One ETN Worth Your While
For the most part, exchange traded notes (ETNs) are better off ignored, but this one is a rare exception to that general principle.
Even if you’re not convinced CAPE (the measure) is not a good gauge of stock market valuations, you can still learn a lot by looking at how CAPE the ETN is constructed. Shiller had a hand in formulating the strategy, and it shows. It’s built on sound principles.
The ETN tracks the Shiller Barclays CAPE US Core Sector Index, which every month rotates its exposures to four of the nine S&P 500 Select Sector indexes, the same ones the Select Sector SPDR ETFs track.
The “Relative CAPE Indicator” indicates which sectors to pick. It’s based on cyclically adjusted price-to-earnings, or CAPE, which divides real price by average ten-year trailing real earnings.
Because sectors have different earnings characteristics, naively picking the lowest-CAPE sectors would structurally bias the fund to low-growth sectors. In order to get around that, a sector’s current CAPE is divided by the trailing 20-year CAPE average to produce the Relative CAPE Indicator. The five sectors most undervalued according to the indicator are chosen. Then, the sector with the lowest 12-month price return is excluded. The remaining four are equally weighted.
The momentum screen is a nice touch. The cheapest sectors are often the most beaten-down, and because momentum is a powerful force in the markets, automatically picking up the cheapest stuff regardless of momentum often exposes you to extra volatility.
While I think the strategy is sensible, keep in mind for most of its back-tested history, which only extends back to late 2002, it kept mostly to five sectors: energy, industrials, consumer staples, health care, and financials. The momentum screen kicked out financials right before the worst of the financial crisis, boosting back-tested returns.
I’m almost somewhat uncomfortable with the short ten-year back-tested history. While I think Shiller has a lot of credibility as a careful economist, I’d feel more at ease if the strategy were shown to work over multiple decades and in foreign countries.
The ETN levies a 0.45% annual investor charge. Keep in mind that ETNs can pretty much calculate expenses any way they want and bury additional fees in the dense prospectus text. Fortunately, I did not find any idiosyncratic fees or calculations, so you can expect the ETN to lag its target index by 0.45% annually.
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