Another look at India’s equity markets

Recent headlines about India have been dire indeed, with currency markets and equity markets selling off. So how bad are things?
Have markets simply given up on a lack of meaningful reform by Prime Minister Manmohan Singh? Are there simply better opportunities elsewhere? Are we witnessing the final demolition of “de-coupling” – the bull market Nirvana where emerging markets were no longer tied to the fortunes of the larger, lumbering western economies.
First, what are the realities? How far has the Indian market fallen? Is the Indian market now cheap?
As seen in the chart below, the five-year performance of the S&P BSE Sensex (green) is positive, though eclipsed by its Asian BRIC partner, China (red). This year’s decline barely even registers on the chart and hardly appears cataclysmic or even confidence-shaking. The divergence in performance this quarter is interesting, no doubt due to some institutional rebalancing away from India.

By comparison, the Indian currency is showing signs of panic – which of course makes the Indian market more attractive to the outside world. Here’s a five year view of the Indian rupee, inverted, against the USD.

Making exports more competitive?
Now the headlines in the currency markets start to make a little more sense. The INR is trading at its lowest level ever against the dollar. One hopes any BRIC fund is currency hedged.
Every economic textbook will tell you that the export sector will help reinvigorate the economy as the falling currency will make it more competitive – and Indian exports account for 24% of GDP according to the World Bank, compared with 14% for the U.S. and 31% for China. Governments on the northern Mediterranean shore will no doubt watch this healing process with envy, as their currency albatross prevents such an effect. Is it time to add some exposure to India?

The case for investment?

Let’s look at the current multiples to see whether there’s a decent investment case. From a P/E perspective, (above chart) India is trading at a reasonable 11.4 times forward earnings (F12M). However in the context of the recent market sell off, that doesn’t seem too appealing. The Asia-Pac aggregate is 10.8 – so India remains above average – and you can buy China, Hong Kong or Korea all on multiples under 9.1. Equally, India is not expensive, but not yet cheap from a Fair Value perspective.
So while the BRIC markets seem to be falling out of favor ,there certainly doesn’t seem to be a compelling story at the aggregate level for India, or indeed for much of Asia. The Chinese market seems to be the furthest along in it’s market correction from inflated levels . For the time being – it looks best to stay on the sidelines.

Homespun Wisdom from the 'Oracle of Omaha'

Although Buffett's experience managing a company with $124 billion in assets is unique, his brand of homespun wisdom can serve all investors evaluating stocks and mutual funds for their own portfolios.

On being a good investor:
"I'm a better businessman because I am an investor and a better investor because I am a businessman. If you have the mentality of both, it aids you in each field."

"I was born at the right time and place, where the ability to allocate capital really counts. I'm adapted to this society. I won the ovarian lottery. I got the ball that said, 'capital allocator -- United States.'"

"Success in investing doesn't correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing."

On identifying good companies:
"We don't do due diligence or go out kicking tires. It doesn't matter. What matters is understanding the competitive dynamics of a business. We can't be taken by a guy with a sales pitch... What really counts is the presence of a competitive advantage. You want a business with a big castle and a moat around it, and you want that moat to widen over time. Coke and Kodak both had marvelous moats 20 or 25 years ago. Kodak's has narrowed, while Coke has been building its moat. We want an economic castle."

"The best thing that happens to us is when a great company gets into temporary trouble... We want to buy them when they're on the operating table."

On the size of his stock portfolio:
"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

"The universe I can't play in [i.e., small companies] has become more attractive than the universe I can play in [that of large companies]. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in."

On selling stocks:
"I don't like to sell. We buy everything with the idea that we will hold them forever... That's the kind of shareholder I want with me in Berkshire. I've never had a target price or a target holding period on a stock. And I have enormous reluctance to sell our wholly owned businesses under almost any circumstances."

"Up until a few years ago, we sold things to buy more because I ran out of money. I had more ideas than money. Now I have more money than ideas."

On holding cash:
"Today we have $15 billion in cash. Do I like getting 5% on it? No. But I like the $15 billion, and I don't want to put it in something that's not going to give it back and then some. The nature of markets is that at times they offer extraordinary values and at other times you have to have the discipline to wait."

"If you think about it [i.e., the markets], you get these huge swings in valuations. It's the ideal business arrangement, as long as you don't go crazy. The 1970s were unbelievable. The world wasn't going to end, but businesses were being given away. Human nature has not changed. People will always behave in a manic-depressive way over time. They will offer great values to you."

On the Internet's impact on business:
"The Internet as a phenomenon is just huge. That much I understand. I just don't know how to make money at it... I don't try to profit from the Internet. But I do want to understand the damage it can do to an established business. Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it's the lack of change that appeals to me. I don't think it is going to be hurt by the Internet. That's the kind of business I like."

On Internet stock valuations:
"There will be enormous amounts of disappointment. The numbers of people buying these stocks to hold them are very few. I think 98% of them are being bought by people because they are going up. If these stocks stop going up, they'll get out... Very few of these companies will be big winners in the long run. It's the nature of capitalism not to get a lot of winners. You get a few."

"With Coke I can come up with a very rational figure for the cash it will generate in the future. But with the top 10 Internet companies, how much cash will they produce over the next 25 years? If you say you don't know, then you don't know what it is worth and you are speculating, not investing. All I know is that I don't know, and if I don't know, I don't invest."

On technology stocks:
"How do you beat Bobby Fischer? You play him at any game but chess. I try to stay in games where I have an edge, and I never will in technology investing."

"I do admire the management of Intel and Microsoft, but I don't have a fix on where they will be in 10 years. I think it is harder to get a fix on those kinds of businesses. I don't know how to value them. And if I started playing around without knowing how to value a company, I might as well buy lottery tickets."

On economics:
"I am not a macro guy. I don't think about it. If Alan Greenspan is whispering in one ear and Bob Rubin in the other, I don't care at all. I'm watching the businesses."

"I don't read economic forecasts. I don't read the funny papers."

On mergers:
"I am very skeptical of most big mergers. The assumptions made tend to be very optimistic. People want to do deals -- you start with that. There's a lot of Darwin going on in companies. And people who get to the top want action. I've been on 19 boards in my life, and I'd say the great majority of deals that I've seen were not very good deals."

On PaineWebber analyst Alice Schroeder's research showing that Berkshire Hathaway is selling at a sizable discount:

"I think she did a very thorough job. It seems to me she varied from the standard approach of securities analysts. But I don't comment on the value. I don't want anybody to come into Berkshire based on what I'm saying about the value of the stock. Our goal is to have the stock sell as close to the intrinsic value as possible, so that people come in and go out on the same basis.

On Coca-Cola (KO):
"I have a very strong feeling that Coca-Cola will dominate a much larger soft drink business 10 years from now than today. But in terms of the short run, I have no idea what will happen."

On daytraders and other speculators:
"We try to communicate in a way that turns people off who have a crazy approach to stocks. It matters as much who you repel as who you attract. If we were sizably owned by day traders, we'd have crazy valuations in no time -- and in both directions."

On past mistakes:
"My biggest lost opportunity was probably Freddie Mac. We owned a savings and loan, and that entitled us to buy 1% of Freddie Mac stock when it first came out. We should have bought 100 S&Ls and loaded up on Freddie Mac. What was I doing? I was sucking my thumb."

"The biggest cause of that kind of mistake [here, failing to buy more Citicorp in 1991], is that I stop buying when the stock starts moving up. I get so enamored of how cheap it was when I started buying that I stop. I have too often folded my tent. I believe in loading up on these things. There wasn't anyone who thought Citibank was going to disappear. And there wasn't anyone who thought it wasn't cheap at $9 a share."

"We've lost very little on errors of commission. The errors of omission are the big ones."

Knowledge does not equal behavior

" Even once we are aware of our biases, we must recognize that knowledge does not equal behavior.The solution lies in designing and adopting an investment process that is at least partially robust to behavioral decision-making errors". The advantage of the quantitative method is that it starts with the idea that most of us are temperamentally unsuited to investment, and then seeks to protect against those potential errors.If we acknowledge this flaw from the outset, we can build a process to force or trick us into exhibiting correct behaviors.Given the diversity of fields in which quantitative models outperform experts, it would be remarkable if we did not observe the phenomenon in value investment.

Have Emerging Markets Gotten Oversold-By Mark Mobius

At Templeton, we've repeatedly championed our value-driven philosophy by frequently buying at times others are most pessimistic. This is not easy to do, even for seasoned market veterans. During the past few months, emerging markets have been subject to such pessimism. These periods of short-term volatility are certainly not new to us, and don't change our long-term conviction of the potential emerging markets hold.
We feel recent declines were overdone and based largely on irrational investor panic, and have viewed the recent pullback as an opportune time to search for bargains for our portfolios. We find valuations in many emerging and frontier stocks particularly attractive right now. No doubt, emerging markets have been beaten up a bit this year. In the second quarter, the MSCI Emerging Markets Index lost 8.0% in US Dollar terms¹, and emerging markets recorded outflows of US$33 billion during the quarter; June alone accounted for US$22 billion of the flows².
This offset the US$32 billion in net inflows from the first quarter of 2013, resulting in a net outflow of about US$1 billion for the first half of the year. What happened? Indications in mid-May from US Federal Reserve Chairman Ben Bernanke about a moderation in the central bank's asset purchase program caused fixed income investors who had invested in offshore bonds, particularly in emerging markets bonds, to view the high yields they were receiving in those bonds as less attractive if US interest rates were to rise. In addition, signals from the People's Bank of China that it would not intervene in the market after a sharp spike in a key interbank lending rate in June raised concerns about the stability of the banking sector there, and further heightened investor concerns that global liquidity could dry up. A sharp, across-the-board sell-off hit emerging market debt, currencies and equities during the second quarter. Those particular emerging market countries with high current account deficits, large foreign holdings of local bonds and exposure to China were among the worst affected. Turkey, Egypt and Brazil were particularly hard hit; their respective equity markets ended the quarter with declines. In addition, periods of social unrest in these countries also heightened investor anxiety. However, as you can see in the two charts below, despite the short term outperformance of world markets, over the longer term emerging markets have outperformed, and we expect this trend to continue for reasons outlined further here.

Appealing ValuationsLike all markets, emerging markets can at times be volatile and dominated by excessive flows and sudden sentiment shifts. Many are now dubbing the BRIC countries (a handy acronym for the grouping of Brazil, Russia, India and China) down and out, but we think there has been too much negativity there. I believe that the strong prospects for growth in many emerging markets are not currently recognized in equity valuations, which generally lag those of developed world markets. We are finding attractive valuations not only in the BRICs but particularly so in the frontier markets (a subset of emerging markets), which in some cases have single-digit price-earnings (P/E) ratios and even lower price-to-book ratios. (See charts below for emerging markets overall, and specifically, China.) But no matter what major market indexes may show, as bottom-up stock pickers, we hone in on individual opportunities, and currently see many good companies that were unjustifiably swept along in the tide of negative sentiment.

 Periods of Pessimism = Best Times to Buy?It is always necessary to take hits from time to time as we maintain our long-term focus. A case-in-point is Thailand, a country with its fair share of turbulent periods. In the mid-90s, while the country was in the midst of a massive financial crisis, I eagerly hopped on a plane to Bangkok, in search of opportunities while many investors gave up on the country. Why did I feel so positive? I certainly knew that in the short-term, Thailand was in trouble. But we did our homework, and felt that in three, four, or five years’ time, the Thai people would bounce back. And they did. Of course, it wasn’t all smooth sailing. After recovering from that crisis period, further setbacks came in 2004, when a tsunami struck the country, and in 2011, when severe flooding hit. But Thailand has been adept at battling back from adversity time and time again, and in 2012, its equity market posted one of the best performances in Asia (and even the world), with the benchmark Stock Exchange of Thailand (SET) Index returning more than 35%³. You can see the merit of buying during these downturns and holding on for the potential recovery. Today, we believe there is great potential for Thailand, which we feel could be on the cusp of a growth spurt, with, of course, corrections along the way. I would not classify this recent bout of emerging market volatility a crisis of confidence as some would, but it marks a good time to again reiterate the value of a long-term perspective and emphasize that we base our analysis and projections not on this year or even next year, but generally five years out in time. Being contrarian or value-driven doesn’t mean we will necessarily buy anything we can get our hands on during a market downturn. During times of extreme stress, liquidity is important. If I have a choice between a small, illiquid stock and a large liquid one, naturally I would pick the latter. When buying stocks during a bust period, it’s important that you don’t buy corpses which have fallen in price but have unhealthy fundamentals (otherwise known as “value traps”), but rather, find patients with good recovery prospects that appear undervalued. There are a few characteristics we’ve seen in companies that often prove fatal and that we seek to avoid, including excessively high levels of debt and management who can’t cope with a difficult environment. In the case of Thailand’s big financial crisis, it was extremely important to be a good stock-picker and do your homework. By the end of 1997, out of the 480 companies trading on Thailand’s stock exchange, about 40 companies had gone belly up, and a near equal number saw trading suspended.

The Case for Emerging MarketsI believe emerging markets in general have three attractive characteristics, which haven’t changed from what I see. First, their growth rates have generally remained well in excess of those for developed markets. Overall, emerging markets are forecast to grow about five times faster than developed markets in 2013, with the IMF forecasting average GDP growth of 5.0% for emerging markets, compared to just 1.2% for developed markets⁴. Second, emerging markets generally have large and growing foreign exchange reserves, which are far greater than that of developed markets. Moreover, unlike developed markets, many emerging and frontier markets still appear to have ample room for fiscal and monetary stimulus.
Although weak growth in developed markets could be transmitted to emerging markets, notably through declines in world trade, this influence could continue to be offset in emerging markets by higher investment spending and increased domestic demand. Third, the debt level of many emerging markets in relation to their GDP is generally much lower than that of many developed markets. Additionally, all this fear and concern about the US central bank starting to “taper” its asset buying program does not necessarily mean it is going to start tightening rates anytime soon or that the money supply will suddenly dry up. We must remember that the various QE programs have been cumulative so that the liquidity pumped into the system has piled up and will not disappear overnight. It is only recently that banks have begun to grow their loans; previously they were using the liquidity supplied by the Fed to strengthen their balance sheets and were holding US Treasuries.
In addition, even if the Fed starts to pull back as the US economy improves, other central banks are still generating liquidity, which we feel could support investor flows into emerging markets. Japan has been embarking on a massive easing program, which is greater as a percentage of their GDP than the US’ program. While we worry about the long-term implications of inflation, if it can be avoided or offset by greater productivity gains, it could be a game-changer for many economies. Overall, I believe emerging markets will likely continue to offer good long-term prospects for patient investors. There are always risks, and unexpected shocks could occur. But I still believe in the comeback story.

ETFs are designed to provide investors with market exposure, nothing more, nothing less - an interview with Valerie Baudson

Investors who participated in the 2012 edition of the annual European ETF Survey, which is part of the Amundi ETF research chair on "Core-Satellite and ETF Investment," indicated that their level of satisfaction with ETFs remained high and that most of them planned to increase their usage. Has this been borne out since the survey was conducted?
 
Valérie Baudson: The growth of the European ETF market in recent years, despite particularly tough market conditions, is proof that ETFs are valuable asset allocation tools and offer solutions to meet investors’ needs in terms of transparency, cost-efficiency, diversification and liquidity.
Without doubt, one of the reasons for their success is the clearly-stated objective that ETFs seek to replicate, in a single transaction, the performance of a benchmark index as closely as possible, whether the market trend is rising or falling.
Their ease of use, combined with their adaptability to different approaches to portfolio investing, should ensure that the popularity of ETFs is here to stay.

You mentioned, at the launch of this year’s survey, that the changes in investor perception regarding risks and transparency are significant developments for the industry. What is your view of the current regulatory framework in these areas, and specifically of the ETF guidelines from the European Securities and Markets Authority (ESMA)?
 
Valérie Baudson: As transparency has been a key pillar of Amundi ETF’s development strategy, we very much welcomed this debate and the new guidelines. These have had a positive impact on steering the ETF world towards improved transparency and a better understanding among investors of the advantages and risks of ETFs.
The debate has also highlighted the importance of differentiating between ETFs and other exchange-traded products (ETNs, ETPs, ETCs) which are not subject to the same strict regulatory guidelines, leading to a more educational approach from ETF providers.
We fully agree with the guidelines issued by ESMA and, in my view, the UCITS ETFs label will ensure excellent protection for investors by clearly differentiating these authorised funds from other types of exchange traded products. Consequently, we have renamed all our 100 ETFs to include the label UCITS ETF.

Demand for innovation is high in different asset categories, with 50% of respondents seeking exposure to new asset classes through ETFs, but there is also a demand for other use such as “hedging and risk management” with ETFs. What is Amundi ETF’s view on this?
 
Valérie Baudson: We value innovation at Amundi ETF, as demonstrated by the fact that one third of our products have been “new” to Europe at their time of launch.
But we have not lost sight of the fact that transparency and liquidity remain key. We pay special attention to the “clarity” of a new product when launched, because we know that investors must be able to understand what a fund aims to do as well as the index which it is tracking.
For example, our latest innovation has been to offer “daily currency-hedged” ETFs. These “all-in-one” products offer investors exposure to American and Japanese equities, based on recognisable indices such as the S&P, NASDAQ and Topix, without the underlying currency risk. The daily readjustment reduces the impact of exchange rate volatility through the use of a currency hedge. These are innovative, yet simple funds.
When it comes to innovation, at Amundi our over-riding belief is that ETFs should remain passive, simple, transparent, and liquid.

There has been an increase in the use of fixed income ETFs (government bonds, emerging market debt, corporate bonds investment grade and high yield), Could you tell us what is Amundi ETF’s view on this segment of the market?
 
Valérie Baudson: At the end of 2012, the 302 ETFs classified as fixed income represented around 21% of the Euro 252bn of European ETF assets under management¹. Last year was a remarkable one for this segment as it accounted for more than half of ETF creation, i.e. 58 out of 102 new ETFs¹. This rapid growth is continuing in 2013 with net inflows in this segment year-to-date representing more than half of total European ETF inflows of Euro 6.8bn².
We believe that fixed income ETFs are still at a very early stage of growth, maybe similar to equity ETFs before 2007, and therefore the increased level of awareness of investors, the record inflows, the diverse range of offerings in this space, and the flexibility and ease of use of these products all point to a very promising future for this segment.

Most of the European investors who responded to the survey think that ETFs should remain beta-producing products (81% of respondents). However, 17% of them think that ETFs should become actively managed, which is an increase from just 11% in 2011. What is your view?
 
Valérie Baudson: Over the last few years, the European ETF market has seen the emergence of “Smart Beta” ETFs, either tracking “quantitative model” indices or replicating actively managed funds. These niche products have generated a lot of interest from the investment community, but their total assets under management remain small. Inflows into this category year-to-date are very limited compared to the Euro 6.8bn of inflows into the overall ETF market³. These are early days and we can probably expect this class of ETFs to continue to grow with the overall market.
At Amundi, we believe that ETFs are designed to provide investors with market exposure, nothing more, nothing less, through “allocation bricks” or tools to express their views on economic growth, interest rates, and relative value across asset classes. In other words, allowing them to make active investment decisions while we provide the passive product solutions.

1. Source DB ETF Yearly Review January 2013
2. Source Amundi ETF-Bloomberg 4 July 2013
3. Source Amundi ETF-Bloomberg 4 July 2013

About Valérie Baudson
Valérie is Managing Director of ETFs and Indexing at Amundi. She is also a Member of the Business Committee. She joined the group in 2008 to launch and develop the ETF business line.
Valérie has a strong and varied background in equity capital markets. From 2004 to 2007, she was Marketing Director and a Member of the European Management Committee of Crédit Agricole Cheuvreux, the European Stockbroking subsidiary of Crédit Agricole Group. From 2000 to 2004, she held the position of Corporate Secretary and was a Member of the Management Committee.
Valérie started her career at Banque Indosuez where she managed international audit missions from 1995 to 1999.
Valérie is a graduate from a leading French business school, HEC (Haute Ecole de Commerce, Paris), where she majored in Finance.

Smart Beta Strategies Are Suddenly in Vogue

Suddenly, it seems, many investors are talking about smart beta. Earlier this year,CFA Magazine ran a feature story on the subject, noting that “pension funds around the world have increased allocations to such strategies.” In April, the EDHEC-Risk Institute published a paper titled " Smart Beta 2.0, " drawing investor attention to the risks inherent in traditional smart beta strategies and proposing a new approach. Last month, the Economist weighed in, pointing out that — despite a terrible name — “the concept is catching on.”
The Economist noted that while only about $142 billion is currently allocated to smart beta funds, compared to more than $2 trillion invested in hedge funds, smart beta funds attracted $15 billion in inflows in the first quarter of the year, up by 45% compared to the same period a year earlier, according to State Street Global Advisors.
There is no single definition of smart beta strategies, but there is one easy way to think about them: If alpha is about outperforming the market and beta is about achieving the market return, smart beta is about improving performance by passively tracking an index that is not based on a traditional market capitalization weighting. In other words, smart beta is an enhanced form of passive investing.
Why smart beta? The case for smart beta is the case against traditional market cap weighting. When you are tracking a cap-weighted benchmark in equities, your portfolio ends up having more and more of what goes up in value and less and less of what goes down. In fixed income, the stakes are even riskier, because you could be investing more and more in the debt of the most indebted companies or countries. Tracking the market in this way does sound like “beta,” but it doesn’t sound very smart (or so the argument goes).
Why now? While there is no single reason that explains the recent rise of smart beta strategies, their growth is often attributed to rising doubts about the effectiveness of active management, the ever-increasing desire to keep a lid on investment management fees, and investors’ growing awareness of the weaknesses of market cap weighting. It is no coincidence that one of the most popular approaches to smart beta strategies involves constructing an index based on fundamental measures such as book value, dividends, sales, or cash flows.
At a recent CFA Society Of the UK event in London, Lionel Martellini, professor of finance at EDHEC Business School and a coauthor of the recent EDHEC paper, offered a comprehensive overview of smart beta strategies. Irina Khan, a member of CFA UK, has filed the following summary of Martellini’s talk.

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Summary by Irina Khan
Why smart beta? Lionel Martellini had a simple answer for attendees: According to a recent research paper titled  " An Evaluation Of Alternative Equity Indexes, " by Andrew Clare, Nick Motson, and Steve Thomas, even portfolios randomly created by monkeys perform better than cap-weighted benchmarks. The underlying reason is poor diversification in cap-weighting.
For that reason, Martellini describes smart beta strategies as new approaches that “aim at adding value in the presence of possibly efficient markets but severely inefficient cap-weighted benchmarks.” He noted that investors often think of diversification as downside protection — but, rather, it should be “about generating the highest possible reward across many market conditions, including the good ones and the bad ones.”
As Clare, Motson, and Thomas noted in their paper, “One of the reasons why the randomly weighted indices rarely produce a set of weights similar to the market-cap index is that there is only a very small prospect of any stock having a weight as high as, for example, 10.0%.”
Martellini noted that a number of indices that do not use cap-weighting are available, such as those provided by MSCI, S&P, FTSE, Russell, and Stoxx. These indices use both non-optimization-based schemes, such as equal weighting, fundamentally weighting, and diversity weighting, as well as optimization-based schemes, such as minimum variance, maximum decorrelation, and risk-parity.
Martellini cautioned that such smart beta indices do not outperform all the time. He explained that although most smart beta strategies have strong probability to outperform poorly diversified cap-weighted indices over the long run, they can in some market conditions underperform for a considerable time. To prove his point, he shared a few “scary numbers” pertaining to the relative risk of various alternative beta strategies showing a maximum relative drawdown of 13.72% and a time under water of 453 days.
(If you tell your clients that monkeys can outperform cap-weighted benchmarks, and then your smart beta portfolio underperforms the cap-weighted benchmark for more than a year, “maybe things are going to get ugly,” Martellini joked.)
Moving from what he called smart beta 1.0 to smart beta 2.0, the EDHEC professor emphasized that “it is of critical importance to better understand the sources of outperformance and the associated risks, so as to assess the robustness of outperformance.” The smart beta 2.0 approach, he said, allows investors to “enjoy the benefits from smart beta investing while controlling the risks of their investments.” He outlined three main ingredients of this newer approach: measuring and managing systematic risks, specific risks, and tracking error, or ex ante control of deviations with respect to a cap-weighted reference index.
With regard to systematic risk, Martellini said that smart indices have factor bias, liquidity bias, style bias, and sector bias, all of which can result in a lower beta than a market-cap-weighted index. However, he believes these biases can be measured and managed — and smart beta methodologies can be customized to still achieve good diversification. For instance, a small-cap bias can be made to disappear if an investor performs minimum-variance optimization based on the largest cap stocks. Martellini suggested that whenever investors pursue a smart beta, they are in fact investing in a bundle of methodological choices that at times are unclear. He advised investors to make their approach and choices explicit, and use them only if they feel comfortable.
Although investors are familiar with managing tracking error, the specific risks of smart beta strategies are “a more complex problem,” Martellini contended, for a simple reason: there is a large amount. “Smart beta weights deviate from market-cap weights so as to generate more attractive risk-adjusted performance; the risk is to fail the objective, because of the use of a suboptimal scheme, and/or because of the use of the wrong parameter estimates,” he explained. Martellini decomposed total specific risk into estimation risk and optimality risk — and further broke down estimation risk into parameter sample risk and parameter model risk. He said the natural approach to managing specific risks is not through hedging but rather through diversification. “In the presence of all this specific risk, investing in more than one smart beta can make sense,” he argued. More specifically, if different portfolio construction schemes involve different types of uncertainty, Martellini suggested that asset managers should be able to add value by packaging and putting together all the smart beta in a more meaningful way in order to diversify away specific risks.

A Top-Down Approach To Investing

An area that most investors struggle with is the art of picking stocks. Should they base their decisions solely on what the company does and how well it does it? Or should investors be more concerned about larger macroeconomic trends, such as the strength of the economy, and then determine which stocks to buy? There is no right or wrong answer to these two questions. However, investors should develop systems that help them to achieve their investment goals. The second option mentioned is referred to as the top-down investing approach to the market. This method allows investors to analyze the market from the big picture all the way down to individual stocks. This differs from the bottom-up approach, which begins with individual stocks' fundamentals and eventually expands to include the global economy. This article will concentrate on the process used when investors implement the macro-to-micro style referred to as the top-down approach.


Start at the Top: The Global View
Because the top-down approach begins at the top, the first step is to determine the health of the world economy. This is done by analyzing not only the developed countries of North America and Western Europe, but also emerging countries in Latin America and Asia. A quick way to determine the health of an economy is to look at the amount of gross domestic product (GDP) growth of the past few years and the estimates going forward. Oftentimes, it is the emerging market countries that will have the best growth numbers when compared with their mature counterparts.

Unfortunately, because we live at a time in which war and geopolitical tensions are heightened, we must not forget to be mindful of what is currently affecting each region of the world. There will be a few regions and countries throughout the world that will fall off the radar immediately and will no longer be included in the remainder of the analysis simply due to the amount of financial instability that could wreak havoc on any investments.


Analyze the Trends


After determining which regions present a high reward-to-risk ratio, the next step is to use charts and technical analysis. By looking at a long-term chart of the specific countries' stock index, we can determine whether the corresponding stock market is in an uptrend and is worth taking further time to do some analysis on or is in a downtrend, which would not be an appropriate place to put our money at this time. These first two steps can help you discover the countries that would match your wants and needs for diversification.  

Look to the Economy
The third step is to do a more in-depth analysis of the U.S. economy along with the health of the stock market in particular. By examining the economic numbers such as interest rates, inflation and employment, we are able to determine the current strength of the market and have a better idea of what the future holds. There is often a divergence between the story the economic numbers tell and the trend of the stock market indexes.

The final step in macroanalysis would be to analyze the major U.S. stock indexes such as the S&P 500 and Nasdaq. Both fundamental and technical analysis can be used as barometers to determine the health of the indexes. The fundamentals of the market can be determined by such ratios as price-to-earnings,price-to-sales and dividend yields. By comparing the numbers to past readings, it can help determine whether the market is at a level that is historically overbought or oversold. Technical analysis will help ascertain where the market is in relation to the long-term cycle. Use charts that show the past several decades and zone down the time horizon to a daily view. For example, indicators such as the 50-day and 200-day moving averages are used to help us find the current trend of the market and whether it is appropriate for investors to be invested heavily in equities.

So far, our process has taken a macro approach to the market and has helped us determine our asset allocation If, after the first few steps, we find that the results are bullish, there is a good chance a majority of the investment-worthy assets will be from the equities market. On the other hand, if the outlook is bleak, the allocation will shift its focus from equities to more conservative investments such as fixed income and money markets.

Microanalysis: Is This Investment Right for You?

Deciding on an asset allocation is only half the battle. The next integral step will help investors determine which sectors to focus on when searching for specific investments such as stocks and exchange traded funds (ETFs). Analyzing the pros and cons of specific sectors (ex. health care, technology and mining) will narrow the search even further. The process of analyzing the sectors involves tactics used in the prior approach such as fundamental and technical analysis. In addition to the mentioned tools, investors also must consider the long-term prospects of the specific sectors. For example, the emergence of an aging baby boom generation over the next decade could serve as a major catalyst for sectors such as healthcare and leisure. Conversely, the increasing demand for energy coupled with higher prices is another long-term theme that could benefit the alternative energy and oil and gas sectors. After the entire amount of information is processed, a number of sectors should rise to the top and offer investors the best opportunities.

The emergence of ETFs and sector-specific mutual funds has allowed the top-down approach to end at this level in certain situations. If an investor decides the biotech sector is an area that must be represented in the portfolio, he or she has the option of buying an ETF or mutual fund that is composed of a basket of biotech stocks. Instead of moving to the next step in the process and taking on the risk of an individual stock, the investor may choose to invest in the entire sector with an ETF or mutual fund.

However, if an investor feels the added risk of selecting and buying an individual stock is worth the extra reward, there is an additional step in the process. This final phase of the top-down approach can often be the most intensive because it involves analysis of individual stocks from a number of perspectives.

Fundamental analysis includes a variety of measurements such as price/earnings to growth ratio,return on equity, and dividend yield, to name a few. An important aspect of individual stock analysis will be the growth potential of the company over the next few years. Ideally, investors want to own a stock with a high growth potential because it will be more likely to lead to a high stock price.

Technical analysis will concentrate on the long-term weekly charts, as well as daily charts, for an entry price. At this point in time, the individual stocks are chosen and the buying process begins.

The Positives of Top-Down
The proponents of the top-down approach argue the system can help investors determine an ideal asset allocation for a portfolio in any type of market environment. Oftentimes a top-down approach will uncover a situation that may not be appropriate for large investments into equities. The ability to keep investors from over-investing in equities during a bear market is the biggest pro for the system. When a market is in a downtrend, the probability of picking winning investments drops dramatically even if the stock meets all the required conditions. When using the bottom-up system, an investor will determine which stocks to buy before taking into consideration the state of the market. This type of approach can lead to investors being overly exposed to equities and the portfolio will likely suffer. Other benefits to the top-down approach include the diversification among not only top sectors, but also the leading foreign markets. This results in a portfolio that is diversified within the top investment worthy sectors and regions. This type of investing is referred to in some small circles as "conversification", a mixture between concentration and diversification.

The Not-So-Positives of Top-Down Investing
So far, the top-down approach may sound foolproof; however, there are a few factors investors must consider. First and foremost, there is the possibility that your research will be incorrect, causing you to miss out on an opportunity. For example, if the top-down approach indicates that the market is set to continue lower in the near future, it may result in a lesser exposure to equities. However, if your analysis is wrong and the market rallies, the portfolio will be underexposed to the market and will miss out on the rally gains. Then there's the problem of being under-invested in a bull market, which can prove to be costly over the long term. Another downfall to the system occurs when sectors are eliminated from the analysis. As a result, all stocks in the sector are not included as possible investments. Oftentimes there will be a leader in the sector that is overlooked due to this process and will never make its way into the portfolio. Finally, investors could miss out on "bargain" stocks when the market is near lows.

Find What You've Been Looking For
In the end, investors must remember there is no single approach to investing and that every approach has its own pros and cons. One of the keys to becoming a successful long-term investor is finding a system that best fits your goals and objectives. Maybe the top-down approach is just what you've been looking for!