The Outperformance of Economically Sensitive Groups in Developed Markets

Feb 10, 2011


Divergences have developed in the marketplace.    There will be rotations ahead at some point but real-time relative strength analysis has greatly aided portfolio positioning.   These themes have been ongoing for months now:  Economically sensitive segments in developed markets (ie U.S. Industrials and U.S Energy) outperforming.   Inflation fears have caused India (INP, EPI) Brazil (EWZ,BRF) and other emerging markets to roll over.  The money flows show up in relative strength.   






Snapshot From Our Relative Strength Reader Application ( RS Reader Tools Page)


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ETF Movement as Research For Understanding Bigger Themes

Feb 03, 2011 in Strategy

"I measure what’s going on, and I adapt to it.” - Martin Zweig

ETFs represent well-defined baskets of securities --- indexes --- and we can use these index movements to better understand money flows and trends. The following list is a blend of ETFs that was based on the most popular securities at ETFreplay. This list of 15 ETFs represent a good sampling of bonds, stocks, commodities etc... Some editing to avoid duplicate indexes from different providers was used.

First lets take a look at what happened if we just held all 15 in equal-weight for the entire year 2010 using the Backtest Portfolio Allocations App (you can hand-input up to 10 symbols in the free version of the page).

Auto-Load Symbols From An Existing Portfolio:


Press 'Test Strategy' Button on Right To Run Chart Of Portfolio:

Scan Supporting Statistics:

Note that the correlation of this equal-weight portfolio is 0.97 to the S&P 500 (see SPY correlation figure in the top-middle of the 3rd chart image above) . This reading actually isn't that big of a surprise. Most buy & hold ETF allocations that contain a large allocation to equities will result in high correlation to an equity index like the S&P 500.   

Now let's take a look a little deeper at how one particular tactical asset allocation (TAA) strategy found leadership in 2010. We will study 2010 by creating a model and then observing which ETFs were held the most during the year within that model. Whatever was held most might be considered a 'theme' for the time period under discussion.

What relative strength does is tries to understand what is strongest and hopefully thereby find ETFs that are beginning to trend. Every leading ETF starts out with relative strength and then either trends or mean-reverts. Judgment based on experience will be necessary ultimately -- but having a quantitative process locate the strongest ETFs will give you thematic ideas as they develop to consider.

We used a monthly rebalance schedule and a basic 3-factor model to choose among the 15 ETFs. We set the backtest to include the top 3 at the end of each month and hold until they fall out of the top 3, at which point they are replaced with the new top 3.

The next table summarizes which ETFs were held using this strategy for 2010:

As this model correctly identified at the time, U.S. Tech stocks (QQQQ) U.S. Midcaps (MDY) were themes. Bonds had strong relative strength bull move into the summer and Treasuries (IEF) and U.S Corporate Bonds (LQD) both show significant days of being held. Using this strategy, Europe (VGK) was NOT held for even a single day during 2010. Below is a chart of a comparison of these 3 ETFs (QQQQ, MDY, IEF). You can easily visualize what the model was picking up.

Forwarding to more recent action, emerging markets have moved down the relative strength rankings while agricultural commodities remain highly ranked. Underweighting emerging markets equities and overweighting agriculture have been recent themes. Will this continue? It is to be determined --- but this is where a quantitative backtest would say to be --- but there will be future rotations in 2011 so we will just have to continue to...measure what is going on and adapt to it.





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Undifferentiated Asset Allocations

Jan 26, 2011

With the growth of the ETF market, you see increasing amounts of discussion of asset-allocations. While this is a good thing, a few realities need to be addressed more often.

An allocation that has no particular bias to it does not do much good.  Yes, it is possible to create a fully-diversified portfolio for very low cost these days. But while having a little exposure to everything might be ok to use as a benchmark, let's not forget that you do actually have to materially bias your portfolio to differentiate it from the benchmark. 

Let's look at an example --- I saw a recent article that attempted to use the "wisdom of the market" to tell you how to set your allocation.   The methodology took the asset allocations from a number of other sources, averaged them and came up with this:



It looks diversified.  It's definitely low-cost.  But that is about all you can say about it.   Using our (free) Backtest Portfolio Allocations App, I ran the above allocation and here is how it looks for the past two years relative to the S&P 500 index:



As you can see, an allocation that has no bias or particular bets just reverts you back to the same basic overall market exposure.  Outperformers and underperformers just offset each other for the most part in this particular portfolio.  It is not just that the overall return is the same --- but the chart makes it clear the path from start to end is the same as well.  If you didn't run the chart and see this for yourself, you probably would have thought that the allocation was actually doing something it is not.

Summary: The hot topic these days is about asset-allocation --- however, don't necessarily assume that just because it's an 'asset-allocation' that it actually is differentiated in any way, shape or form.  Many asset-allocations just ultimately mimic the same basic exposure.   It doesn't take much testing or research to determine this -- but it does take a little.

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Various ETF Performances From The Past 2 Years on S&P 500 Down Days

Jan 19, 2011 in S&P 500

As we enter a period of higher volatility after a long sustained move up in equities, we ran some statistics on 25 of the largest ETFs in the world to see how they performed on a relative basis when the S&P drops X%.  

In this case, we chose to use 10 S&P pts, which works out to about 0.75%.  How did various ETFs perform on just those particular down days?  

Since the March 2009 low, the S&P 500 has dropped in excess of -0.75% eighty-five times.  The average S&P 500 loss for these 85 days was -1.68%.   Here are some results for 25 ETFs which summarize their performance on just those 85 days:


You can see that among the worst for this period were REITs (VNQ), U.S. financials (XLF),  Brazil (EWZ) and U.S. Small Cap Stocks (IWM).    It makes sense, these are all higher volatility market segments. Technology stands out for doing a bit better than you might have expected.


Bond indexes have low standard deviation and low correlation to U.S. stocks so they generally rose --- but as you can see, very modestly and not nearly enough to offset much of the loss in equities.


Gold, Preferred Stocks and High-Yield Bonds all show losses on average -- but more modest losses given their lower correlations with stocks.   Dividend ETFs (DVY, SDY) were down on all 85 days (85 for 85) -- which isn't a big surprise.   The dividend indexes didn't do particularly well on a relative basis however and lost almost as much as the S&P 500.

Now let's look at todays (Jan 19th) drop in various markets:

At the bottom of the list of todays (1-Day) performance are the exact same ETFs as the first list. 

A couple of ideas here:

1) If you think you are going to get any diversification benefit from owning REITs in a down S&P market, we would tend to doubt that.

2) Bonds don't provide much absolute protection in S&P 500 down days --- but they do obviously serve their purpose of stabilizing a portfolio.

3) Dividend stocks may offer only modest protection in down markets. 

Note that the China ETF (FXI) went up slightly today -- so there is the outlier of the day (of course no conclusion to draw here off 1 day of data).

Summary: it helps to study volatility and down markets. Todays performance was quite consistent with the same relative stats of the last two years.


Update: The first screenshot is now available in application form -- because it runs by auto-loading your user-created portfolios, it needs a login to access the page: ETFreplay Tools Page

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Snapshot of Some Select Mid-Size ETF Managers

Jan 18, 2011

The exchange traded world currently sits at over 1,100 products --- and there are another 700+ in registration.  Assuming a number of closures this year offset a reasonable percentage of new ETFs,  1500 exchange traded products seems like a reasonably conservative estimate for where we are headed.


Below is a snapshot of a number of ETF firms and their assets at year end 2010 compared with assets on the same firms total assets December 31, 2005.   Note that I have intentionally excluded the bigger ETF players -- all of which have also grown massively over the same time period.  



$100 billion in assets now for these firms that had essentially zero five years ago.   Not bad for a period that included a recession and a financial crisis.


Here is a view of the last 18 months of growth for Market Vectors (owned by Van Eck).  



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Backtesting: Combining Relative Strength With A Moving Average Filter

Jan 11, 2011 in Backtest | moving average | Relative Strength

We have added an optional moving average (MA) filter feature to the RS backtest app.  With the recently expanded date start and stop functionality, the applications continue to get more versatile.  

Combining a long-term moving average within the construct of relative strength has been highly requested and we wanted to discuss one idea when considering whether to use it (note that you can just leave it set to ‘off’ as well).  

If you build a relative strength list of say 10 ETFs and you are choosing the top 2,  you could protect your portfolio by including 2 bond funds.   You don’t need a moving average filter because the bond funds will naturally be the ones with the relative strength when equity markets are dropping.   This method actually can get more interesting because you can make better use of more type of ETFs.   Rather than just use cash-like bond funds, you might want to extend the potential holdings to an intermediate bond fund like IEF (7-8 year duration) or others. You don't HAVE to restrict yourself to just stocks and cash.   

Another way to test is by using a moving average.   If you do it this way, then you will inherently be out of ETFs as they go into extended downtrends.  You don’t have to proportionally keep X number of bond funds in your list if you do it this way.    

But a lot of indexes can go above or below a long-term moving average and still not really be a source of market leadership and enhance your return.   Moreover, you may save a lot of money between the time ETFs lose relative strength and the time they actually cross below the moving average.   For these reasons, we believe adding relative strength to a MA strategy will generally be more robust.   Adding MA to a RS strategy is optional -- and you may find works better or worse than your existing method.   Continuous testing leads to better decisions.




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High-Quality -- Just Another Exposure

Jan 04, 2011

The history of [traditional] active management is that one-dimensional active strategies tend to do well for a while and then the strategy falls out of favor --- sometimes for long periods of time. Investors traditionally have piled into funds that have done well thinking it was fund manager insight --- but then the funds invariably do worse when the market rotates and the strategy favored by the fund manager underperforms.

The value-add in focusing on one segment of the world is limited over time --- though in the short-run can be lucrative. Over the long-run, it’s the higher level strategy changes that really matter – the tactical adjustments made at a level above security selection. You are far better off focusing on these decisions. Even if you are successful in your stock-picking --- that is, you outperform say U.S. stocks --- U.S. stocks as a group could be flat or down while other market segments do well (preferred stocks, REITs, Int’l stocks, emerging markets, junk bonds, precious metals, agricultural commodities etc…)

On a similar topic, we have noticed multiple discussions of ‘high-quality’ lately --- the managers weren’t that specific about what exactly they meant other than the classic low-debt, high return-on-equity etc…. Yes, high-quality might be the leadership group sometimes and perhaps you would like to bias your portfolio this way ---- but this strategy by itself is hardly that universally appealing to weather the extended periods of underpreformance.

Powershares actually has an ETF (PIV [1]) based on the Standard & Poors ‘High-Quality Index.’ Sounds great, right? I mean, who wouldn’t want to own high-quality and thereby avoid ‘junk.’ But the investment world hardly works like that. ‘High-quality’ is really just another way of saying large-cap U.S. stocks ---- and we know that is what the S&P 500 is too. There are countless ETFs like this. They sound good (high quality, 130/30 etc...) but they are in most cases just marketing hype that only capture the same core exposure as other long-existing indexes. These ETF's might have their day in the sun and outperform for a period --- but treat them for what they are -- an exposure to one particular strategy.

Here are some examples:



[1] Be aware that Powershares pulled a fast one on the ‘high-quality’ ETF (PIV). The price history prior to June 30, 2010 is actually of a different index. As ETF analysts, we do not include price histories of ETFs that change their strategies altogether --- the backtest would be not just meaningless – but potentially harmful. The same thing has happened in other cases and we track these and have adjusted the starting dates to begin when the tracking period began.


Here is a 130/30 Fund doing nothing more than tracking the S&P 500:


This one below (ONEF) is a global equity fund basically capturing the return of a global index like ACWI or VT.



ETF Charts



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ETF Basics: ETFs are No More Of A 'Derivative' Than Mutual Funds

Dec 28, 2010

We have noticed that there still seems to be a fair bit of misunderstanding among those new to ETFs. While the structure of ETF's is different than you may be used to  -- it is really not that complex.   

Ignoring leveraged and inverse ETFs --- the vast majority of ETF assets are plain vanilla index funds --- they are not derivatives.  

Some people think that since ETFs are only representing shares -- and that they aren't actually the underlying securities--- this therefore makes an ETF a derivative.   But this is simply not true.    The ETF holds the actual shares it represents just as when you buy a mutual fund, you don't get the shares delievered to you --- you get mutual fund shares that represent the underlying securities.    Clearly everyone should understand that mutual funds are not derivatives.   They are classified by the S.E.C. as investment funds --- which is how the S.E.C. categorizes ETF's as well.

In fact, you could argue ETFs are less of a derivative than a mutual fund as in the ETF process, actual shares are passed for any creation/redemption.    This is not true when buying a mutual fund.   If you send $2,000,000 to a mutual fund, they create shares for your purchase -- but they do not necessarily buy anything with that money --- it could just sit in cash, it depends on the decision of the portfolio managers.   During this process, no exchange is necessarily involved.   You can send your money directly to a mutual fund company and no exchange would ever know the difference. There were some scandals on this topic in the early 2000's that you may remember regarding late-trading and manipulation --- this was only possible because there was little transparency of this off-exchange activity.   

To better understand how simple this really is, below is an image of the basic mechanics.    Note that in reality there are actually custodians, index information providers, authorized participants and market makers involved ----   but those are all peripheral considerations.


Note also that because the shares are created behind the scenes and the shares traded are on an exchange, this opens up a few new markets.   Now you can sell ETFs short and/or you can trade options on these exchange products.   Neither of these are possible when the creation occurs directly to the investor. Even if you never sell short or trade options, this activity is actually good for you --- as all this incremental trading volume created by options participants allows the ETF provider to cycle out lower-cost shares in the tax-free exchange between the exchange and the ETF provider. You can see in the diagram above how this is only possible because the exchange sits BETWEEN you and the fund provider.




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Vinik ETF Holdings & $1 Trillion In Assets

Dec 18, 2010 in Hedge Funds
Two interesting news items this week:

U.S. ETF assets broke through $1 Trillion in assets for the first time this past week. Global Head of ETF Research and Implementation Strategy at BlackRock Deborah Fuhr said in a press release:

“Increasingly both retail and institutional investors are building global, multi-asset portfolios that are designed to capture the performance of key ‘benchmarks’ for attractive market sectors -- an application for which ETFs and ETPs are particularly well suited,” Ms. Fuhr said. 

Dovetailing nicely with Ms. Fuhrs quote above --- there was a report late in the week that highlighted the extensive use of ETF's by former Fidelity Magellan portfolio manager and long-time hedge-fund manager Jeff Vinik.

As an institutional investor, Vinik must disclose holdings and his September 30, 2010 13-F from his SEC filing is summarized below:

Looking over Viniks holdings, the exposures are specific: U.S. sector tilts, U.S. Small Cap, and Emerging Markets exposure.  Note that SPY is the only of Viniks ETF holdings that is a diversified U.S. large cap index. 10 of the 11 other ETFs represent targeted exposures. 

In the grand scheme of things, $1 trillion in assets is still a drop in the bucket --- ETF/ETN assets are poised to head dramatically higher over the next 3-5 years. 

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ETF Screener Feature Added

Dec 14, 2010 in Screener

Screenshot of ability to combine multiple ETF portfolios into a single list on the ETF screener.    This example takes a list of 25 commodity ETN's (tracking the underlying commodity) and combines this list with 25 commodity stock ETF's.   You can combine as many lists as you would like and/or 'Select All.'



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