YTD 2012 Update: Generic Stock-Bond Index Fund vs Hedge Fund Index

Jul 03, 2012 in Hedge Funds

We updated this chart for YTD 2012 Performance:

Link to the 2011 Chart as well as the 7-Year Chart Ended March


2 Other Generic 'Endowment-Style' Allocations For Reference  (note: including the above stock-bond chart, all of these YTD returns are clustered in the +5 to +7% range)



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Some Summary Index Charts At June 30, 2012

Jun 30, 2012



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'Bernanke Is Killing Savers' -- Reality Check Part 2

Jun 24, 2012

We wrote some blog posts in  2011 about the top 25 bond ETFs in terms of assets.    This is by definition what fixed-income ETF investors actually own.    We don't have to guess -- or say comments like 'Bernanke has killed savers returns with its 0% interest rate policy'  ---  we can just observe the assets in each fund and calculate the actual achieved returns.

Using the exact same list from a May 2011 blog as a proxy, over the past 13 months fixed-income ETF investors are up in the range of +7.0%.   Over exactly 12 months, its +6.3%.



It's not spectacular -- but it certainly hasn't been 'near 0%'  as some commentators seemed to be predicting based on their views of U.S. Federal Reserve policies.   If you are just watching the stated yield-to-maturity of 10-year Treasuries relative to history and think that is all there is to it,  well then --- good luck.

Two ETFs we like to watch closely are IEF and LQD.   They aren't the only ones to watch of course, but these are 2 key intermediate index segments (Treasuries and Investment Grade Corporates).  Neither has much in terms of yield now....  NOR DID THEY 12-13 months ago.  For LQD, the total return path neatly factors in all of the following:   1) the interest earned along the way   2) the change in interest rates since the start date (for the index)  3) the change in the credit spread vs treasuries  and 4) all the bond trades the ETF manager has done to maintain the characteristics of the underlying index.    As CFA charterholders, we had to learn bond mechanics like how to calculate convexity/duration and Option Adjusted Spreads (OAS).  But in the end, a portfolio manager just wants to analyze portfolio management strategies that make money --- the mechanics of individual security analysis are important to a bond fund manager in competition with an index  -- but such mechanics are really not very meaningful when put in the context of managing an overall asset-allocation.

Below is a chart of IEF & LQD  -- and then we include XLE and DBC (the Deutsche Bank commodity index) since May 2011.  The point here is simply to re-iterate the point made 1 and 2 and 3 years ago -- you can't simplify something as vast and nuanced as the bond market into 'avoid bonds' just because the YTM of 10-year Treasuries is low.


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Learning Through Portfolio Backtesting - The Short-Term Isn't That Meaningful

Jun 10, 2012 in Backtest

In this post, we will check back in on the 'Sample Portfolio' -- which was a portfolio we set up over 2 years ago and included as the starter example portfolio for new members.   The idea behind it was to show one type of simple mix of ETFs that can serve as good complements to each other in terms of a rotation strategy.

As seen below,  this rotation portfolio has performed pretty well over the past 2 years.   

But the more specific point we wanted to make here was in the statistical profile that accompanies the report (marked with an arrow at the bottom).  

In the last 'out of sample' 18 monthly results (2011 & 2012), while this strategy is well ahead of the major indexes -- it has actually underperformed the S&P 500 in 10 out of 18 of those months.   Yes, that is right --  it has handily beat the S&P 500 on a cumulative basis while still underperforming more times than not in terms of months.  That seems counter-intuitive -- but this actually isn't that unusual in investing.  

Many times you run a backtest and it shows good results --- make sure to scan down to that number in the table below and take a look at how often is outperforms your inputted benchmark.  If you do this a lot, you will start to understand some of the common pitfalls of bahavioral finance issues.

This is the important part --- if you didn't know this, imagine how your psychology might affect your investing process.  The start to 2012 is a good example.  Our allocations board portfolio fell behind the S&P 500 return on a Year-To-Date basis in March (relative basis only).   Was this underperformance meaningful?  No.  Not if we believe that our strategy is solid and that we don't care about the short-run --- we only care about the equity curve over time.  Through backtesting, we are armed with the knowledge that good strategies might indeed underperform in 40% or more of the months and this does nothing to change the validity of the strategy.

Summary:   We all want to outperform the indexes in every single period --- but if you obsess about this kind of thing --- chasing a benchmark around in every short-term timeframe -- it will ultimately be your un-doing.   The behavioral/mental side of investing is hugely underrated.   The specific numbers in this one example are not the point.   The point here is to use the portfolio backtesting process as a way to battle against the behavioral biases that keep you from doing well in investing.   In our view, backtesting ideas can greatly help because if you are like us, you have to SEE it and imprint it on your brain to actually believe it.  Only through a good and never-ending research process will we ever truly believe in these kinds of things.


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ETF Bond Market Performance Since QE Began

Jun 07, 2012 in Bonds

The Federal Reserve has made a lot of money on its Treasury Bond purchases.  However, that is dwarfed by what high-yield bond investors have received over the last few years:

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Corporate Bonds vs MLPs

Jun 02, 2012


Treasury Bonds Are Going Parabolic.   But its not well reported that high-grade US corporate bonds are also in a strong rally.  It's not just treasuries.   Meanwhile,  Oil & Gas MLPs are having very poor run and should be a reminder of the difference between fixed-income securities and riskier assets.


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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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