Some ETF Structures Are Flawed As Investments

Apr 26, 2011

Quick Tip: The U.S. Stock Market over the past 18 years has an annualized standard deviation of about 17%. One good clue that an ETF structure is dangerous is if the volatility is multiples of this, i.e.  40-150%.   Volatility is easily viewable on our ETF Charts and ETF Screener pages.


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PIMCO Total Return Fund Lookback

Apr 21, 2011 in Bonds

PIMCO's flagship fund PTTRX, the largest mutual fund in the world, filed for an active ETF yesterday. We have followed PIMCO in general for many years and find it a good example of a strategy based on tactical exposures. Note that Bill Gross is definitely NOT from the passive 'allocate and rebalance' school of portfolio management. PIMCO alters exposures consistent with its tactical views, often aggressively. This is by the way, really what index ETFs are perfectly suited to do.

2010 was something of an off-year for PIMCO Total Return, it slightly underperformed some generic treasury and corporate bond index funds. Prior to 2010, PTTRX had been performing between the return of Intermediate Treasuries and Intermediate Corporate Bonds in each of the prior 2 years. That is, Gross was able to favorably rotate between the better of the two funds. Lets take a closer look in a quick slideshow.


Click Lower Left 'Menu' Button To View Full Screen.

We would note that you can enter a few of these bond funds into relative strength models and see how well some of these strategies work. Keep in mind you do also have many other return enhancement ETFs available with junk bonds, preferred stocks, emerging market bonds, foreign soverign and foreign credit bonds etc...

While we have been highlighting commodities for many months (something of the antithesis of fixed-income), we thought we would mention that for more conservative balanced accounts, there are an increasing number of excellent, targeted, tactical bond strategies available in ETF form.

Note: we have added the ability to backtest 50 ETFs together at once and our backtesting reports have added many new features over the past few weeks. Take a look on the Backtest App Menu



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Weekly ETF/ETN Snapshot For April 15th, 2011

Apr 16, 2011

Warning: Gratuitous Example of Exchange Traded Products Below:




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How Many ETFs In Order To Track The World?

Apr 07, 2011

How many ETFs do we need to follow in order to track the world?   There is obviously no easy answer as it depends on how far you care to go.    We've discussed before how there has been strong innovation in the world of specialized indexes and that this process has effectively allowed everyone to rearrange their portfolio exposures at virtually no cost.   This used to be done through program trading of hundreds of securities and it was costly.   Now you can swap 300 Preferred Stocks (PFF) for 14 Futures Contracts (DBC) for zero commission and a penny spread.   Of course, a carpenters tools can create a wonderful piece of furniture -- or chop off a finger.   But the opportunity for broad or targeted strategies is there.

Below is a visual for how the ETF market is structured in assets.   The top few hundred represent the vast majority of the assets.   The number of funds > $100 million is now 537.   This is considered by some to be the level where profits are being made by the product provider.    Clearly, this is low risk and high reward for an investment manager.   If you can create a multi-billion dollar product, the benefits of scale are tremendous as you don't have to pay for star managers.   $1 trillion in assets now surely going to $2 trillion and beyond someday.   Most people we talk to still equate ETFs with SPY --- the understanding of ETFs is still very, very low.    Then again, many people (even professionals) for some strange reason equate the fixed-income market with 30-year treasuries.    



Separately, an update on the 'High-Quality' index.    Recall all the hype for past year about overweighting 'high-quality'.    While there is no one definition of what constitutes high-quality, it is implied that high-quality is synonymous with 'high credit ratings'.    Does it work to overweight EQUITIES with high credit ratings and therefore underweight low credit equities?    Maybe it does and maybe it doesn't but with so many ETF choices out there,  this argument strikes us as pretty weak primary strategy.  Someday, high-quality will be in favor --- and then again out of favor.   But we have so many other options.






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S&P 500 First Day Of Month Tendency

Mar 31, 2011 in S&P 500

Quick shot of how often S&P 500 has traded up vs down on first trading day of a new month.   While the S&P 500 has traded up more often than down, 2010 was not a 'normal' year.   Remember not to draw conclusions off just recent experience.  



Snapshot of 25 Exchange Traded Products -- Total Return For Q1 2011


New eBook on ETF Rotation:

Profiting From ETF Rotation Strategies In Turbulent Markets


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Getting A Feel For The DB Commodity Index: DBC

Mar 26, 2011 in Commodities

The business cycle favors different segments of the investment landscape at different times. Good relative strength analysis helps read money flows to give a view on how the market is indicating where we are in the business cycle in terms of stocks, bonds & commodities.

We highlighted the Deutsche Bank Commodity Index ETN (DBC) late last month and let's now take a closer look. One thing about the exchange traded market is that unlike being a stock generalist where various names turn over and you may never come back to some of them, what you learn now about the core ETF/ETN products will likely remain relevant for the rest of your investing life. One such family of indexes to get to know is the Deutsche Bank Commodity indices.

The DB Commodity index has four distinct components: Energy, Agriculture, Base Metals & Precious Metals. Each component has the convenient symbol structure of DB_ with the final letter telling you what it is. ie, DB[E] is Energy.

Deutsche Bank built DBC based on fourteen of the most heavily traded and important physical commodities in the world. "The Index commodity components were chosen based on the depth and liquidity of their markets and to provide diversified commodity performance." It makes sense that since Energy is the most economically important commodity group in the world, it should get the largest weight. That said, Deutsche Bank found a balance for diversification purposes and kept the energy component at 55%.

Below is a graph of the components and performance for this month. You can see that while precious metals have been strong (particularly Silver SLV), that the 10% weighting of Precious Metals is relatively small. The real driver here has been energy. Agriculture ( DBA) is down for the month but this has been dwarfed by the strength in the energy complex.


While commodities are less correlated to stocks than many other indices are to stocks, it should be pointed out that both commodities and stocks are at the core related to economic strength. That is, a bad economy reduces demand for commodities and also hurts corporate earnings, which negatively affects stocks. Correlations over time can be erratic so we need to be careful on assuming too much with regard to the diversification benefits of commodities.


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Backtests Become Forward Tests

Mar 18, 2011 in Backtest

It is well accepted in professional money management that having a quantitative aspect to your investment process is additive. That is, quantitative methods can greatly help in screening and monitoring lists of securities into a manageable ranking for further analysis. The vast majority of institutional-oriented firms do this kind of thing.

The classic, basic steps of an investment process involve:

1. Install a (Quantitative) Method To Rank A Relevant Universe of Securities
2. Take The Top-Ranked Securities And Do Further Research
3. Construct a Portfolio Using Securities That Pass The First 2 Steps
4. Monitor And Update The Portfolio
5. Repeat

We view backtesting as a very practical and useful part of the research process. The way you rank securities should be based on something consistent with your beliefs on what actually works.

Once you have done some research and found a method to rank securities, run some backtests. You will learn about your method greatly and can understand more aspects and characteristics of such strategies. You will speed up your understanding and you will be forced to think through all the details of how you are going to execute your process.

Once you have created a portfolio (per Step 3 above), that portfolio effectively now becomes a ‘forward-test.’ Monitoring these portfolios and seeing these various rotation strategies behave is a crucial part of the process. Track your various rotation strategies. You can learn a lot by running many simultaneous ‘forward tests’ at once. Importantly, you will get a feeling for the ‘short-term noise’ that occurs around your strategy. Even for professionals, the psychological aspects of short-term volatility will cause them to doubt themselves. Back/Forward tests will make you much more aware of the kind of thing you will face in the future. You must get used to this as psychological aspects to investing are absolutely critical.

Back/forward-testing accelerates the learning process and you can then feed the incremental improvements you discover back into your actual portfolio. The point is that just doing a backtest and then ‘stopping your research’ is very limiting. Don’t stop learning, don’t stop improving. Small incremental improvements add up over time.

We are entering the golden age of active indexing. The specialized, targeted index fund is really a somewhat new phenomenon. Index funds in the 1980s were all very broad vehicles. Many specialized index products (Vanguard REIT index mutual fund, country fund ETFs) actually only have histories back to 1996. You can simulate prior performance -- but they weren't so inexpensively accessible. TIPS securities weren’t even issued by the Treasury until 1997. The World Equity Index products (mutual fund AND etf) didn’t launch until 2008.

Important new areas of future investment may come from newly investable products. For example, the emerging markets small cap index might become as mainstream a product as some other well-accepted benchmarks are today. Understanding the important indices of tomorrow might be as good an idea as understanding REIT and emerging markets indices when they were new PRODUCTS (ie, investable and tradeable at reasonable cost).

Understanding and processing relative performance, relative volatilities and observing relative drawdowns in present ‘forward-test’ environment strikes us as a pretty good idea.

iShares is bringing to market an Internationally focused preferred stock index. Wisdomtree just launched an Asia-Pacific regional intermediate bond ETF. Remember that at one point, the emerging markets index mutual fund was brand new (1994).  Today it is a primary index everyone follows.   Growth vs value wasn’t mainstream until the 1990s -- and indexing these products came later.  The world evolves.  Embrace the change and learn from it – let many simultaneous forward tests accelerate the learning.

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Commodity ETF Products At A Glance

Mar 03, 2011 in Commodities

ETF investors have been especially fond of energy stock ETFs. Here is a combined look at the growing popularity (and underlying appreciation) of energy equity ETFs from the 'Big 3' (SPDR, iShares and Vanguard).


But perhaps more important is the continued growth of commodity exchange-traded products. Many tactical participants consider commodites to have cleaner trending behavior than stocks and therefore somewhat easier to trade. We won't attempt to try to show this within a blog. We will point out though that there are also options markets made on commodity ETPs as another way to access these markets.

It's interesting to take a look at the amount of money being made off these growing asset bases by the providers. This has become significant. Even excluding Gold products (GLD, IAU, DBP etc...) and only using the top 13 as a sample, we see these products generating approximately $220 million in annualized fees at current (February month-end) levels. If you include GLD and others, this number more than doubles --- call it $450 million. While that sounds like a lot, consider that these products charge less than 1/2 of what mutual funds charge on a percentage basis. And mutual funds have $9 trillion in assets. (note that Vanguard has not entered the commodity ETN space or else things might be different).


By viewing assets, we see the combination of price strength and investor inflows/outflows -- which has caused this group to rise very quickly. I put these 13 together to show the growth in assets since the middle of 2009:


Finally, I used the free Backtest Portfolio Allocations App to create my own custom equal-weighted master index that shows the actual investor ETN return since the middle of 2010 (excludes USCI because its history is too short).


List of Commodity ETFs


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Notice: New Feature Added To Backtesting

Feb 25, 2011 in Backtest | Relative Strength

Last summer, we added a feature to the portfolio relative strength backtest application. We added a line that showed what the 'provisional picks' would be if the update period had just ended. The provisional picks listed are the exact same as if you ran the ETF screener using the same list of ETFs and same parameters. We added this feature just as a convenience so it wouldn't be necessary to open another tab and check what was strongest now -- rather than at the last update period.

Depending on the list you use, it is of course possible that the 'provisional pick' is not the final pick (hence the term 'provisional'). But what if we just looked up the provisional pick on the next-to-last day of a given month and bought that ETF the next day on the close and held it for the subsequent period? What would the performance look like assuming we did that? Would it be similar?

Let's look at a simple example just to discuss the mechanics of what we mean. We will compare using the 'next-to-last day picks' with the 'last day picks.' The holding periods will be the exact same, we are just reading the picks of the ETF screener with a one day offset. Of course, for many periods the picks (and therefore performance) will be the exact same.

In this example, we will use one of the Ivy Portfolio lists of 5 basic ETFs and a semi-monthly update period. We are choosing the top 1 of 5 and holding it on 2-week intervals. The settings are the exact same except we are checking the box "Invest in next to last day pick(s) near the top of images below.

Using Regular 'Last Day' Picks:

Using Next To Last Day Picks:

We can see that the returns follow similar paths but that there was a difference -- even for this list of just 5 ETFs. In this case, the next-to-last day picks actually performed better -- which means very little in and of itself. We simply are pointing out the mechanics of how it works. Users should test this using their lists across various other settings and draw their own conclusions. Our view is that this doesn't change anything -- if your backtest is well thought-out, then this extra analysis will very likely show a result that is in the same ballpark as the original method.

Final note is that today is Friday, February 25th -- so the next-to-last days picks will be locked in and known after todays close. The final picks will update using Monday's (Feb 28) closing price. In both cases, the backtests will assume the cost-basis for March performance is the closing price as of Feb 28.


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Summary of ETF Performance Since Just Before Fed Embarked on QE2

Feb 15, 2011


Back in beginning of November,  the Fed began QE2 --- though it was extremely well telegraphed in advance as yields had already dropped substantially.   Since that time, here is quick snapshot of how various indexes have performed:




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