Plan Ahead. Updating your portfolio vs the use of stop-loss orders.

May 11, 2010

In portfolio management, the term strategic is code for long-term.   The term tactical is used as a way to describe a strategy that is shorter-term, such as a portfolio adjustment based on seasonality.  

So for example, you may want to own the India Fund (INP) in a strategic long-term sense --- though you may be underweight on a tactical/short-term basis etc…  Or you may not care about the Gold ETF (GLD) long-term but you see a tactical opportunity in it now --- something we have highlighted recently.

We know that you can greatly improve your Sharpe Ratio by employing some relative strength strategies to your ETF investing.  One of’s primary strengths is allowing users to easily test various overweight/underweight methods.  Our relative strength application ‘updates’ on a pre-defined date -- we do not use stop loss orders.   The ‘stop’ is in effect the next update period.   We view this as a far superior method as it removes the emotional nature of the markets and keeps you from acting on whipsaws, like we saw last Thursday. But the primary benefit of this framework is that it keeps you focused on the bigger picture -- and it is global asset allocation that ultimately drives 90%+ of your portfolio returns. Is your portfolio positioned correctly as of the end of each quarter?   Is it positioned correctly at the end of each month?   You can of course update your portfolio during any day – but hopefully, you are doing this in accordance with a larger strategic plan.

If you plan ahead and watch your overall volatility, you can sleep at night knowing that you have the Sharpe Ratio on your side.  Over the long-term, the relative strength models will find markets that go up ---- and good portfolio management will limit your drawdowns.  If instead you recklessly buy a list of securities and have no idea what your portfolio volatility even is --- then you are going to be placed in some very difficult situations.  The key is to plan ahead of time.   Hopefully, our models and backtests can aid you in this thought process and help you find some good reward-risk situations to overweight.   

On Monday, the market gapped up a very large percentage on the nearly 1 trillion Euro bailout.  Importantly, this followed a very significant correction in European stocks.  This is the kind of thing that is a more technical aspect of tactical portfolio moves.   Indeed, vicious short squeezes should be viewed as the norm after sharp market corrections, like that experienced in Europe. This is the very definition of volatility.  

Precious metals --- Gold (GLD) and the precious metals ETF (DBP) are the thematic leaders of the market now.  Be on guard regarding your overall portfolio as volatility has surged – but keep your tactical trades in line with your strategic ideas and you will consistently be updating your portfolio with the best reward-risk situations.   Combined with intentionally keeping your volatility low, your Sharpe Ratio will rise – and this should be your ultimate focus.

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Index ETF Focus: Gold (GLD)

May 07, 2010 in Backtest | Gold

We highlighted potential leadership developing in gold at month-end.  Last Friday, the Gold ETF triggered a buy vs SPY in the Relative Strength application.



As of Tuesdays close,GLD had then moved to the top of our screener relative strength list.   When volatility began surging in the equity markets, it should have become clear that US equities were going to drop in the screener rankings as high volatility is penalized in the model.  The logical asset to assume new leadership was Gold (GLD) as it had already been moving up the rankings, as highlighted in our May outlook and as also being supported by the RS ‘app.’   This is a good example of reading ‘market generated information.’   



While Gold (GLD) advanced this week, of course the best relative strength-based call was staying short international equities, particularly Europe.    Europe has some serious problems to deal with  and you can see the horrid relative performance of international stocks over the past few weeks.  This is an example of an opportunity that was available to globally focused investors and invisible to those with only a domestic focus.


Summary:  volatility has increased sharply in the equity markets, which makes equities LESS desirable to hold vs a fixed payment security like a short-term bond.   Meanwhile, the Gold ETF (GLD) is rising in price, which makes it more attractive as its volatility is justified by its improving relative strength.   


In a world of talking heads, rumors of computer errors and extreme emotion, it pays over the long-run to ground yourself with some strong reading of money flows that is statistically supported by backtested models.

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ETF Portfolios : Corrections are when the Sharpe Ratio proves itself

May 06, 2010 in Volatility

One of the major benefits of exchange traded funds is that they provide greater precision in allocating risk. has intentionally built virtually every one of our website pages with risk/volatility in mind.  When we designed the layout, we felt that volatility should not be an indicator in the lower pane of a charting layout – it is too important – so we created an ETF Charts layout that deliberately puts the 2 main components of the Sharpe Ratio in the upper pane.    We do this because for sophisticated investors:  discussing returns without the context of risk is meaningless.



One interesting way to appreciate the Sharpe Ratio is to show how it cannot be fooled by something like the ProShares leveraged index ETFs.  This is a useful exercise as the nature of compounded returns is actually quite a bit more complex than it seems.  

SSO is the 2x leveraged long S&P 500 ETF.  By construction, it will always have 2x the volatility as the S&P 500 --- but as you look past the short-run, only in the very best case scenario will it equal 2x the daily mean return of the S&P 500.    

It is possible that leveraged ETFs can have roughly equal Sharpe ratios vs the unlevered ETF --- but never more --- and very often much worse.   The compounding of returns over time is the killer -- only in the case of a non-stop upward move will the sharpe ratio be approximately equal.   The nature of compounding is that large losses are disproportionately hard to make up in a rally while outperformance can be quite easy to give up in a correction if you are not careful on watching volatility.

From an investors perspective  – the leveraged products are flawed.  We will spare the reader the math on this and instead show the very dramatic leveraged ETF charts as a more extreme example of how important it is to avoid high volatility ETF’s when they do not have relative strength – the losses are just too great.   The converse of this is that by focusing on the Sharpe Ratio for your portfolio (intentionally reducing volatility when there is no relative strength), you stand at a distinct advantage of benefitting from the likely long-term outcome of markets that don’t just forever run up in non-stop fashion:


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MSCI Index ETF : World Focus (ACWI)

May 05, 2010 in Country Funds | Strategy

The MSCI Index ETF list is quite useful as a starting point for ways to think about the global investment landscape.  Moving from a domestic to a world focus expands the individual equity universe to well north of 8,000 securities (vs the typical Russell 1000 focus of domestic managers). Global exports are increasing on a secular basis as the world increasingly trades goods and services with each other ---- globalization is unstoppable.

Ironically, I say all of this as our models have been favoring domestic over international ETFs for months now and being short (or avoiding) Europe in particular seems like more than just a short-term trade.

Nevertheless, over the long-run it makes sense that more choices will offer diversification benefits in terms of enhancing return (long and short) and likely reducing risk (though this benefit becomes less as globalization increases).  Without going into a long dissertation on this topic, I will just instead show the current relative valuations of the MSCI World Index ETF (ACWI).   

MSCI Index ETF ACWI Weightings


Note that approximately 2/3 of this index is in the United States and Europe.   It is not AS out of balance as it may at first seem as companies like those in China have very low profit margins. In the U.S., a company like Google might not contribute a lot to GDP – but it does have very high overall profits.   Conversely, Wal-Mart contributes a lot to U.S. GDP but has very low margins – and China supplies Wal-Mart so you can imagine how their profit margins look.    So each country will have GDP changes and profit margin cycles to think about --- its not JUST about GDP growth and population trends.   

Over the very long-run though, these world weightings will likely change in favor of countries with stronger demographics --- (the above chart should only be viewed as a snapshot in time).  Importantly, it is not going to be a smooth ride -- even as it seems obvious that countries like China and India grow to be much higher percentages of the total.  

The next chart from the ETF Portfolios page re-creates the MSCI World Index ETF as a sanity check.  We can do this with regional and country funds.   It won’t be perfect because there are some anomalies with indexes regarding 'sampling' and starting vs ending weights etc.…



So within the context of a dynamic and volatile global marketplace, is based upon – finding quantifiable, back-testable methods to help the investor think about balancing reward and risk.  In other words,  to participate in global strength and to avoid/underweight/short regions of the world showing global weakness.  There will be many large corrections within secular themes.  You need to protect yourself by balancing the longer-term demographic trends with the realities of extremely volatile markets.  This is doable -- so long as you show proper respect for the markets inherent volatility.  

Finally, here is a look at our ETF Screener.    The ‘ Selected Betas’ grouping has most of these indexes scattered within it.  We don’t think its complete to just look at regions of the world --- we like to view Relative Strength across asset-classes as well, not just equities.   Note here that this is not properly done unless you are tracking total return  --- dividends and distributions can make a significant difference in your screens and models.  You need clean data to properly calculate relative strength -- especially across asset classes. As experienced professionals, we want to stress the relative benefit of a well-maintained total return database of 400 ETF's --- vs a 15,000 security database that simply reports trading numbers and ignores total return.  We have intentionally created a focused environment (based on ETFs) to minimize the data integrity issues that can greatly affect financial models.    

Details are important.   We cannot be perfect -- but we know that simply ignoring the issue (as others do) is particularly disingenuous.  ETFs are based on indexes.  Index returns are ALWAYS based on total return.  Price alone does not reflect total return, adjustments are needed.  We make these adjustments so you don't have to... 


ETF Screener

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Where Is Global Money Flowing Now?

May 03, 2010 in Screener | Strategy

Here is our read on global money flows as we begin May:

Asset allocations are the most important aspect to portfolio management. Our ETF Screener helps tell us where global money is flowing. We think it’s a good idea to use experience and market savvy in conjunction with the quant models. There are countless ways to actually implement a given higher-level ‘strategy.’ We would strongly suggest staying with the theme of the backtested models -- but also keeping a watchful eye on overall portfolio volatility as a sanity check. Volatility is a good way to think about the potential for drawdown – so this focus protects you when there are strong rotations within the global marketplace.

Our models have not seen much change recently. Stay overweight US equities and underweight (or short) international equities, particularly Europe. Given instability in Europe and the already large outperformance of US Equity this year, a large divergence like this is a bit of a concern.

Other regions of the world, such as Latin America, Emerging Asia and the Pacific countries do not appear to be worth an investment at this time --- these regional ETFs have high volatilities and are not showing relative strength.  Interestingly, US REIT’s have been showing strong movement within the rankings – indicating global money continues to have a risk appetite for segments of the U.S.

It makes sense to us to stay aggressive on the non-equity portion of the investment landscape. U.S. treasuries do not look interesting at this point as yields are low and the global economy – outside of Europe – appears to be fine. If the U.S. were not strengthening, why are junk bonds continually making new 6-months highs?

Outside of the primary indexes (and REITs) – 2 interesting developments we have noticed over past 4-6 weeks:

1) Precious metals are rising in the relative strength rankings
2) Emerging market bonds look good in the rankings (note that EMB/PCY are dollar-denominated) -- they tend to trade a lot like U.S. high-yield bonds -- and they have pulled back recently.

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ETF’s --- The Mainstreaming Of Advanced ‘Basket-Trading’

May 01, 2010 in Backtest | Strategy

In a recent institutional research piece by Goldman Sachs targeted at European portfolio managers, they offer various ways to trade ‘the divergence theme in the Eurozone.’

In the note, they discuss the problems with domestic demand in Europe within the construct of strong global growth, led by the BRIC (Brazil, Russia, India, China) theme. This note was on April 28th and followed a similar note discussing a similar theme targeted at US portfolio managers.

The basic idea of the note is to “Go long international growth & short Eurozone domestic demand.” In both research pieces, they do a lengthy analysis of long lists of ‘basket trades’ that portfolio managers could do to implement this longer-term trend. The bottom line of these studies was to create a long basket of stocks (to be long) that has companies with high sales exposure to the strong parts of the world and create another basket with high sales exposure to mainstream Europe and go short that basket.

To execute this, you would submit a list of trades, with quantities of shares, to a firm like Goldman or Morgan Stanley or Merrill Lynch and say ‘buy(sell) this basket of 70 stocks on the market close today.’ Then, Goldmans quantitative ‘experts’ figure out how they are going to both ‘guarantee you closing price’ – and make money for themselves. They ultimately do some kind of elaborate combination of trades that hedges themselves --- and can use the liquidity in the futures market with a hedge ratio or whatever else they do to create a profit for themselves – and then they charge an extra fee to the buyside firm to do the program trade.

Now – enter ETFs. Think about what you can do now – you can buy any of 1000 pre-set trading baskets that were created by index construction experts at MSCI, S&P, Russell etc. In some cases, such as at Schwab or Fidelity, you can do this for zero transaction fee. Its like the world has aligned in favor of the small investor/advisor here. This is very powerful.

I should go on to note that in this most recent research piece by Goldman on ‘trading the divergence’ --- they spend nearly 1/3 of the report going into backtests of their newly created trading baskets.

Well, with ETF’s – the trading history total return chart of the ‘basket’ is known. You don’t have to simulate it with portfolio management software --- you can just run the total return chart on our site.

So this is the power in ETFs: 1) the index has been constructed for you by index experts already (the people at firms like MSCI are every bit as smart (I would say smarter) as the people at your typical large financial institution) – they know what they are doing. 2) the trading history of the ETF ‘basket’ is known and 3) you haven’t done any actual work yet and you are already analyzing the characteristics of the ‘ ETF basket’ (its volatility, out/underperformance, historical relationships etc).

The bottom line is that banks makes good money recommending these kinds of things for portfolio managers. The longer the list, the more the profits. Big portfolio managers with huge assets under management cannot buy most ETF’s – the ETF’s just aren’t big enough. But you – as the small advisor, small hedge fund or individual investor can -- and that is what our site is all about -- leveraging the inherent and underrated power that ETF’s bring to neutralize the investment landscape.

(by the way, our relative strength model pointed towards this weakness in Europe months before Goldman wrote research on this – just go into the ETF screener and move the date back to January and see for yourself)

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The Universal Nature of The Sharpe Ratio

Apr 29, 2010 in Volatility

Lets look at 3 common methods different investors use to reach their goals:

Investment Advisors:  a typical advisor buys a combination of stocks and bonds to dilute/diversify the risk of owning stocks alone.   They participate in bull markets but give up pure equity returns in pursuit of stability.  The bond component to portfolios is generally uncorrelated to equities in down equity markets.  The stock portion of a portfolio is compared to a stock index and the total portfolio is compared to a blended stock-bond index.

Options Players Selling Covered Calls:  This group buys the underlying stocks/ETFs and sells calls to earn extra income.  If the securities go up, their securities make money.  The also earn the premium and the stocks are called away.  Like the advisor, they give up some upside in order to outperform in down markets (the calls they sell expire worthless to the purchaser and the income they make results in outperformance vs an index return).  

Hedge Fund Long-Short Portfolio:  This group holds longs and shorts.   They generally have a long bias to catch upward nature of equities – but once again, their short positions protect them in down markets and dilute overall volatility.  This strategy tends to avoid drawdowns well but generally does not perform as well as the first two strategies in bull markets.   Essentially, the long-short portfolio is not unlike holding a mostly bond portfolio -- with a small long equity component.   Think something like: 90% bonds with 10% midcap US stocks.  Or 90% bonds with 10% emerging markets exposure.   These kinds of portfolios are very tame -- don't drawdown much and can participate in part when equities do well.  The hedge fund will not have interest rate risk so it won't act like the bond portfolios in reality -- but it is a fair comparison from a volatility perspective. 

The Sharpe Ratio does a good job of enabling a comparison of these different methods.  

The actual calculation of the Sharpe Ratio seems simple enough – though perhaps it is not as straightforward as you may at first think. calculates the Sharpe Ratio as the AVERAGE daily excess total return divided by the daily standard deviation.  Note that the denominator is the same way an options market maker calculates realized volatility.  The mean return and the standard deviation of return is the standard way you describe any 'distribution' of returns.  We are unique though in that we calculate TOTAL return.  We do this because ETF's represent underlying indexes --- and an index return is ALWAYS stated as total return.   We are shocked at how poorly this concept is understood by professional websites, bloggers and aggregation sites like Seeking Alpha.  The difference is at times significant.   

In each of the mentioned strategies above, the standard deviation is being diluted with some kind of paired combination of either bonds, call selling or short selling.    These are all good ideas because when you reduce volatitlity, you increase your chances of improving your Sharpe Ratio.   If there is one statistic every investor should learn -- it is the Sharpe Ratio. makes it easy to understand because our charts de-compose the numerator and the denominator into visual bar charts.

If you focus only on the return of a benchmark and not Sharpe – you will get caught in the same problem the mutual fund industry has – chasing an index around in fear of losing to it in the short-run.  You end up as a closet index, your performance looks great in a bull market --- but you invariably end up with low long-term returns due to the occasional large drawdown.   

We like the combination of finding good relative strength investment opportunities -- and combining that with keeping an eye on your overall portfolio volatility.  By relative strength, we don’t just mean limiting yourself to any one thing – such as U.S. equities.   We mean looking globally and across asset-classes.  The ETF market allows so many more interesting things on a global scale --- find global, cross asset-class relative strength and overweight these segments.

In the above 3 strategies, all of them essentially have portfolios with standard deviations set intentionally BELOW the S&P 500.   How far below is up to each investors ability and willingness to take risk.  But in the long-run, it is not hard to beat the S&P 500's sharpe ratio -- as the reward-risk relationship of the S&P 500 is quite poor -- you get a lot of volatility without a lot of return over the long-run.

We hope that our charts, our screener, our backtesting applications and all of the other pages we have created do a good job of taking portfolio concepts and making them visual and easy.  This is what 'data visualization' is all about.  We very deliberately designed the entire website with the Sharpe Ratio in mind.


ETF Performance Analysis for S&P -2.0% Day -- April 27, 2010

Apr 28, 2010 in S&P 500 | Screener | Volatility

Volatility spiked on April 27th, lets take a closer look.

First note that while the S&P 500 dropped -2.0%, the higher volatility ETF's are in steeper drawdowns:

What performed well? The usual suspects --- those with negative correlations to equities, including the VIX ETF's, the inverse ETFs from ProShares, long duration US treasuries, precious metals, the U.S. Dollar and the Japanese Yen.


The last chart goes back to focus on U.S. Sector SPDR ETF's. Note again that those with higher volatilities led to largest drawdowns.

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Simple Strategy Using The Relative Strength Themes of our 'Screener'

Apr 26, 2010 in Screener | Strategy

While it may not be particularly interesting from a global perspective -- the relative strength model in our Screener has been quite clear for past few months. Long US Equity and Negative on Europe. Here is an example using the relative strength model as of the last day of February to create a subsequent long-short portfolio that is representative of the broad themes in the marketplace:

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New Relative Strength Backtest 'App' Added To Site. Check it out.

Apr 26, 2010 in Backtest | Relative Strength

We have added an innovative new relative strength backtest application to the site.

Click Here: ETF Relative Strength Backtest App



For a video tutorial on this 'app' click here: Relative Strength Tutorial"

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