Comparing Some Benchmark Allocations Through Q3 2012

Oct 01, 2012 in Hedge Funds


Snapshot of some basic allocation returns for the Year To Date period ending Sep 30, 2012.   


Hedge funds are having a truly dismal year.   It is actually shocking to see the spread this wide.   For what its worth, the S&P 500 is +16.4% through Sep 30, 2012 --- it is not shown relative to these others because we do not consider the S&P 500 a relevant benchmark for an overall allocation.    It would be appropriate if we were to isolate the performance of just the stock holdings of a given allocation.



Note how the first 3 allocations shown below are all clustered near +11% for 2012.



And we include the below chart to show the paths taken for both the Yale and Ivy Portfolios:


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ETF Country Funds

Sep 28, 2012 in Country Funds
Good analysis is the synthesis of a lot of different research you do.   Below is one way to look at the global market in terms of its trend.   By this account, the trend remains up and the fact that the world markets had problems in the middle part of the year (significant drawdowns) is entirely consistent with many other bullish years.   September proved rewarding for the bullish camp.  On to October.   #RiskReward #Sharperatio
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Avoiding Trouble

Sep 24, 2012

U.S. Industrials have continued to be poor relative performers.   The weak performance has been accompanied by weak earnings guidance from firms like FedEx (FDX) and Caterpillar (CAT).     Allocation board portfolios have tilts to segments like financials and small caps -- and have avoided industrial ETFs altogether.

While we favor the use of relative strength lists for what to look to buy/overweight,  simplified relative strength ratio charts can sometimes be useful to your overall process by helping to see what to possibly avoid/underweight:


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"All Others Bring Data"

Sep 06, 2012

Eric Schmidt, Chairman of Google, often uses the phrase  "In God we trust, all others bring data."  He is referring to Googles ability to position itself based on a lot of data, not just guessing -- or being fooled by mainstream commentator group-think. 

Like the Internet in general, the financial markets are filled with a lot of confusing and erratic noise.  That sound-byte you heard on TV (or this blog post for that matter) is one tiny, tiny, tiny piece of the bigger picture. 

Let's look at some data.   Below is a list of 52 equity ETFs, including international index ETFs.   To avoid any perceived bias,  we just used the Ameritrade list of no-commission ETFs.   There are 101 of those but of the 101, just 52 are equity ETF's.


Note how in each of the past few years, there has been a drawdown and a recovery.   We use 3-months because generally speaking, you really don't want to wait for everything to be making 6 or 12-month highs before you make a move.   August was a month loaded with new highs and you could also see this in our ETF moving average and relative strength backtesting modules.    Do you want to just go with your gut and be a victim of the pitfalls of behavioral finance related to reading news headlines?   Or would you rather be data-driven?


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Junk Bonds vs Treasury Bonds Backtest

Aug 31, 2012 in Bonds | Ratio

Credit markets don't appear to be too concerned about recession in United States.   Junk Bonds have been outperforming Treasury Bonds lately.

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Survivor Bias

Aug 19, 2012 in Backtest | Stocks

Survivor bias is a real problem in individual stock backtesting.   A quick statistic:   ~30% (90 / 308) of the stocks in the DJ Financial services index on Dec 31, 2007 have since been removed from the index.     

Said another way, if you were running a stock backtest using all of the current individual stock components of this index as a starting point to backtest today, you would have a massive positive bias in your study.   Your list would not include names like:   

Wachovia (failed bank), Merrill Lynch (likely insolvent in 2008),  Fannie Mae (insolvent), Lehman Brothers (bankrupt), Washington Mutual (failed), Bear Stearns (insolvent), Countrywide (BofA acquisition disaster), MF Global (bankrupt) etc...

Nearly 1/3 of the list is gone. That is a TON of survivor bias.

Back up a few years and it was names like Worldcom (bankrupt), Enron (bankrupt), Global Crossing (bankrupt) along with all the other Tech, Media & Telecom (TMT) companies that lost -98% of their value and were removed from their respective indices.

Of course, if you operate at a level of long-established indices (as with ETF backtesting), you can largely avoid the survivorship bias problem as the historical index data reflects all of the securities that left the index due to bankruptcy and/or similar resons.   That is, while the DJ Finanicals Index no longer has those 90 companies in the index -- the index RETURN of course does indeed reflect the effect of all those failed/insolvent firms.   Survivorship bias is no longer relevant if using established index ETFs. This is one key benefit you get with using securities that actually traded at the time --- and not just theoretical indices (an index is NOT an investment, an index FUND is what you invest in).

The issue in ETFs is that of newly-created indices that were created only to sell a financial product.   Many of these are going away and the ETF analyst should differentiate between what is a 'real' index and what is a financial gimmick. Does anyone think that the S&P Financial Sector Index isn't going to still exist in 10-20 years? It will. MSCI Emerging Markets -- yes it will too.

New important indexes do come along -- but you should be discerning in this and really focus most of your efforts on long-established indices. Learn about new ETFs as part of your efforts -- but spend 95% of your time on what is already out there.

RIP these Direxion ETFs: Direxion Decides To Close 9 3x ETFs

Note also that having valid indices is no guarantee that YOU will be the provider of choice --- Russell Investments is giving up on its ETF effort after starting far too late and hence gaining virtually zero traction in the marketplace: Russell Pulls Plug On ETFs


See Also: New ETF Tracking Error Nuances

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Update on Hedge Fund Index

Aug 07, 2012 in Hedge Funds

Bloomberg Hedge Fund Index through July 31, 2012.    While there may be room until most managers get back above their high-water marks -- eventually you run into the same core problem --  2+20% of profits will be taken away from investors and go to the fund managers.   Upside is therefore quite limited.  Downside is limited as well but so is the case with a good, risk-managed allocation.


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How 'long-term' are we talking about?

Aug 02, 2012

How long-term is long-term?  Everyone says they are long-term -- but the question of time horizon is a tricky one.

Certainly a good deal of your portfolio can be very long-term buy and hold oriented.  But what if your portfolio is structured poorly?  You can rationalize almost anything saying 'yes but it's long-term so I don't care about that' and if you are long-term, then you don't actually admit to mistakes until its been many years -- and that can be catastrophic if you portfolio strategy is flawed.  

The bond market is good for understanding return and risk because its so structured.   10-year bonds are clearly a lot more volatile than 5-year bonds.  20-30 year bonds move around a lot as they are quite volatile (often more volatile than stocks).

So let's back up to November 2011.  Is the time from November 2011 to today long-term?   Most would probably say no.   However, an awful lot has happened in terms of movement since then.   So we have two very different ideas.   One is acting in a useful and realistic timeframe.   The other is essentailly ignoring 8-9 months of movement and claiming nothing can be done about such a short timeframe. A core-tactical portfolio structure acknowledges there is some validity in both ideas. Multi-faceted portfolios may not lead the world in performance -- but they will help you reach your goals.

On November 30, 2011 --- the stated Yield-To-Maturity of one of iShares main intermediate investment-grade bond funds (LQD) was listed at 4.3%.   A treasury bond fund with similar duration (IEF) was listed at 1.8%.

Since that date, LQD has achieved a total return of 12.5%.   IEF is up 6.2%.    So each has achieved a return that is 3x its stated yield --- and its only been 8 months.

Looking at an extreme case,  a long-term treasury bond fund (EDV) is up +65% over the last 12 months.   A year ago it yielded 4%.   So the actual achieved return in that case was 15x the stated yield to maturity.

For the amount of times we hear about how low yields are -- very little is said about the uselessness of YTM as a predictor of INTERMEDIATE-term return.   I guess its just not 'long-term' enough.   It is the sensitivity to changes in interest rates (duration) that dominates the return.   The best way to both grow (and protect) a portfolio is to blend stocks and bonds together in a way with both the long AND intermediate term in mind.

We are involved in stocks in the first place because over the long-run, stocks are a good way to grow capital.   So we are long-term just like everyone else.   However, the long-run orientation is frankly a 'given' --- what we are really talking about is the intermediate-term tactical moves and in this regard, the returns and volatilities of intermediate moves are substantial.    Saying TLT has a yield to maturity of 3.0% is an interesting piece of information --- it is just not in any way a reliable indicator of the 6-18 month total return.  

Below is a quick snapshot of various bond funds stated YTM's from November 30, 2011 and their ACTUAL total return since that date.   If back then you thought YTM was an accurate predictor -- you're 'only' off by 3x in 8 months.

Summary:   It helps to understand the basic mechanics of portfolio management.    Indeed, portfolio structure and PM techniques are just as important as anything in investing.   Bonds are a useful way to understand different ideas like volatility.   We want to be in equities long-term and for the core long-term portfolio, it is perfectly reasonable to do that.   But there is clearly more opportunity than that in the intermediate-term timeframe. 



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Sector ETF Investing: Black Diamond, Beware

Jul 30, 2012 in Sectors


At ski resorts in the U.S. each ski run is denoted with a symbol.  A green circle is for 'Easiest' runs, a Blue Square is for 'Moderate' and the more difficult runs are marked with a 'Black Diamond'.  A Double black diamond would be for experts only.   Perhaps ETFs should adopt this system?  


The most volatile are black diamonds and any short-duration bond funds would be marked Green.   Of course, there is no enjoyment in going 'down' green runs, you spend all your time and effort just planning how you are going to maintain some speed so that you don't come to a complete stop. 


If you look at virtually any institutional money managers quarterly or semi-annual review,  there is usually something that has a few lines similar to this:  'we are overweight energy for reason X [and insert reason why] and underweight financials for reason Y [and insert reason why]' etc...   Then there is usually a data table comparing the fund to its benchmark across each sector.


Let's take a look at some recent trends in Sector ETF investing.  For this, we pair up 2 sectors:  [Financials + Energy] vs [Staples + Utilities].    We link these together because these are classic 'High-Beta' vs 'Low-Vol' types of analysis (in recent years the popular terminology has been: 'risk-on' / 'risk-off') -- but it's all the same idea.   


Below is the second half of 2011.  


Put yourself in the spot of a fund manager trying to explain their sector positioning at each point in time.   Note that Staples + Utilities had a sharp but very short-lived corrective move beginning in July, 2011 and then promptly retraced the entire amount back up in September and then actually went back above the July/Aug highs soon thereafter.  Meanwhile, Financials and Energy continued to correct hard into very beginning of October and then go into a vertical short-squeeze type of move up that lasts about a month and then entering a volatile trading range through the end of the year.

By the time the year ends, many managers not watching such things in this format are wondering how in the world the S&P 500 ended up +2.0% (total return) for the year.    Hedge funds got whipped around badly as this action is indeed very tricky if you are spending your time trying to figure out how it all makes sense fundamentally.  But the fact is that the market doesn't sit around and wait for you to figure out how it all makes sense before it does its next thing.    Managers coming up with reasons for their quarterly positioning often have a tough go of figuring out how to make it look like they know what they are talking about.

Ok, so now say you got it right during the second half of 2011 and were overweight low-vol segments (think high dividend stocks).  Great.  Now the first quarter of 2012 begins and the exact opposite occurs.


As the new year got underway, the market begins with a large rally in 'high-beta' assets while classic low-vol sectors like Staples & Utilities actually go down.   High-beta had a big first quarter with low-vol lagging.   The manager who was (rightly) defensive in 2011 now has a tough time justifying why they are off to such a rough start to 2012.   Some managers likely then took their high-beta exposure up to reduce the pain.     And what has happened since then?  


Naturally, there was another large internal rotation with the overall market going nowhere while low-vol segments outperforming strongly with high-beta trading down.

So that is where we stand now --- these sets of ETFs are now essentially up about the same amount YTD -- but with very different paths to get here.    Given the large outperformance during the second half of 2011, the 12-month chart of course looks quite different --- with low-vol segments like Staples and Utilities back at all-time highs.

A lot of members who begin at ETFreplay set up a 'sector portfolio' --- ie, the Sector SPDRs or Vanguard Sectors.  It might be natural -- that is how a lot of people think about investing -- overweight this sector and underweight that sector.     But once you start backtesting such strategies, you may start to realize --- wow, this doesn't work very well.  

Well, look on the bright side, it's a good thing you tested it before thinking you had something.   Indeed, sector investing can be treacherous and that isn't a new thing.   We have done many examples on this blog and within the demos on the site and we've never done a sector example (it wasn't for a lack of trying various ideas).  The reason is that we just think there is a lot of lower hanging fruit than that.   We don't care to ski double black-diamonds when there are nice blue square runs out there.  

That all said, if you do indeed want to test sector strategies -- then we suggest a particular module called  'Ratio Moving Average backtest' -- our work shows some potential in this area.   However, we would stay away from things like XLE vs SPY.  There are 1400 ETFs after all, it's ok to have some imagination beyond the over-researched and over-analyzed sector approach.

Thinking from a return-risk perspective,  we do have one idea for sectors -- it involves just buying and holding lower-vol sectors and then barbelling that by tactically adjusting higher-beta exposures using the 'Ratio Moving Average' module.   If you do it like that, then you will generally create risk in the end that is similar to the overall market -- and you will greatly reduce getting caught in buying back into high-beta AFTER its had a run.

The 'Ratio MA' module compares 2 ETFs and attaches rules to trade the ratio between two market segments.   We prefer using uncorrelated ETFs in this analysis --- ie,  XLF vs IEF  --- rather than one equity ETF vs another equity ETF.  But we certainly look forward to seeing other possible techniques by watching members ideas develop on the Allocations Board

Summary:  In our opinion, sector ETF timing is something that we think is probably over-researched (and the charts above indicate its 'black-diamond' nature).

Backtesting is inherently evidence-based.   When you learn something in backtesting, then use that knowledge.   Don't try to force-fit a generic sector list into a strategy --  be flexible and don't stop the learning process.  Financial relationships can be dynamic --- that is, they can change in sometimes tricky ways.   If you have trouble making something deliver good reward/risk -- then take heed -- it probably has no edge and is therefore just a random walk.  Like the signs in the picture above --- there are various levels of difficulty.   If you go down the steepest run,  you may 'expect' to get to your destination more quickly -- but that doesn't mean you actually will -- the chance of crashing and burning is the other possible outcome.   The last 20 years are filled with managers who ski'd recklessly and won the short-term race  --- and then eventually ended up in the Ski Patrol sled.

Focus on reward-risk as a relationship.   Not just return and not just risk.




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Allocation Example Making 'New Equity High'

Jul 16, 2012

It's still less than 7 months old but this allocation demonstrates what has been working lately.    This 'new equity high' has been driven by REITs, preferred stocks and EM Bond positions.   It's not clear what the benchmark should be on this one --- it's beating 60-40 but it actually holds 'liquid alternative' ETFs -- not equities.     Benchmarks are less important than making new all-time equity highs and generating return at reasonable risk.



New equity high has been driven by some very solid performances in areas like REITs and E.M. Bonds:


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