Video Blog: Using and Understanding the Portfolio Relative Strength Application

May 27, 2010 in Backtest | Video

This video discusses some ideas related to our powerful new ETF Relative Strength Application. The key to understanding how it works is to understand its relationship with the ETF screener

Comments and feedback appreciated.



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Watch Global ETFs for Important Global Trends

May 24, 2010

The past few months (not just May) have been an example of why watching the entire globe, not just the United States, is important.  The convenient aspect to todays marketplace is that the ETF landscape makes this quite easy to do.  The stock market is just one slice of a global, multi-asset pie – spanning treasury bonds, real estate, corporate bonds, commodities, developed international markets, emerging markets  etc….  

 

ETF’s offer an opportunity for investors to benefit from volatility in ways that institutions cannot.   No large institution can rotate asset classes and global segments efficiently – it’s simply a matter of liquidity – they are too big relative to the trading volumes in the marketplace.   Nimble hedge funds and advisors as well as individual investors have a very significant advantage in gaining and reducing ‘exposure’ to various asset classes.  

 

As stated in our ‘ETF Overview’ page -- we believe investors should de-emphasize the micro issue of how to beat any particular market with stock-picking and instead focus their efforts on which MARKETS they would like exposure (long or short).   These asset class decisions are what drives your portfolio returns and while you can certainly buy individual stocks or mutual funds or individual bonds --- it STILL should matter to you what is going on in the broader investment landscape.

 

Pure momentum strategies have been shown to work over the long-run – but with significant drawdowns.   Our website is targeted at both finding relative strength AND building portfolios that limit drawdowns.  We offer a portfolio management page where you can compare the volatility of your portfolio vs that of the main benchmarks.  If your portfolio is more volatile than the global index then you should expect some very large drawdowns.   If you take time to understand the important link between volatility and drawdowns then you will be much better off.     

 

 

Backtest ETF Portfolio

 

 

Most investors were blindsided by focusing on the US economy and missed the larger issue of rising global volatility.   When volatility rises, correlations between markets rise --- this is a strong statistical tendency.  This is what happened to the U.S. stock market --- it would have been very odd if the global markets just continued to diverge amid rising volatility.

There will be a time to be more aggressive on global equities but there is no need to guess when – the relative strength models are sensitive to change and will show rising relative strength.  As we highlighted in prior posts, equity volatility is rising and the relative strength of equities is falling vs other asset classes. This is not a change -- it is just a continuation of a process that began months ago and   U.S. equities just finally joined in. 

 

We have suggested keeping portfolio volatility down – by staying away from global equities – and this situation will continue for a while as the models are unlikely to just reverse sharply back up after a strong rotation out.   If they do, we will have dry powder to join the big money forces that move assets classes into bull and bear phases.

 


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What are the differences between the Treasury Bond ETFs?

May 17, 2010 in Bonds

Richard Bernstein, the long-time market strategist from Merrill Lynch, has said many times that ‘U.S. Treasuries are the only true diversifying asset.’ We wanted to make a few more specific comments that add to the discussion with regard to US Treasury ETFs.

First, there is a very large difference between a short or intermediate 3-7 year type of treasury security and a 10-30 year long-term bond. The term ‘US Treasury’ is too vague to actually be practical. The short and long-term Treasury ETFs are really entirely different categories of securities.

The ETF world has securities all up and down the maturity spectrum. Let’s look at an extreme example to help understand what we are talking about: EDV (the Vanguard Extended Duration ETF) had a very large -41% high to low daily closing move (drawdown) in 2009. ‘Maximum drawdown’ is a nice, easy way to think about ‘risk’ --- everyone can understand it intuitively: When this asset class goes down, how much does XYZ go down vs others in the same asset class?

At the same time EDV was dropping -41%, the iShares 3-7 year Treasury bond ETFs largest drawdown was -6%. Maximum drawdown is the amount of loss if you bought the exact closing high and sold the subsequent exact closing low (the worst trade possible based on closing prices). While certainly far from perfect, this is a useful way for investors to at least incorporate some type of risk analysis into their thinking. Discussing returns without the context of risk is a common error made by investors across all segments of the industry.

As a general rule, you should avoid the highest volatility securities as these will tend to have the largest drawdowns -- and the ultimate goal is to think in terms of reward and risk – not just return.

Long-term bonds are quite tricky to analyze, given their low yields and highly volatile nature. Intermediate-term bonds (treasuries and non-treasury bond ETFs) are much more straightforward. If your timing is off, the penalty for this is much lower as this maturity zone won’t drop much when the equity markets are rising. But more importantly, this group will offer a nice hedge for nearly any other security you hold.

This table summarizes a list of U.S. Treasury ETFs and their Maximum drawdowns over the past few years:

Note: EDV had a very large capital gains distribution in 2009. Be aware that if you look at this on a regular charting platform that doesn’t adjust ETF for total return, the chart will not be representative of the underlying index that the ETF is tracking.

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Volatility Storms, Crises and ETF Correlation

May 16, 2010 in Correlation

First, a chart of GLD vs the FXE Euro Currency ETF is a simple yet powerful way to show the primary issue in the world right now:  

This EC (Euro currency) crisis has brought on a volatility storm (sharply rising volatility/VIX).   It is common to hear analysts and portfolio managers say --- what does a Greek default have to do with my US domestic small cap stock??   Well, a lot actually if the Greek problems lead to a crisis – as a crisis will cause overall market volatility to rise.

Correlations RISE in times of crisis.  This is not just a random statement, it can be viewed mathematically using the Capital Asset Pricing Model (CAPM) framework.

In CAPM, the correlation between two assets can be expressed as a function of their Betas and the variance of the market.  If we assume that both assets have a beta of 1.0 and identical residual risk, then it becomes mathematically true that correlations rise as variance rises.  Thus, some type of crisis causes overall variance to rise (in this case it’s the escalating debt problems in Europe)--- and then this rising variance will cause correlations to rise.  

Note the serious divergence of small cap US stocks and the MSCI ETF Europe (correlation at first drops on the lower chart) -- and then the subsequent increase in ETF correlation when VIX/volatility increased sharply.

 

 

 

see also:

Correlations Rise In Times of Crisis

for a more complete technical explanation of this topic see "Active Portfolio Management"  (Grinold & Kahn, 2000).  This book is extremely technical and really only for professional investors with mathematical orientation. 

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Vanguard Moves All-In

May 13, 2010

Recently, there has been a price-war in the ETF marketplace which is a very significant development. Schwab moved first, Fidelity raised Schwab -- and now Vanguard has pushed all-in. Neither Schwab nor Fidelity has been a strong player in the ETF market. But now industry heavyweight Vanguard has made each and every one of its 46 Vanguard ETFs free to trade --- assuming you have your account at Vanguard.

If this story sounds familiar, it's because the same thing happened many years ago in the mutual fund business. Prior to the 1970’s, banks and trust companies controlled most of the assets in the industry. Then the mutual fund became the product of choice and this was a multi-decade trend that led to an eventual $25 trillion mutual fund industry. Along the way, funds went ‘no-load’ – that is, no transaction fee. This was a very significant development as transaction costs like commissions and loads take money out of the investors pocket.

Today, we sit in the early innings of a major transition away from mutual funds and towards exchange traded funds. This current price war will serve to accelerate that transition.

Here is a breakdown of the ETF line-up at Vanguard. We do not view this as a complete list - as it fails to capture many of the interesting things that are likely to occur on a global scale over the next 10 years (long and short).   That said, Vanguard has recently launched fixed-income ETF’s so this at least begines to round-out a very heavy 'U.S. Equity' view of the world. We respect Vanguard as one of the most investor-friendly institutions in the world so we enthusiastically support this ETF list – but treat it for what is, a US dominated list.

 


 

We have also added a Vanguard list to the ETF screener  page:

 

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Plan Ahead. Updating your portfolio vs the use of stop-loss orders.

May 11, 2010

In portfolio management, the term strategic is code for long-term.   The term tactical is used as a way to describe a strategy that is shorter-term, such as a portfolio adjustment based on seasonality.  

So for example, you may want to own the India Fund (INP) in a strategic long-term sense --- though you may be underweight on a tactical/short-term basis etc…  Or you may not care about the Gold ETF (GLD) long-term but you see a tactical opportunity in it now --- something we have highlighted recently.

We know that you can greatly improve your Sharpe Ratio by employing some relative strength strategies to your ETF investing.  One of ETFreplay.com’s primary strengths is allowing users to easily test various overweight/underweight methods.  Our relative strength application ‘updates’ on a pre-defined date -- we do not use stop loss orders.   The ‘stop’ is in effect the next update period.   We view this as a far superior method as it removes the emotional nature of the markets and keeps you from acting on whipsaws, like we saw last Thursday. But the primary benefit of this framework is that it keeps you focused on the bigger picture -- and it is global asset allocation that ultimately drives 90%+ of your portfolio returns. Is your portfolio positioned correctly as of the end of each quarter?   Is it positioned correctly at the end of each month?   You can of course update your portfolio during any day – but hopefully, you are doing this in accordance with a larger strategic plan.

If you plan ahead and watch your overall volatility, you can sleep at night knowing that you have the Sharpe Ratio on your side.  Over the long-term, the relative strength models will find markets that go up ---- and good portfolio management will limit your drawdowns.  If instead you recklessly buy a list of securities and have no idea what your portfolio volatility even is --- then you are going to be placed in some very difficult situations.  The key is to plan ahead of time.   Hopefully, our models and backtests can aid you in this thought process and help you find some good reward-risk situations to overweight.   

On Monday, the market gapped up a very large percentage on the nearly 1 trillion Euro bailout.  Importantly, this followed a very significant correction in European stocks.  This is the kind of thing that is a more technical aspect of tactical portfolio moves.   Indeed, vicious short squeezes should be viewed as the norm after sharp market corrections, like that experienced in Europe. This is the very definition of volatility.  

Precious metals --- Gold (GLD) and the precious metals ETF (DBP) are the thematic leaders of the market now.  Be on guard regarding your overall portfolio as volatility has surged – but keep your tactical trades in line with your strategic ideas and you will consistently be updating your portfolio with the best reward-risk situations.   Combined with intentionally keeping your volatility low, your Sharpe Ratio will rise – and this should be your ultimate focus.


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Index ETF Focus: Gold (GLD)

May 07, 2010 in Backtest | Gold

We highlighted potential leadership developing in gold at month-end.  Last Friday, the Gold ETF triggered a buy vs SPY in the Relative Strength application.

 

 

As of Tuesdays close,GLD had then moved to the top of our screener relative strength list.   When volatility began surging in the equity markets, it should have become clear that US equities were going to drop in the screener rankings as high volatility is penalized in the model.  The logical asset to assume new leadership was Gold (GLD) as it had already been moving up the rankings, as highlighted in our May outlook and as also being supported by the RS ‘app.’   This is a good example of reading ‘market generated information.’   

 

 

While Gold (GLD) advanced this week, of course the best relative strength-based call was staying short international equities, particularly Europe.    Europe has some serious problems to deal with  and you can see the horrid relative performance of international stocks over the past few weeks.  This is an example of an opportunity that was available to globally focused investors and invisible to those with only a domestic focus.

 

Summary:  volatility has increased sharply in the equity markets, which makes equities LESS desirable to hold vs a fixed payment security like a short-term bond.   Meanwhile, the Gold ETF (GLD) is rising in price, which makes it more attractive as its volatility is justified by its improving relative strength.   

 

In a world of talking heads, rumors of computer errors and extreme emotion, it pays over the long-run to ground yourself with some strong reading of money flows that is statistically supported by backtested models.



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ETF Portfolios : Corrections are when the Sharpe Ratio proves itself

May 06, 2010 in Volatility

One of the major benefits of exchange traded funds is that they provide greater precision in allocating risk. ETFreplay.com has intentionally built virtually every one of our website pages with risk/volatility in mind.  When we designed the layout, we felt that volatility should not be an indicator in the lower pane of a charting layout – it is too important – so we created an ETF Charts layout that deliberately puts the 2 main components of the Sharpe Ratio in the upper pane.    We do this because for sophisticated investors:  discussing returns without the context of risk is meaningless.

 

 

One interesting way to appreciate the Sharpe Ratio is to show how it cannot be fooled by something like the ProShares leveraged index ETFs.  This is a useful exercise as the nature of compounded returns is actually quite a bit more complex than it seems.  

SSO is the 2x leveraged long S&P 500 ETF.  By construction, it will always have 2x the volatility as the S&P 500 --- but as you look past the short-run, only in the very best case scenario will it equal 2x the daily mean return of the S&P 500.    

It is possible that leveraged ETFs can have roughly equal Sharpe ratios vs the unlevered ETF --- but never more --- and very often much worse.   The compounding of returns over time is the killer -- only in the case of a non-stop upward move will the sharpe ratio be approximately equal.   The nature of compounding is that large losses are disproportionately hard to make up in a rally while outperformance can be quite easy to give up in a correction if you are not careful on watching volatility.

From an investors perspective  – the leveraged products are flawed.  We will spare the reader the math on this and instead show the very dramatic leveraged ETF charts as a more extreme example of how important it is to avoid high volatility ETF’s when they do not have relative strength – the losses are just too great.   The converse of this is that by focusing on the Sharpe Ratio for your portfolio (intentionally reducing volatility when there is no relative strength), you stand at a distinct advantage of benefitting from the likely long-term outcome of markets that don’t just forever run up in non-stop fashion:

 

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MSCI Index ETF : World Focus (ACWI)

May 05, 2010 in Country Funds | Strategy

The MSCI Index ETF list is quite useful as a starting point for ways to think about the global investment landscape.  Moving from a domestic to a world focus expands the individual equity universe to well north of 8,000 securities (vs the typical Russell 1000 focus of domestic managers). Global exports are increasing on a secular basis as the world increasingly trades goods and services with each other ---- globalization is unstoppable.

Ironically, I say all of this as our models have been favoring domestic over international ETFs for months now and being short (or avoiding) Europe in particular seems like more than just a short-term trade.

Nevertheless, over the long-run it makes sense that more choices will offer diversification benefits in terms of enhancing return (long and short) and likely reducing risk (though this benefit becomes less as globalization increases).  Without going into a long dissertation on this topic, I will just instead show the current relative valuations of the MSCI World Index ETF (ACWI).   

MSCI Index ETF ACWI Weightings

 

Note that approximately 2/3 of this index is in the United States and Europe.   It is not AS out of balance as it may at first seem as companies like those in China have very low profit margins. In the U.S., a company like Google might not contribute a lot to GDP – but it does have very high overall profits.   Conversely, Wal-Mart contributes a lot to U.S. GDP but has very low margins – and China supplies Wal-Mart so you can imagine how their profit margins look.    So each country will have GDP changes and profit margin cycles to think about --- its not JUST about GDP growth and population trends.   

Over the very long-run though, these world weightings will likely change in favor of countries with stronger demographics --- (the above chart should only be viewed as a snapshot in time).  Importantly, it is not going to be a smooth ride -- even as it seems obvious that countries like China and India grow to be much higher percentages of the total.  

The next chart from the ETF Portfolios page re-creates the MSCI World Index ETF as a sanity check.  We can do this with regional and country funds.   It won’t be perfect because there are some anomalies with indexes regarding 'sampling' and starting vs ending weights etc.…

 

 

So within the context of a dynamic and volatile global marketplace, ETFreplay.com is based upon – finding quantifiable, back-testable methods to help the investor think about balancing reward and risk.  In other words,  to participate in global strength and to avoid/underweight/short regions of the world showing global weakness.  There will be many large corrections within secular themes.  You need to protect yourself by balancing the longer-term demographic trends with the realities of extremely volatile markets.  This is doable -- so long as you show proper respect for the markets inherent volatility.  

Finally, here is a look at our ETF Screener.    The ‘ETFreplay.com Selected Betas’ grouping has most of these indexes scattered within it.  We don’t think its complete to just look at regions of the world --- we like to view Relative Strength across asset-classes as well, not just equities.   Note here that this is not properly done unless you are tracking total return  --- dividends and distributions can make a significant difference in your screens and models.  You need clean data to properly calculate relative strength -- especially across asset classes. As experienced professionals, we want to stress the relative benefit of a well-maintained total return database of 400 ETF's --- vs a 15,000 security database that simply reports trading numbers and ignores total return.  We have intentionally created a focused environment (based on ETFs) to minimize the data integrity issues that can greatly affect financial models.    

Details are important.   We cannot be perfect -- but we know that simply ignoring the issue (as others do) is particularly disingenuous.  ETFs are based on indexes.  Index returns are ALWAYS based on total return.  Price alone does not reflect total return, adjustments are needed.  We make these adjustments so you don't have to... 

 

ETF Screener

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Where Is Global Money Flowing Now?

May 03, 2010 in Screener | Strategy

Here is our read on global money flows as we begin May:

Asset allocations are the most important aspect to portfolio management. Our ETF Screener helps tell us where global money is flowing. We think it’s a good idea to use experience and market savvy in conjunction with the quant models. There are countless ways to actually implement a given higher-level ‘strategy.’ We would strongly suggest staying with the theme of the backtested models -- but also keeping a watchful eye on overall portfolio volatility as a sanity check. Volatility is a good way to think about the potential for drawdown – so this focus protects you when there are strong rotations within the global marketplace.

Our models have not seen much change recently. Stay overweight US equities and underweight (or short) international equities, particularly Europe. Given instability in Europe and the already large outperformance of US Equity this year, a large divergence like this is a bit of a concern.



Other regions of the world, such as Latin America, Emerging Asia and the Pacific countries do not appear to be worth an investment at this time --- these regional ETFs have high volatilities and are not showing relative strength.  Interestingly, US REIT’s have been showing strong movement within the rankings – indicating global money continues to have a risk appetite for segments of the U.S.

It makes sense to us to stay aggressive on the non-equity portion of the investment landscape. U.S. treasuries do not look interesting at this point as yields are low and the global economy – outside of Europe – appears to be fine. If the U.S. were not strengthening, why are junk bonds continually making new 6-months highs?

Outside of the primary indexes (and REITs) – 2 interesting developments we have noticed over past 4-6 weeks:

1) Precious metals are rising in the relative strength rankings
2) Emerging market bonds look good in the rankings (note that EMB/PCY are dollar-denominated) -- they tend to trade a lot like U.S. high-yield bonds -- and they have pulled back recently.



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