Digging for Bargains

As 2012 develops, one unchanged investment trend is the continued expansion of the ETF universe. In January, the combined assets of all U.S. listed ETFs grew to $1.134 trillion or 13% compared to a year earlier, according to the Investment Company Institute.

This means advisors will need the right tools to choose among ETF investments for clients and to communicate their choices. And Michael Krause, the president and founder of Alta Vista Research, wants to help.

Krause’s firm initiated research on just a few ETFs back in 2004. Krause was disgruntled by backward-looking ETF ratings that focus too much on historical fund performance. So he assembled a research approach emphasizing forward-looking fundamentals like sales and earnings per share growth of the underlying securities that make up ETFs. This led to the development of Alta Vista’s proprietary “ALTAR Score,” which measures ETFs’ overall investment merit. The ALTAR Score attempts to forecast the likely internal rate of return to ETF shareholders and also provides a basis of comparison between funds within a given category or across categories.

Today, the New York-based research firm provides independent analysis on 711 U.S.-listed ETFs, 47 ETFs in Australia and a handful of funds in Hong Kong. Krause spoke with Research magazine about his investment process for identifying bargains in a shaky world.

There seems to be a disconnect between the stock market and the real economy. On one hand, U.S. stocks just had their best yearly start in 15 years, on the other hand, the job market and housing market is still in major funk. How do you explain these discrepancies?

Last year was all about defensive areas, and since the economic news has been a tad better recently, January saw a reversal of that. So far this year it has been “risk on” with cyclical areas performing best among sectors, and emerging markets doing especially well internationally.

As for the economy, employment data has been better but a falling unemployment rate which is primarily the result of a declining workforce isn’t cause for celebration. Further, I think the European debt crisis has yet to run its course.

One flashing warning sign is the lousy earnings season we just had for Q4 2011. Sales growth was lackluster, margins were slimmer in most sectors, disappointments were widespread and, above all, Q4 was likely the first sequential decline in EPS for the S&P 500 as a whole since the profit recovery began. And that is not a bullish signal.

U.S. national debt is on target to reach $16 trillion this year and the debt-to-GDP ratio is now above 100%. Do you think the U.S. government’s heavy debt load should change the way financial advisors invest their clients’ money?

Advisors should always be in search of the best opportunities and values for clients, and the size of Treasury debt means that it is now likely to have a larger impact on where such opportunities are to be found. The biggest effect could be on the most basic asset allocation decision of all: stocks versus bonds.

Given the supply of Treasuries you’d expect interest rates to be higher than they are now. Instead they are exceptionally low, for a number of reasons which may not endure. As a result, Treasuries would seem to offer far less reward and greater risk than normal. Target-date funds that put investors on a glide path of purchasing ever more U.S. government debt as time goes on, without regard to the value of such debt vis-à-vis the alternative of equities, could be a big mistake.

The Federal Reserve said it plans to keep short-term interest rates near zero percent until at least 2014. Is the Fed really helping the economy or are they just creating another bubble in asset prices?

Printing money and flooding the system with liquidity is the right response during a full-blown panic; it is not the right response three and a half years later. We don’t have a liquidity problem now, but the velocity of money is low. The Fed may in fact be creating other asset bubbles (such as in commodities); they are certainly not helping people who’ve saved and depend upon the income to live.

Another problem is that if and when the recovery becomes durable and rates start to rise, interest payments on the national debt will go up rather dramatically, and the increased tax receipts from faster GDP growth may not cover it, making our fiscal situation even worse.