Mary Shelley, Frankenstein

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1 Q The winter has been dreadfully severe; but the spring promises well Mary Shelley, Frankenstein It s Alive. It s Escaped. A secretive re-animation performed using stolen body parts, curious chemicals and dangerous knowledge. I am, of course, referencing Dr. Frankenstein s monster, but current popular opinion might have you thinking I am making a poetic reference to the current market environment and the many rounds of stimulus packages, market intervention, and Federal Reserve soothsaying it took to re-animate it. Newfound Research LLC 425 Boylston St. 3 rd Floor Boston, MA thinknewfound.com info@thinknewfound.com That same market has become a monster in our own eyes, being dubbed on its 3 rd birthday over two years ago the most hated bull market ever. First was the magnificent cry of it s alive! Now, the eerie whisper of: [a]nd it s escaped. Like Dr. Frankenstein, we have become consumed by hatred for our own creation. We cry, this market isn t real; it is a re-animated monster! Yet the market climbs indomitably upward. S&P 500 Total Return & Federal Open Market Committee Actions $2,100 $1,900 $1,700 $1,500 $1,300 $1,100 $900 $700 $500 QE1 QE2 Operation Twist QE3 S&P 500 Alive? Dead? Do We Even Care? As a quantitative firm, we try to refrain from waxing philosophical about economic conditions and policy. We ascribe to the theory that markets are chaotic: while trends emerge and persist, predicting those trends is nearly impossible. We don t particularly care that Dr. Frankenstein s monster was an eight-foot tall, grotesque beast; by all Newfound Research LLC The Best Questions You re NOT Asking and ETF Strategist

2 clinical and scientific definitions, it was alive. Frankly, so is this market at least for now. So whether we should or should not have re-animated the market is a topic best left to economic historians. Rather, what now? is the question we need to address. In exploring that question, we find the true ugliness of the monster we have created: 1. The recession babies year olds are so scarred by the last several years that they have the most conservative portfolio profile of any age bracket under ws/ /recession-babymillennials-scarred-by-u-sdownturn-spurn-stocks.html 2. In trying to control our monster, we ve suppressed the yield curve. Ten-year bond yield a terrific predictor of the forward 10-year annualized return for a constant maturity 10-year bond index sits at only 2.53%. 18% 10-Year Annualized Treasury Return 16% 14% 12% 10% 8% 6% 4% 2% 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Beginning Bond Yield With a few simplifying assumptions, it can be demonstrated that the expected return of a constant-maturity bond index is equal to current on-the-run bond yields; we see this theoretical relationship play out in the high degree of correlation between the starting period bond yields and forward 10-year annualized returns for 10- year U.S. Treasuries. Combined, we have a frightening picture: a generation that should have the most aggressive profile has instead loaded up their portfolio with risk mitigating asset classes with expected returns that barely scratch past inflation. At Newfound, we believe that by combining a quantitative approach with tactical flexibility, we can create an objective approach whereby we can cast aside emotional biases and re-introduce return generating asset classes into our portfolio; all with the comfort that these solutions can adequately de-risk in times of crisis. Newfound Research LLC Q Commentary 2

3 Frankenstein s Monster in the ETF Managed Portfolio Space It is no surprise that in this market environment, an unconstrained approach has continued to gain traction. In particular, we continue to see tremendous growth in the managed ETF strategist space. Having advocated for such an approach for nearly six years, we re proud to be part of the growth of the industry. Nevertheless, with low barriers to entry we have also witnessed the ingress of many unqualified firms looking to merely capitalize on the growth. We ve even witnessed firms that have sought to knock-off our tactical models, and those of our peers, without a true understanding of the reasons behind their design. In a sense, the monster we helped make seems to have escaped us. Our own Andrew Gogerty recently penned a white paper entitled The Best Questions You re Not Asking An ETF Strategist. The paper highlights many qualitative questions that can help separate the chaff from the wheat and identify the truly exceptional firms in the space (of which there are many). For those looking to take a multi-manager approach in their tactical allocations (which we advocate), we highly recommend reading it. See thinknewfound.com/research Growth in our Strategy Line-up We re pleased to introduce our Core Bond Alternative (CBA) strategy, a managed solution that seeks to create a traditional bond experience in a non-traditional way. It is a multi-strategy solution that breaks down fixed-income into three primary objectives, matches those objectives with solutions, and dynamically re-bundles those solutions into a managed portfolio. The fixed-income bull market of the last 30 years has allowed investors to meet three objectives with a single asset class: income generation, a diversified return stream, and a hedge to equity losses. With low current interest rates and the risk that they may soon be rising, meeting these three objectives with solely fixed-income is a difficult proposition. For each of these objectives, CBA matches a solution: Objective Income Generation Diversified Return Stream Equity Hedge Solution Newfound s 4% Target Excess Yield Newfound s U.S. Equity Dynamic Long/Short Long-Dated Maturity U.S. Treasuries Allocations to each sleeve in the strategy are dynamically rebalanced and volatilityweighted, allowing each objective solution to contribute equally to the overall profile of the strategy. Looking Forward At Newfound Research, we utilize a fully quantitative, rule-driven process to govern our investment decisions. While we expect our portfolio positioning to change from time-to-time in response to rotational trends that may be emerging between asset Newfound Research LLC Q Commentary 3

4 classes, as a firm, we do not hold an opinion on near- or long-term economic outlooks. As we close out 2014 Q2, our portfolio positioning can be instructive as to how our models are interpreting economic and political information flow into the market as it is reflected in price level changes seen across broad and targeted asset class ETFs. In general: On an absolute basis, we continue to see strong equity momentum across the majority of domestic and global sectors and factors. Satellite equities (emerging Asia, international small-cap, Latin American equities, domestic and international REITs and domestic MLPs) have shown increasing strength except for emerging Europe. Among the most interesting developments this quarter was the violent strength and reversion of value equities in Q2. The large gap in relative strength of growth vs. value equities (a trend which emerged in Q1) collapsed in a dramatic fashion. Going forward, we are now positioned for a return of strength in growth equities relative to value securities. High beta and dividend factors have emerged with broad strength, though all factors are strong among international developed markets. Momentum appears to be the weakest factor. In fixed income, the model remains positioned towards U.S. credit, both for total return and as a means to generate income, but with shorter duration portfolios. We ve seen increasing strength in emerging market fixed-income, both U.S. and local currency. In our alternative income strategies, overall tilts remain focused towards bank loans, high yield bonds, preferred-securities and mortgage REITs. While our portfolios are generally positioned in this manner as of the end of this quarter, our models are designed to react to changes in the market environment. There is no assurance that the general themes outlined above will remain persistent through the remainder of How our portfolios are positioned in the future will ultimately be dictated by the changes in market currents that our models identify as significant, emerging trends. Newfound Research LLC Q Commentary 4

5 Newfound Risk Managed Global Sectors About The Newfound Risk Managed Global Sectors ( RMGS ) strategy provides access to global equities within a disciplined risk management process with the ability to move entirely to short-term U.S. Treasuries. The strategy can complement core and satellite equity exposures as well as serve as a pivot point in the asset allocations between equities and fixed income depending on the current market environment. The strategy makes tactical moves between global equities and short-term U.S. Treasuries. The equity sector ETFs cover U.S., international and emerging market stocks. Commentary The RMGS model returned 5.59% vs. 5.09% for the MSCI ACWI ETF ( ACWI ) in the second quarter of Year-to-date through the second quarter, RMGS has returned 7.48% with 9.92% annualized volatility versus 6.04% with 10.83% annualized volatility for the ACWI. The model remained equally invested across all global sectors throughout the entirety of the quarter. Q Performance April May June Q2 YTD Model 1.56% 1.84% 2.09% 5.59% 7.48% MSCI ACWI (ACWI) 1.19% 2.00% 1.82% 5.09% 6.04% Model returns are presented gross of advisor and transaction costs and net of the underlying ETF expense ratios ACWI returns are presented net of fees and transaction costs Newfound Research LLC Q Commentary 5

6 Newfound Risk Managed Small-Cap Sectors About The Newfound Risk Managed Small-Cap Sectors ( RMSS ) strategy provides access to U.S. small-cap equities within a disciplined risk-management process with the ability to move entirely to short-term treasuries. The strategy can complement existing small-cap equity exposures as well as serve as a tool to manage small-cap equity exposure within a risk-managed framework. The strategy makes tactical moves between U.S. small-cap equities and short-term U.S. Treasuries. The equity sector ETFs cover U.S. small-cap stocks. Commentary The RMSS model returned 2.00% vs. 2.12% for the Russell 2000 ETF ( IWM ) benchmark in the second quarter of Year-to-date through the second quarter, RMSS has returned 4.16% with 14.68% annualized volatility versus 3.26% with 16.24% annualized volatility for IWM. The dynamic window that governs how much data is utilized by our proprietary momentum measures is derived from the price series of each ETF independently. While the correlated nature of the sectors often means that the dynamic windows for each sector are similar in size, since the beginning of the year, we ve witnessed a divergence in two sectors in particular: The dynamic window for industrials has increased nearly 30% to almost twoyears of market data The dynamic window for technology has shrunk by 50% to almost half a year of market data We believe that this divergence highlights the importance of both the independent evaluation of each sector as well as the use of volatility to provide context for total returns. While both sectors have traded sideways, for the most part, in 2014, technology did so with more directional movement whereas industrials appeared to be more noise driven. Thus, for technology, the model has contracted its window to try to be more adaptive to potential emerging trends, whereas for industrials, the model has expanded its window, seeking to average out the impact of day-to-day noise on trend estimation. Newfound Research LLC Q Commentary 6

7 Dyanmic Window Size for Technology Sector Dynamic Window Size for Industrial Sector Q Performance April May June Q2 YTD Model -2.30% 0.04% 4.37% 2.01% 4.16% Russell 2000 (IWM) -3.75% 0.79% 5.27% 2.12% 3.26% Model returns are presented gross of advisor and transaction costs and net of the underlying ETF expense ratios IWM returns are presented net of fees and transaction costs Newfound Research LLC Q Commentary 7

8 Newfound Risk Managed Income About The Newfound Risk Managed Income ( RMI ) strategy provides access to alternative income generating asset classes within a disciplined risk-management process. The strategy attempts to increase portfolio income over a full market cycle by emphasizing both yield and capital protection. It can complement an existing core equity exposure by diversifying the exposure level over time while also increasing portfolio income. The strategy makes tactical moves between U.S. and international equity and fixed income ETFs and short-term U.S. Treasuries. Commentary The RMI model returned 3.79% for the quarter and is up 6.71% year-to-date with 3.56% annualized volatility. The estimated forward annualized yield for the model is 5.73% versus 2.18% for the Barclay s Aggregate Bond ETF (AGG) and 1.81% for the S&P 500 ETF (SPY) 1. During the quarter, the model re-introduced emerging market bonds (both U.S. and local-currency denominated), international REITs, and long-term U.S. Treasuries into the portfolio, making the entire universe eligible for allocation. Initial Q2 Model Allocations bwx, 2.8% vnq, 3.3% dvy, 3.0% bkln, 25.0% hyg, 15.4% pff, 16.2% rem, 11.5% igf, 3.1% cwb, 3.9% idv, 3.3% amj, 4.5% lqd, 7.9% Ending Q2 Model Allocations vnqi, bwx, vnq, dvy, tlt, 2.17% 2.19% 2.36% 2.46% 2.53% hyg, 14.18% bkln, 20.98% pff, 14.10% rem, 10.86% igf, 2.58% cwb, 2.73% idv, 3.15% amj, 3.24% emlc, 4.92% pcy, 5.50% lqd, 6.05% Q Performance April May June Q2 YTD Model 1.25% 1.50% 0.99% 3.80% 6.72% S&P 500 (SPY) 0.69% 2.32% 2.07% 5.16% 6.95% 1 Computed using a weighted average of trailing 12-month yield estimates, as of 7/1/2014, from Morningstar. Newfound Research LLC Q Commentary 8

9 Barclay s Aggregate (AGG) 0.82% 1.19% -0.06% 1.95% 3.75% Model returns are presented gross of advisor and transaction costs and net of the underlying ETF expense ratios SPY and AGG returns are presented net of fees and transaction costs Newfound Research LLC Q Commentary 9

10 Newfound Target Excess Yield 3% and 4% About The Newfound Target Excess Yield ( TEY ) 3% and 4% strategies seek to achieve a yield that is 3% or 4% in excess of that offered by short-term U.S. Treasuries, with minimum volatility. The strategy can supplement an existing fixed income exposure to increase income without adding excessive risk to the entire portfolio. The strategy makes tactical moves between U.S. and international fixed income ETFs. Asset classes in the universe include, but are not limited to, Treasuries, mortgage-backed, corporate and high-yield exposures, and emerging market bonds. Target Excess Yield 3% Commentary The TEY 3% model returned 1.32% for the quarter and is up 2.72% year-to-date. The estimated forward annualized yield for the model based on Q2 dividends is 3.10% versus 2.18% for the Barclay s Aggregate Bond ETF (AGG) and 0.28% for the Barclays 1-3 Year Treasury Bond ETF (SHY) 2. The strategy made no trades throughout the quarter; exposure remained concentrated in short-term corporate bonds and high yield bonds. Target Excess Yield 4% Commentary The TEY 4% model returned 1.81% for the quarter and is up 3.87% year-to-date. The estimated forward annualized yield for the model based on Q2 dividends is 4.23% versus 2.18% for the Barclay s Aggregate Bond ETF (AGG) and 0.28% for the Barclays 1-3 Year Treasury Bond ETF (SHY) 3. The strategy made no trades throughout the quarter; exposure remained concentrated in short-term corporate bonds and high yield bonds. Q Performance April May June Q2 YTD TEY 3% Model 0.29% 0.74% 0.27% 1.30% 2.69% TEY 4% Model 0.40% 0.99% 0.40% 1.80% 3.85% Barclay s Aggregate (AGG) 0.82% 1.17% -0.05% 1.95% 3.76% Barclays 1-3 Yr Tres. (SHY) 0.11% 0.18% -0.08% 0.20% 0.34% 2 Computed using a weighted average of trailing 12-month yield estimates, as of 7/1/2014, from Morningstar Newfound Research LLC Q Commentary 10

11 Model returns are presented gross of advisor and transaction costs and net of the underlying ETF expense ratios AGG and SHY returns are presented net of fees and transaction costs Newfound Research LLC Q Commentary 11

12 Newfound U.S. Equity Dynamic Long/Short About The Newfound U.S. Equity Dynamic Long/Short ( DLS ) strategy provides access to non-correlated, market-neutral exposures. The strategy attempts to exploit U.S. equity market tailwinds by selectively adding market beta exposures when prudent. The intended target outcome is to deliver a diversified return stream that can complement existing core holdings. Commentary The DLS model returned 2.37% for the quarter and is up 3.53% year-to-date with 5.22% annualized volatility. Our models signaled that positive momentum carried through the quarter in all six of the long-only U.S. factor (small-cap, large-cap, value, growth, low volatility and high beta) ETFs we track within the strategy. We added a new exposure in the long/short sleeve of the allocation in June: the Invesco PowerShares Multi-Strategy Alternative Portfolio (LALT). The ETF expands the assets tracked in the long/short sleeve beyond stylistic factor strategies to now include volatility risk premium and carry strategies. Q Performance April May June Q2 YTD Model 0.46% 0.59% 1.30% 2.37% 3.53% S&P 500 (SPY) 0.69% 2.32% 2.07% 5.16% 6.95% Barclay s Aggregate (AGG) 0.82% 1.17% -0.05% 1.95% 3.76% Model returns are presented gross of advisor and transaction costs and net of the underlying ETF expense ratios AGG and SPY returns are presented net of fees and transaction costs Newfound Research LLC Q Commentary 12

13 For more information about Newfound Research call us at , visit us at or us at These materials represent an assessment of the market environment at specific points in time and are intended neither to be a guarantee of future events nor as a primary basis for investment decisions. The performance results should not be construed as advice meeting the particular needs of any investor. Neither the information presented nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any security. Past performance is not indicative of future performance and investments in equity securities do present risk of loss. Newfound Research LLC s results are historical and their ability to repeat could be effected by material market or economic conditions, among other things. Except as noted, model and index results are gross of fees, costs and expenses. Index or model results do not reflect the performance results of a live, actual account or fund that invested to track the results of the index. All index and model results are total return, meaning they reflect the reinvestment of all dividends, capital gains, interest and other income. The commentary is prepared by Newfound Research LLC for informational purposes only and is not presented as an offer or solicitation for the purchase or sale of any security. The information contained herein is neither investment advice nor legal opinion. The views expressed are those of the author as of the date of the publication of this report, and are subject to change without notice. Performance results are presented in U.S. dollars. Actual fees may vary based on, among other factors, account size and custodial relationship. No current or prospective client should assume future performance of any specific investment strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may cause the performance results of your portfolio to differ materially from the reported composite performance. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client's investment portfolio. Historical performance results for market indices generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark. The investment strategy and types of securities held by comparison indices may be substantially different from the investment strategy and the types of securities held by the Newfound Research LLC strategies. Newfound Research LLC Q Commentary 13