This month, I’ll share some thoughts on a topic that has popped up in recent client meetings: exchange-traded funds (ETFs). As I write this in mid-February, ETFs are back in the headlines, thanks to a spectacular blow-up in one of the more exotic niches of this product universe. Short volatility ETFs – funds that allow their holders to bet against market volatility – saw much of their market value go poof when long-dormant stock market volatility resurfaced with a vengeance.
The ProShares Short VIX Short-Term Futures ETF (ticker: SVXY) is one of the poster children for this group of products. SVXY delivered massive returns to shareholders in both 2016 (+80%) and 2017 (+181%), as stock market volatility took an unusually extended sabbatical. Stories of instant multimillionaires, like 40-year-old Seth Golden, a Target employee who left his job to trade such products, attracted a herd of volatility-selling wannabes. By the turn of the year, billions of dollars had flowed into these products. And it wasn’t only individual day traders who were in on the party. Institutional investors, like those running money for Harvard’s endowment fund and the Employees’ Retirement System of the State of Hawaii, were making bets on the continuation of a low market volatility world, too. Golden, interviewed last summer by the New York Times, acknowledged the boom: “Yes, it is a crowded trade, but I don’t worry about crowds – I just worry what the next existential shock might be.”
Well, the existential shock for the short volatility ETF crowd came in the form of a monthly employment report that surprised markets. Wage gains beat expectations, and financial markets reacted negatively. The possibility for higher inflation sent interest rates higher, and that caused a severe case of heartburn for stocks that had just staged a surge in January. As stocks were dumped, volatility spiked and those who were betting against volatility with these specialty ETFs got spanked. Graphically, the carnage for SVXY looked like the chart below.
Volatility-related funds like SVXY are just one of many exotic offspring spawned from a much-plainer-vanilla ETF that celebrated its 25th birthday this month: the SPDR S&P 500 Trust (ticker: SPY). SPY was invented to give professional traders a tool to buy and sell the entire S&P 500 with a single publicly traded share. Unlike passively managed mutual funds, which also serve this function but can only be bought and sold at the end of each trading day, ETFs offer their holders the flexibility of intraday trading. This flexibility, as well as the comparatively low fees charged for these products, has attracted hordes of professional and everyday investors alike.
The chart below shows how massive the embrace of ETFs has been over the last two decades. Worldwide, the number of ETFs has ballooned to more than 7,200, with combined assets now greater than $4.8 trillion. And, unlike the relatively straightforward SPY (whose primary risk is simply that of the underlying U.S. stock market that it invests in), many of the latest, greatest ETFs are incredibly complex and can present significant additional risks to their holders. Some of these risks are: financial leverage (borrowing), unusual taxation, hidden costs, poor trading liquidity of their underlying holdings, and tracking challenges (issues related to how accurately the ETF tracks its underlying index over time).
“So, Zach,” you ask, “what does this have to do with FIM Group and my portfolio? I thought you invested in individual stocks and bonds. Do you use these ETFs or even spend time thinking about them while managing my money?”
Yes, we do use ETFs (though in limited applications), and yes, these products have, over the years, become a more frequent discussion topic with our team. Before diving in a bit further on FIM’s interaction with ETFs, allow me to quickly make a distinction between ETFs and CEFs (hang with me on the alphabet soup). CEFs (closed-end funds) are funds that also trade on an exchange and are more likely to be found in FIM Group-managed portfolios.
Like ETFs, CEFs trade throughout the day. As mentioned, this gives us the flexibility that traditional mutual funds do not. Rather than be forced to buy or sell at an unknown, end-of-day price, we can target specific prices with CEFs and trade them on our own terms. Unlike most ETFs, however, which are generally designed to track a given index, CEFs are actively managed by professional teams. This aligns with our overall belief system that the quality of what we own and the price we pay has a significant influence on long-term investment outcomes.
The other big difference between CEFs and ETFs is that the former do not have a formal creation/redemption mechanism to keep the price of the trading in a tight range relative to the price of its underlying holdings. In contrast, with ETFs, like the above-mentioned S&P 500 stock index tracker SPY, large, authorized market participants can exchange baskets of S&P 500 stocks for new shares of SPY or, conversely, can bring shares of SPY in exchange for the same basket of stocks. Because there is essentially risk-free money to be made by these participants if the price of SPY deviates too much from the price of the S&P 500 stock basket, such deviations are usually very small. With no such mechanism, the share price of CEFs can swing far above (premium) or below (discount) the value of their holdings. We like to buy when CEF discounts become unusually high and then patiently wait for these discounts to “normalize.” If we do this successfully, we can pick up an extra return element not available in individual stocks, bonds, or ETFs.
With that detour out of the way, let’s get back to FIM Group’s limited use of ETFs as a tool in our portfolio management toolbox. Although many of the ETFs available today contain risks that we simply can’t get comfortable with, there are times when some of the plain-vanilla ETFs make sense. The most typical ETF applications you’ll find in our managed portfolios are U.S. Government bond ETFs. These products allow us to cost effectively buy a basket of U.S. Treasury bonds when needed to meet a specific portfolio objective. In today’s low interest rate environment, we generally use such ETFs as a parking spot for cash as we await better opportunities in stocks or corporate bonds. The U.S. Government bond ETFs we use do not employ leverage, have extremely liquid underlying assets, and present no credit risk. In other words, they sit on the opposite side of the risk spectrum relative to short volatility ETFs like SVXY.
Although our strategies today make sparing use of ETFs, we routinely monitor “innovation” trends in “ETF Land.” Doing so helps us identify areas where investor enthusiasm might be getting ahead of itself. Our experience has shown that Wall Street’s launch of slick new sector-specific ETFs often signals a peak in investor demand for a given area – and trouble for go-forward returns, if that indeed proves to be the case.
Remember back in 2010 when rare-earth metals were all the rage? Prices were skyrocketing on fears that China had supplies cornered for these materials used in smartphones, solar panels, and hybrid vehicles, among other things, and investors were eager to speculate on the mining companies producing them. Enter the Market Vectors Rare Earth/Strategic Metals ETF (ticker: REMX), which offered one-click exposure to the entire hot sector. Launching late in 2010, this ETF debuted in time to ride the rare-earth wave for just a few months before companies began to find alternative sources for these metals. The chart below shows what happened next as rare-earth-metals mania faded and latecomers to the party were left searching for the punchbowl.
Fast-forward to 2018, and what are some of the more unique ETFs vying for investor dollars today? I’ll give you two tickers and let you guess: MJ and BLOK. The ETFMG Alternative Harvest ETF (MJ) is a product that launched on December 26, 2017. Its purpose: “to track companies likely to benefit from the increasing global acceptance of various uses of the cannabis plant.” Meanwhile, the Amplify Transformational Data Sharing ETF (BLOK) hit the exchanges on January 17 of this year. With this one, investors are provided “access to an actively managed basket of global companies at the forefront of blockchain- based technology.” Will these new ETFs be the death knell for pot stocks and the cryptocurrency stock boom? Maybe, maybe not – but anytime Wall Street launches products like these, red flags should go up that a peak may be near.
Beyond monitoring Wall Street’s ETF product launches for signals of sector or investment theme overexuberance, our team also considers the structural risks that ETF proliferation potentially creates for markets. After all, it’s one thing if those speculating against volatility get blown up or those punting on rare-earth-minerals mania get burned. But what about the broader impacts that ETFs may be having on financial market structure and behavior? Some have blamed ETFs for high levels of valuation in stock markets today, as well as for the “flash crashes” that stock markets have endured over the last decade (including the August 24, 2015, episode when volatility spiked and nearly 1,300 trading halts were triggered). Others insist that there is no direct connection to valuation or market fragility and that concerns on this front are overblown.
I expect that this debate will be with us for years to come, but I believe that the prudent course is to prepare for the possibility that the mountain of money moving into “cheap” and “one-stop” ETFs is distorting markets in unknown ways that will only be revealed in future periods of market stress. The good news is that our team really doesn’t need to change the approach we take when considering this ETF proliferation wildcard. Our approach, which emphasizes quality and price in every investment decision (buy, hold, or sell), thoughtful diversification, and not being afraid to hold dry powder as necessary, should continue to serve us well regardless of the path the ETF boom takes.
In closing, let me reiterate that ETFs come in many varieties. Each carries with it a unique risk profile that should be fully understood before making any investment. Some, like the plain-vanilla baskets of U.S. Treasury bonds that we utilize, can be cost-effective alternatives to buying the underlying investments directly. But others, especially those that hold illiquid assets or employ large amounts of leverage, should generally be avoided. With stalwarts like the 25-year-old SPY well-established, I would expect that most of the ETF “innovations” coming out of the Wall Street product machine from here on will be trend-chasing in nature. For value-focused investors, monitoring these new products can still be useful as a barometer of which market sectors or themes might be peaking. With that in mind, I’ll let you decide what, if anything, the ETF Industry Exposure and Financial Services ETF (ticker: TETF), which debuted less than a year ago, means for those banking on a further run for the ETF boom.
In the 100 years since the charitable deduction was first established, U.S. residents have been some of the world’s most generous donors to charity. Our total charitable giving in 2016 was estimated at $390 billion.* One of the provisions included in the recent Tax Cuts and Jobs Act was the doubling of the standard deduction limits for individuals to $12,000 and joint filers to $24,000. This has caused a lot of concern from charitable organizations that donations are likely to suffer, based on most individuals’ moving from itemized deductions, including charitable ones, to the standard deduction. Their hope is that philanthropic-oriented individuals will continue to be mission driven with their charitable goals and not get sidetracked by the potential impact on the deductions. Here we outline a few planning options that might preserve some of the tax benefits of future charitable giving.
The Tax Cuts and Jobs Act extended the ability for individuals over 70½ and subject to Required Minimum Distributions (RMDs) to make Qualified Charitable Distributions (QCDs). Until now, many people who have taken taxable distributions from IRAs also have claimed itemized charitable contribution deductions, which offset the taxable income. Going forward, and taking into consideration the higher standard deduction, the tax benefit from taking the charity deduction is reduced, so in these circumstances you will be better off making gifts to charity by using QCDs. Because QCDs are not included in income, the tax result of a QCD is a 100% reduction of the taxable distribution. To qualify for a QCD, you must be over 70½ and the QCD must be made directly to a charity from the IRA, can be as high as $100,000, and can be used to satisfy your required minimum distribution requirements. One caveat for the QCDs is that you will need to get an acknowledgment from the charity and provide it to your CPA at tax time so that the distribution is properly accounted for.
Another planning option is to bunch itemized deductions, such as bunching charitable donations in alternate years to get your overall itemized deductions above the standard deduction thresholds for every other year, and then rely on the standard deduction in the alternate years. This option will be unique to each client’s situation and can be advantageous when your overall itemized deductions come close to the standard deductions.
For clients with significant charitable intentions, the use of a donor-advised fund is a great tax planning option that allows you to make a sizable charitable gift in one year and make disbursements to charities over time. Contributions to donor-advised funds are deductible in the year they are made and, depending on the amount, can result in surpassing the standard deduction thresholds when combined with other itemized deductions. As an example, Charles Schwab offers the Schwab Charitable Donor Advised Fund, which requires an initial contribution of $5,000 and provides for minimum grants to charity of $50. Another tax benefit is that the contribution can be accomplished with highly appreciated assets, in effect gifting the appreciation to the fund versus incurring tax associated with selling the asset and then gifting the proceeds.
Other charitable funding strategies are available, such as the use of Charitable Remainder Trusts (CRTs) to dispose of highly appreciated property in a tax-efficient manner while funding a charity or charities with a sizable donation in a single year. This is a more complex strategy, involving both legal drafting and ongoing accounting, but it can be a great strategy for tax efficiently by disposing of a sizable appreciated asset.
If you have any questions or would like to explore some of these options in more detail, please contact one of the FIM Group’s advisors.
Share Price | Market Capitalization (02-16-2018): $56.29 | $153.36B
Company Description: Merck’s story begins in 1654–1668 when Jacob Friedrick Merck acquired Angel Pharmacy in Darmstadt, Germany (Merck KgA). The Merck we know in the United States (U.S.) began as a subsidiary of Merck KgA in 1891 when George Merck immigrated to America. During World War I, U.S. Merck was expropriated by the U.S. Government, becoming a separate entity from Merck KgA. Outside of Canada and the U.S., Merck goes by the name MSD, since Merck KgA still owns the Merck name and trademark in all other countries.
Kenilworth, New Jersey – based Merck has roughly 69,000 employees spanning 140 countries. Its notable breakthroughs include: vitamin B1, mumps vaccine, rubella vaccine, MMR vaccine, hepatitis B vaccine, thiazide diuretics (e.g., Diuril), Mevacor (the first statin), and antibacterials (e.g., Streptomycin).
Merck’s three business areas are: Pharmaceuticals, Vaccines, and Animal Health. In 2017 Merck spent $9.98B on research and development (R&D), against revenues of $40.1B, in line with its net income ($10.9B) and a touch above its marketing and administrative costs ($9.8B). Areas of focus include: Oncology, Hepatitis C (recently scaled back), Diabetes, Infectious Diseases, Vaccines, and Alzheimer’s.
Investment Thesis: We do not want you to think that we are skipping a key piece of Merck’s history.
The Vioxx scandal of the early 2000s, no doubt, is something that quickly comes to mind. We’ve read a fair amount on the topic, and Merck’s decision to pull Vioxx remains a controversial one in the scientific community. Vioxx was a part of the NSAID class, a COX-2 inhibitor; it was and is not unique, with competitors (both COX-2 and NSAIDs) remaining on the market. Studies are still ongoing, and interesting results in other fields have been trickling out. Regardless, the Vioxx scandal was an unfortunate situation all around, though we believe important lessons were learned – by the company, regulators, physicians, and patients. We believe Merck has implemented the necessary procedures to realign its business with patients, which was its founding mission.
“We try to remember that medicine is for the patient. We try never to forget that medicine is for the people. It is not for the profits. The profits follow, and if we have remembered that, they have never failed to appear. The better we have remembered it, the larger they have been.” – George Merck, December 1, 1950
Our investment case for Merck is threefold. Principally, we believe it has a defensible moat, bolstered through its R&D investments. Second, we believe its governance and ethics to be sound. Finally, we believe its strategic vision and balanced business model provide a solid framework.
In absolute terms, Merck is one of the leaders in R&D spending, especially, when considering licensing, collaboration, mergers, and the like.
The homecoming, in 2013, of Roger M. Perlmutter, M.D., Ph.D., from a fruitful decade at Amgen returned a missing piece to the puzzle. Dr. Perlmutter built on the most promising projects of his predecessor (Peter S. Kim, Ph.D.), refocusing researchers and accelerating work on Pembrolizumab.
Keytruda (Pembrolizumab), now synonymous with oncology immunotherapies, was brought in through a cascade of acquisitions. First Schering-Plough bought Organon (the First link in this chain) from AkzoNobel, only later to be purchased by Merck. What accelerated this success was Merck’s management and scientists’ recognizing and acting on the opportunity within their pipeline.
Environmental, Social, and Governance (ESG) is our second area of focus. We believe that Vioxx was an anomalous event and that enough has been implemented to prevent something similar in the future.
While we would prefer that a M.D./Ph.D. were running the company, we understand the direction the Merck board took in 2011 by elevating Kenneth C. Frazier (a lawyer by training) to the C.E.O. post. Ultimately, Frazier has proven himself capable of trusting his board and his company’s scientists, as we’ve seen increases in R&D spending under his tenure at the expense of near-term profits. However, without the shareholder dynamic seen at companies like Roche or Investor AB, Merck will require more ongoing diligence on our part, because there is no control- ling shareholder.
On the social side, Merck’s ongoing Mectizan program is an interesting philanthropic example. In 1987 the company “committed to donate Mectizan – as much as needed for as long as needed – with the goal to help eliminate river blindness…. The program reaches more than 250 million people…annually, with more than 2.8 billion treatments donated since 1987.”
In 2016, the company’s grants and contributions (total cash and products) totaled $2.24B and employees volunteered nearly 215,000 hours.
Merck’s environmental goals are substantive, and they are progressing well.
Merck has been a good steward of capital, making rational investments – both organic and external (that is, via partnerships, mergers, and acquisitions). A robust pipeline is good for the shareholder, reassuring for the employees, and great for humanity. With a commitment to science and patients first, Merck can weather R&D failures, competition, and increased regulatory scrutiny. Its success will further the exponential advancement that humanity is experiencing. This balance between shareholders and stakeholders rounds out our case for Merck.
Through Merck we gain exposure to global demographic megatrends, solid growth, and increasing capital returns (dividends plus buybacks) – all at a practical price.
Merck is an innovator and we estimate its business model to be economically robust and able to, on average, give us both strong shareholder value and yield through market cycles. Nevertheless, we will closely monitor the company to ensure that none of the elements that make it exemplary are eroding.
For those interested, here is a link to Merck’s pipeline: https://www.merck.com/research...
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