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Endowment Index Press Releases Discontinued

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SEC Marketing Rule 206(4)-1, places new requirements on the distribution of hypothetical performance on investment advisers. To comply with the Rule, ETF Model Solutions will no longer provide Endowment Index® performance data via press release. Investment professionals, institutional investors, endowment managers, family office staff and accredited investors who wish to continue to receive Endowment Index® performance data should visit EndowmentIndex.com and sign up to receive future updates directly

The Endowment Index® represents the investable opportunity for managers of portfolios utilizing the Endowment Investment Philosophy® or who otherwise incorporate alternative investments within a comprehensive asset allocation. The Endowment Index® measures performance for a multi-asset, globally diversified, three-dimensional portfolio that includes Global Equity, Global Fixed Income, and Alternative Investments (like Private Equity, Hedge Funds and Real Assets). The Index applies an objective, rules-based construction methodology based upon portfolio allocation data obtained from over 700 educational institutions that collectively manage over $820 billion as of 6/30/21. Each of the 22 sub-indexes that currently comprise the Index are investable and contained within those sub-indexes are over 47,000 underlying securities.

ETF Model Solutions, LLC serves its clients as an ETF strategist, designing and managing ETF-based investment solutions for advisers, institutions, retirement plans and individual investors based upon the Endowment Investment Philosophy®. The Firm offers ETF-based diversified target-risk models, and asset class models for use by investment advisers and retirement plans. ETF Model Solutions, LLC also provides digital investment services to individual investors through the website, www.MyRoboAdviser.com.

Contact: Tim Landolt MBA, Managing Director, 920.785.6012
Info: www.ETFModelSolutions.com or www.EndowmentIndex.com

Disclosure: Information presented for educational purposes only and is not intended as an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies, nor shall it be construed to be the provision of investment advice. You cannot invest directly in an index. Indexes do not contain fees. Past performance is not necessarily indicative of future results. Investments involve risk and unless otherwise stated, are not insured or guaranteed. Performance information provided is net of any underlying exchange-traded fund expenses but does not include any other fees or expenses. A copy of the Firm’s disclosure document, Form ADV Brochure Part 2, is available upon request.

2016 Year End High Yield Default Rates

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Moody’s reported that its global speculative-grade default rate stood at 4.4% at the end of Q4’16, according to its own release. It sees the rate falling to 3.0% by December 2017. Moody’s puts the historical average default rate at 4.2% since 1983. In 2016, the number of defaults totaled 142, the highest amount since 2009. The U.S. speculative-grade default rate stood at 5.6% at the end of Q4’16. It sees the U.S. rate falling to 3.8% by December 2017. The default rate on senior loans stood at 2.06% in December, according to S&P Global Market Intelligence.

A Macro View – Election Impact on International Equity Markets

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After struggling in recent years, international equity markets have been performing well so far this year. Year to date, as of September 29th, developed equity markets, as measured by the MSCI EAFE Index, gained nearly 3%, despite all the problems ranging from negative interest rates to Brexit. Emerging markets equities, as measured by the MSCI Emerging Market Index, did even better, jumping nearly 18%, far exceeding the 7% gain of the S&P 500 Index. However, international equities are facing a huge test: the upcoming US presidential election. Although these markets deal with this every four years, the stakes are even higher this year due to the unique characteristics of the two candidates.

 

Mr. Trump, the Republican Party nominee, has almost made this US election all about unfair international trade—unfair trade has caused job loss in the US, unfair trade has caused huge national debt, and unfair trade has made the US not so great. Apparently, if Mr. Trump wins, and follows through with his anti-trade election rhetoric, international equity markets will be affected, as a number of countries still rely heavily on exports to the US to grow their economies. However, potentially more damaging and less dramatized by the media is his anti-Federal Reserve (Fed) rhetoric, and he truly may mean it. Mr. Trump shares a quite popular view among many that the Fed is too political, keeps interest rates too low for too long, and is creating a huge asset bubble that is bound to burst. If he becomes the next president, and rushes to reverse Fed policy in his “Trump” style, interest rates could potentially jump and the dollar could surge. Whereas the sudden change and chaos may affect financial markets worldwide, emerging markets are likely to be hit the hardest. Currency values of many emerging markets countries are somewhat pegged to the US dollar, and some of them use the US dollar as their currency outright, without bothering to issue their own currency. As a result, their monetary policies are highly dictated by the Fed, and for some, the Fed is essentially their central bank as well. A sudden rise in both US interest rates and the dollar means monetary policies can tighten quickly, a shock that few emerging markets economies, (which tend to have relatively fragile financial systems), can handle.

 

Ms. Clinton, the Democratic Party nominee, is a status-quo candidate, and the status-quo, while not ideal for all stakeholders of the economy, has been great for most investors in recent years. As the former First Lady, US Senator, and Secretary of State, Ms. Clinton may have greater insight into the international situation, and she is also a more familiar figure to leaders of other countries. From this familiarity perspective alone, Ms. Clinton may be less of a risk than Mr. Trump for international equity markets. The TPP (Trans-Pacific Partnership) is so far about the only thing in which Ms. Clinton differs from President Obama, as she has switched from supporting to opposing TPP when her presidential campaign started. She may very well switch back if and when she becomes president. TPP is not really a giveaway from the US to other countries, and so far only 12 countries are included in the deal (China is not even part of it). There should be limited damage to the international equity markets if TPP is revoked.

Real Estate is officially a new Sector

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In November 2014, S&P Dow Jones Indices and MSCI Inc. issued a press release announcing the creation of an 11th sector under the Global Classification Standard (GICS) structure. That sector, Real Estate, was implemented last week—marking the first time the GICS structure has been updated since it was created in 1999. Although the impact of this decision will play out over time, it now is clear that Real Estate Investment Trusts (REITs) have found their own home.

Formerly housed under Financials, the Real Estate sector will include equity REITs (REITs that own physical property), as well as real estate management and development companies. Mortgage REITs (REITs that comprise mortgage-backed securities) will remain within the Financials sector. The most immediate impact of this decision is its effect on various benchmarks widely used by investors. For example, the S&P 500 will include the Real Estate sector in its asset allocation beginning September 16. This will result in a 3.23% weight for Real Estate within the S&P 500 moving forward—which is greater than both Telecommunication Services and Materials. The market weight for Financials, on the other hand, will dip from 15.75% to 12.52%, and will rank below Healthcare as the second-largest sector within the index. The impact on many smaller cap indices—in which REITs make up a greater percentage of publicly-traded companies—is likely to be even more profound.

Asset managers undoubtedly will be forced to rehash how they both view the Real Estate sector and implement REITs in their portfolios. Historically, many asset managers and investors alike have underweighted REITs, since they were not deliberately carved out within their benchmarks. That is, a benchmark-aware investor could avoid REITs altogether by investing in enough financial stocks to remain sector-neutral. As asset managers who once underweighted real estate in portfolios begin to change their tune, demand for REITS could increase significantly, and potentially be a boon for the sector as a whole.

Whereas the increase in demand seems a foregone conclusion, investors should remain wary. Adding the Real Estate sector to the major indices also makes REITs far more visible than when they were hidden within Financials. Analysts and stock pickers often neglected REITs because they failed to understand that traditional accounting metrics do not accurately reflect REIT valuations. Ratios such as price-to-earnings (P/E) or earnings per share (EPS) do not apply nearly as well as either price-to-funds from operations (FFO) or the capitalization rate for REITS. This increased visibility is likely to result in increased scrutiny as analysts and portfolio managers are forced to become more familiar with REITs. As Wall Street shifts its focus to the new Real Estate sector, the market for REIT shares could become more efficient—materially changing the risk/return dynamics. For a market area that has outperformed the broader equity market dramatically over the early part of the 21st century, it’s anyone’s guess as to what this could mean moving forward.

At the end of the day, we can draw one conclusion for certain:  Real estate deserves a seat at the table within in a well-diversified portfolio. The asset class has grown tremendously over the past quarter of a century—breaching the $1 Trillion mark in total equity market capitalization in recent months. S&P and MSCI have responded by offering real estate its own home for the first time.

 

Interest Rates and the Stock Market

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Correlations can be a misleading measure of the interaction between economic variables. Here, we take a look at interest rates and the stock market.

Consider the cause-and-effect chains that exist between the economy, interest rates, and the stock market. Economic growth should in general be good news for the stock market, and it should also generally mean upward pressure on interest rates. A weak economy should be the opposite.

However, the stock market tends to welcome news of a cut in rates, and dislike increases.

This creates a slightly complex picture as regards the interaction between interest rates and the stock market. On the one hand, the direct connection might be expected to lead to a negative correlation; falling rates being good for markets. On the other hand, the way that the broader economic picture affects each would point to a positive correlation; when the economy is strong, we expect rising rates and strong markets.

In isolation, a rate increase can be seen as bad news for the market, but as a symptom of a strong economy it can be seen as good news. These relationships aren’t really that confusing, but they become so if we try to reduce them to a single correlation number.

Evidence of the nuanced relationship can be found in historical returns patterns as shown in the table below:  U.S equities did well when rates rose slowly (i.e. rate less than 1% per year), but not so well when rates rose rapidly (perhaps because rapid increases are often associated with economic distress); meanwhile, when rates fell, U.S. equities did better when they fell rapidly, and not so well when they fell slowly.

Annualized returns on U.S. equities in different interest rate environments (This analysis covered the period January 1970-September 2013).

Source: Russell Investments (Madden & Totten (2014) When rates rise, do stocks fall?)

U.S. Equity Returns in Different Interest Rate Environments

A Macro View – Disappearing Dots Late in the Game

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On Wednesday, the Federal Reserve (Fed) decided to maintain rates at their current level. More importantly, the Fed’s forward-looking expectations for rate increases (the dots) have gone from forecasting, just a couple of months ago, four rate increases in 2016, to yesterday’s forecast of just two rate increases. Interestingly enough, when the Fed raised rates in December, and targeted four increases for 2016, the futures market was predicting only a 50 bps rate rise this year, which is now what the Fed is targeting.

Currency markets quickly reacted, as the US dollar weakened, and other markets digested the news. Beyond the markets’ short term reaction, the slowdown in rate hikes raises concerns in the long term about how much dry powder the Fed and other central banks have at their disposal, given the state of the world economy. The truth is, economic growth has been slow since the massive injection of liquidity post the credit crisis, with annual GDP growth in America averaging around 2% since June of 2009. With so much liquidity injected into the system for so little an increase in economic output, the question becomes: What can central banks do if we enter another recession, considering rates are at record lows and trillions of dollars/euros/yen have already been printed?

Interestingly, Bank of America Merrill Lynch recently released a survey of fund managers in which 59% believe we are nearing the end of the game in terms of world economic growth. The signs are starting to emerge: a rapid decrease in commodity prices; concerns in the credit markets; and increased equity market volatility. Although asset prices quickly inflated after the credit crisis of 2008 due to a large injection of central bank liquidity, economic growth has not been as robust. This has exacerbated a number of social issues, ranging from increasing the wealth disparity (those with exposure to risky assets in 2009 have become much wealthier while those without continue to struggle) to reducing cash flow to older Americans who rely on “clipping coupons” to fund their retirement income needs. To paraphrase Winston Churchill, never has so much liquidity been used by so many central banks to benefit so few people. Economic growth has been slow, the wealth disparity has increased, and the reflation of asset prices has had the biggest benefit for those who already are wealthy.

In addition to these social ramifications, there is real concern over how much dry powder central banks have to fight the next recession. If we are nearing the end of economic growth, what options will they have to prop up the economy? This is a real concern, and is why some investment professionals have been lowering their long-term forecast of stock market growth. No matter how much liquidity you place in the system to re-inflate assets, stocks need economic growth for long-run appreciation. The question is: Will central banks have the tools to stimulate the economy if we slide into a recession? Many investors are concerned they will not, and that should concern us all.