The Universal Nature of The Sharpe Ratio

Apr 29, 2010 in Volatility

Lets look at 3 common methods different investors use to reach their goals:

Investment Advisors:  a typical advisor buys a combination of stocks and bonds to dilute/diversify the risk of owning stocks alone.   They participate in bull markets but give up pure equity returns in pursuit of stability.  The bond component to portfolios is generally uncorrelated to equities in down equity markets.  The stock portion of a portfolio is compared to a stock index and the total portfolio is compared to a blended stock-bond index.

Options Players Selling Covered Calls:  This group buys the underlying stocks/ETFs and sells calls to earn extra income.  If the securities go up, their securities make money.  The also earn the premium and the stocks are called away.  Like the advisor, they give up some upside in order to outperform in down markets (the calls they sell expire worthless to the purchaser and the income they make results in outperformance vs an index return).  

Hedge Fund Long-Short Portfolio:  This group holds longs and shorts.   They generally have a long bias to catch upward nature of equities – but once again, their short positions protect them in down markets and dilute overall volatility.  This strategy tends to avoid drawdowns well but generally does not perform as well as the first two strategies in bull markets.   Essentially, the long-short portfolio is not unlike holding a mostly bond portfolio -- with a small long equity component.   Think something like: 90% bonds with 10% midcap US stocks.  Or 90% bonds with 10% emerging markets exposure.   These kinds of portfolios are very tame -- don't drawdown much and can participate in part when equities do well.  The hedge fund will not have interest rate risk so it won't act like the bond portfolios in reality -- but it is a fair comparison from a volatility perspective. 

The Sharpe Ratio does a good job of enabling a comparison of these different methods.  

The actual calculation of the Sharpe Ratio seems simple enough – though perhaps it is not as straightforward as you may at first think.  ETFreplay.com calculates the Sharpe Ratio as the AVERAGE daily excess total return divided by the daily standard deviation.  Note that the denominator is the same way an options market maker calculates realized volatility.  The mean return and the standard deviation of return is the standard way you describe any 'distribution' of returns.  We are unique though in that we calculate TOTAL return.  We do this because ETF's represent underlying indexes --- and an index return is ALWAYS stated as total return.   We are shocked at how poorly this concept is understood by professional websites, bloggers and aggregation sites like Seeking Alpha.  The difference is at times significant.   

In each of the mentioned strategies above, the standard deviation is being diluted with some kind of paired combination of either bonds, call selling or short selling.    These are all good ideas because when you reduce volatitlity, you increase your chances of improving your Sharpe Ratio.   If there is one statistic every investor should learn -- it is the Sharpe Ratio.   ETFreplay.com makes it easy to understand because our charts de-compose the numerator and the denominator into visual bar charts.

If you focus only on the return of a benchmark and not Sharpe – you will get caught in the same problem the mutual fund industry has – chasing an index around in fear of losing to it in the short-run.  You end up as a closet index, your performance looks great in a bull market --- but you invariably end up with low long-term returns due to the occasional large drawdown.   

We like the combination of finding good relative strength investment opportunities -- and combining that with keeping an eye on your overall portfolio volatility.  By relative strength, we don’t just mean limiting yourself to any one thing – such as U.S. equities.   We mean looking globally and across asset-classes.  The ETF market allows so many more interesting things on a global scale --- find global, cross asset-class relative strength and overweight these segments.

In the above 3 strategies, all of them essentially have portfolios with standard deviations set intentionally BELOW the S&P 500.   How far below is up to each investors ability and willingness to take risk.  But in the long-run, it is not hard to beat the S&P 500's sharpe ratio -- as the reward-risk relationship of the S&P 500 is quite poor -- you get a lot of volatility without a lot of return over the long-run.

We hope that our charts, our screener, our backtesting applications and all of the other pages we have created do a good job of taking portfolio concepts and making them visual and easy.  This is what 'data visualization' is all about.  We very deliberately designed the entire website with the Sharpe Ratio in mind.

Tags:

ETF Performance Analysis for S&P -2.0% Day -- April 27, 2010

Apr 28, 2010 in Screener | Volatility

Volatility spiked on April 27th, lets take a closer look.

First note that while the S&P 500 dropped -2.0%, the higher volatility ETF's are in steeper drawdowns:

What performed well? The usual suspects --- those with negative correlations to equities, including the VIX ETF's, the inverse ETFs from ProShares, long duration US treasuries, precious metals, the U.S. Dollar and the Japanese Yen.

 

The last chart goes back to focus on U.S. Sector SPDR ETF's. Note again that those with higher volatilities led to largest drawdowns.

Follow us on Twitter: http://twitter.com/etfreplay

Tags:

Simple Strategy Using The Relative Strength Themes of our 'Screener'

Apr 26, 2010 in Screener | Strategy

While it may not be particularly interesting from a global perspective -- the relative strength model in our Screener has been quite clear for past few months. Long US Equity and Negative on Europe. Here is an example using the relative strength model as of the last day of February to create a subsequent long-short portfolio that is representative of the broad themes in the marketplace:

Follow us on Twitter:

http://twitter.com/etfreplay

Tags:

New Relative Strength Backtest 'App' Added To Site. Check it out.

Apr 26, 2010 in Backtest | Relative Strength

We have added an innovative new relative strength backtest application to the site.

Click Here: ETF Relative Strength Backtest App

 

 

For a video tutorial on this 'app' click here: Relative Strength Tutorial"

Follow us on Twitter:

http://twitter.com/etfreplay

Tags:

Credit Spreads and S&P 500 Review Chart

Apr 24, 2010 in Credit Spreads

A look at corporate bonds vs treasuries with S&P 500 overlay.

Note that this relationship can only be viewed if your database calculates total return (re-calculating the data series to adjust for dividends and distributions). No other websites do this but ETFreplay.com

 

Follow us on Twitter:

http://twitter.com/etfreplay

Tags:

The Higher The Volatility, The Higher The Drawdowns

Apr 22, 2010 in Volatility | Drawdown

 

Lately I have read in a few places that "investors too often equate risk with volatility." The people who say these kinds of things rarely go on to present an argument based in statistical fact. This blog post is not to say anything is absolute --- but I will show some simple recent data that hardly refutes the statement put forth on the first page of Chapter 3 in ‘the bible’ of quantitative finance ‘Active Portfolio Management’ (Grinold & Kahn, 1999): – it could not be much clearer: “Risk is the standard deviation of return.”

Below is data from the past bear market for 5 of the largest ETF’s in the world. I have chosen to use the standard deviation of the period PRIOR to 2008, Q4 2007. I then show the subsequent drawdown in 2008. Note how in each case of higher standard deviation, the drawdown was larger in the NEXT period.

 

While the above is just a sample --- I can show this over many, many more ETF's. Thinking about your portfolio from the viewpoint of standard deviation can help you understand at least in some small way about how your portfolio might drawdown relative to some common benchmarks. This chart shows volatilities across these same 5 ETF's over time. Note that each ETF has held its relative position for the past 3 years -- zero change. While you cannot know with precision what the future holds -- you can to some extent understand your relative drawdown given S&P volatility of XX.

 

.

 

 

Follow us on Twitter:

http://twitter.com/etfreplay

Tags:

Video: Find Relative Strength Ideas -- Then Integrate Ideas Into A Portfolio

Apr 20, 2010 in Backtest | Screener | Video

 

4 minute video going over a few recent examples:

 

 

Follow us on Twitter:

http://twitter.com/etfreplay

Tags:

2010 Regional Equity Themes

Apr 20, 2010 in Regions

Starting late 2009 and re-inforcing in early 2010: Emerging markets have just tracked the world index --- while US equities have enjoyed large money flows IN and European equities have seen large money flows OUT. Note that the structure of our ETF screener demands stronger relative strength if volatility is higher. Thus, given identical relative strength across 2 timeframes, it will favor the lower volatility ETF. US equities continue to enjoy the potent combination of high relative strength and low relative volatility and this continues to be the primary theme in the marketplace.

 

Follow us on Twitter:

http://twitter.com/etfreplay

Tags:

Moving Average Backtest Page Added To Site, Have A Look

Apr 13, 2010 in Backtest

New application added. This simple application generates a report for any ETF in our database based on the user-defined rules regarding a moving average cross.

 

 

Moving Average Backtest Page

Comments and feedback appreciated.

Thanks,

www.ETFreplay.com

Tags:

Hedge Funds and ETF's

Apr 12, 2010 in Volatility

In the world of hedge funds, it is standard practice to list a ‘volatility target’ within a presentation to potential investors. You never see this listed in any mutual fund or investment advisor type of presentation. Nevertheless, whether it’s in the presentation or not, it’s a topic that is important to post about as often as possible.

First, volatility is a good way to think about ‘drawdown potential.’ High volatility means that the high to low intermediate moves are likely to be large – and since you can never be quite sure what the future will bring, you should generally avoid the highest volatility ETFs unless you feel especially confident in a high return expectation. The relationship between your general return expectation and the underlying volatility of the ETF is an important one.

What hedge funds state in their presentations is a ‘volatility range’ to expect – that is, what the hedge fund manager believes their strategy equates to in a bottom-line percentage, always stated as an annual figure. Many presentations then try to target a ratio of returns relative to that volatility figure. Two such examples are listed here:

 

Target: <15% Volatility with >15% Return

 

 

Target: 8-12% Volatility with 1.5x+ Return

 


 

Both of the above examples from actual hedge-fund marketing books are stated within the same structure: namely, the Sharpe Ratio. Return and volatility of return are both used as quantitative targets.

How does this apply to ETF’s? Each ETF has its own same characteristics. Viewing total return and annualized volatility for each ETF is a nice breakdown of the major components of the Sharpe Ratio. Moreover, you can COMBINE ETF's into portfolios that suit your own risk tolerance.

 

 

 

One major issue for all investors is that volatility is not static. Large changes in market volatility complicate the discussion of absolute targets of volatility. But what we can observe from actual experience is that RELATIVE volatility across different types of ETFs have been quite consistent. Below is an example of a few different types of ETFs. You can see that while the LEVEL has swung around significantly, if we were to rank each of these ETF’s – you would see that each ETF has maintained its exact ranking for every period for the last few years. Emerging markets have maintained high relative volatility vs the S&P 500, which has been more volatile than the defensive Consumer Staples Sector SPDR which in turn has been more volatile than the aggregate bond market.

 

 

What this says is that the risk of drawdown among these different ETF’s is skewed. We cannot precisely say what kind of risk there is --- but we can think that if we entered a long position in bonds and mis-timed the entry, the punishment for being wrong would not be as great as if we did the same thing in Emerging Markets.
Summary:

It is professional to think in terms of volatility and risk-adjusted returns. But you do not need to be a ‘long-short’ hedge fund manager to maintain an efficient (risk-adjusted) portfolio. Overall portfolio volatility can be diluted through exposure to shorter-term fixed income. Indeed, rotating between high returning ETF segments (high relative strength) and low-volatility investments is a strategy that generally leads to the same place hedge funds are ultimately targeting: a high Sharpe Ratio.

Note: The Sharpe Ratio measures reward per unit of risk. It is calculated as the annualized average daily excess return divided by the standard deviation of daily excess return.


 

Tags: