ETF Volatility Targeting

May 30, 2012 in Drawdown | Volatility

A new book in the Market Wizards series (by author Jack Schwager) has come out this month.  While these books are a collection of interviews of great money managers -- Schwager himself also does a nice job of summarizing some of the themes he personally has gleaned by incorporating his decades of experience into a series of observations.   

He also recently summarized a few of these observations on his twitter account (@jackschwager).  

A few of his takeaways from interviewing top money managers:


* It is not about predicting what will happen -- but rather recognizing what is happening


* Many go wrong by failing to adjust exposures to changing market volatility


This all conveniently ties into ETFreplay, using Relative Strength to help recognize what is happening is foremost.   But on the second point, we recently added a module to help think about how to adjust exposures to changing Market Volatility.  Let's look at one example of the latter.

Let's think about the Russell 2000 Index, the most popular index for small cap U.S. stocks, which is one of many important market segments we can access at ultra low-cost (never any redemption fees or lock-ups with ETFs) and it of course has total transparency and is deeply liquid.

Let's look back at 2010 for an interesting example of how this segment has traded.  

2010 was a very good year -- but you wouldn't have said that during the summer of 2010 when there was a large drawdown following a flash crash in May and yes, continual negative newsflow from... drumroll... Europe.    The final IWM return was very strong +27% but masks the mid-year washout and pain many investors felt.


Here is 2010 as full year snapshot. 

Go forward one year to 2011, the IWM final return of -4% for IWM also greatly masks the 'path-taken.'  Another large drawdown, this time -29% and about the same actually as the European index loss (VGK was off -30% from peak to trough).

This is very important and something that investors must study a great deal --- the long-term return of the markets is not all that great in relation to the often wild path taken to get that return.  That is, a long-term return of say +7% might have huge drawdowns along the way that cause investors to actually end up losing money if they don't learn how to deal with this.    

(In modern portfolio theory terms, you describe this situation (low return relative to high volatility) by saying simply that the Sharpe Ratio is not very good.)   

If the short-term S&P 500 sharpe ratio gets really high, just wait -- it's coming back in at some point.   This is what happened in Q1 2012 when the S&P 500 YTD sharpe ratio was over 3.00 at one point.   We noted this as an unsustainable figure on our Allocations board timeline.   And now we see the inevitable washout that occurs with assets that don't have good long-term sharpe ratios.   If you want a more efficient equity curve, then don't buy and hold stocks --- unless its part of a well thought-out allocation that adjusts to prevailing conditions.

On the Tools page is a new module 'Volatility Target Test.'  This module executes a convenient, clean performance backtesting report for you complete with detailed period-by-period weightings and return.   

It combines any ETF of your choosing (such as IWM) with a cash-like ETF (SHY) and allows you to therefore approximate a level of volatility for the combination based on changing (dynamic) market conditions.  It continually adapts to the current environment and records the performance of such a mechanical targeting approach.

It should be clear that if you target low volatility and the market goes up a lot -- then obviously it will underperform.   But if you target lower volatility and the market goes down a lot, it will obviously then outperform.    The point of the application is not to be an optimal weighting, it is to help us all understand how volatility targeting is working and how to avoid one of Schwagers main points repeated here

* Many go wrong by failing to adjust exposures to changing market volatility

Below is a single view screenshot of the new volatility Tool:

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Tactical Asset Allocation vs 'Market Timing'

May 14, 2012

Being tactical and market timing are not the same thing.  Let's review.

Market timing in its pure sense means choosing a beta where the beta of the market equals 1 and the beta of cash equals 0.  Asset allocation generally refers to a mix of 5-20 different types of investments.

A portfolio manager who is engaged in choosing country funds and makes a sale is not market timing, they are allocating assets.   To the extent that their return and/or risk expectations change about a country, they of course may alter the portfolios holdings.  Since they are making decisions on many different investments, it is not just based on changing between a beta and cash --- they are choosing and mixing many betas -- this is allocation.

Now let's review active vs passive.   The most purely passive investor would have some type of a global allocation and would not change the portfolio weights based on expectations because a passive strategy does not have tactical expectations.  It is having the ability to change your expectations of future returns that defines someone as active.  A passive investor simply doesn't change their expectations about the capital markets -- or at least if they do and don't do anything about it when they change --- they are acting passively.  

(Note that technically you can be passive and change the allocation, it would just have to be for some reasons other than capital markets expectations.  An example here would be that some type of financial event happens in your life and you now need to take less risk as you will have some extra liquidity need sometime soon.  The allocation could change to reflect this -- its just not due to investment related expectations).

Some people get confused and think that changing an allocation automatically means you are timing the market.  No, if you fall into the 'active' category and your expectations change about a particular segment of the market, then it is frankly inconsistent with basic logic to NOT change your allocation. You change when your expectations for returns between assets change.  

We think ETFs are interesting for their ability to alter portfolios efficiently, transparently and at ultra low-cost.  Whatever your investment process is -- try to remain open on how to improve it.  We think emphasizing portfolio management implementation techniques is what really matters most --- that is, allocation decisions.   You can augment this core idea with either stock-selection or some component of passive buy & hold allocation ideas.   There are no hard & fast rules on portfolio management other than this: favor reward/risk over just reward.

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Employment Trends

May 03, 2012

As we prepare for tomorrows big employment number, step back for the real issue in the world right now:  overall problems in Europe and inept policymakers are in a serious spiral.



Here is the last 10 months relative stock performance:


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What is the ETF land speed record to $2 billion anyway?

May 01, 2012

Once upon a time there were sales loads (they still exist).   Let's say you bought the PIMCO Total Return fund through a broker and paid a 3% load on Feb 29.    The appreciation of the fund still leaves you -1.5% underwater.   Meanwhile, the PIMCO Total Return ETF is up +3.8%.   In 2 months you have given up +530 basis points in performance relative to simply buying the ETF.   While fees like loads are not officially counted against Bill Gross' performance, trust that many investors have been paying ludicrous fees like this for years and years ---  and it still goes on.     If you think we are making this up, then you don't understand how the financial services industry works.



This ETF is likely going to blow through $1 billion and then head much higher.   $665 million in less than 50 trading days.



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