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Fintech Stocks – Investing in the companies that are disrupting finance

Fintech stocks have emerged as one of the most interesting investment themes this year. Several fintech companies are now worth well over $100 billion, while many more have become publicly listed in the last 18 months. The recent rally in cryptocurrencies has also focussed attention on the broader fintech ecosystem.

Fintech Industry
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This article highlights the various types of fintech companies and the most prominent fintech stocks to consider investing in.

What is fintech?

Fintech / Mobile Phone
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Fintech, which is short for financial technology, is a term used to describe companies, platforms and applications that use technology to deliver a financial service. It’s usually implied that technology is being used to reduce costs or improve the service in some way.

Historically, the largest companies in the financial services industry have been protected from competition by regulatory regimes. Starting a bank, an insurance company or a stock broking firm requires large amounts of capital and various licences. This has prevented start-ups from competing in the industry. It also resulted in institutions having little incentive to innovate.

Advances in technology and certain regulatory changes have allowed tech focussed start-ups to slowly build a presence over the last 25 years. The first financial industry to embrace technology was retail stock broking with the introduction of online trading in the 1990s. The investment and payment industries followed, though progress was slow. Disruption of the insurance industry has only begun in the last few years.

Digital Wallet / Cryptocurrency
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Cryptocurrencies are very much a part of the fintech revolution. Most cryptocurrency and blockchain projects aim to solve the same problems that other fintech firms are trying to solve. In addition, the massive amounts of capital that have flowed into cryptocurrencies are funding fintech innovation.

Open banking and mobile phones are also enabling fintech innovation. Open banking regulations allow consumers to give third party service providers access to data related to bank accounts and investments. This allows consumers to shop around for financial services, rather than being forced to use those offered by institutions. Smartphones, and in particular fintech apps, have also emerged as an important platform for the delivery of financial services.

Types of fintech companies

Fintech Companies
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Fintech companies can be categorised in several ways, and there will always be overlap across the categories that are chosen. Nevertheless, most fintech stocks fit into the following five categories:

  • Payments and digital wallets – There are now thousands of online services around the world that provide basic banking services. Relatively few have global reach, but most countries now have several local payment platforms. Digital wallets are like bank accounts that can only be accessed using a website or a mobile app. Digital payment can easily be made from these wallets and often bypass the banking system entirely. Mobile payments and banking services have made a significant impact in emerging markets economies where very few people have access to traditional bank accounts.
  • Cryptocurrencies and blockchain technology – Blockchain technology is being used to deliver solutions to most problems in the financial sector, as well as in other parts of the economy. Cryptocurrencies are essentially „programable money“ and enable entirely new financial services to emerge. Hundreds of decentralised finance (DEFI) applications that operate on various blockchains are currently being built. DEFI applications make trading, investment, lending and money market services available for cryptocurrencies, and even real-world assets. These applications operate without the control of a single entity. The crypto category overlaps with all the other categories in this list.
  • Crowdfunding and lending – Peer to peer (P2P) lending platforms facilitate loans and fundraising for individuals and small organizations and businesses. P2P lending benefits both lenders and borrowers as the margin typically earned by intermediaries is removed. These platforms can also make credit available to people who struggle to borrow from traditional lenders. Crowdfunding platforms help individuals and charities raise small donations from a large audience. Small businesses can also raise capital from these platforms.
  • Investing and financial markets – The world of investing and trading is perhaps the most vibrant category for fintech companies. Some of the world’s first fintech companies were the online trading platforms of the 1990s. Since then, fintech companies have revolutionised most parts of the investment industry. Some of these types of companies include:
    • Robo-advisors help individuals save toward financial goals. These platforms use quantitative models to optimise a customer’s asset allocation, and then use passive investment funds to implement the strategy.
    • Marketplaces for alternative financial data sets and algorithmic trading strategies.
    • Stock trading apps, like Robinhood, make investing in stocks very easy for retail investors. These companies focus on simplifying the process of investing and providing a seamless user experience.
  • Other fintech niches – Fintech companies operate in almost every area of the financial industry. Many of the first fintech apps and websites helped consumers manage their budget by consolidating information from multiple institutions. Mortgage origination platforms have also been around for some time. These platforms help users get mortgage quotes from multiple lenders with a single application process. The newest frontier for fintech is insurance. It’s taken a long time for tech companies to disrupt the insurance industry because significant critical mass is required. However, now that competition has increased in the other fintech industries, more capital may be invested in insurance focussed fintech companies.
Fintech Stocks / Nasdaq
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The following ten stocks are amongst the most prominent and interesting listed fintech stocks. Visa (NYSE: V) and Mastercard Inc (NYSE: MA) could also be included – but we are leaving them out as they are well-known and established.

  • PayPal Holdings, Inc (Nasdaq: PYPL) – PayPal is arguably the most successful fintech company in the world. It is the leading online payments platform outside of China. PayPal was started by Confinity, which was then acquired by Elon Musk’s X.com in 2000. The company was listed in 2002 but acquired by eBay a few months later. eBay spun PayPal off again in 2015 and it became a listed company for the second time. Since being relisted the stock price has risen 570%. The platform allows users to store money in their accounts and send money to other users and numerous ecommerce sites. There are currently nearly 400 million active user accounts on PayPal. More than 20 years after it was founded, PayPal continues to innovate, make strategic acquisitions and form partnerships. The company now owns Xoom, a money transfer service, and Venmo a successful P2P payments platform. Earlier this year PayPal began accepting Bitcoin for payments. PayPal has a market value of $324 billion, with revenues running at $22 billion a year. Sales are currently growing at around 25% with an operating margin of 17%.
  • Square, Inc (NYSE: SQ) – Square provides payment solutions for merchants and consumers. The company’s stock price has risen 1,744% since listing in 2015, making Square one of the most successful listed fintech companies. Square has two business segments, an ecosystem of apps for merchants, and the Cash App for consumers. Initially Square focused on helping small business clients accept credit card payments with a mobile phone. Over the last decade it has substantially expanded the services it offers merchants. These include free online stores, a small-business lending platform and business management tools. The CashApp is a digital wallet that allows consumers to make peer to peer (P2P) payments. The CashApp can also be used to buy and sell Bitcoin which has increased its popularity. Both of Square’s ecosystems benefit from network effects. Both platforms become more valuable and useful as the number of services and users increases. The company sales were $9.4 billion in 2020, up 680% from 2015. It now has a market value of $105 billion.
  • Mercado Libre Inc (Nasdaq: MELI) – Mercado Libre is an ecommerce platform based in Argentina. It is often referred to as the Amazon.com of Latin America, but there is a little more to the company than ecommerce. The company also operates the Mercado Pago payment platform and provides a range of fincial services to merchants and consumers. While the company is regarded as a marketplace, in 2020 it earned 65% of its revenue from payments. Furthermore, more than half the payment income came from transactions outside the ecommerce platform. Mercado Libre is also expanding the number of financial services it offers to its 20 million users. The impressive growth of the payment platform has made Mercado Libre the top fintech stock in Latin America. The company is now worth $71 billion. In 2020 revenue was $3.9 billion, having risen 510% in five years. Mercado Libre primarily operates in Argentina, Brazil and Mexico. If it can replicate its success elsewhere there will be significant upside for investors.
  • Lemonade, Inc (Nasdaq: LMND) – Lemonade is a fintech platform aiming to disrupt the insurance industry by offering customers a better user experience. Currently, individuals can buy life insurance, pet insurance and home insurance on the platform. There are plans to provide other types of insurance in the future. Lemonade uses artificial intelligence extensively to improve its customer interface and deal with claims. The platform, which was only launched in 2015 already has over a million users and 12-month revenues of just under $100 million. Having said that, the company is not yet profitable, and the business model still needs to be proven. Lemonade is one of the more speculative fintech stocks, but it has tremendous potential when you consider the size and inefficiency of the insurance industry.
  • Coinbase Global Inc (Nasdaq: COIN) – Coinbase is one of the leading cryptocurrency exchanges in the world. The company went public via a direct listing earlier this year. Coinbase is best known for its mobile app which makes buying and selling cryptocurrencies very easy. The app has over 56 million users and earns very good margins. Coinbase Pro is a more advanced cryptocurrency trading platform for professional traders and hedge funds. In addition, Coinbase provides various services to institutions including custody, listing and investments to institutions. In many ways Coinbase is fulfilling the role of an investment bank within the crypto economy. The company earned $2.5 billion in revenue in the last 12 months, and most notably has a 47% operating margin. Most of the platform’s revenue is earned from the retail market. But the company has a lot of potential in the institutional market where it is now the most established player.
  • Fiserv Inc. (Nasdaq: FISV) – Fiserv isn’t as exciting as some of the other fintech stocks listed here. However, it has an enviable track record, having grown earnings at double digits for 35 consecutive years. The company provides technology that allows banks and other financial service companies to offer online services and helps merchants accept and process payments. The company manages the third largest debit card network in US and provides the software that a lot of banks use to operate day to day. Fiserv recently acquired First Data, a merchant acquiring company that settles card payments made to merchants. Fiserv has a considerable advantage due to the very high switching costs a client would incur moving to a different provider. The company has a market value of $73 billion with annual sales of $14 billion. It has managed to grow revenue at 23% over the last five years with an operating margin of 11.4%.
  • SoFi Technologies (Nasdaq: SOFI) – SoFi is one of the more prominent companies that has come to market via a SPAC deal. In January the company announced that it was merging with one of Chamath Palihapitiya’s SPACs. The merger was completed last month. SoFi is a platform that offers a growing suite of financial products to a predominantly millennial customer base. The company started out in 2012 providing student loans. Since then, it has expanded into other types of lending, banking services, investments and trading. Recently, SoFi acquired Galileo another fintech company that provides infrastructure and software to online banks. SoFi’s growth has been phenomenal. The company now has 70 million accounts and has grown revenue 195% in the last three years. The stock has a market value of $19 billion.
  • Affirm (Nasdaq: AFRM) – Affirm makes credit available to consumers at the point of sale on ecommerce sites. Essentially it offers consumers an alternative to paying for a purchase using a credit card. Buyers also get to decide on a payment plan for each purchase. Users manage their accounts using a mobile app. The service also provides online merchants with an alternative payment solution, and the opportunity to make more sales. The company is able to offer competitive rates and lower fees by eliminating credit card processing fees. Affirm was founded in 2012 and held its IPO in January this year. The company has a market value of $17 billion with annual revenue running at just under $500 million. While Affirm is a long way from profitability, sales have increased 230% in the last two years.
  • Upstart (Nasdaq: UPST) – Upstart is a cloud-based artificial intelligence lending platform. The platform uses AI and demographic data to determine the risk for each loan, rather than the credit scores that banks typically use. Millions of people have low credit scores for various reasons but may actually be low risk borrowers. Upstart’s approach gives these people access to credit and opens up a new market for lenders. Only 2% of loans are actually on Upstart’s balance sheet, with the remainder of loans being made by third party banks. So, Upstart really acts as a sales channel for lenders but remains „capital light“. Upstart held its IPO in December last year and is now worth around $9 billion. Twelve-month revenues are around $210 million and currently growing at 100% year on year. Unlike many other new listings, the company is already profitable with an operating margin of 7.3%.
  • Adyen (Euronext: ADYEN, US OTC: ADYEY) – Adyen is a payment technology company based in the Netherlands. It provides a range of services related to processing and settling payments, whether they are made on websites, mobile apps or in-store. Essentially the company provides the technology to link merchants directly to Visa, Mastercard and other card issuers. The company started operating in 2006 making it one of the more established fintech stocks. Annual revenues are over $4.4 billion and Adyen’s operating margin is10%. Revenues are still growing at over 50% year on year, although growth has slowed in the past few years.

Fintech ETFs

ETF Investing
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Stock picking fintech stocks can be challenging. If you don’t want to select individual stocks you can invest in ETFs (exchange traded funds) that hold fintech stocks.

  • Ark Fintech Innovation ETF (ARKF) – This ETF is one of the popular actively manged ETFs managed by Ark Invest. The fund holds 44 stocks, though some are only loosely related to Fintech. The largest holdings include Square, Shopify, Sea Ltd and Paypal. The relatively high expense ratio of 0.75% reflects the fact that the fund is actively managed.
  • Global X ETF (FINX) – The Global X fintech fund tracks the Indxx Global FinTech Thematic Index. It holds 41 stocks, including the likes of Square, Paypal, Intuit and Adyen. The expense ratio is 0.68%.
  • Amplify Transformational Data Sharing ETF (BLOK) – The Amplify fund invests in a subset of fintech stocks connected in some way to blockchain technology and cryptocurrencies. Besides purely fintech companies, the fund invests in companies like Nvidia that provide the physical infrastructure for blockchain technology.

Upcoming fintech IPOs

IPO
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The number of listed fintech stocks is expected to grow over the next few years with several keenly anticipated IPOs on the horizon. The first of these will be Robinhood which is set to go public in July. Robinhood has been one of the most successful fintech start-ups and already has 13 million users.

In China, online payments are dominated by Alipay, which is owned by Alibaba and WeChat Pay which Tencent owns. Alipay falls under Ant Group (previously Ant Financial) which was due to go public in November last year. The IPO which was expected to value the company at $315 billion was cancelled due to regulatory issues. Ant Group is now being restructured to allow an IPO at some point in the future.

One of the most successful unlisted fintech companies is Stripe. Stripe is a SaaS company that provides an API that ecommerce companies use to integrate payment processing on their websites. In March Stripe raised $600 million at a $95 billion valuation, though no other financial details have been disclosed. The company is expected to eventually become listed, though it is well funded at present.

Betterment and Wealthfront are the leading robo advisor platforms in the US. Both companies are expected to eventually become publicly traded, though there is no timeline.

Investing in fintech stocks

Trader Analyzing Data
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From an investors point of view, fintech stocks can be loosely divided between those that are profitable and those that are yet to reach profitability. Profitable companies can be compared to other tech stocks. They can be assessed based on revenue growth rates and margins and the valuations can be compared to similar growth stocks.

If you want to find potential multibagger stocks in the fintech space, you will probably need to consider the more speculative stocks. These stocks need to be assessed in a more qualitative way as they don’t have long term track records. The key is to work out if a company is gaining traction at the product level and ignore the hype that tends to get generated in the media.

Speculative fintech stocks are likely to be very volatile over the next few years. On the one hand they have tremendous potential, while on the other hand they tend to trade on very rich valuations. However, volatility will create the best opportunities to make fintech investments.

Conclusion – Investing in fintech stocks

The financial industry is ripe for disruption, and there is every chance some of the best performing stocks of the next decade will be fintech stocks. This is an industry to keep a close eye on – but as is always the case with emerging industries, it’s important to exercise caution and keep positions relatively small.

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Asset Management

Renewable Energy Stocks – Investing in the transition to clean energy

Renewable energy has been an investment theme for a few decades already. However, it has taken a long time for the industry to really gain momentum. But clean, sustainable energy is now finally gaining political support and momentum around the world.

Renewable Energy Stocks
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In this post we take a look at the industry, the types of alternative energy companies, and some of the important renewable stocks for investors to consider.

World’s transition to green energy

Green Evolution
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It is now widely accepted that the world needs to move away from using fossil fuels to generate electricity. The world’s reserves of oil, natural gas, and coal are being depleted at an increasing rate. Perhaps more pressing is the need to reduce carbon emissions to combat global warming.

It has taken a long time for world leaders to develop the political will to invest in clean energy at the scale required to make a meaningful change. In the last 20 years the amount of energy generated from renewable sources has grown by about 129%. Yet, renewable energy’s share of the total energy generated has only increased from 6.6% to 10.7% during the same period. During the same period, the amount of energy generated from oil, gas and coal has increased by close to 45%. It’s likely that the total amount of energy the world produces will continue to increase.

Transitioning away from fossil fuel energy will require immense amounts of investment. One report estimated that moving the world to 100% clean energy by 2050 will cost $73 trillion. Realistically, the cost could be a lot higher or a lot lower, depending on future innovation and energy use. However, to give the number some context, the combined market value of all the green energy stocks is less than $1 trillion today. While governments and corporations are investing billions in renewable energy projects each year, investment in the space is still gaining momentum. However, this doesn’t mean renewable energy stocks are all good investments.

Types of renewable energy

Transition Green Energy
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When you think of renewable energy you probably think of electricity generated from either wind or solar energy. In fact, around 60% of renewable energy around the world is generated from hydroelectric power. A substantial amount of electricity has been generated by hydro-electric projects for over 50 years. But, while hydro power can be quite efficient, it does have negative impacts on ecosystems and on access to water. In addition, the world is running out of locations to build new hydroelectric plants. For these reasons, and because of advances in technology, solar and wind power are quickly catching up with hydroelectric power.

Wind power now accounts for 20% of clean energy production, up from 8% in 2010. Wind power is more efficient than solar energy, but more capital intensive. The wind power industry has received a major boost over the last 15 years. The share of renewable energy generated from solar projects has grown even faster in the last 10 years. In 2010 solar power accounted for 1% of the world’s clean energy, and this number has now grown to over 10%. This has a lot to do with the rapidly decreasing prices of photovoltaic panels.

Other forms of renewable energy now account for around 9% of the total. Most of this power is generated from various forms of bioenergy. There are several ways in which plant materials are used to generate heat or turned into biofuel and biogas. A small percentage of clean anergy is generated from geo-thermal sources and from marine wave and tidal energy. For public market investors, opportunities are generally limited to companies involved with hydro, solar and wind power. Companies generating other forms of green energy have yet to reach the critical mass needed for public markets.

Types of renewable energy companies

Renewable Energy Companies
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The types of companies that operate in each renewable energy industry tend to offer different types of investment opportunities.

  • Renewable energy utilities generate clean energy. Exchanges actually classify these companies as utilities and not in the energy sector. Utilities play an essential role in economies and need to be operated sustanably. To ensure they are stable and can easily raise capital, utilities often benefit from regulated pricing. This means they are very profitable even if they don’t grow rapidly. The stocks of these companies usually pay attractive dividends. As such they are typically regarded as defensive, income generating investments. In the US, these investments are often structured as master limited partnerships or ‘yieldcos’ which are more tax efficient.
  • Wind energy companies manufacture, install, and service wind turbines. Installing wind turbines is a major logistical challenge as the blades on wind turbines are 25 to 100 meters long. In addition, turbines are usually installed offshore or in remote areas. For this reason, location is an important factor when suppliers for projects are chosen. Wind energy companies have the potential for long term sustainable growth. They can also develop economic moats due to the high barriers to entry. At the same time there are risks due to the capital-intensive nature of the industry.
  • Solar energy companies manufacture and install solar panels. Some focus on manufacturing panels, while others install utility scale solar projects or residential systems. The solar industry is extremely competitive and cyclical. Solar panel manufacturers have to compete on price, while they have little control over input costs. However, solar stocks are often the first clean energy stocks investors turn to when sentiment rises. As a result, solar energy stocks are quite speculative and often trade at stretched valuations.
  • Fuel cell companies manufacture fuel cells to store energy and generate auxiliary energy when needed. The biggest challenge for both solar and wind energy is storage. Energy from fossil fuels like coal and natural gas are generated when needed. Solar and wind power is generated intermittently when wind and sunlight are available. These sources of energy need to be supplemented with energy stored in batteries or energy generated on demand. There are several competing methods of storing electricity, and of generating clean energy on demand. There is tremendous potential for new technologies that can improve efficiencies. For this reason, there is a lot of ongoing research and innovation happening in this space. As a result, the renewable energy stocks in this space are also quite speculative.
  • Electric vehicle companies are also closely related to the transition to green energy. The transport sector is responsible for carbon emissions equivalent to 60% of the electricity generation industry. So, transitioning transport away from fossil fuels is just as important as generating clean electricity. EV makers are also at the forefront fuel cell and battery innovation.
  • Materials producers supply the various renewable industries with raw and manufactured materials. This is a very cyclical part of the sector, but also particularly important. Some of the materials required to generate and store energy are rare and prone to significant price spikes.

Prominent renewable energy stocks to know about

Nasdaq / Renewable Energy Stocks
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This post is not long enough to cover all the investable renewable energy stocks within each industry – so we have included the prominent and interesting ones to know about.

Clean energy utilities

Electricity
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As mentioned, renewable energy utilities generate income and moderate. These are three of the largest utilities that produce clean energy.

  • NextEra Energy, Inc (NYSE: NEE) – NextEra is the largest electric utility in North America. The company generates power from coal, natural gas, nuclear, oil, solar and wind. It may be debatable whether NextEra can be counted amongst green energy stocks or not. On the one hand only 20-30% of the company’s energy generation comes from renewable sources. On the other, it is the largest utility in the US and generates more renewable energy than any other company. NextEra is also one of the biggest investors in the renewable energy segment. The company plans to be generating all of its power from renewable sources by 2035. NextEra has a market value of $141 billion and annual revenue of $17 billion. The operating margin is 22% and its dividend yield is 2%. The stock was recently added to the list of dividend aristocrats. These are companies in the S&P500 index that have increased their dividends for 25 consecutive years. You can also invest in NextEra Energy Partners (NYSE: NEP), a subsidiary of NextEra that is focused on renewable energy. NEP is valued at $4.9 billion and has a generous dividend yield of 3.8%. This yield is supported by an operating margin of 22%.
  • Orsted A/S (OMX: ORSTED, US OTC: DOGEF) – Orsted A/S is a multinational power company and the world’s largest developer of offshore wind farms. The company is based in Denmark and also operates in, Germany, Sweden, Netherlands, Norway, and the UK. Orsted currently produces 29% of the world’s offshore wind energy. The company is now embarking on plans to expand into Asia. Besides wind power, Orsted is also involved in bioenergy and thermal power and heating. Orsted and Siemens are joint owners of A2SEA, a company that specializes in installing and servicing offshore wind turbine farms. The company has a market value of $62 billion and annual revenue of $8 billion. Orsted is listed on the Copenhagen Nasdaq exchange, but also trades on the US OTC markets. It is 50% owned by the Danish Government.
  • Brookfield Renewable Partners LP (NYSE: BEP, Toronto: BEP-UN) – Brookfield is a Canadian limited partnership that owns a portfolio of renewable energy assets. The partnership is managed by Brookfield Asset Management which also manages portfolios of infrastructure assets and real estate. BEP owns and operates clean energy plants in North America, Europe, and Latin America. Currently around 50% of revenues come from hydro assets, but the company is adding wind and solar assets at a faster rate. With a market value of $11 billion and revenue of $3 billion, this is the largest pure-play renewable energy utility based in North America. BEP has very predictable cashflows due to the long fixed rate purchase agreements it commits to. Brookfield offers an attractive 3% dividend yield as well as the opportunity for price appreciation. Over the last 20 years the company has managed to increase its divided consistently at around 6% each year. Investors can also invest in the same energy portfolio via shares of Brookfield Renewable Corporation (NYSE: BEPC, Toronto: BEPC-UN).

Wind energy engineering companies

Wind Energy Engineering
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The following renewable energy stocks belong to four of the most established wind turbine manufacturers in the world.

  • Vestas Wind Systems A/S (OMX: VWS, US OTC: VWDRY) – Vestas is based in Denmark and manufactures and installs wind turbines. Vestas is a highly regarded company and currently has the highest market share at about 20%. Vestas also earns recurring revenue servicing existing turbines.
  • Siemens Gamesa Renewable Energy SA (BME: SGRE, US OTC: GCTAY) – Siemens Gamesa is a Spanish company that manufactures wind turbines and other equipment used to generate electricity from the wind. The company operates around the world and currently installs around 12% of the new turbines each year.
  • General Electric Co (NYSE: GE) – GE Renewable Energy, a manufacturer of wind turbines, is a subsidiary of General Electric. The business unit only contributes around 18% of GE’s total revenue and is barley profitable. However, GE has significant market share of around 10% of the global wind turbine market. The unit is also considered an important growth driver for GE as other business units are growing very slowly. GE has been in a state of decline over the last decade and renewable energy is an important part of its future.
  • TPI Composites Inc (Nasdaq: TPIC) – TPI Composites manufactures wind blades for wind turbines. The company supplies all the major manufacturers and has a relatively small market value of $1.7 billion. The company has very tight margins at present but is worth keeping an eye on as it is well positioned in the industry.

Solar stocks

Solar Panels
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As mentioned, the solar energy industry is very competitive and there are a lot of competing companies. We mention four stocks here, though there are quite a few other viable companies to consider.

  • First Solar Inc. (Nasdaq: FSLR) – First Solar manufactures thin-film solar panels. These panels are more efficient during periods of low light and hot or humid weather. They are also favored for utility scale installations. Like most renewable energy stocks, First Solar’s stock price rallied hard in 2020 and has since fallen around 30%. This leaves the company with a market value of $8 billion on 12-month revenue of about $3 billion.
  • Canadian Solar Inc (Nasdaq: CSIQ) – Canadian Solar is a leading manufacturer of solar panels with global market share of around 10%. The company also installs and operates large solar projects around the world. It has installed projects as large as 258MW in North America. Canadian Solar has a strong project pipeline and is thus trading on a fairly steep price multiple of 40.
  • SolarEdge Technologies Inc (Nasdaq: SEDG) – Solar Edge, which is based in Israel makes inverters and power optimizers for solar panels. SolarEdge’s inverters are very efficient, and it is often the preferred supplier for large solar projects.
  • Enphase Energy Inc (Nasdaq: ENPH) – Enphase Energy manufactures equipment and software to manage energy for homes. Its solutions allow consumers to generate solar energy and store and manage energy. In particular, the company sells microinverters that draw energy from individual panels and are more efficient and flexible for home use.

Fuel cell technology stocks

Green Energy Technology
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Fuel cell technology is an area where there is a lot of crossover between green energy stocks and EV stocks. We covered Tesla, BYD Company, and NIO previously in the post on EV stocks. These companies are all at the forefront of research into energy storage using lithium-ion batteries. While these companies all offer some exposure to energy storage, their stocks prices are more dependent on vehicles sales. FuelCell Energy and Bloom Energy are two other green energy stocks involved in fuel cell technology.

  • FuelCell Energy Inc (Nasdaq: FCEL) – FuelCell Energy manufactures fuel cell power plants that generate energy from natural gas and bigas. While its plants are not free of carbon emissions, they are a lot cleaner than those that use fossil fuel.
  • Bloom Energy Corporation (NYSE: BE) – Bloom Energy Corporation sells fuel cells that use a different mechanism to generate power. Its cells generate energy using solid oxide fuel cell technology which is more efficient for larger installations. Bloom’s fuel cells can supply back up power to large buildings and utilities rather than to homes.

Materials producers

Lithium Producer
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The following three companies are leading producers of the materials used by renewable energy companies.

  • Daqo New Energy Corp (NYSE: DQ) – Daqo is a Chinese company that produces the polysilicon used to manufacture solar panels. China is the leading manufacturer of solar panels, so Daqo is ideally located. The price of polysilicon rises and falls with demand, so Daqo’s share price behaves like cyclical stocks.
  • Albemarle Corporation (NYSE: ALB) – Albemarle is a leading producer of Lithium. The company operates in the US, Chile and Australia. Lithium is an essential material for modern batteries, and there are very few deposits around the world.
  • Glencore plc (LSE: GLEN, US OTC: GLNCY) – Cobalt is another metal that is essential for batteries. Cobalt is also used in several other modern industries, so demand is rising. Glencore is the world’s largest producer of cobalt. It mines for cobalt and other metals in Africa, Australia, Canada and Norway.

Exchange traded funds

ETF Investing
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For a lot of investors, ETF investing is sensible way to invest in renewable energy stocks. There are quite a ETFs that invest in green energy stocks and the way they define their universe varies a lot. With a portfolio of ETFs, you can manage risk and still ensure you have exposure to certain parts of the industry. Another advantage of these ETFs is that you will have exposure to some of the more obscure emerging markets renewable energy stocks. If you invest in ESG investing ETFs you will also have exposure to renewable energy stocks, alongside other shares.

  • iShares Global Clean Energy ETF (ICLN): This is the largest renewable energy stocks ETF in the world with $5.4 billion in AUM. A large proportion of the fund is invested in the largest green energy stocks from around the world. This means the fund owns a lot of utilities and is more defensive than others.
  • Invesco Solar Energy ETF (TAN): Invesco’s solar ETF has become a go to fund for speculating on renewable energy. The fund holds all the key solar stocks from around the world, which means it has the potential for strong trends. However, performance can also be quite volatile.
  • Global X Global Renewable Energy Producers ETF (RNRG): This global fund is a good alternative if you want exposure to green energy stocks around the world. The fund holds 44 stocks from 20 countries. There’s also a good balance between utilities and other types of stocks.
  • First Trust Global Wind Energy ETF (FAN): First Trust’s wind energy fund is the largest fund with a focus on companies in the wind energy industry. The fund holds a large number of utilities as well as all the major wind turbine manufacturers.
  • Global X Lithium & Battery Tech ETF (LIT): This fund invests in companies involved in energy storage. This includes rare earth companies, chip makers and companies that sell batteries.
  • ALPS Clean Energy ETF (ACES): The ALPs fund has a very broad definition of green energy stocks. This means it includes EV stocks and stocks of companies that produce energy saving lightbulbs, amongst others. This fund will give you exposure to a wide range of industries within the clean energy space.

Investing in green energy stocks

Investing Green Energy
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It is almost certain that vast amounts of capital will flow into the renewable energy sector over the next few decades. However, this doesn’t mean the prices of green energy stocks will rise consistently. It also doesn’t mean that green energy stocks all make good investments. When an industry is associated with a good narrative, there’s an inclination toward speculation. In 2020, as it became clear that Joe Biden had a good chance of becoming US President, some renewable energy stocks rallied as much as 300%. The reality is that when the momentum slows, valuations do matter.

The stocks in very completive industries, like the solar industry, should probably be treated as momentum stocks – unless they are really trading at bargain valuations. If you are looking for sustainable growth stocks, you will need to find companies with a competitive advantage that can’t be replicated. This can often take the form of barriers to entry related to regulations and licenses.

Trading Graph / Chart
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The companies involved in wind energy and established battery makers fit into this category. The stocks involved in fuel cell technology and rare earth minerals are also quite speculative, but some of them should ultimately produce very strong returns. The most reliable renewable energy stocks are the utilities. They are unlikely to evolve into multibagger stocks but can still generate very respectable returns over time – along with an income stream.

You can reduce risk by paying attention to asset allocation. If you build a core portfolio of utilities and other established green energy stocks, your volatility should be manageable. You can then consider stock picking to find a few stocks with more risk that have the potential for multibagger returns.

Conclusion: Investing in renewable energy stocks

It’s almost certain that the wave of capital flowing into renewable energy projects will continue to grow in the coming years. As this develops into one of the decade’s big megatrends there will be plenty of opportunities for investors. However, along the way it’s likely that a series of speculative bubbles will form. So, investors will need do need to pay attention to fundamentals and the types of companies they are investing in.

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Asset Management

Semiconductor Stocks – Companies that are enabling the digital revolution

Semiconductor chips act as both the „brains“ and the infrastructure of the information economy. Most of the growth industries of today rely on processors, memory chips and integrated circuits. Without these components, there would be no cloud computing revolution, no artificial intelligence, and no software industry.

Semiconductor Industry
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In this article we give you a basic overview of the semiconductor industry and how to go about investing in the industry. We also highlight the most important companies in the industry.

What are semiconductors

Semiconductor / Chips
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A semiconductor is a material that can be both an electrical conductor and an insulator. Their conductive properties can be changed by manipulating the material, or exposing them to electrical fields, heat, or light. In the world of technology, the term semiconductor chip is used to refer to semiconductor wafers with electric circuits & transistors on them. Silicon is typically used as the semiconductive material, although the search is on to find other materials.

Semiconductor materials and chips are used to make processors, memory chips and other components. They are used to store data, process data using logic, and to transmit data. They are also used for sensors, displays and solar cells. Semiconductor chips are the physical building blocks that enable computing and the digital economy.

Semiconductor industry

Semiconductor Manufacturing
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While semiconductor companies are often referred to as chipmakers, most do not actually manufacture their own chips. Historically chipmakers did manufacture their own products, but over the past three or four decades the industry has become fragmented. The reason is that semiconductor fabrication is extremely difficult. It’s usually easier to outsource manufacturing to companies with proven capabilities.

Fabrication is done in factories known as foundries. Today, just five companies own the foundries responsible for over 90% of chip fabrication. Companies that design and sell chips while outsourcing the fabrication are known as fabless semiconductor producers. Some companies simply design and then license their intellectual property to manufacturers. Finally, there are companies that provide equipment, software, and services to semiconductor producers. Most of the industry is involved in a race to make chips of ever decreasing size. Smaller chips draw less power and allow more components and functionality in each device.

The smallest chips currently being produced are 5nm chips. The 5nm (nanometer) term is actually just a marketing term, but theoretically refers to the size of the nodes that can be created. Intel and Samsung are developing 3nm chips, and IBM recently announced it is developing a 2nm chip.

Investing in semiconductor companies

Trader Analyzing Data
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The semiconductor industry is cyclical and it’s the most cyclical industry in the technology sector. Semiconductor stocks are affected by business cycles like other cyclical stocks in the financial and consumer discretionary sectors. However, the industry is probably more like the basic materials and energy sectors, where both supply and demand are cyclical.

Demand for chips often depends on sales of products that are brand new – which makes forecasting difficult. Supply is affected by the time it takes for companies to respond to changes in demand. These dynamics can lead to dramatic cycles for the companies and their stock prices. While the industry is cyclical, chip stocks can also be growth stocks. A company’s revenue can increase rapidly and high barriers to entry lead to very wide margins.

When it comes to stock picking in the industry, you need to consider the industry as whole and how well individual companies are positioned in growing markets. Valuation metrics like PE ratios can be useful to determine the relative valuation of a stock to the industry. You then need to consider what that company’s sales are likely to look like three to five years from now.

10 Largest semiconductor stocks

Semiconductor Stocks
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There are a lot of excellent semiconductor stocks and it’s not possible to cover them all. So, we will mention ten of the largest and most notable companies in the industry. For reference, we will compare returns to the Philadelphia Semiconductor Index. This is the benchmark index for the industry. The index has returned 358% over the last five years and 72% in the past year.

  • Taiwan Semiconductor Manufacturing Company (NYSE: TSM) – TSMC is a semiconductor foundry company that manufactures chips for most of the other chip makers. The company was founded in 1987 by Morris Chang, a former Texas instruments executive. TSMC now has numerous fabs (fabrication facilities) in Taiwan and a few other countries. The company accounts for around 55% of the world’s chip fabrication, and most electronic products in the world now contain components built by TSMC. It is the world’s 11th most valuable company with a market cap of $540 billion. TSMC’s stock price has matched the performance of the semiconductor index over the past five years but has accelerated in the last 12 months.
  • Nvidia Corporation (Nasdaq: NVDA) – Nvidia has been one of the most popular semiconductor stocks of the last decade because of the way it is positioned to benefit from several technology megatrends. The company pioneered the use of GPUs (graphics processing unit) in graphics cards for the gaming industry. Since then, these cards have become integral to artificial intelligence, visualization, data centers and mining cryptocurrencies. GPUs have been essential to the advances in artificial intelligence of the past few years. Nvidia has been one of the best multibaggers for investors over the last few years. Its stock price has risen 14-fold in five years. This growth hasn’t been based on speculation as revenue has grown 4-fold and EPS have increased from 7-fold. Nvidia is trying to acquire UK based ARM Holdings but is facing resistance from regulators. ARM designs and licenses processors for smart phones and other devices. If the deal is approved, it will make Nvidia a major player in the mobile technology and internet of things industries, in addition to the industries it already supplies.
  • Intel Corporation (Nasdaq: INTC) – Historically, Intel was the largest and most successful chip maker in the world. Intel pioneered several types of chips during the 1970s and 1980s, including the x86 processors that still power PCs and notebooks. Intel produces CPUs, chipsets, solid state drives and other integrated circuits. The company still fabricates its own chips unlike many of its competitors. Intel is still the largest producer of x86 chips but has lost market share to competitors like AMD in recent years. The stock price has underperformed its peers and even the S&P500 in recent years. Intel recently announced it will invest $20 billion in new fabrication facilities in the US.
  • Broadcom Inc (Nasdaq: AVGO) – Broadcom produces digital and analog semiconductor products used for communication and networking technologies like Bluetooth and fiber optics. The company supplies the data center, cloud storage, networking, and infrastructure software industries. The company also recently announced a new chip that will be used to power the world’s first Wi-Fi 6E phone produced by Samsung. This is a new Wi-Fi spectrum and Broadcom is in a leading position to supply technology for phones and routers using the technology. Broadcom’s stock price has underperformed the semi-index over the past five years but is comfortably ahead of the S&P 500.
  • Texas instruments Inc (Nasdaq: TXN) – Texas Instruments is one of the oldest semiconductor companies, having manufactured its first transistor in 1952. The chipmaker has been responsible for several notable innovations over the last seven decades. These include the first commercial silicon transistor, the first transistor radio, one of the original integrated circuits and the first hand-held calculator. Nowadays Texas Instruments produces a large assortment of semiconductor products and is one of the few older companies that still fabricates chips. TXN is not the most exciting of the semiconductor stocks, but it has managed to steadily grow revenue and earnings year after year.  Over the last few years, the stock price has underperformed the index, but returned twice what the S&P500 has.
  • Samsung Electronics (Korea Stock Exchange: 005930.KS) – Samsung is often overlooked because the stock is only listed in Korea. The company is best known for the smartphones and other electronic devices it makes. Samsung also designs and fabricates a wide range of semiconductor products for itself and for other companies. Samsung is actually a supplier of OLED displays to one of its biggest competitors, Apple. It ranks second in the world behind TSMC in terms of chip fabrication. With a market value of $490 billion, Samsung is actually the second most valuable of the semiconductor stocks. The stock price has underperformed the semiconductor industry over the past five years, but still returned twice the S&P500’s gain.
  • Qualcomm (Nasdaq: QCOM) – Qualcomm is a major supplier of wireless communications products and services. Qualcomm’s Snapdragon chips are a key component of many of the smartphones available today. Qualcomm is also positioned to be a major supplier to global rollout of 5G technology. Qualcomm’s growth slowed between 2015 and 2019 which led to underperformance. However, growth has accelerated over the last 12 months.
  • Micron Technology Inc (Nasdaq: MU) – Micron Technology produces memory chips and other semiconductor products. The company is a major supplier of products like RAM memory, microSD cards, and USB flash drives. Micron’s products are used in PCs, vehicles, and other consumer electronics. The company’s shares have been a solid performer over the past 5 years, beating the semi-index comfortably.
  • Advanced Micro Devices Inc (Nasdaq: AMD) – AMD designs and sells CPUs, GPUs, semi-custom chips, and other semiconductors. AMD is a key supplier to the PC, graphics, cloud computing, and gaming industry and competes head-to-head with both Nvidia and Intel. Global Foundries, one of largest foundries in the world was previously part of AMD but was spun off in 2009. Since then, AMD has been a fabless chip maker. In 2020 AMD announced it would be acquiring Xilinx, the leading manufacturer of field programmable chips. Over the last few years AMD has been the top performer amongst the larger semiconductor stocks.
  • Infineon Technologies AG (XETRA: IFX) – Infineon is a German semiconductor manufacturer which was originally part of Siemens AG. Today, Infineon is a one of the largest vertically integrated chip makers in the world with operations in numerous countries. Infineon is best known for supplying components to the auto industry and for its power semiconductors. The company also produces sensors, SIM cards, and chip-based security solutions. In 2019, Infineon acquired Cypress Semiconductor, another vertically integrated chip company. Other notable semiconductor stocks include NXP, Marvell, Skyworks Solutions, Analogue Devices, and ON semiconductor.

Semiconductor equipment and design companies

Semiconductor Silicon Wafers
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As is often the case, the companies that supply equipment, services and software to an industry are often a good investment too. These companies stand to benefit as long as there is investment in new chip design and fabrication capacity around the world.

  • ASML Holdings (Nasdaq: ASML, Euronext: ASML) – ASML Holdings, which is based in the Netherlands manufactures equipment used to produce chips. The company is the leading supplier of photolithography devices which are used to create circuits on silicon wafers. ASML’s lithography devices are used to create features as small as 10 nanometers on nanochips. To do this an immersion lens or extreme ultraviolet light is used to produce light with a low wavelength. The stock price has outperformed the industry in the last year as the industry increases capacity. Prior to 2020, revenue was growing steadily at around 15%, but ASML also has incredibly good margins.  
  • Applied Materials Inc (Nasdaq: AMAT) – Applied Materials supplies the industry with manufacturing equipment, software, and services. The company also supplies equipment used to manufacture LCD screens and photovoltaic cells used to generate solar power.
  • Lam Research Corporation (Nasdaq: LRCX) – Lam Research designs and manufactures semiconductor processing equipment. The company’s machines are used to create semiconductor components and wafer level packaging.
  • Synopsis Inc (Nasdaq: SNPS) and Cadence Design Systems Inc (Nasdaq: CDNS) – Synopsis and Cadence both sell software and equipment used to design and test integrated circuits. Typically, new chips are designed digitally, and then prototypes are built using emulators and prototyping hardware. Testing is also done at each stage of the process. These two companies are both integral to the design and development of new chips.
  • Cohu Inc (Nasdaq: Cohu) – Cohu specializes in testing semiconductors and testing the equipment used to make them. Cohu is another company that is essential to semiconductor manufacturing and its products are used throughout the industry.

Semiconductor ETFs

ETF Investing
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The easiest way to invest in semiconductor stocks is by buying one of several semiconductor ETFs. These are the four largest funds available in the US. There are similar funds listed on other exchanges too.

  • iShares PHLX Semiconductor ETF (SOXX): The largest industry ETF tracks the Philadelphia Semiconductor Index, which has 32 constituents. The index is weighted by modified market capitalization, and has an annual expense ratio of 0.46%
  • VanEck Vectors Semiconductor ETF (SMH): VanEck’s chip fund is a very popular fund. This fund includes the 25 most valuable companies involved in the semiconductor industry. It is weighted by market value and investors pay 0.35% a year.
  • SPDR S&P Semiconductor ETF (XSD): The State Street chip ETF is a lot smaller than the funds but includes more companies. It only holds stocks that are listed in the US and has an expense ratio of 0.35%.
  • Invesco Dynamic Semiconductors ETF (PSI): The Invesco fund uses a smart beta approach to weight holdings. Factors like momentum, earnings growth, value, and management are combined to calculate weights. The fund holds 30 stocks, and the expense ratio is 0.57%.

Global chip shortage and what it means for investors

EV Manufacturers
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The world is currently facing a chip shortage. Chip shortages occur from time to time due to the cyclical nature of the industry, but the current shortage is particularly severe. When the pandemic began last year, automakers cancelled orders, and manufacturers switched to producing more chips for other industries. Later in the year demand from automakers returned while demand from the cloud computing industry and device manufacturers accelerated.

Wall Street analysts believe it may take as long as two years for supply to match demand. The worst affected sectors are EV stocks, and the stocks of companies that need older chips. In general, though, the effect on financial markets has been quite limited. The companies that stand to benefit from the shortage are those that fabricate chips and those that supply equipment to the industry.

Conclusion: Investing in the semiconductor industry

The semiconductor industry is unique in that most of the companies are exposed to hyper growth industries, yet they have real cash flows. This means the stocks can be valued properly, unlike companies that are still unprofitable. Most chipmakers are exposed to several different industries too – so, their revenue isn’t dependent on a single company or industry. Chip stocks should have a place in most equity portfolios – but it’s important to remember that they are cyclical, and positions may need to be managed.

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Asset Management

Actively Managed ETFs – The revival of active asset management with ETFs

Exchange traded funds are generally associated with passive investing. But there are now nearly 500 actively managed ETFs, and some have performed exceptionally well recently.

Actively Managed ETFs
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This post examines the differences between active and passive ETFs, and whether the universe of actively managed ETFs is likely to expand further.

Active vs. passive ETFs

ETF Investing / Actively Managed ETFs
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Most of the exchange traded funds currently available to investors are managed passively. These funds simply replicate an index of securities or other assets. Changes are only made when the index itself is rebalanced. This typically occurs on a quarterly basis.

While the goal for index ETFs is to track a benchmark index as closely as possible, the goal for actively managed ETFs is to outperform the benchmark index. Active ETFs are managed by a portfolio manager or a team of fund managers and analysts. Decisions regarding the investment strategy, stock picking and asset allocation can be made as often as on a daily basis. Both passively and actively managed ETFs can be constructed to offer exposure to broad investment strategies like growth or value investing and across various asset classes.

Asset Management
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However, some investment themes and strategies are better aligned with either active or passive mandates. Passive investing is better suited to quantitative strategies like factor investing, smart beta, and systematic investing. Active investing is better suited to strategies that require qualitative decision making. This is often the case with fundamental analysis, ESG investing and investing in companies that are not yet cash flow positive. Active strategies are also well suited when indexes aren’t as meaningful. This is the reason most actively managed ETFs invest in fixed income securities.

The major advantage of passively managed ETFs is that they enable investors to earn beta while paying low management fees. The advantage of actively managed ETFs is that they can generate alpha, though there is no guarantee that they will. However, more resources are required to manage active ETFs, and so they have significantly higher expense ratios.

Active ETFs vs. mutual funds

Analyzing Charts
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Actively managed ETFs are managed in a similar manner to most mutual funds, apart from index tracker mutual funds. However, unlike mutual funds, active ETFs are traded on exchanges like shares. They are bought and sold at a price determined by supply and demand, rather than at the NAV of the fund.

Actively managed ETFs and mutual funds serve a similar purpose. But there is a distinct advantage to ETFs in that one trading account gives an investor access to any fund listed on a stock exchange. Investing in mutual funds requires a separate account with each provider, or with a fund platform that may offer a limited range of funds.

The case for active ETFs

Trader Buy / Sell
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The majority of index funds track indices that are weighted by market cap. These funds have enjoyed a unique set of circumstances over the last 10 to 15 years. The bull market of the last decade or so has been led by large cap growth stocks, like Amazon, Apple, and Microsoft. As these stocks have grown, their influence on market cap weighted indexes has increased. The result has been particularly good environment for ETF investing with passive funds.

The majority of actively managed portfolios had historically a value investing bias. Value investing has underperformed in recent years, partly due to the combination of disruptive technology and low interest rates. So, while market conditions have favored index investing, they have been a challenge for active managers.

Trading Graph / Chart
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If the investment environment changes, and there are some indications that it is, market cap weighted indexes could be heavily weighted to underperforming stocks and have low exposure to outperforming stocks. This would favor active managers and those with a bias toward value stocks and cyclical stocks.

Investments in stocks that turn out to be multibagger stocks are typically made when the company still has a low market value. By the time these stocks are included in a market index, the biggest gains have already been made. Active managers are free to take meaningful stakes in smaller companies.

Passive investing has risen in prominence since 2005. During this period there have only been two substantial bear markets, and both were relatively short lived. If the market experiences a secular bear market that lasts longer, active managers may be in a better position to navigate such an environment. Fund managers who are skilled at market timing and interpreting investment warning signs would be well positioned to deal with a protracted bear market.

ARK Invest ETFs

Investing / Trading Graph
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ARK Invest has arguably been the most successful manager of active ETFs. The company currently manages the six largest active equity ETFs in the world. ARK was founded by Cathie Wood in 2014 and already manages $50 billion in assets. ARK Invest focusses on investing in companies building disruptive technology and software. Specific areas of focus include electric vehicles and other types of automation, artificial intelligence, healthcare technology and fintech. These industries are all participating in the megatrends reshaping the global economy.

The company’s success arguably has as much to do with its sectors and industries of focus than on stock picking or portfolio management. Nevertheless, the company has made some remarkably successful stock picks over the last few years.

  • ARK Innovation ETF (ARKK) – The flagship ARK fund invests in companies engaged in disruptive innovation. Notable holdings include Tesla, Square, Teladoc, and Roku. These are all companies that are disrupting industries with technology. The fund has returns 538% over the past five years and 144% over the last 12 months. The fund currently has AUM (assets under management) of nearly $24 billion.
  • ARK Genomic Revolution ETF (ARKG) – ARK’s second largest fund invests in companies engaged in gene editing, genetic therapy, molecular diagnostics, and stem cell science. Investing in these industries requires very specific knowledge and skills, and it makes sense to employ an active approach. The fund’s largest holdings include Teladoc Health, Exact Sciences, Regeneron Pharmaceuticals and Pacific Biosciences. This fund has $9 billion in AUM. The fund has returned 129% over the last 12 months and 417% over the last five years.
  • ARK Next Generation Internet ETF (ARKW) – ARK’s other large ETF, with AUM of $6.7 billion, is a more general fund that invests in companies in any industry associated with the internet. The industries include cloud computing, e-commerce, big data, artificial intelligence, mobile technology, social platforms, and financial technology. The universe is quite loosely defined with the result that the largest holding is Tesla. Other notable holdings are Square, Grayscale Bitcoin Trust, Roku, Spotify, and Shopify. The fund has returned 142% over the last 12 months and 692% over five years.

The other ARK ETFs focus on fintech, industrial innovation, space exploration, 3D printing and Israeli tech stocks. The funds all have expense ratios of between 0.49 and 0.79%. These are a lot higher than index funds, but reasonable when compared to actively managed mutual funds.

Other active ETFs

Other Actively Managed ETFs
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The vast majority of actively managed ETFs are bond funds, but there is a growing number of equity funds and multi-asset funds. These are just a few of the prominent active ETFs:

  • Amplify Transformational Data Sharing ETF (BLOK) – One of the largest active equity ETFs is this Amplify fund which invests in companies with exposure to blockchain technology and cryptocurrencies. The fund’s largest holding is MicroStrategy, a company that holds 90,000 Bitcoins on its balance sheet. Other holdings include PayPal, Square, Galaxy Digital Holdings Ltd, and Nvidia. The fund has around $1 billion in AUM. This is more a function of the fact that there are very few other ways to invest in cryptocurrencies via the stock market. Nevertheless, the ETF has generated returns of 183% since inception three years ago and 213% in the last year.
  • First Trust Long / Short Equity ETF (FTLS) – As the name implies, the First Trust Long / Short fund holds long and short equity positions. The objective of this portfolio hedging strategy is reduce volatility and generate positive returns over the long term. The fund holds long positions worth 80 to 100% of the value of the fund, hedged with short positions worth 0 to 50% of the fund’s value. This ETF has AUM of $330 million and has a relatively high expense ratio of 1.6%. The fund has returned 19% over the last 12 months and 50.6% over five years.
  • Avantis U.S. Small Cap Value ETF (AVUV) – American Century Investments manages several active ETFs including the Avantis Small Cap Value fund. Small Cap stocks are better suited to active management due to the increased risk. The fund’s largest holdings are Cimarex Energy Co, Louisiana-Pacific Corporation and Targa Resources Corp which operate in the energy and resources sectors. These stocks all have market values lower than $10 billion. The fund was launched in 2019 and has returned 125% over the last 12 months. This impressive performance, along with the relatively low expense ratio of 0.25% has attracted assets of $1 billion already.
  • Main Sector Rotation ETF (SECT) – Main Management’s sector rotation fund is a fund of funds that rotates between sector ETFs. The objective is to outperform the S&P500 during bull markets and limit downside during bear markets. The fund has managed an impressive 61% return over the last year and charges 0.8% in annual fees. The fund has AUM of $799 million.
  • AdvisorShares Pure US Cannabis ETF (MSOS) – The advisor shares Pure US Cannabis fund was only launched in September last year, but already has nearly $1 billion under management. This is no doubt due to the attention the US cannabis industry has attracted since the election in November. The largest holdings in the fund are Green Thumb Industries, Cresco Labs and Curaleaf. The fund has generated a 51% return over the last six months.
  • Vanguard U.S. Value Factor ETF (VFVA) – Vanguard launched the world’s first index fund and remains the second largest ETF manager. The company has now leveraged its fund management resources to launch a low-cost active ETF. The fund is actively managed but clearly draws from the Vanguard’s extensive quantitative research on factors. Prominent holdings include blue-chip growth stocks like AT&T, Verizon, and CVS Health. The fund was launched in 2018 and generated a 98% return over the last year. This is particularly impressive when one considers the 0.14% expense ratio.
  • First Trust Preferred Securities and Income ETF (FPE) – This First Trust ETF earns income for investors with a dividend investing strategy. The fund invests in preferred shares with good yields and convertible bonds. This enables the fund to generate capital gains as well as income. The funds has $6 billion under management and currently yields 4.7%. It has also generated capital gains of 23% over 12 months and 42% over 5 years.
  • SPDR DoubleLine Total Return Tactical ETF (TOTL) – The SPDR DoubleLine fund is a popular bond ETF managed by Jeffrey Gundlach, one of the fixed income world’s best investors of all time. The fund invests in bonds issued by governments around the world, corporate and mortgage bonds, and other debt instruments. The fund has returned 3.19% over the last 12 months and 13.48% over 5 years.
  • RPAR Risk Parity ETF (RPAR) – This multi-asset class ETF is managed by Advanced Research Investment Solutions. The fund holds bonds, equities, commodity ETFs, and currencies to reduce portfolio risk and volatility. This is a strategy popularized by Ray Dalio at Bridgewater Capital. The ETF was launched in December 2019 and has AUM of $1.2 billion. Over the last 12 months the fund has returned 16.9%.

Risks of investing in actively managed ETFs

Risk Active ETFs
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In most respects actively managed ETFs can be compared to actively managed mutual funds. With any actively managed product, the biggest risk is that investors often chase performance. Very often the best performing funds in the short term are those that invest in specific types of stocks, or with a specific investment style. Investors are often tempted by historical returns that are difficult to repeat.

To get an accurate idea of a fund’s long-term potential, you need a longer track record. Ideally the track record should include periods of volatility and bear markets too. In the absence of a longer track record, the fund manager’s track record and the management company itself needs to be evaluated.

Morningstar recently pointed out that the ARK Invest funds carry considerable risk because they own large stakes in some companies. In the event of a stock market crash leading to redemptions, the fund itself would put pressure on the prices of those stocks. They also pointed out that the team is inexperienced and risk controls are lax. This doesn’t mean ARK investment funds aren’t a good investment, but they should not be treated as low-risk investments.

Future of active ETFs

Future of Actively Managed ETFs
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Whether or not actively managed ETFs outperform in the future will depend on two things. Firstly, if market conditions no longer favor the largest stocks in indexes like the S&P500, it will be easier for active managers to generate alpha. The other factor concerns the way the fund’s themselves are managed.

As a group, actively managed funds have underperformed their benchmarks over the long term. If active ETFs are managed in the same way, there will probably be a few that stand out, while most underperform. However, we may see new approaches to active management that result in better performance.

Data Intelligence Fund
Data Intelligence Fund managed by Catana Capital

If a new era of active management emerges it will probably leverage the power of artificial intelligence, big data, sentiment analysis and alternative financial data. Investment funds like the LI Data Intelligence Fund or the LI Data Intelligence Fund German Equities are already leveraging these technology led approaches, which are increasingly finding their way into mainstream fund management.

Market liquidity is better than it’s ever been, and trading costs are the lowest they have ever been. This means a more active trading strategy that wasn’t viable in the past may now offer an edge. It’s entirely possible that some actively managed ETFs will be very actively managed.

Conclusion: Investing in actively managed ETFs

If active ETFs manage to outperform indexes in the next few years, we will probably see a lot more of them in the market. They may also displace mutual funds as the investment vehicle of choice for active managers. Active managers will also need to perform better than actively managed mutual funds have in the past. No doubt there will be some successful funds, but whether or not the industry can reverse the flow to passive funds remains to be seen.

Kategorien
Asset Management

Paper Trading – How to use stock market simulators for virtual stock trading and backtesting without risking money

Most people with at least some exposure to the stock market have heard of paper trading. Whether you are a trader or an investor, there are several advantages to trading with virtual money or a stock market simulator. Furthermore, paper stock trading can be beneficial to beginners and advanced traders alike. If you want to know how you can benefit from paper trading and how to go about it, read on.

Paper Trading
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What is paper trading?

Definition Paper Trading
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Paper trading is also known as demo trading, practice trading, hypothetical trading, and simulated trading. Essentially you are trading with virtual money. This means you can’t make real profits, but it also means you can’t lose real money. This is a particularly good approach to use if you aren’t sure your trades will be successful.

Traditionally paper trading was done by simply writing trades down or entering them in a spreadsheet. These days the entire process can be automated by using a stock market simulator or a demo account. We will cover the various ways to paper trade in more detail later.

Why it makes sense to practice before investing real money

Group of Traders
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There are lots of reasons to do some form of practice trading before you trade with real money. For beginners, paper trading allows you to do a lot of learning before you risk a cent using real money in the real market. If you are learning to trade, paper trading is an opportunity to learn basic tasks like entering an order, moving a profit target, or exiting a trade quickly. You can also get to know how a platform works and get to know the instruments you plan to trade. If you start out by paper trading, you can make as many mistakes as you want, and it won’t cost you a cent.

There are also psychological benefits that are just as important. Paper trading will introduce you to the effect emotions can have on your trading. It also allows you to get used to what a real P&L curve looks like. The reality of trading is that a successful string of trades includes winners and losers. To trade successfully you need to work out how to maximize the winners and minimize the losers. Trading skills improve with practice. This practice can be expensive if real money is on the line, but completely free with a stock market simulator. 

How experienced traders can also benefit from virtual stock trading

Paper Trader
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Virtual trading is not only for beginners. Experienced traders often paper trade to test new strategies, practice their execution and build confidence. They will typically paper trade when they are trying out a new strategy or trading a market, they are not familiar with.

For many traders, paper trading is an integral component of ongoing strategy and skills development. For example, you can test different order types to work out whether limit or market orders are best for a particular strategy. In this case you can keep two paper trading accounts each using a different order type. Once you have executed 30 or so practice trades you will have a better idea of which order type works best. This is something you will only know if you record trades based on live market data.

Analyzing Charts
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On shorter timeframes, execution is far more important than it is on longer term timeframes. Whether or not day trading strategies are profitable will often depend on the price at which each trade can be realistically executed. This in turn depends on liquidity, the bid offer spread and other factors. In such a case, you will only be able to determine whether the system is viable by paper trading using live data.

Finally, even the best traders in the world go through bad stretches. They will often use paper trading simulators or a demo account to get back „in the zone“ and work out if they are in sync with a market. By doing so they can regain their confidence before risking capital again.

Backtesting vs. paper trading

Backtesting vs. Paper Trading
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Backtesting and paper trading are similar. However, they are not identical, and they serve different purposes. Typically, when a new strategy is developed, backtesting is the first test, paper trading is the second test and live trading is the final test. If the strategy fails either test, the trader needs to go back a step or two and find the weakness in the system. When a strategy is backtested, historical market data is used to get an indication of how well the strategy would have done in the past. Each trade included in backtest results is a simulated trade based on historical data.

There are however two potential problems. Firstly, the strategy may be overoptimized to perform on historical data and may not perform as well in the future. Secondly, the trade prices used in the backtest may be unrealistic. Paper trading is a way to test for both of these issues. Not all trading strategies can be backtested at all. Rules based strategies can usually be tested, however, there is no way to backtest a discretionary strategy based on qualitative data. In this case, only paper trading can be done before real money is put on the line.

Psychology of paper trading vs. live trading

The Cycle of Market Emotions
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One of the objectives of paper trading is to slow down and break up the learning curve. By using a demo account or stock market simulator you do not need to learn to trade and learn to manage your emotions at the same time. And, if you get it right you can actually learn how to eliminate many of your losing trades before putting real money on the line. Traders need to preserve both financial and psychological capital.

Losing money doesn’t only impair your financial capital, but your psychological capital too. And, when that happens, it affects your decision making. So, paper trading is a great way to build your confidence while learning how to trade. However, for many there is a challenge in transitioning from paper trading to real trading. Some decision making will just never be the same if you don’t have real money on the line. When you are trading with paper money there is no difference between $100 and $10,000.

In reality, there is a big psychological difference between having $0 and $100 on the line and a big difference between having $100 and $10,000 at risk. The implication is that traders may struggle to move from paper trading to trading with real money. They may also struggle to increase their trading size. The solution is to be aware of this limitation and to learn to think in terms of the percentage of an account that you are risking on each trade – whether it’s a real or demo account.

How to start virtual stock trading

Start Paper Trading
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These days most brokers offer some form of paper trade accounts – usually in the form of a demo brokerage account. A demo account is exactly like a live trading account except that it is funded with virtual money – typically $100,000 or $1 million. Demo accounts don’t only apply to trading stocks, but other assets like forex too.

A demo account is the easiest way to get started, but you can also use a dedicated stock market simulator, a spreadsheet or you can simply write your trades down in a journal. However, the advantage of a demo account is that you can seamlessly move from demo trading to live trading on the same platform.

You really don’t need to spend too much time deciding which tool to use. You can easily move from one tool to another at a later stage. There are two things to consider though. Firstly, whichever method you use, you should easily be able to calculate the P/L for each trade and keep track of the total account value. Secondly, it’s useful if you can attach notes to each trade detailing your thoughts when you entered and exited each trade.

Trader Workstation
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Paper trading tools can be divided into 3 categories: demo accounts, paper trading simulators and tools, and stock market games. The following are some of the most popular in each category:

Demo accounts

As mentioned, most brokers offer a demo account option, but the following brokers stand out:

  • TD Ameritrade’s Think or Swim platform allows you to trade with „paper money“, a virtual currency, alongside your live trades. It includes some of the most advanced trading tools available today.
  • NinjaTrader is a trading platform rather than a broker but offers the equivalent of a demo account. The advantage of this platform is that you can paper trade using real time or historical data. You can even go back and paper trade your way through the GFC of 2008.

Stock trading simulators

Paper Trading Simulators
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The best standalone paper trading simulators are not free like games and demo accounts. However, the fee may be worth it if you are taking your paper trading seriously.

  • TradingSim allows traders to practice day trading the market without risking a single penny. This trading simulator and market replay platform allows traders to simulate trades for any trading day in the past two years.
  • TradingView’s paper trading tools are highly rated. There are several payment levels offering different tools. The advantage of TradingView is that it is one of the best charting platforms around.
  • Warrior Trading offers a stock market simulator with rich data and educational tools attached to the platform. This is the most popular option for those learning to day trade US stocks.

Stock market games

Excited Stock Market Trader
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An immensely popular segment amongst newbie traders are stock market simulators that have been turned into games. The idea is that you can enter competitions or start competitions amongst friends. Whilst the trading is done with virtual money, real prizes can be won. This provides an incentive to make an effort, whilst learning in the process.

  • Wealthbase is a mobile phone app which offers various types of stock market games.
  • The MarketWatch simulator is one of the oldest and most popular around.

Pros and cons of paper trading

Pros / Cons Paper Trading
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There are several notable advantages to paper trading, as well as a small number of drawbacks to be aware of.

Advantages

  • You can avoid large and unnecessary losses early in your trading career.
  • Paper trading is an opportunity to familiarize yourself with new trading platforms and markets without putting real capital at risk.
  • You can test new trading strategies and systems without risking capital.
  • Your investing education can begin long before you have enough capital to start a portfolio.
  • During challenging periods, you can get in sync with the market whilst preserving financial and psychological capital.

Disadvantages

  • Sometimes, a stock market simulator can give you a false sense of confidence. This can result in overtrading and risking too much when you start live trading.
  • If you don’t spend long enough paper trading, you may not realize the impact of luck on a trading account.
  • Traders often struggle to transition from a stock market simulator to live trading.

Is virtual stock trading useful to investors?

Stock Market Investor
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If you are a long-term investor you may be wondering if virtual stock trading is as beneficial as it is for active traders. Trading typically requires better execution and market timing and a better understanding of supply and demand, technical analysis, and liquidity. On the other hand, earnings, margins, investment warning signs and valuation metrics are more relevant for investment strategies.

Simulated trading is certainly more relevant to trading where execution and psychology play a bigger role. However, trading skills can be especially helpful to investors in certain situations like buying and selling momentum and growth stocks which exhibit higher volatility or hedging by short selling.

Paper trading is a way to learn the trading skills that may be useful to your investing and speculating, without risking real money. A few extra skills can improve your edge – remember, it’s an investment myth that only the pros have an edge. But you still need to build your edge.

Tips to help you get the most out of your paper trading

Paper Trading Tips
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The following tips will help you get the most out of paper trading:

  • Take it seriously. You may have nothing to lose when you trade on a stock market simulator, but the more you treat it like the real thing the more you will benefit from the experience. One way to make the experience more realistic is to put a certain amount of real money on the line for each trade – say $10 or so. For each winning trade, the cash goes towards a reward for yourself, while the cash goes to charity for losing trades.
  • Try to become aware of the times your decision-making starts being affected by emotions like fear & greed. Becoming aware of the effects of emotion on your trading is the first step in reducing their effects.
  • When you move to a live account, try to be aware of any differences in the way you treat risk. The objective is to try and treat it the same way whether you have virtual or real money on the line.
  • Try to think in terms of probabilities and the percentage of your trading account at risk on each trade. Then, continue to do this when you move to a real-world account. If you can do this, the transition will be easier, and you will also be able to scale your trading effectively.

Conclusion: Practice trading with stock market simulators

As you can see there are lots of advantages to paper trading. Perhaps most important of all is that while you still need to put time and effort into your trading, you don’t always need to put real money on the line. In that sense you are risking your time and not your capital, which is itself a very good investment of your time.

Kategorien
Asset Management

Cyclical Stocks – Evaluating stocks that benefit from periods of economic expansion

Over the last six months the cyclical sectors have come to life. Some well-known cyclical stocks have broken 20-year resistance levels, while others are emerging from decade long trading ranges.

Cyclical Stocks
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In this post we highlight the types of stocks that are most sensitive to economic cycles and how you can go about evaluating them. We also compare the current economic recovery to typical economic growth phases.

What are cyclical stocks?

Cyclical Stocks / Recovery
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Cyclical companies are companies that are sensitive to economic cycles. Their profits increase when the economy expands but decline when there is an economic slowdown. When the economy begins to grow at above average rates, consumer confidence, business confidence and investor confidence all increase. If unemployment rates fall and wages rise, consumers are more likely to increase discretionary spending. They are also more likely to extend their credit. The immediate beneficiaries are consumer facing business.

Businesses respond to increased consumer spending by investing to build capacity. This has a knock-on effect through most sectors of the economy. First manufacturers and construction companies see an increase in demand, and eventually commodity producers and shipping companies do too. Investor confidence improves when the economy is strong, and valuations, particularly for cyclical stocks, trade at the upper end of their range. Stock prices tend to anticipate earnings 6 to 12 months ahead, which can also make valuations appear stretched.

When a recession occurs, unemployment rises and spending falls. Cyclical companies therefore experience a drop in earnings. The effect is often amplified by the fact that companies may have over-invested during the expansionary phase, and possibly increased debt levels too. This results in share prices falling to below average valuations. The next cycle then begins. Any company that sees its profits rise and fall along with the economy is a cyclical company. They differ from other types of companies that have different dynamics. Some good cyclical stock examples include General Motors, Nike, JP Morgan, and Starbucks.

Cyclical sectors

Cyclical Sectors
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It’s generally accepted that six of the major sectors are cyclical. These are the consumer discretionary, financial, industrial, basic material, energy, and real estate sectors. However, there are some industries and companies in these sectors that are not cyclical. There are also cyclical industries in other sectors. 

  • Consumer cyclicals – The consumer discretionary sector includes companies that sell goods and services to consumers but excludes non-cyclical industries. Consumer stocks are particularly sensitive to consumer spending and consumer confidence, which is in turn affected by economic indicators like employment and interest rates. This sector is also known as the consumer cyclical sector, and includes retailers, consumer goods manufacturers, and companies providing entertainment, tourism, and hospitability services.
  • Financials – The financial sector, which includes banks, insurers and brokerages benefits from the expansionary phase of a cycle in several ways. Interest rates usually rise during the growth cycle, allowing banks to earn a wider margin, while also lending more. Insurance companies hold large equity portfolios, and these portfolios rise along with the stock market. Rising equity prices and increased trading volumes benefits brokers and fund managers.
  • Industrials – The industrial sector includes a broad range of industries, most of which are cyclical. Examples include airlines, freight industries and most manufacturing and construction industries. They benefit from business investment, increased trade, and as more people and goods are transported.
  • Basic materials and energy – The basic materials sector consists of commodity producing companies. Commodity prices are themselves cyclical and subject to long, deep cycles – or super cycles as they are known. Rising demand leads to new exploration and production, and eventually to oversupply. When commodity prices fall, some producers cease production. This eventually leads to a shortage of supply, and the cycle starts again. When the economy expands, producers sell more of whatever it is they produce, and at higher prices. The same occurs for the energy sector when activity in the manufacturing and transport industries rises. Oil and gas producers benefit from higher prices and higher volumes. The combination of higher volumes and prices can lead to very rapid earnings growth.
  • Real estate – It isn’t surprising that real estate is also a cyclical industry. The property market is affected by interest rates, business confidence and consumer confidence. Longer cycles can also lead to oversupply of residential and commercial property, which amplifies the cycle.

How cyclical stocks differ from other types of shares

Analyzing Charts
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Non-cyclical stocks, which are also known as defensive stocks, are those that are less sensitive to the business cycle. These stocks belong to sectors like the consumer staples (also called consumer non-cyclicals), utilities, and healthcare sectors. The goods and services produced by these sectors are those that are needed, rather than wanted. Some industries within other sectors are also defensive – the aerospace and defense industry is a good example.

Counter-cyclical businesses are those that are more profitable during recessions than periods of growth. Examples would include pawn shops and some law firms. To an extent the alcohol, tobacco and gambling industries can also prove to be counter-cyclical too. However, there are very few listed companies that are truly counter- cyclical. Some growth companies are cyclical, while others are not. Growing companies that serve the consumer markets are more likely to be affected by economic downturns.

Companies that are participating in some of the megatrends shaping the future are less likely to be affected by the business cycle. Companies in the cloud computing, Software as a Service and electric vehicle industries are operating in markets that are growing regardless of the economic cycle. In many cases these companies help customers reduce costs, which mean they can do just as well during recessions. Value investing and cyclical investing are closely related. Business cycles can create deep discounts for patient value investors.

Early-stage vs. late-stage cyclical stocks

Economic Cycle
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In most cases, trying to time the market isn’t a good idea. However, if you are stock picking in cyclical industries, the timing is actually important. The best cyclical stocks at any time will differ according to the stage of the business cycle, so effective cyclical investment strategies will typically rotate from one sector to another throughout the cycle.

  • Early cycle – The business cycle typically begins as the economy emerges from a recession that ended the previous cycle. Often interest rates are at below average levels, and stocks prices have declined. The first companies to benefit are in the consumer cyclical, industrial, financial, and real estate sectors. These companies benefit from the low interest rates coupled with rising consumer confidence.
  • Mid cycle – Businesses respond to improving sentiment by investing to increase capacity for the future. This is when revenue growth in the technology, communication, and media sectors begins to accelerate. The sectors that saw gains in the first stage continue to see growing demand, but some may begin to experience capacity constraints.
  • Late cycle – Later in the cycle, the prices of commodities like metals, oil, gas and building materials have strong momentum. Commodity producers and energy companies benefit from the higher prices and rising volumes. As the cycle progresses, inflationary pressures begin to build. Central banks then begin to raise interest rates. Consumer facing businesses with pricing power can still raise prices, while those that can’t, experience a slowdown in sales and falling margins. This is when investors begin to rotate into inflation proof and defensive companies.
  • Recession – Eventually cyclical companies find themselves in a situation where sales and margins are both falling as inflation and higher interest rates take their toll. Companies stop making new investments, and some may have to retrench staff. During a recession non-cyclical stocks outperform. Indexes typically correct or experience a full-blown stock market crash. Every cycle is different, but the severity of the downturn usually depends on the levels of over investment during the previous three phases.

How to invest in cyclical stocks

Investor / Tablet / Stock Market
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Investing in cyclical stocks is all about managing your expectations for a stock. Generally, when we invest in a stock we expect (or hope) the price will rise indefinitely. With cyclical stocks you should be expecting the price to both rise and fall as economic conditions change. An understanding of behavioral finance will also help you manage your expectations. Cyclical stock valuations often appear high early in the cycle as the market starts anticipating a strong economy. Similarly, when the cycle ends and stock prices decline, cyclicals may appear cheap, when they are actually value traps.

It’s also important to consider companies individually, rather than trying to apply a „one size fits all“ approach. The same can also be said for each cycle because there are always different dynamics at play. Companies that are regarded as cyclical because of the industry they are in, may actually have fairly consistent earnings. An example is McDonalds which is classified as a consumer cyclical but has proved to be quite defensive in the past.

We live in a globalized world and the economic cycles of different countries are often correlated. However, individual countries can buck the global trend. Ultimately, a company’s performance will depend on the markets it operates in, not necessarily the country where it is located. Commodity producers for example, are closely tied to China’s economy, though they operate around the world.

Cyclical stock valuations

Fundamental Analysis / Technical Analysis
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Cyclicals have very lumpy cash flows. This makes valuing a cyclical business challenging. To compensate for cyclical effects, you can use average earnings over at least 10 years. You should also use the long-term average growth rate, rather than extrapolating the current growth rate into the future.

Historical price earnings ratios for individual cyclical companies are also useful. You can use them to get a sense of what reasonable valuations look like at different stages of the cycle. For example, if a stock’s PE ratio has historically ranged between 15 and 25, that tells you that as long as the economy continues to grow, a price multiple of 25 is probably justified. But it also tell you that the multiple could easily drop to 15 during a recession, when earnings may also fall. So, if earnings fall by 50% and the PE falls from 25 to 15, the share price could fall as much as 70%.

In some cases, it may be worth holding a stock through multiple cycles. This is especially true if you manage to buy it at a historically low valuation. It’s also applicable if the company has growth attributes. In other instances, it may be worth selling when the fundamentals deteriorate. Cyclical stocks can exhibit strong trends lasting anywhere from six months to three years. It’s worth taking advantage of these trends. But, if your entry is based more on momentum than fundamental analysis, then you’ll probably want to exit the position when the price begins to fall.

Managing risks with cyclical stock investing

Managing Risk
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The risk levels for cyclical stocks vary from moderately to extremely high. The easiest way to reduce risk is to focus on the more profitable, well financed companies. At the end of every cycle there will be a number of cyclical companies either on the verge of bankruptcy, or in need of capital to remain in business. In most instances these are companies that took on too much debt when business was good. The companies that take on a lot of debt are the ones you don’t want to hold through a full cycle. Even if they do survive, your shareholding is likely to be diluted.

Investing in cyclical stocks is really a tactical asset allocation (TAA) decision. As such, you should only be making minor changes to your broader portfolio. Economic forecasts often turn out to be wrong, and you don’t want your entire portfolio to be dependent on them.

Portfolio risk and volatility can also be reduced by allocating to more defensive investment funds like factor investing funds and hedge funds. Dividend investing funds also focus on companies with more predictable cashflows and are a good way to reduce the risk of investing in cyclicals.

How the current cycle differs from previous cycles

Coronavirus / 2019-nCoV / COVID-19
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The global economy is currently undergoing a recovery following the recession caused by the Coronavirus. For the last six months cyclical sectors have been leading the stock market, as one would expect. Year-on-year GDP figures that are published in the next few months will be showing changes from the exceptionally low base created a year ago. So, it’s likely that the cyclical sectors will continue to perform well over the next few months.

Beyond that, this cycle may be a little different from previous cycles. The recession itself was not caused by an overheated economy or rising rates. In fact, global interest rates were at historically low levels when the recession began. Bond yields are now rising, suggesting interest rates will follow.

Every business cycle is different, but this cycle is likely to be even more unique than usual. Beside the unique reason for last year’s recession, the world hasn’t enjoyed a prolonged period of above average growth for a long time. There is also a wide gap between the valuations of cyclical companies and those of growth stocks. In addition, interest rates may become relevant again, following an extended period of „cheap money“.

Conclusion: Evaluating cyclical stocks and economic cycles

Cyclical stocks are experiencing a long overdue period of outperformance. The outlook for these sectors is also looking good for the medium term. Beyond that, their performance will depend on whether or not the global economy continues to grow, and on whether interest rates rise significantly or not.

Kategorien
Asset Management

Portfolio Risk – How to measure and manage the risk of your investment portfolio

Investors all face a trade-off between risk and return. Investors are rewarded with returns for taking on risk – but that risk must be managed. For any portfolio, the appropriate level of risk must first be determined. And then the portfolio risk needs to be calculated to make sure it lies within that level of risk.

Portfolio Risk
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Knowing and managing investment portfolio risk is the most important factor in growing and preserving capital. In this post we discuss the ways in which portfolio risk can be calculated and managed.

What is investment portfolio risk?

Portfolio risk reflects the overall risk for a portfolio of investments. It is the combined risk of each individual investment within a portfolio. The different components of a portfolio and their weightings contribute to the extent to which the portfolio is exposed to various risks.

The major risks a portfolio will face are market and other systemic risks. These risks need to be managed to ensure a portfolio meets its objectives. You can only manage this risk if you can first quantify it.

Determining your risk tolerance

Risk Tolerance
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In the US market the worst year for bonds was 1969 when bonds returned -5%. The US equity market, as per the DJIA index, has fallen more than 30% on 5 occasions, the worst being 51% in 1931. If both markets were to experience equivalent crashes in the same year, then;

  • An 80% equity / 20% bond portfolio would lose 41.8%
  • An 20% equity / 80% bond portfolio would lose 14.2%

Both portfolios would eventually recover, but this would take far longer for the first portfolio. A portfolio needs to be constructed with this in mind.

Before constructing a portfolio, you need to work out how much you can afford to lose, both financially and psychologically. This is your risk tolerance. Losing too much money late in your career may mean your portfolio will never recover. Losing more money than you are comfortable with can result in stress and irrational decision making. You should never be in a situation where you can lose enough capital to cause you to make irrational decisions.

Financial Advisor / Risk Tolerance
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To properly determine your risk tolerance, you should speak to a financial advisor. You can also use one of the tools wealth managers often include on their websites. You can however get an idea of your risk tolerance by considering your portfolio value, time horizon, monthly income, monthly expenses and the reliability of your income. You should also consider your temperament and how much you are psychologically prepared to lose.

Risk tolerance can be rated as high, moderate or low. If you are at least 20 years off retirement age, have a reliable income stream and some cash savings, your risk tolerance will be high. In the case of a market crash you will have time for the market to recover and you won’t need to draw from your portfolio. On the other hand, if you are approaching retirement age or may lose your source of income, your risk tolerance will be low. Losing money on your portfolio close to, or during retirement, will result in drawing capital from an impaired portfolio.

Risk tolerance is closely related to risk appetite and risk capacity. Your risk tolerance will change only gradually over time. At any given time, it will dictate your risk capacity. Risk capacity can also be thought of as the amount of risk that must be taken to achieve investment goals. Risk appetite considers both tolerance and capacity, and the investment landscape at any given time.

Types of portfolio risks

Portfolio Risks
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There are lots of types of investment risks, both at the portfolio level and the individual security level. Firstly, the following are examples of risks that are specific to individual securities. These risks can easily be managed through diversification:

  • Liquidity risk
  • Default risk
  • Regulatory risk and political risk
  • Duration risk
  • Style risk

Broader portfolio risks can affect the entire portfolio. Managing these risks requires more creative diversification and other strategies. The following are the main portfolio level risks.

The greatest risk facing any portfolio is market risk. This is also known as systematic risk. Most assets correlate to some extent. The result is that a stock market crash will result in most stocks falling. In fact, most financial assets will lose value during a bear market.

At the other end of the risk spectrum is inflation risk. This is the risk that a portfolio’s buying power will not keep up with inflation. Thus, the reason a portfolio needs to include „risky assets“ and risk needs to be managed. Over the long term, owning risky assets allows you to outperform inflation.

Investment / Making Money
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Reinvestment risk can affect the entire bond portion of a portfolio. If bonds are purchased when yields are high, the holder earns those high yields even if interest rates fall. However, if yields are low when the bond matures, the principal cannot be reinvested at a high yield.

Concentration risk concerns the correlation of assets within a portfolio. Having too much exposure to specific sectors, assets, regions can create systemic risks for that portion of the portfolio. Hidden risk can occur when assets do not seem correlated but are affected by the same economic forces. For example, Chinese equities, commodities and emerging market currencies would all be affected by a downturn in the Chinese economy.

Interest rate risk and currency risk both affect any portfolio. All assets in a portfolio should be analysed to determine their exposure to interest rates and currencies.

How to measure the risk of your investment portfolio

Risk / Reward Ratio
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There are numerous approaches to measuring portfolio risk. All have their advantages and drawbacks. There is no full proof method, so several methods are usually combined. Volatility is the most common proxy for risk – though there are risks that volatility does not capture. Standard deviation is the typical way to measure volatility. This applies to individual securities and to portfolios.

The return of a portfolio can be calculated by simply averaging the weighted returns. Calculating the standard deviation of a portfolio is a little more complicated. A portfolio’s historical standard deviation can be calculated as the square root of the variance of returns. But when you want to calculate the expected volatility, you must include the covariance or correlation of each asset.

Calculating the correlation and covariance for each stock can become very complicated. The covariance must be calculated between each security and the rest of the portfolio. The weighted standard deviation for each security is then multiplied by the covariance. This will usually result in the portfolio’s volatility being lower than most of its components.

Trading Graph / Chart
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The Sharpe ratio normalizes returns for a given level of risk. This allows one to compare investments and determine the return for every dollar of risk taken. The Sortino ratio is similar, but only considers downside volatility. These ratios can be used for the performance of model portfolios, real portfolios and individual securities. However, they are backward looking, and cannot predict future risk and return.

Beta gives an indication of the riskiness of an individual security relative to the market. The overall market has a beta of 1. A stock with a beta of 1 would be expected to move up and down the same amount as the market. A stock with a beta of 0.5 would only be expected to rise or fall half as much as the market. A stock with a beta of 2 would be expected to rise and fall twice as much as the market.

The beta of a portfolio is calculated as the weighted average of each component’s beta. A portfolio with a high beta means you may be risking more than you think you are. If your portfolio has a beta of 1.5, and the market falls 10%, your portfolio would be expected to fall 15%.

Value at risk (VaR) is used to calculate the maximum loss a portfolio can be expected to lose in a given period. The result is calculated for a specific level of confidence, usually 95 or 99%. There are two methods of calculating VaR – using either a normal distribution, or simulations. VaR is widely used for quantifying risk by banks and regulators. However, it has also been widely criticised and is no longer used by portfolio managers very often.

How to manage the risk of your investment portfolio

Manage Risk Investment Portfolio
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There are several ways to limit portfolio risk. In most cases more than one approach is combined. The stock market has historically generated the highest returns but has also experienced the greatest volatility. For this reason, diversifying investments across several asset classes is the first step in managing a portfolio’s risk. A substantial percentage of most portfolios should be invested in equities, but this needs to be balanced with other types of assets.

A basic diversified portfolio would include stocks, bonds and cash. Stocks provide the greatest long-term returns, bonds provide predictable income, and cash offers immediate liquidity. While this would be a vast improvement on a single asset portfolio, risk can be further diversified with other asset classes. The objective then is to find assets that have very low correlations with equities and bonds.

Commodities / Alternative Assets
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This brings us to alternative assets. These are assets that provide long term capital growth, but relatively low correlation with equities. Real assets like commodities and real estate are more resilient to inflation than other assets. Their intrinsic value depends on physical supply and demand, rather than on the complex dynamics that drive financial assets.

Private equity and venture capital funds come with varying degrees of risk. These types of investments are illiquid, and their values are only calculated monthly or even quarterly. This would usually be viewed as a disadvantage. However, in the context of managing portfolio volatility, it can be an advantage. The value of these funds doesn’t fall during market corrections which result in volatility across other asset classes.

Hedge funds are the only asset class specifically created to generate uncorrelated returns. Hedge funds use a wide variety of strategies to generate returns that are not dependent on market performance. They also use short selling, leverage and derivatives to capture alpha.

Data Intelligence Fund
Data Intelligence Fund managed by Catana Capital

Some hedge funds use unconventional methods to find opportunities that other types of funds cannot exploit. An example is Catana Capital’s Data Intelligence Fund which combines big data, A.I., and market sentiment to find overlooked opportunities in real time.

In many cases hedge funds are the only types of investment funds that can protect capital during major bear markets. The only way to protect a fund from a black swan event is by using funds with inverse or neutral exposure to equity markets. Diversification is usually considered in the context of asset classes. However, diversification can also be done by investment style and by timeframe.

Traditionally most portfolios were made up of share portfolios and mutual funds. However, the popularity of ETF investing has resulted in a much wider range of low-cost funds being made available to investors. Commissions have also declined making diversification by time more affordable. The growing recognition of quantitative investing and factor investing means portfolios can be diversified across numerous factors and styles.

Modern Portfolio Theory
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Modern portfolio theory is one process that can be used to construct a portfolio that maximizes the expected return for a given amount of risk. This is done using mean variance optimization. The objective is to combine stocks in such a way as to reduce portfolio volatility as much as possible. A series of simulations is done to maximise the portfolio’s expected return for a given level of risk. This approach works very well for stock portfolios. Other methods are then used at the asset allocation level.

The risk parity approach is similar but is done at the asset class level. Asset classes are weighted so that their contribution to overall portfolio risk is equal. If for example equities are four times more volatile than bonds, the bond weighting will be four times the equity weighting. Risk parity is associated more with capital preservation than with earning alpha.

Conclusion: Diversify your portfolio across various asset classes

Understanding and managing portfolio risk is perhaps the most important role within portfolio management. Asset allocation decisions will have the greatest impact on the risk a portfolio will face. Being able to quantify the risk of a portfolio allows investors to optimize potential returns. The more risk can be quantified and managed, the more capital can be allocated to riskier assets that generate the highest returns.

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Asset Management

Fundamental vs. technical analysis – Beginner’s guide with pros and cons of each investment analysis method

The debate over the relative merits of fundamental and technical analysis is a contentious one. Investors and traders alike often miss out when they pick one over the other. In fact, both can be combined effectively.

Fundamental Analysis / Technical Analysis
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In this post we explain the differences and highlight the strengths and weaknesses of each. We also list a few ways the two approaches can be combined, and what the future holds for the various forms of investment analysis.

What is fundamental analysis?

Fundamental Analysis
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Fundamental analysis in the stock market is a method of evaluating a company and determining the intrinsic value of its stock. Companies are valued as though they were unlisted, with no regard for their market prices. Buy and sell decisions are then made based on whether a stock is trading at a discount or a premium to its fair value.

Although a stock’s value is ultimately an opinion, relatively undervalued companies can outperform over the long term. Fundamental analysis can also be applied to other markets including currencies and commodities. In that case any factors that affect the value of the asset are considered.

What is technical analysis?

Chart Analysis
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Technical analysis is based only on stock price or volume data. The objective is not to predict the future, but to identify the most likely scenarios. Price action is used as an indication of how market participants have acted in the past and how they may act in the future.

Technical analysts use chart patterns and trends, support and resistance levels, and price and volume behavior to identify trading opportunities with positive expectancy. Technical analysis does not consider the underlying business, or the economics that affect the value of a company.

Understanding the difference

Technical vs. Fundamental Analysis
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The difference between the two approaches comes down to what determines a stock’s value and price. Fundamental analysis considers the value of the company. This ultimately depends on the value of its assets and the profits it can generate. Fundamental analysts are concerned with the difference between a stock’s value, and the price at which it is trading.

Technical analysis is concerned with price action, which gives clues as to the stock’s supply and demand dynamics – which is what ultimately determines the stock price. Patterns often repeat themselves because investors often behave in the same way in the same situation. Technical analysis is concerned with price and volume data alone.

Tools used for fundamental and technical analysis

Investment Tools / Trading Tools
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Fundamental analysts consider a company’s financial positions and performance, the market in which it operates, competitors and the economy. The most important source of data for fundamental analysis is the company’s financial statements. These include the income statement, balance sheet and cash flow statements.

Data from these statements can be used to calculate ratios and metrics that reflect the company’s performance, health and growth rates. Industry data and economic factors, like interest rates and retail spending, are also used to forecast future growth rates. Ultimately, a fair value is arrived at after comparing several models and ratios.

Technical analysis is a lot broader than many people realize. All chartists use price charts – usually either line charts, bar charts or candlestick charts. Apart from price charts, the tools used can vary widely. Some analysts use indicators like moving averages and oscillators calculated from stock prices. Others use price patterns, and complex analysis frameworks like Elliott Waves and Market Profile. Trend followers use other tools to identify price trends and measure momentum.

Fundamental vs. technical analysis: Which is better?

Technical vs. Fundamental Analysis
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The debate over fundamental and technical analysis is contentious. Proponents of either form of analysis often write the alternative off but misunderstand that they can both have their place. Fundamental analysis is most useful for long term investments, while technical analysis is more useful for short term trading and market timing. Both can also be combined to plan and execute investments over the medium and long term.

Short term price movements are determined by supply and demand, which are in turn affected by a lot more than what typically goes into fundamental analysis. Market sentiment and the effect of emotion on market activity can only be analyzed by using price and volume data. On the other hand, charts cannot be used to determine whether a stock is under or overvalued and what its value may be years into the future. Charts reflect what has happened in the past, and their value diminishes the longer the time horizon.

Pros and cons of fundamental analysis

Fundamental Analysis Pros
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Analysis based on a company’s financial and competitive position has several advantages. Analyzing the environment in which it operates is also of value. Focusing only on the business, rather than on the stock price, gives investors an idea of what the company is actually worth. This is invaluable for long term investing. Investing during market bubbles can be rewarding – but it’s still important to know when the market is in a bubble.

Portfolio risk can be managed by calculating the premium to fair value at which stocks are trading. Asset allocation decisions can then be made to reduce the potential downside of a portfolio. The biggest profits are usually made by the investors that are correct when the rest of the market is wrong. This can only be achieved with fundamental analysis. Also, decisions based on fundamental analysis typically have a higher probability of being correct, particularly over the long term.

Fundamental Analysis Cons
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There are also several drawbacks to fundamental analysis. It’s important to be realistic about its limitations. Fundamental analysis is time consuming – each company must be studied independently and in detail. Most of the information used in fundamental analysis is widely available. To gain an edge with fundamentals, you need to find unique datasets that aren’t available to most investors.

Fundamental analysis tells you very little about what might happen in the short term. Short term price movements and volatility cannot be forecast by looking at financial statements. Fundamental analysis is a lot less precise than often perceived. Valuation models like the discounted cash flow model are based on numerous assumptions which are seldom very accurate. Target valuations can be useful on a relative basis but are limited when it comes to valuing a company more than one or two years into the future.

Pros and cons of technical analysis

Analyzing Charts
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One of the major advantages of technical analysis is that stocks can be analyzed quickly. Also, some tasks can be automated which saves time. This means a technical analyst can cover more stocks and draw ideas from a larger universe. Technical analysis can also be used to identify price targets, and levels at which an idea is obviously wrong. This allows traders to create investment strategies with clearly defined risk and reward profiles.

In the short term, price action is affected by several factors that fundamental analysis cannot pick up. The effects of market sentiment, market psychology, and supply and demand can all be observed by looking at a chart. Technical analysis can be used to improve timing, and to trade strategies appropriate to market conditions.

It can improve hedging strategies by improving your timing when short selling or buying options. By looking at a chart you can quickly see whether a stock price is in a trading range or a trend. Some technical strategies can be back tested. This means they can be scientifically tested and applied. Strategies that can be back tested form the basis of many algorithmic trading strategies.

Technical Analysis Cons
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Technical analysis does of course have its drawbacks. First amongst these is that while some technical approaches can be back tested, many cannot. Pattern trading, Elliott Wave analysis and other forms of technical analysis are subjective and rely on judgement. Using charts is often regarded as more of an art than a science.

Technical analysis frequently results in ambiguity. Two technical analysts can come to very different conclusions about the same stock by using different approaches. Charts often appear very different on different time frames. And, with the large number of analysis methods, indicators and time frames available, forming a single view can be a challenge. This happens often and is known as analysis paralysis.

Technical trading setups have a relatively low win rate. While a pattern or setup may have an edge, the win rate is often less than 60%. To trade setups like this profitably requires a large number of trades.

Using fundamental and technical analysis together

Stock Trader / Charts
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There are several ways in which technical and fundamental analysis can be used effectively together. The following are a few of the ways you can combine the two methods:

  • Simply looking at a price chart can give you an idea of the direction of a trend. This will give you an idea of whether the market agrees with your valuation or not. You should have stronger conviction when going against the crowd and also be prepared to exit quickly if a stock is widely owned and the fundamentals change.
  • You can build a watchlist of stocks you are prepared to own based on fundamental analysis, and then use technical analysis to decide if or when to buy them.
  • Quantitative studies have found that a combination of value and momentum can be an effective method of stock picking. In essence, stocks trading on low valuations but with strong momentum tend to outperform.
  • Technical analysis can be used to find favorable entry levels for growth stocks that are in an uptrend. Companies that have high growth rates and trade on high valuations often experience large corrections. In such cases, technical analysis can be used to identify oversold levels. These are often the best opportunities investors will ever get to buy growth stocks.
  • Stocks can continue trading higher long after they become overvalued. Selling a stock just because it is expensive often means missing out on a large percentage of a rally. By using price and volume trends you can continue to hold the stock until the momentum is exhausted.
  • If a stock is trading close to its fair value, it makes sense for the price to consolidate or trade in its range. While the fundamental picture remains the same, you can use technical methods to trade within the range.
  • Fundamental research can sometimes be used to determine which parts of a business cycle are most profitable for a company. Technical analysis can then be used to confirm anticipated trends.

The future of investment analysis

Future of Investment Analysis
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In the future it is likely that the various forms of analysis will increasingly be combined. The field of quantitative investing has rapidly gained recognition in the asset management industry due to its more scientific approach. Technology now allows fundamental, technical and quantitative analysis to be effectively combined, and tested. Increasingly, behavioral finance and market sentiment are being incorporated in algorithmic trading strategies. And, new technologies like artificial intelligence and big data can also enhance all three forms of analysis.

New sources of big data, in particular, can be used to find unique insights. Catana Capital is a leader in the field of combining systematic trading, artificial intelligence and big data. In the case of Catana’s Data Intelligence Fund, trading strategies employ user generated data combined with market data. This gives the fund an edge by measuring market sentiment in real time and identifying profitable trades. We can expect the lines between fundamental analysis and technical analysis to be blurred further as the investment industry evolves.

Conclusion

If you invest in an unlisted company, fundamental analysis is all you have available to work with. But, when it comes to listed stocks, there is a lot that can be learnt from their trading history. The price of tradeable securities is also affected by a lot more than the underlying fundamentals. For these reasons, technical analysis does have value.

However, for long term investors, it’s important to have an idea of the value of a company. This is important when picking stocks to hold for the long term, to manage portfolio risk, and to know when to exit extended price moves. In the future, the debate over the two styles of analysis may become immaterial as multiple approaches are combined with quantitative and systematic approaches to investing.

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Asset Management

Portfolio Hedging – 10 Ways to hedge your stock portfolio to reduce market risk

As we mentioned in the post on portfolio risk, any investment portfolio is vulnerable to a range of different risks. No one knows for sure if, or when, there may be a market crash coming, but we can reduce risk with portfolio hedging and diversification.

Portfolio Hedging / Reduce Market Risk
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Whether you are picking individual stocks or ETF investing, a variety of hedging strategies can be used to reduce downside risk, as well as other risks. In this post, we consider the different ways you can hedge a portfolio.

What is portfolio hedging?

Question Marks
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A hedge is a strategy that mitigates against the risks to an investment. In many cases a hedge is an instrument or strategy that appreciates in value when your portfolio loses value. The profit on the hedge therefore offsets some or all of the losses to the portfolio.

There are several different risks that can be hedged. Moreover, there are numerous strategies to hedge these risks. Some portfolio hedging strategies offset specific risks, while others offset a range of risks. In this article we are focusing on hedging stock portfolios against volatility and loss of capital. However, portfolio hedging can also be used to hedge against other risks including inflation, currency risk, interest rate risk and duration risk.

How portfolio hedging works

Protect Portfolio / Financial Markets
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You can implement a hedge to protect an individual security. However, if individual securities carry risk, it makes more sense to reduce or close the position. Investors typically want to protect their entire stock portfolio from market risk rather than specific risks. Therefore, you would hedge at the portfolio level, usually by using an instrument related to a market index.

You can implement a hedge by buying another asset, or by short selling an asset. Purchasing an asset like an option transfers the risk to another party. Short selling is a more direct form of executing a hedge. Hedges are very seldom perfect, and if they were, they would serve no real function as there would be no potential for upside or for downside. In many cases only part of the portfolio will be hedged. The goal is to reduce risk to an acceptable level, rather than removing it.

Ways of hedging a stock portfolio

Stockbrokers / Conversation
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As mentioned, there are many different ways of hedging stocks. We will start with five approaches using options, and then consider five other approaches to portfolio hedging. An option contract is an agreement that gives the buyer the right, but not the obligation to buy or sell an asset at a specific price. In some cases, an option can be executed anytime before the expiry date, and in others it can only be executed on the expiry date.

A call option gives the holder the right to buy the underlying instrument at the strike price. A put option gives the holder the right to sell the underlying asset at the strike price and is therefore most commonly used for hedging purposes. For put options, the option is said to be in the money if the current spot price is below the strike price. The option is out of the money if the strike price is below the spot price.

The price paid for an option is the premium. Deep in the money options are more expensive as they have intrinsic value. Options that are a long way out of the money have very little value, as there is little chance they will expire with any intrinsic value. The objective of an option hedge is to reduce the impact of a market decline on a portfolio. This can be achieved in a number of ways – using just one option, or a combination of two or three options. The following are five option hedging strategies commonly used by portfolio managers to reduce risk.

Long-put position

Trading Tools / Technical Indicators
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A long-put position is the simplest, but also the most expensive option hedge. Usually an option with a strike price 5 or 10% below the current market price will be used. These options will be cheaper but will not protect the portfolio against the first 5 or 10% that the index declines.

Collar

A collar entails buying a put option and selling a call option. By selling a call option, part of the cost of the put option is covered. The trade-off is that upside will be capped. If the index rises above the call option strike price, the call option will result in losses. These will be offset by gains in the portfolio.

Put spread

A put spread consists of long and short put positions. For example, a portfolio manager can buy a put with a strike price at 95% of the spot price and sell a put with an 85% strike. Again, the sale of the put will offset part of the cost of the bought put. In this example, the portfolio would only be hedged while the market falls from 95% to 85% of the original strike. If the spot price falls below the lower strike, gains on the long put will be offset by losses on the short put.

Fence

Trader Buy / Sell
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A fence is a combination of a collar and a put spread. This entails buying a put with a strike price just below the current market level and selling both a put with a lower strike price and a call with a much higher strike price. The result is a low-cost structure that protects part of the downside while allowing for some upside.

Covered call

A covered call strategy involves selling out of the money call options against a long equity position. This doesn’t actually reduce downside risk, but the premium earned does offset potential losses to an extent. This strategy is usually used on individual stocks. If the stock price rises above the strike price, losses on the option position offset gains on the equity position.

Now we come to some other approaches to hedging stocks, without using options:

Holding cash

Trader / Profit Trading
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Holding cash is one way to reduce volatility and downside risk. The less a portfolio has allocated to risky assets like equities, the less it can lose during a stock market crash. The trade-off is that cash earns little to no return and loses buying power due to inflation.

Diversification

Diversification is one of the most effective ways to hedge a portfolio over the long term. By holding uncorrelated assets as well as stocks in a portfolio, overall volatility is reduced. Alternative assets typically lose less value during a bear market, so a diversified portfolio will suffer lower average losses.

Unlike cash, alternative assets generate positive returns over time, so they are less of a drag on performance. Hedge funds can also generate positive returns during a bear market because they hold long and short positions. Catana Capital’s Data Intelligence Fund uses real-time data to respond to changes in market sentiment. Because this fund responds to changing market conditions so quickly and holds long and short positions it acts as a hedge against volatility and downside risk.

Short selling stocks or futures

Stock Market Analysts
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Short selling stocks or futures is a cost-effective way of hedging stocks against an expected short-term decline. Selling and then repurchasing stocks can have an impact on the stock price, while there is minimal market impact from trading futures. Selling a futures contract is a cheaper more efficient means of reducing equity exposure.

Buying products with inverse returns

Buying products with inverse returns is a relatively new method of hedging stocks. You can now buy ETFs and other securities that appreciate in price when the broad stock market loses money. Some of these instruments are leveraged, which requires less capital for a hedge to be implemented. The advantage of these securities is that they can be traded in an ordinary stock trading account, without the need for a futures or options account. However, before using them, they should be carefully vetted to ensure they inversely track the underlying security closely.

Buying volatility

VIX Index
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Buying volatility is another way to hedge equities that has become available recently. The VIX index is an index of implied volatility for a range of S&P options. There is an active market for futures based on the VIX index, and there are also ETFs and options based on these futures. Because volatility typically rises during market corrections, these instruments gain value when a long position in equities loses value. Buying volatility ETFs when the VIX is at historically low levels is an effective method of hedging. It should be noted that volatility products do typically lose value over time.

How to select a suitable hedge for your portfolio

Investing Decision
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There is no sure way to choose the best available options when hedging stocks. You can, however, consider the pros and cons of the available options and make an informed choice. You will need to consider several factors when considering your alternatives. The first decision will be to decide how much of the portfolio to hedge. If you are hedging an equity portfolio that forms part of a diversified portfolio, your entire portfolio is already hedged to an extent. In that case a smaller hedge would be required.

On the other hand, if all of your wealth is in equities, you would probably want to hedge at least 50% of it. You will also need to consider the portfolio and determine which market indices the portfolio most closely matches. Moreover, you should calculate the average beta of the stocks it holds. A higher beta will require a larger hedge. Also worth considering is how much upside you would be prepared to forfeit. Selling call options can reduce the cost of a hedge but will limit gains. Selling futures contracts will also limit your returns.

Once you have an idea of the type of hedge that would make sense, you should look at some indicative prices to work out how much appropriate strategies will cost. For S&P options, you can see a list of liquid option contracts here. For other indices, you can search for „X index option chain“ to get an idea of prices. Once you have an idea of the costs you can weigh up the different strategies, how much each will cost and the level of protection they offer.

What does hedging a stock portfolio cost?

Portfolio Hedging Cost
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Hedging stocks with options requires the payment of premiums. The premium of an option depends on several variables including the current price of the underlying instrument, the strike price, the current interest rate, the time to expiry, expected dividends and expected volatility. While most of these inputs are fairly static, volatility is subject to supply and demand.

The following are approximate premiums an investor would pay for options on the S&P 500 index which is the most active option market in the world. In this case the average volatility level for the last 10 years of 17.8% is used. In these examples we assume the portfolio being hedged contains only S&P 500 ETFs.

Based on an index level of 2,950, a put option with a 2,950 strike and 180 days to expiry would cost 132 index points. This is equivalent to 4.4% of the index but protects 100% of the index value. The minimum and maximum loss for the next 100 days would be equal to the premium of 4.4%.

If the strike price was moved down to 90% of the index level at 2,655, the cost of the option would fall to 61 index points or 2% of the index. A long position would now have a minimum loss of 2% and a maximum loss of 12% for the next 100 days. A strike at 80% of the index value would cost just 0.8% of the index value but would still leave a portfolio exposed to the first 20% of downside.

If we extended the term of the option to 360 days, the at-the-money put option would increase to 6%, the 90% put would increase to 4%, and the 80% put would increase to 2% of the index values. For US markets you can view a hedge calculator on the CBOE website here. The examples listed above are just one aspect of the cost of portfolio hedging. Other costs include the transaction fees and commissions. Another cost is incurred when potential returns are forfeited by strategies that cap upside.

Example of portfolio hedging

Portfolio Hedging Example
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As a hedging example, consider a portfolio worth $1 million. In this case the S&P 500 index has been chosen as the most appropriate index, but the average portfolio beta is calculated at 0.8. This means a full hedge would only need to have a nominal value of $800,000. The portfolio manager does not want the portfolio to lose more than 5% in the next year. The manager does not expect the index to rise more than 8% in that time.

With the index at 2950, a put option with a strike of 2,680 will limit losses to 4%. These options cost 116 index points. The manager can also sell call options with a 3200 strike for 91 points. These options will cap returns at 8.5% for the next year. The manager buys 3 puts and sells 3 calls, paying a net premium of 22 points. The 3 puts provide protection on $268,000 x 3, or $804,000 in total. The total premium paid is 22 x 3 x $100, or $6,600. This premium is 0.8% of the amount protected and is the minimum the strategy will cost.

The maximum loss for the portfolio over the following year will be 4.8% as the options cost 0.8% and protect the portfolio 4% below the current market level. The maximum gain will be 7.7%, with gains capped at 8.5% and being reduced by the 0.8% paid out.

Disadvantages of portfolio hedging

Portfolio Hedging Disadvantages
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The process of portfolio hedging or hedging stocks is a trade-off. There is usually a cost, and there is no guarantee that a hedge will perform as planned. A significant hedging risk can come from a mismatch between the portfolio being hedged and the instrument being used to hedge. Constructing a hedge that accurately matches a portfolio is very costly, so the mismatch has to be accepted.

Hedging stocks can only be feasibly done once or twice a year. If the market rises after a hedge is implemented, the new gains won’t be protected. In addition, time decay devalues options rapidly as expiry approaches. The price at which options are valued in a portfolio is based on daily mark to market prices. These prices are subject to market forces and increase portfolio volatility even when they protect its ultimate value. Buying options requires margin to be paid out. To do this, cash has to be borrowed using the portfolio as collateral. This will usually come with a cost.

Conclusion: Hedge your stock portfolio to reduce market risk

Risk and uncertainty are a given when it comes to financial markets. While risks can seldom be avoided completely, portfolio hedging is one way to protect a portfolio against a potential loss. Hedging stocks does come at a cost but can give investors peace of mind. This can help investors take on enough risk to achieve long-term investment goals. Hedging can also prevent catastrophic losses if a black swan event occurs.