Understanding ETF Volatility Part 2

Dec 22, 2011 in Drawdown | Volatility

We are updating our 'Volatility vs Subsequent Drawdown' Chart for 2011.   We did a similar post a year ago and you can review that blog post here: Understanding ETF Volatility Part 1.


The way to read these charts is to simply note the relationship.   By definition, high standard deviation investments offer wider opportunities for both out and underperformance.  The S&P 500 dropped -18.6% off its high during 2011 (using closing total return values).   This was -3.2% worse than the mid-year loss in 2010, when the S&P dropped -15.6%.   

Gold had a more normal drawdown in 2011 at -17.5% vs 2010's -7.8%, due mostly to its more aggressive slope up during the summer.   Gold never got particularly volatile in 2010 but in 2011 it traded more typical of a commodity market -- where there is often a momentum-oriented blow-off move.   Still, if you were watching volatility dynamically, you would take note of it becoming riskier during the July-August advance.   

The NASDAQ-100 actually dropped slightly less from high to low in 2011 vs 2010.  Large-cap tech -- particulary AAPL have been relatively calm in 2011 -- which was also the case in 2010.   Can it go 3 years with just a mid-teens drawdown?  We don't know but there are certainly other more attractive segments as we close 2011.

It may sound odd but the losses in both 1) small cap US stocks (IWM) and 2) US Energy stocks (XLE) were about the same from high to low as the European ETF (VGK), which dropped -30%.   However, both of the US ETFs have seen strong rebounds in Q4 and are a few percentage points from flat on the year.

Silver (SLV) is pretty consistently the most volatile (unlevered) ETF around and it didn't disappoint with a -41% high to low move in 2011 (and the year isn't quite over).

Treasury bonds ground out fantatstic years.   We've blogged many times about how intermediate and low-duration bonds are the ultimate safe-haven.   You can't count on consistent correlations in times of crisis -- but you can count on low-duration bonds,  the fixed-maturity dates of the underlying securities ensure it.  This is not true of long-term bonds -- which look susceptible to significant drawdowns in 2012.  As much hype as the US downgrade received, it proved yet another meaningless move by the ratings agencies in the United States, which for some antiquated reasons seem to remain relevant to some.

Note that many ETF providers launched 'minimum volatility' ETFs in 2011.  Since starting ETFreplay.com in early 2010 we have always used volatility as 1 of 3 key inputs in our multi-factor screener model -- so we are not surprised to see this development from the ETF providers.   Volatility has and always will be important --- but it's certainly not the only thing that matters.  Myopically focusing on volatility is taking this all too far as building ETFs off a singular concept like this is very limiting.  

We view risk-adjusted (volatility-adjusted) relative strength as the cornerstone philosophy of ETFeplay.com and this led to a fixed-income bias throughout most of 2011.  However, a tactical investment process continually looks to adapt to the environment --- and we would look for continue rotations in 2012 --- and every other year for that matter.   There is plenty of room to add value in any year and it's up to you to figure out which group that is and how to manage it.  In 2011, fixed-income ETF showed excellent total returns.  You can't always be right of course --- but you can pursue a process on thoughtful consideration of which markets to be involved with --- and then layering some trend-following techniques on top of that ---  all the while continually striving to protect yourself for the times you are wrong.   If you simply stay consistently loaded in a group of highly volatile securities -- it is just a matter of time before you have a large drawdown. 

As can be seen in our tracked Portfolio Allocations, we view equities to be attractive as we end 2011 -- particularly small and midcap US stocks.  We see signs of P/E multiple expansion with rates low and liquidity being added to the problem areas of the global economy.  However, even assuming we enter an intermediate uptrend (which may or may not occur), this does not mean that more rotations within the markets won't occur.  It is never easy in the moment and we will carefully continue to watch and adapt to new potential themes/trends --- while always watching our backs to avoid too much portfolio volatility (and its associated drawdown).


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Comments (5) -

Dec 23, 2011 04:05 #

From the tracked Portfolio Allocations list, how do we indentify those from ETFreplay.com staff?


Ernest United States

Dec 23, 2011 06:23 #

We began that module so that we can see various ideas within the context of different users portfolio allocation.   I have been using a similar approach in some 3rd party tracking websites for a longer period of time and rank pretty well on those  --- however,  we've found those sites do an  inconsistent job with tracking total return -- missing many distributions and mixing up trades.   So the primary benefit of fixed-income (income) is ultimately lost and the equity curve inaccurate.

My username is SharpeRatio and portfolio symbols are  E-ETFRS and E-ETFRE.   To see some other portfolios I watch -- try  E-DREAM, E-ESCHR & E-APOLL.   The consistent theme here is that they seem to understand the return-risk portfolio relationship well.

Happy holdidays

Chris United States

Dec 23, 2011 06:41 #

Thank you for the information, Chris.

Happy holidays

Ernest United States

Dec 24, 2011 06:50 #

It would be helpful in the allocation portfolio's columns to have year to date, one year as well as lifetime return as time evolves.  Currently have to go into each to see how they are doing which is cumbersome to do.  


(thanks if this is already in the hooper)

GRock United States

Dec 24, 2011 09:56 #

We understand GRock,  this is just still relatively new --- having only began working on it over the Summer.   It needs time to create longer histories and then it can get more interesting.

Chris United States

Comments are closed