US equities had led all asset classes for many months headed into late April. When global volatility picked up on the problems in Europe, this caused global equity correlations to rise. Since rising volatility is a negative contributor to expected equity returns, we forecasted a move down in the relative strength rankings for US equities relative to bonds and gold.
We highlighted a move to gold that triggered in our Relative Strength Application at the end of April. Gold has already shown its worth as gold had a positive return in May of +3% (+1100 basis points vs S&P 500) despite possible deflationary conditions in the Eurozone.
Our ETF Screener models tell us how money is flowing and US Treasury bond ETFs continue to lead the ETF relative strength rankings and are attractive on pullbacks. Because long-duration treasuries are quite volatile and don’t offer much yield, we prefer the 3-10 year treasury maturities. The chance of a large drawdown with an average duration in the 5-7 year range is quite low because of the very structure of intermediate bonds. We can look at history as a guide on this and see that while there were very large drawdowns in long-dated treasuries during the 2009 bond-market correction, the mid-term treasuries were significantly safer. So while a continued ‘flight-to-safety’ trade benefits long-duration treasuries most, we think investors should always consider risk in relation to return. And so for risk reasons, our preference is for intermediate treasury ETFs (for example IEI, IEF, BND).
This is a common situation ETF investors should get used to --- where you can like an area of the marketplace but choose to simply avoid the highest volatility ETF’s within that segment in order to control portfolio risk and target Sharpe Ratio (risk-adjusted returns).
Controlling drawdowns is a significant aspect to money management and is a primary reason we created ETFreplay. The very first application we built was a portfolio management module in order to help investors understand volatility and that implication for drawdowns. Remember this basic rule: the higher the volatility, the higher the drawdown.
On the negative side of the ETF Screener models, global forces have continued to aggressively sell equities. As seen below, the broad FTSE All-World Ex-US ETF (VEU) has so far experienced an -18.8% high to low drawdown over the last 6 weeks.
Summary: risk budgeting is a very important aspect to portfolio management . For sophisticated investors, discussing return without the context of risk is meaningless. Our backtest portfolio app allows users to simulate risk budgets by entering ETF weightings and viewing various market segments (as represented in ETFs) relative to some common major benchmarks, whose properties are well understood.
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