RESEARCH UPDATE. ETFs AS INDICATORS

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1 DAY HAGAN RESEARCH UPDATE JANUARY 30, 2016 RESEARCH UPDATE FEBRUARY 16, 2016 Even if you don t use ETFs for investing, they are a great tool to evaluate market trends and other thoughts about the markets. ETFs AS INDICATORS Even if you don t use ETFs for investing, they are a great tool to evaluate market trends. Today I want to look at ETFs that are worth paying attention to, even if you are not going to trade them. And at the end of this blog, I will summarize my current thoughts on the markets. FLOWS Many of you probably already know that shares of ETFs can be created and redeemed throughout the day by authorized participants (APs). This is done in what is called the primary market. I won t go into the mechanics, but this process is the main difference between a mutual fund and an ETF and is the main reason why ETFs are more efficient and charge lower fees than mutual funds. I have studied ETF flows for the past eight years and have a few rule-of-thumb thoughts when evaluating them: 1. Aggregate flows are typically a better indicator than individual flows. By aggregate (net total), I mean the net inflows/outflows into certain segments of the market, like Health Care sector funds or emerging market funds. An individual fund can experience volatile day-to-day inflows and outflows because of various institutions (institutions are the ones that typically trade ETFs in the primary market). 2. Flows can be considered sentiment indicators. As with most sentiment indicators, investors should go with the flow until it reaches an extreme and reverses. 3. ETF shares can be created to go short. This is very important to understand. You may see net inflows because an investor is getting short an ETF, not long. So when you are evaluating flows, you should also know where the level of short interest is in a fund. 4. The percentage of shares short in a fund can be greater than 100%. I won t go into the mechanics of how this occurs, but you shouldn t just ignore a fund (on the buy side) because of this condition. Trend is more important than level. 5. Flows will tell you if a fund is a darling of the institutional investor. If there isn t an active (daily transactions) creation/redemption process in a fund, the fund will typically be less volatile in significant market moves. If you look at aggregate flow data, you will find the following: Commodity funds took in over $1.2 billion of new money, and nearly all of that was in precious metal funds (below). Nearly $26 billion has come out of equity ETFs this year. Fixed income funds have seen a net inflow of $15.5 billion. Several sector categories have seen significant outflows this year: Consumer Discretionary (-$2 billion), Financials (-$2.6 billion), Health Care (-$3.4 billion), and Technology (-$5.4 billion). Not a single global region has seen positive net inflows this year.

2 LOW VOLATILITY ETF performance is an easily obtainable indicator that provides insight into what areas of the market are doing better/worse than others. SPLV, the PowerShares S&P 500 Low Volatility fund, is down just over 3.4% this year compared with a loss of over 8.4% for the SPDR S&P 500 fund (SPY). Other low volatility funds for emerging markets and EAFE funds are also outperforming their cap-weighted counterparts. It is important to understand that in declining markets low volatility funds outperform, and in rising markets, low volatility underperforms. Note ETF providers make the daily constituents for their funds available on their websites at no charge. So you can see what stocks meet PowerShares low volatility criteria. As shown in the second clip of the chart below, SPLV has clearly outperformed SPY since May of Since owning low volatility names is a defense strategy, monitoring this simple ratio will alert you to any change in trend from defensive positioning. Day Hagan Research Update Page 2 of 5

3 QUALITY AND DIVIDENDS In this market decline, investors have migrated towards high quality stocks and stocks that are paying and growing their dividends. Typically, in bull markets, low quality stocks outperform higher quality names. And those stocks with higher yields (value) underperform non-dividend paying growth stocks. Once again, as shown below, simple ratio charts tell the story. SPHD, the PowerShares S&P 500 High Dividend Portfolio ETF, is clearly outperforming SPY (second clip below). However, look at the most recent data and you will see that SPY has started to improve relative to SPHD. Could this be the change in trend that we have all been waiting for? Well, it is too early to tell, but the initial inversion is encouraging and should be monitored. Day Hagan Research Update Page 3 of 5

4 ACTIVELY MANAGED ETFS There have been several actively managed funds launched over the past few years. Many of these funds, like the specialty index funds, provide investors with insight into market direction. You may not want to own these funds, but why not use them as a starting point for your own stock selection or research purposes? Take the funds from O Shares Investments, for example. Many of these funds have not gathered assets and trade infrequently in the secondary market with wide bid/ask spreads. I may not want to buy one of their pseudoactive funds (I use pseudo because they are rule-based funds, which are touted as passive), but funds like OUSA, the O Shares FTSE Quality Dividend ETF, provides me with a list of stocks I may want to consider given inclusion in the fund based on liquidity, quality, low volatility and dividend yields. Even better, I cross this with SPHD, or SPHQ, and see what drops out. Another fund worth keeping an eye on is TTFS, the AdvisorShares TrimTabs Float Shrink ETF. This is an actively managed fund that looks for stocks that generate long-term returns and increase shareholder value. TrimTabs has done the work; you just need to look under the covers. If you are negative on this market and you want to short stocks or have downside protection, you may want to look at a fund like HDGE, the AdvisorShares Ranger Equity Bear Fund. The manager of this fund does bottomup research on stocks, looking for financial accounting irregularities. You can see what stocks they are shorting and compare that with your holdings or join in. SUMMARY While I still look at major market indexes and indicators, ETFs have become an essential part of my research process. The majority of my allocation ideas come from monitoring a broad array of ETFs. I use them as breadth, sentiment, technical, fundamental and theme-based inputs into a weight-of-the-evidence process. In Day Hagan Research Update Page 4 of 5

5 the current environment I typically start with relative strength, move to flows (to see if the institutions are interested), and finish with the technical. For now, I have put less weight on the fundamentals since their usefulness in market declines is diminished. The following is a summary of what I see: Emerging markets are starting to improve versus developed markets. In general, most broad equity markets are oversold on a short-term basis. But watch for reversals before getting too aggressive. Utilities are over-owned and overbought; watching for a reversal. Financials are oversold. And too many people are betting on a big reversal in Energy sector equity ETFs. Gold is short-term overbought, but still has room to run before becoming long-term overbought. Small caps remain weak and oversold. We need their participation for the broader market to move higher. A whole host for dividend-themed funds is reversing from long-term oversold levels. Treasury funds are due for a breather. They are very overbought; would look to buy on pullbacks and hold until economic data strengthens. Our yields will remain attractive to foreigners for some time. Consider hedged international funds over non-hedged funds. The dollar is poised to regain some strength. Have a wonderful week, Neil Leeson Day Hagan Asset Management Investment Committee Written Disclosure: The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Day Hagan Asset Management (DHAM), any of its affiliates or employees, or any third party data provider, shall not have any liability for any loss sustained by anyone who has relied on the information contained in any Day Hagan Asset Management literature or marketing materials. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before investing. DHAM, accounts that DHAM or its affiliated companies manage, or their respective shareholders, directors, officers and/or employees, may have long or short positions in the securities discussed herein and may purchase or sell such securities without notice. DHAM uses and has historically used various methods to evaluate investments which, at times, produce contradictory recommendations with respect to the same securities. When evaluating the results of prior DHAM recommendations or DHAM performance rankings, one should also consider that DHAM may modify the methods it uses to evaluate investment opportunities from time to time, that model results do not impute or show the compounded adverse effect of transactions costs or management fees or reflect actual investment results, that some model results do not reflect actual historical recommendations, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, the performance of DHAM s past recommendations and model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Day Hagan Research Update Page 5 of 5