Cars of the future

Maybe not flying yet like Jetsons or Back to the Future, but advances are in process and inevitable.

From Zacks Investment Management:

Self-Driving Cars Reach New Milestone – for those readers who are still reluctant to believe in the electric car and self-driving car revolutions, we understand (but it’s time to start believing). Where the U.S. government is generally snail-pace slow in legislating in lockstep with technological change, they have passed a bill that creates a national framework of regulations for the industry. The bill includes amendments covering cybersecurity issues and allows automakers to sell up to 80,000 self-driving vehicles annually, assuming that safety standards are met. On the automakers front, it’s been an active week as Ford detailed a strategy for future investment of research and resources into self-driving cars. General Motors followed suit by indicating that its ‘Cruise Automation’ business is making rapid progress on fully autonomous driving capabilities.

Lots of hate on Tesla and Elon Musk is a continuing theme, but Tesla just keeps on keepin’ on.  As soon as production of the Model 3 ramps up to plan, electric cars are a done deal and cannot be stopped.  I’m not sure why Zero Hedge has such an axe to grind (lots of MLP and energy positions, perhaps?), but they sure do.  Here’s a couple of the latest screeds:  http://www.zerohedge.com/news/2017-10-07/visualizing-many-failures-elon-musk

http://www.zerohedge.com/news/2017-10-06/teslas-big-secret-its-building-model-3s-hand

Meanwhile, the production line continues to go through development and troubleshooting:

The Model 3 body line slowed down to 1/10th speed

A post shared by Elon Musk (@elonmusk) on

And GM, Volvo, and Jaguar have also already announced they will be eliminating internal combustion engines completely.  https://www.wired.com/story/general-motors-electric-cars-plan-gm?mbid=social_twitter

 

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Neuroscience & Module Model

From Eric Barker:

Both neuroscience and psychology are starting to agree. Sometimes you don’t act like you because there is no singular “you.”

Here’s noted science author Robert Wright:

In this view, your mind is composed of lots of specialized modules—modules for sizing up situations and reacting to them—and it’s the interplay among these modules that shapes your behavior. And much of this interplay happens without conscious awareness on your part. The modular model of the mind, though still young and not fully fleshed out, holds a lot of promise. For starters, it makes sense in terms of evolution: the mind got built bit by bit, chunk by chunk, and as our species encountered new challenges, new chunks would have been added. As we’ll see, this model also helps make sense of some of life’s great internal conflicts, such as whether to cheat on your spouse, whether to take addictive drugs, and whether to eat another powdered-sugar doughnut.

Now modules aren’t physical structures in the brain, just like apps aren’t hardware in your phone. They’re software; the human nature algorithms that Mother Nature coded over thousands of generations of evolution.

Whichever module has the most emotional kick attached to it at any point wins the competition to be “you.”

Buddhism recognized this problem over 1000 years ago. And it also came up with a solution: mindfulness meditation.

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Fundamental Indexing

Consider the purpose of a market index.  We use an index to define the value of the market, overall.  When we use a market index as a benchmark for any specific holding or portfolio, we need to be able to rely on that index as a reasonable measurement for what “the market” is worth at any given moment, and over time.  If you are an efficient market hypothesis believer, market capitalization weighting is the only accurate way to measure the economic value of any specified market.

But what if you think that at least some of the time, prices for individual companies, sectors, and even the whole market can diverge from their true economic value?  This premise is the basis of factor investing, “smart beta,” and behavioral investing.  Several “fundamental” weighting schemes have been developed to try to measure economic value in ways other than equity price.

Dividend discount model is a simple and common method of determining the economic value of a stock.  Free cash flow models based on earnings are also widely recognized.  WisdomTree has offered both dividends and earnings weighted funds for over 10 years.  Jeff Weniger offers a thorough explanation of the advantages of earnings weighting at https://www.wisdomtree.com/blog/2017-05-15/the-wisdomtree-earnings-500-trexing-money-managements-accident-of-history and Jeremy Schwartz published a white paper in 2016 detailing dividend weighting,  https://www.wisdomtree.com/-/media/us-media-files/documents/resource-library/whitepaper/the-dividends-of-a-dividend-approach.pdf.  Pacer US Cash Cows 100 Index selects and weights the largest 100 companies by free cash flow.  The associated ETF, COWZ, just opened in December 2016.  They describe their approach here: https://youtu.be/kUyMqNq5IMo.  Please note that this is a new index as well, so it really doesn’t have a track record other than backtesting.

Oppenheimer weights by top line revenue, as explained by David Mazza, https://www.oppenheimerfunds.com/advisors/article/revenue-uncovers-value-in-a-rich-stock-market. The tech bubble is used as an example here.  You can see how at the height of the bubble, a minority of the stocks with increasing prices came to dominate the cap weighted index, but not so much the revenue weighted index.

Oppenheimer Revenue Weighting – graph from page 16 of Oppenheimer presentation – used with permission.

Rob Arnott (arguably the originator of fundamental weighting) and Research Affiliates (RAFI) have developed 3 unique indexes, which weight companies with varying combinations and definitions of sales, cash flow, dividends, and book value.   The FTSE RAFI US 1000 Index consists of the 1000 largest companies as calculated by their economic value, using a formula including total cash dividends, free cash flow, total sales, and book equity value.  Invesco, who sponsors the ETF for this index (PRF), shows the converse of the Oppenheimer example:  during the last crisis, the financial sector became under valued, and thus under weighted in the cap weighted index.

Invesco chart – used with permission.

Critics of the fundamental approach to indexing call it value investing by another name.  This is true by definition.  However, the difference between a value index and a fundamental index is that the fundamental index is not using the equity price in any form to determine inclusion or weight in the index.  A value index will always include some form of the price in its inclusion and/or weighting calculations, usually in a ratio (P/E, P/S, etc.).  The amount of value tilt changes over time for a fundamental index, while it is defined for a value index.  Issuers of fundamental indexes consider this a feature, not a bug.  The goal of the fundamental index is to represent the market constituents weighted by their economic value or economic impact, not to determine which equities or sectors are “incorrectly” priced.

What about performance?

As of 6/30/17 3 yr 5 yr 10 yr
YTD 1 yr 3 yr 5 yr 10 yr sd beta sd beta sd beta
S&P 500 TR Index 9.34 17.9 9.61 14.63 7.18 10.35 9.56 15.21
FTSE RAFI US 1000 Index 4.69 16.92 7.89 14.82 7.68 10.25 0.96 9.73 0.99 16.02 1.04
WisdomTree LargeCap Dividend Index 6.7 14.23 9.08 13.19 6.72 9.87 0.93 9.12 0.92 14.63 0.93
OFI Revenue Weighted Large Cap TR 7.41 16.49 8.7 15.55 7.29 10.38 0.98 9.9 1.01 16.51 1.07
WisdomTree US Earnings 500 Index 9.39 22.29 9.46 14.65 7.35 10.81 1.03 9.91 1.02 15.03 0.98
Pacer US 100 Cash Cows Index 6.74 23.15 9.02 16.98 10.32 13.46 1.2 12.41 1.2 19.83 1.21
Russell RAFI US Large Company Index 4.8 14.2 7.75 14.3 7.91 10.25 0.96 9.73 0.99 16.02 1.04
*Data from ETF providers and Morningstar

Please note that the outlier in this group, Pacer, reflects backtesting data prior to 2017.  The three year betas less then one suggest that the fundamental indexes are not performing as well as the S&P 500 over this portion of a bull market, and they are not.  A full market cycle would be the best way to evaluate performance.  The 10 year betas less than one might be what is expected – a dampening effect from removing the impact of excess pricing at market highs, and oversold equities at market lows. Another way to look at it would be that the market tends to overshoot at both extremes – the real economy is not moving as much.  But of the 6 indexes, only 2 reflect this theory.

What explains this?  The fundamental indexes are rebalanced quarterly or annually, while a cap weighted index self-rebalances on a continuous basis, other than adjustments for changes in listings and float. Rebalancing also adds trading costs as well as possible tax liabilities.  RAFI methodologies use 5 year averages of data, so they will be slower to respond to changes in issuer value than the cap weighted index.  The Oppenheimer and WisdomTree indexes are also capped by issuer and sector.  Similar to smart beta, it’s just more complicated to implement these strategies than cap weighted.

The ETFs based on fundamental indexes generally charge around .25% – .50%, while the cap weighted index ETF can be bought for .03%.  The 10 year returns net of fees are very similar to the cap weighted index.  Other cost considerations are size and trading cost of the ETFs, as well as tax implications. Obviously dividend weighted funds will have higher taxable income than cap weighted.

In summary, the theory of the fundamental index is quite compelling, but the current indexes somewhat less so. It seems likely that this reflects the difficulty in implementation rather than flaw in theory.

Disclosure:  I do not currently hold or plan to add any fundamental weight products for myself or clients.  Do have positions in cap weighted funds and ETFs.

 

 

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More EV confirmation

I recognize this is just me finding more confirmation of my existing beliefs, but, from Zacks Investment Management...

Electric Car Announcements – two European nations gave new meaning to the phrase “plug and play” this week, when both France and Britain made announcements about new rules banning all gas and diesel vehicle sales. France’s announcement came a day after the automaker Volvo said it would phase out the internal combustible engine, and both countries have made this pledge applicable to 2040. Meanwhile, the second largest automaker in the world, Toyota, said they are working on an electric car with an improved driving range and a fast-charging battery. The Japanese automaker wants to build an electric vehicle (EV) using solid-state batteries that can be recharged in minutes, with expectations for the new model to arrive as early as 2022. It appears the question is no longer if automakers are shifting to hybrids and EVs, but rather how soon. The race to electric should be fun to watch.

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Fiduciary Rule blowback from customers

Rick Kahler recently reported that a J.D. Power survey showed that current clients of brokers are likely to leave when switched to fee-only accounts.  He envisioned a conversation like this:

Broker: “Because of the new DOL regulations I can no longer sell you a high fee and commission variable annuity to be owned by your IRA. To comply with the ruling, my company has eliminated the 7% upfront commission on this annuity; we will now charge you a 1% annual fee. They also reduced the annual management expenses from 3% to 1%. Plus, now any advice I give you or product I recommend must be in your best interests.”

Customer: “So you are eliminating the upfront 7% commission and replacing that with a 1% annual fee, which means 7% more of my money immediately goes to work for me in the investment, right?”

Broker: “That’s right.”

 

Customer:  “And instead of the upfront commission you are charging a new 1% annual fee, but reducing the annual management costs of the investments from 3% to 1%. So I’ll still make an additional 1% every year I own this, in addition to saving 7% up front, right?”

Broker: “That’s right.”

Customer: “And further, you’re now going to look out for my best interests rather than the best interests of your company.”

Broker: “Yep.”

Customer: “This is ridiculous. I’m outta here!”

Broker: “Where are you going?”

Customer: “To find a firm that will continue to sell me high commission, high fee products for my IRA and that will work against my best interests!”

Broker: “You probably won’t find any. Every financial company selling investment products to IRAs has to comply.”

Customer: “I’ll find someone, somewhere. Goodbye!”

I envision a conversation more like this:

Broker: “Because of the new DOL regulations I can no longer sell you a high fee and commission variable annuity to be owned by your IRA. To comply with the ruling, my company has eliminated the 7% upfront commission on this annuity; we will now charge you a 1% annual fee. They also reduced the annual management expenses from 3% to 1%. Plus, now any advice I give you or product I recommend must be in your best interests.”

Customer:  “So you’re telling me that for all these years, you have been taking a 7% cut right off the top, and charging me 3 times the expenses for no reason other than to take more of my  money and put it in your pocket??”

Broker: “ummmm…….”

Customer: “And further, you’ve never been out for my best interests, but rather the best interests of your company?”

Broker: “ummmm…….”

Customer: “This is ridiculous. I’m outta here!”

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Size of Government vs. Growth

Charles Gave recently published a post showing a simple but important fact:  economic growth is inversely proportional to the size of the government.  This is shown in developed economies over varying conditions.  Published on John Mauldin’s website:

In the US, a similarly straight forward picture emerges, with the big increase in government spending that took place after 2009 being the main cause of the subsequent decline in the US’s structural growth rate.

By way of contrast, consider the reverse case of Canada, which in the mid-1990s slashed government spending to good effect. In two years Canadian government spending was cut from 31% of GDP to about 25%. The ensuing 18 months saw predictable howls of protest from economists that a depression must follow. In fact, not only was a recession avoided but Canada’s structural growth rate quickly picked up and in the next two decades a record uninterrupted economic expansion was achieved.

As an aside, I would ask readers to cite one case in the post-1971 fiat money era when a big rise in government spending did not lead to a structural slowdown. Alternatively, if they could cite an episode when cuts to public spending resulted in the growth rate falling. I am always willing to learn and change my mind!

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Vertical Farming

This is really cool, and great news in a lot of ways.  From impactalpha.com:

Bowery Farming raises $20 million for vertical farm expansion. Indoor farming is still small but investors think it’s poised for growth with rising global food need and the environmental strain of traditional agriculture. Bowery Farming, based in Kearny, N.J., calls itself a tech venture focused on the future of food and claims its approach grows 100 times more produce than a similarly-sized outdoor farm. It has raised $27.5 million to date for its approach to growing greens indoors. The process uses LED lighting, robotics and specially-developed software. The latest funding round was backed by Google’s venture fund, GV; General Catalyst; and GGV Capital—a venture capital firm focused on the U.S. and China. Vertical farming “is no longer just a pie-in-the-sky theory,” says GGV’s Hans Tung. “It has the chance to scale in the next five years.” Earlier this month, AeroFarms, another New Jersey indoor farming operation, raised $34 million from Emirati investors interested in bringing the technology to the desert-covered Gulf region.

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