Slightly Worse Than The Flash Crash Week

Aug 06, 2011

First, a look back at this past week.   While the flash crash of 2010 was a memorable one, this past week saw many indices go down more than the week of the flash crash.


We have made the point over and over and over again in this blog (and indeed the underlying thesis of the entire website) of how tactical allocation is what really matters to portfolio performance.    Picking stocks in an environment like August 2011 or May 2010 or Q1 2009 or 2H 2008 is akin to arranging deck-chairs on the Titanic.  Material larger tactical adjustments are the key decisions.  ETFs make at least the implementation aspect far easier for the investor.   

Bonds have been in a bull market for 4-5 months now.   We’ve written about the relative strength bonds have been showing --- but the parabolic moves of bonds here are unsustainable and lowering durations  is a prudent move, relative strength or not.  

The other big point we want to highlight is that of focusing on your Sharpe Ratio (volatility-adjusted returns) rather than just a traditional index.   If you are going for good sharpe ratio – and you should – then you will quickly see that you are not going to be able to get a good sharpe ratio if your portfolios standard deviation is too high.  Return is of course the #1 factor --- but remember this:   the higher the vol, the higher the draw  (as in drawdown).   

When we released the backtesting applications in 2010, we fielded some questions about how to implement the concepts --- which we then enhanced the apps with solutions to address these.   At the same time, we repeatedly discussed how the real important part was the higher-level decisions.   Implementation techniques are of course important – and we strive to be as specific as we can by using well-defined rules for the applications – but in the end, this month again shows that implementing the concepts and even just getting it ‘generally right’ is plenty good enough.

After a few flattish consolidation months, it may start to seem frustrating --- but this is how markets are – lots of low returns and then some non-linear bursts of movement.    Now after the steep losses of the market recently, getting bond market (positive) returns should sit just fine.   Indeed, the updated performance of the sample portfolio is +12.3% vs -4.6% for the S&P 500 YTD.   That is using ‘first day’ picks specified a full day in advance.   Using actual picks the return spread is a bit higher.   Similarly, the other simple portfolio we used as an example (last November) – called ’01 Beta Strategies’ is currently +1,590 basis pts better than the S&P 500 (+11.3% vs -4.6%) using first day picks.  

We would like to emphasize though that your time and effort should not be to obsess over how to beat the models -- or even track them perfectly.   Models always have some assumptions in them that will keep them from being perfectly realistic.     In the end though, it should just be to get it 'generally right' as often as you can -- and good models can clearly help in that regard.  

Lastly, we would highlight that research is an ongoing process, continual enhancing of strategies is important --- small improvements add up over time.    ETFs are an empowering innovation -- there are always a few very interesting new products that come out each year.   This industry is still in the early innings of its development.





Comments (10) -

Aug 07, 2011 02:57 #

could you list the etf's which are in the sample portfolios you mention here?

turnleaf Belgium

Aug 07, 2011 07:04 #

I was about to ask the same question as turnleaf, above.  I no longer have the sample portfolios.  It would be nice to make all the sample portfolios available again.


Ernest United States

Aug 07, 2011 07:40 #

We did the 01 Beta Strategies when launched the RS Reader app last November -  it was based on research done at the time and because it's a dynamic application,  it updated itself during subsequent months.   The video that accompanied the app launch is still up on the backtest page so you can check back in on that.

The sample portfolio was done in the Spring of 2010 and every new member to this day has received the exact same one.    The results have been significantly better than expected on that portolio (using default settings -  which are also unchanged).

Email me privately for the sample portfolio components.

Chris United States

Aug 08, 2011 10:40 #

It seems volatility is almost always associated with downside risk, yet my understanding is a portfolio with significant outperformance (over any common benchmark like the S&P 500) will probably have high volatility numbers too. It seems its possible to be tactical and seek and attain aggressive returns and also miss some of the very nasty drawdown periods like 2008 -2009 (admittedly not easy) even if volatility figures are high. What am I missing?

jreev42 United States

Aug 08, 2011 13:02 #

If you could be sure that you have a portfolio that will double in the next few years,  then you wouldn't care about the volatility and you probably shouldn't care about the drawdowns.   It doesn't matter if it loses a lot in the near-term if you know it will be materially higher X years from now.    But there are no assurances.   That is the nature of volatility --- there is always the problem of what happens if your investments drop a lot and then you need the money --- or something changes your opinion of which investments you should hold?

There are times to be aggressive and seek the returns of more volatile securities --- so agree with you on that part.   But most people don't need to shoot the lights out --- they just want to grow their capital without large drawdowns.    We try to build our applications so that you can even take the same ETFs but apply them in different allocations -- depending on your risk tolerance and return objective.  

In an uncertain world, if you miss the large drawdowns, then expose yourself during the uptrends, your capital compounds from a higher level and this is the best reward-risk scenario, imo.


Chris United States

Aug 08, 2011 23:49 #

It would be highly intructional to provide a number of sample portfolios which show via backtesting, from say 2003, what is possible as combinations of return and volatility.

Of course we can all experiment with potfolios of various ETF's to achieve good Sharpe ratios.

But for new (and current) subscribers of ETFreplay, having a set of 'ready-made' sample portfolios (more than the basic one which is currently included for new subscribers) available would be very instructional.

You guys who created this great platform have a lot more insight than most of us here do.
Seeing your 'wisdom' reflected in a set of portfolios, would be very valuable.

You could show:
- a diversified portfolio with very strong returns since 2003, but high volatility
- a diversified portfolio with moderate returns, but low volatility
- a portfolio with significantly better returns than SPY, and which also has better volatility


Paul Belgium

Aug 16, 2011 06:51 #

   I completely agree with Paul.  It would also be great if we could have a forum for users in addition or instead of the blog.   The forum could have Topics and ETF Replay Users could easily converse with each other regarding their experiences and Success etc..

   I have a question regarding Draw Downs:   If I am getting this right, the drawdowns are based upon the particular Time Period Chosen which is usually monthly and not Peak to Valley Drawdown.   Is this correct?    If so, is their a way for you to add this feature?


Jack United States

Aug 16, 2011 09:05 #

a user forum would add a lot of value
we could compare and discuss various allocation strategies, portfolios, etc
would give many new insights

Paul Belgium

Aug 17, 2011 18:59 #

Yes, a user forum would be very nice.

Matt United States

Aug 25, 2011 07:05 #

What are safe investments?

Joe Lucus United States

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