Ten Percent of Nothing

Rock'em Sock'em Robots was a big game when I was a kid. Fast forward over half a century later, the robots are still battling, but this time it's in the inner workings of the stock market exchanges. There's a lot of finger pointing going on about what caused the S&P 500 to correct more than 10% in just a couple of days two weeks ago. With a significant selloff of 4.1% on February 5th that precipitated in minutes, many investors are up in arms because the algos went wild. Although the market had a nice bounce back last week, you can understand why so many are angry.

The main culprit being singled out for the collapse is the Credit Suisse issued VelocityShares Daily Inverse VIX Short-Term ETN (XIV). This is an Exchange Traded Note, not an Exchange Traded Fund. A financially engineered instrument. After much fanfare for over a year, it lost the majority of its value in hours causing great wealth destruction not only for its owners, but market participants globally. In examining the disruptive market tendencies of XIV, we have to go back to high school physics to Newton's First Law:

"Every object will remain at rest or in uniform motion in a straight line unless compelled to change its state by the action of an external force."

With Quant Hedge Funds programming investor sentiment and momentum into their algorithms, investment managers made fortunes as the S&P 500 went up in a straight line with low volatility for almost 15 months. Then that low volatility spiked. The external force occurred in the form of the liquidation of XIV as traders jettisoned the ETN. According to Jim Collins in Forbes:

"While some news outlets are describing XIV as an "obscure" security, the market value of XIV was nearly $2 billion last week, so it is clearly a meaningful name to professional traders...XIV holds no assets; the value of the notes is determined by an underlying index that represents the inverse of futures linked to the VIX volatility index...In two trading days XIV went from hedge fund darling to effectively a defunct security."

XIV lost 80% of its value in one day.

The liquidation of XIV caused an industrial strength chain reaction in the entire global marketplace because of that same foil in The Crash of 1929 - margin calls. In a Washington Post article, Steven Pearlstein gives a succinct explanation concerning the circular trading logic and the margin calls that ensued:

"It apparently created a vicious cycle in which selling begat more selling and wound up wiping out nearly $3 billion in valuation for investors...the amount of trading done with borrowed money is higher than it has ever been...major central banks that allow hedge funds to borrow $4 or $5 for every one of their own they put at risk. When prices start to fall rapidly, the funds are forced to sell their positions to pay back the banks and brokerage houses, driving down the price even further."

Although there is some discrepancy between the two preceding quotes as to how much money investors lost in XIV to the tune of a billion dollars, you can clearly ascertain that a significant amount of assets eroded. To paraphrase an old Wall Street idiom: "A billion here, a billion there, pretty soon, you're talking real money.".

Even though I don't condone or engage in financial engineering, especially after the Great Recession of 2008-2009, I'd like to point a few things out concerning the recent market drop.:

• The market was way over its skis, gaining close to 7.5% since New Year's and in need of a long overdue correction. Ten percent corrections happen annually on a historic basis, and we hadn't had one since early 2016. Additionally, we've had a reduced amount of both 5% and 10% pullbacks since the market bottom in March 2009. Investors got used the the gravy train.
• Things aren't what they used to be. In the recent movie "All the Money in the World", Christopher Plummer playing Jean Paul Getty circa 1973, continuously checks stock quotes via a Ticker Tape Machine. That world is dead and buried. Laymen now get split second access to stock quotes on smartphones from globally connected financial exchanges. In fact, not only did the recent correction effect the domestic markets, but the international markets sold off 10% in concert.
• In the Stock Market Crash of 1929, the DOW fell 20% in two days in an analogue world. Traders were exchanging buy and sell orders manually on pieces of paper, not via bits and bytes through mainframes and servers. Fiscally painful corrections happen, sometimes without the threat of recession during bull markets.

Double Digit S&P 500 Losses With No Recession

YEAR	LOSS
1939-40	(31.9%)
1941	(34.5%)
1943	(13.1%)
1947	(14.7%)
1961-62	(26.4%)
1966	(22.2%)
1967-68	(10.1%)
1971	(13.9%)
1978	(13.6%)
1983-84	(14.4%)
1987	(33.5%)
1998	(19.3%)
2002	(14.7%)
2010	(16%)
2011	(19.4%)
2015	(12.4%)

(source: A Wealth of Common Sense)

If you examine the chart, you can see that some of these double digit corrections occurred during boom times. The one most investors may relate to because it's the most recent excluding the current advance, is the run the S&P 500 had from approximately 1974-2000. I would be remiss if I didn't mention the Crash of 1987 transpired in the middle of the run, but it's included in the chart above. Three other non-recessionary selloffs happened during this period - 1978, 1983-84, and 1998. Those were good times for investors, and these are, too.

You need catalysts to keep the economic engine running and we've got many of them now - artificial intelligence, 5G, and, blockchain just to name a few. Even with interest rates rising, this market has room to run. As I have mentioned before, the hashtag is ten years old, Best Buy will discontinue selling compact discs and The Village Voice no longer has a print edition. We're not quite in Fahrenheit 451 territory, but times have changed. The market should reflect that in an era of rapid technological advancement although there will be bumps along the way.

Conclusion

Credit Suisse is closing VelocityShares Daily Inverse VIX Short-Term ETN. By next month, it will be a footnote in the annals of Wall Street. However, financially engineered instruments are like the city bus - there's always another one coming around the corner. They will make hedge funds and investment bankers a lot of money, but Main Street investors will be left holding the bag. Avoid them. That said, you can't avoid computerized stock exchanges. They're here to stay, so use diversified S&P 500 and Total Market index funds. You will lose principal during market selloffs, but historically you gain close to 10% annually if you reinvest your dividends.

Paranoid Android: Artificial Intelligence in your Portfolio

In the 2014 Sci-Fi mystery movie "Ex Machina", Stanley Kubrick's film"A.I.Artificial Intelligence", and the HBO television series "Westworld", humans are having sex with robots. Although we haven't quite reached that juncture in evolution, the proliferation of Artificial Intelligence is everywhere including your stock portfolio. It's so pervasive now that saying you have A.I. in your investments is like saying you've got corn in your Cornflakes. Digirarti guru Mark Cuban believes technological advancement in the next ten years will be swifter than the last thirty years with A.I. being one of the main catalysts.

(click to enlarge)

Since late 2017, financial Websites have been inundated with articles about Artificial Intelligence pureplays, suggesting single stock selections to goose your investment portfolios. Although you will occasionally find a semiconductor equity such as Nvidia (NVDA) included, business writers primarily suggest the FANG stocks. FANG is an acronym CNBC's Jim Cramer coined in the past two years that stands for Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google (GOOG) (now known at Alphabet). The term recently morphed into FAAANG to include Apple (AAPL) and Alibaba (BABA). With the exception of Apple, all are Internet stocks.

I've written ad nauseam about my personal preference of investing in plain vanilla S&P 500 or Total Market index ETFs, but sector ETFs are an option for investors wanting to generate alpha in their portfolios. Even with elevated expense ratios, these niche ETFs can boost your overall returns if, and only if, you catch them at the right time. They primarily come in two flavors, passively managed Internet ETFs issued by mid tier ETF companies and A.I. specific funds from boutique financial firms.

Internet ETFs

Liquidity and longevity are two critical ingredients when selecting subsector ETFs. In the Internet space, First Trust Dow Jones Internet Index Fund (FDN) and PowerShares NASDAQ Internet Portfolio (PNQI) are the two largest with track records going back at least a decade. In fact, since the market crash of 2008-2009, they are two of the best performing ETFs in the financial universe. Domestically focused FDN is the preferred investment vehicle for traders because of its liquidity, but PNQI has performed equally as well with an international leaning. FDN has 9 times the daily volume as PNQI. Expense ratios for both are steep, 0.54% for FDN and 0.60% for PNQI.

Nevertheless, with market-cap-weighted holdings greatly exposed to the FANG stocks, both ETFs have kicked in the afterburners where performance is concerned. Average gains are roughly 23% per year the past five years outpacing the S&P 500. Besides the liquidity, the big difference between the two funds are geographic allocation and number of holdings. PNQI includes overseas equities with a significant exposure to Chinese Internet companies with the exception of Alibaba. The exclusion of Alibaba continues to perplex me, but organizations like Baidu (BIDU) and JD.com (JD) are under its umbrella. Another heavy hitter in the fold is British travel company Priceline Group (PCLN). PNQI holds 88 securities, over double the amount as FDN.

A.I. ETFs

• Global X Robotics & Artificial Intelligence ETF (BOTZ): News travels fast in the financial world. BOTZ had its inception date on 9/12/16, and in a short period of time, it became one of the best non-leveraged ETFs of 2017 gaining 49%. Some of this performance may have to do with an overweight position in Nvidia which constitutes almost 10% of holdings. With only 28 stocks, it's a concentrated portfolio, but that hasn't stopped speculators from bidding it up. Like all of these specialty ETFs, the expense ratio is high, 0.68%. No FANG stocks in its top 10 holdings, so you're getting more of a robotics story here.
• ROBO Global Robotics and Automation Index ETF (ROBO): ROBO has been trading three years longer than BOTZ, but has a much higher expense ratio of 0.95%. You expect some alpha generation with those fees, and although it gained 36% last year, it pales compared to the performance of BOTZ. ROBO holds 89 equities which gives you some global diversification. Like its brother BOTZ, there is not a lot of liquidity with this fund, so you are best suited to use limit orders. The top holding only constitutes 2% of the portfolio.
• ARK Industrial Innovation ETF (ARKQ): ARKQ is another high flyer from 2017 gaining approximately 45%. It's also another low volume, lofty expense ratio ETF charging 0.75% annually. International in scope and actively managed, I found it interesting that Tesla (TSLA) comprised almost 10% of the portfolio of 43 equities. Inception date was 9/30/14, so it's got some history behind it, but don't confuse brains with a bull market. There are thousands of ETFs issued worldwide and any significant downturn in the market could put any of these thematic ETFs in jeopardy.

Conclusion

An oligopoly has formed in the A.I. arena. The same Internet companies we've come to depend on for our everyday technology needs devour smaller startups. The Google and Amazon of 15 years ago are no longer mom and pop shops. They are the IBM and AT&T of the 1950's, if not the Standard Oil of New Jersey in 1900. The Gilded Age redux. That is why if I were to purchase an Artificial Intelligence ETF, I would select either PNQI or FDN with heavier leanings toward the Internet. Unless the European Union or the United States Government breaks them up, there is plenty of room to run.

FDN receives my most favored nation status only because of its relatively high volume. In an up-to-the-second connected world, PNQI, BOTZ, ROBO and ARKQ may frustrate investors or traders with quotes delayed as much as 5-10 minutes. Sometimes as much as a half an hour. That is why I can't stress enough the importance of using limit orders. Although your broker can probably provide you with CFRA reports powered by S&P Global on these smaller exchange traded funds, I find ETF.com is the best source for statistical analytics. It's free. Just go to their Website and register.

I Was Born at Night, But Not Last Night

Last week while surfing Seeking Alpha, I came across Bill Ackman's Pershing Square London Investor Meeting slide deck. What caught my attention wasn't the securities the renown hedge fund was buying or shorting, but the recent performance history of the company as compared the the S&P 500.

Year	Pershing Square	S&P 500
2013	9.6%	32.4%
2014	40.4%	13.7%
2015	(20.5%)	1.4%
2016	(13.5%)	11.9%
2017	(4.0%)	21.8%

Although Pershing Square trounced the S&P 500 by approximately 27% in 2014, the remaining years aren't even close with the S&P 500 shellacking the hedge fund. In fact, while 2013 and 2014 are a wash if you compare the index to Pershing Square, 2015-2017 shows the S&P 500 gaining roughly 35% compared to Bill Ackman's investments losing 38%. It's a 73% difference in performance for those three years. Small sample size? Yes, but we're in a bull market and these are the times when investors make money.

I don't mean to single Pershing Square out, but Bill Ackman puts himself in this position by making frequent television appearances on high profile business networks such as CNBC. His dust up with activist investor Carl Icahn on CNBC's Fast Money over Herbalife (HLF) was all the rage in the business press over a year ago. Mr. Icahn was buying shares of Herbalife while Mr. Ackman took a significant short position, calling the company a pyramid-scheme. The big story here wasn't the overall success or failures of their portfolios, but the pissing match they created on national television.

In a recent CNBC Fast Money segment, money manager Mario Gabelli of GAMCO Investors, defended Bill Ackman's poor performance stating that Ackman's company would be back after a rough patch. Gabelli also stated his own firm has 600 securities under management. That's closet indexing. Being the highest paid money manager on Wall Street, he has a vested interest to promote active management. These guys are thick as thieves.

In reality, when you're dealing with investments, the bottom line should always be performance. The majority of hedge funds have underperformed the market the past decade. Icahn Enterprises (IEP) may be an outlier only because it gained a whopping 154.83% in 2013. However, for the most part, the returns have been lackluster to negative for the past decade. If you put your money in Icahn Enterprises beginning in 2014, you're behind the eightball. According to multiple reports, hedge funds in total gained 8.5% in 2017 as opposed to 21.8% for the S&P 500, and that was the best performance year since 2013.

Anecdotally, in 2007 Warren Buffett bet one million dollars with asset managers Protégé Partners LLC that over a 10 year period, an index fund would outperform a basket of hedge funds, otherwise known as a fund of funds. Over the decade, the S&P 500 returned 7.1% compounded annually while Protégé Partners selections averaged 2.2%. Protégé Partners ponied up. Although the wager was for charity, you get my point. Mr. Buffett has long promoted the use of index funds for individual investors. In his 2013 annual Letter to Shareholders, he stated that he would allocate 90% of his fortune bestowed to his wife in S&P 500 index investments. That's a big time endorsement.

I expect more from the high costs associated with these well heeled money managers. Hedge Fund Research reports the average hedge fund management fee is 1.45% of assets. Pershing Square charges clients 1.5%. I'd rather be in an S&P 500 index fund such as the iShares Core S&P 500 ETF (IVV) which charges 0.04%. That's $4 for every $10,000 invested. SPDR S&P 500 ETF Trust (SPY) has an expense ratio 5 basis points higher than the lowest priced S&P 500 index trackers, but you're paying for liquidity and it's still much less expensive than an actively managed fund.

With the expense wars heating up between ETF providers, you can find ETFs with smaller expense ratios than iShares Core S&P 500 ETF. The SPDR Portfolio Total Market ETF (SPTM), which includes over 3,000 domestic equities, has an expense ratio of 0.03%. Many sources in the business press have reported about the ongoing ETF expense ratio reductions. Some are speculating that some index funds holding fees will drop to zero within the next few years to enable management firms such as Vanguard, Blackrock and State Street Global Investors to commandeer your assets.

Standing in the Shadows of Love

Damon Runyon once said: "The race is not always to the swift, nor the battle to the strong, but that's the way to bet.". That pearl of wisdom may have been true in an era before the proliferation of high frequency trading and computer algorithms, but now that we are in the age of artificial intelligence, the turtle, not the hare appears to be the smarter way to wager - at least in the long run. Don't take my word for it, just examine the statistics. Sabermetrics is not only confined to baseball. Big Data in the investing industry is current and prevalent. There are many excellent books up-to-date and available that prove this thesis.

In the mid 1970's, Charles Ellis wrote a research paper that later morphed into his pioneering passive investing book "Winning the Loser's Game". I read it years ago and recommend the most recent edition as a starting point. However, during the past six months there are two books I've read that are fresher in my memory. The first is "The Incredible Shrinking Alpha" by Larry Swedroe and Larry Berkin. It's like a pamphlet, but well worth the price of admission. The second is the 10th anniversary edition on John Bogle's "The Little Book of Common Sense Investing". If you are new to investing, they are eye openers.

Although the debate over active vs. passive investing rages on, it's passive indexing that trounces active managers once you remove fees and expenses from the equation. That is the overarching theme in the three books I have just recommended. This is especially true in a computerized stock market. Trust me, you're not faster than a bot. "Everyone is entitled to his own opinion, but not his own facts.". That old political chestnut by Daniel P. Moynihan was prescient in a time before being inundated by artificial intelligence from Google, Facebook, Amazon and Apple. Ego has no amigo in the investing world. Just follow the facts.