGT Portfolio.

Observations:

Around 6.3 percent of dollars invested in the 109 positions of VGT are in firms with negative earnings.  Around 17.4 percent of the 109 firms had negative earnings.

Over 13 percent of dollars invested in the 109 VGT positions had PE ratios over 40.   Over 128 percent of the firms in this group had a PE ratio over 40.

Analysis:

 What can we conclude about the question of whether tech stocks are overvalued after examining the distribution of stocks in VGT?

The large number of tech stocks with high PE ratios or worse yet negative earnings is consistent with a bubble.   Perhaps the bubble is in the early stages and some people can buy, sell, and make money before the crash.   However, there are a lot of overtly optimistic analysts and a lot of inaccurate or misleading information out there.

This is not going to end well.