Utilities XLU and China GXC

Nov 11, 2012


Utility stocks are having very tough month so far.   The Utility index is often a big part of dividend funds and this segment is having a very tough go lately with dividend tax rates likely to increase.  XLU is now negative YTD 2012:




Here are all monthly returns for the past 10 years sorted from low to high for a logical look at XLU vs its own volatility over time.  This month is not over but if it closed here would be the 8th worst since 2002:




Perhaps this is decent example of how markets continually rotate.   Once hated, China ETFs have have now outperformed U.S. Utilities by well over 10% since June 30:


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Reaction on Day After Election 2008

Nov 07, 2012

You can set the ETF screener back to historical dates --- here is a look at what happened the day after the 2008 election:




Using the Fidelity No-Commission List As A Sample


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Global Investing and Home Country Bias

Nov 01, 2012 in Country Funds

If you follow the daily news cycle at all, you are probably getting a lot of news exposure to things that are pretty meaningless in the context of a global asset allocation.    Think about it for a minute -- a typical 'growth' allocation portfolio might be 75% risk assets and 25% income-oriented ('spread product' or gov't bonds).   Of that 75% risky, some percentage is U.S. equities -- and some percentage of that might be risk assets OTHER than US-based common stocks.  Already, we are taking a percentage of a percentage.

Then you think about how much coverage CNBC and other media outlets give to domestic company earnings reports -- and then compare that to something like the coverage of the entire "Asia-Pac" regional ETF investment opportunity.  Do you really need any coverage at all on Zynga and GroupOn? 

Let's put it another way -- how much have you heard about the Pacific Ex-Japan segment (Australia, Hong Kong & Singapore all combined) returning +20% this year?  Just the Hong Kong market alone has a weight in the Global index well above that of Apple or any other single stock.    Apple is of course a very important company and you should certainly pay attention to it -- but then you should also think about global investing opportunities at least as much (more) than you think about any specific individual U.S. company.  If you don't, you will be missing a lot of opportunities that may provide leadership for extended periods of time.

Let's look at the last ten years as an example.   While the U.S. market was leading the worlds equity markets for much of 2011-2012, keep it in context of what happened prior to that:

Home country bias is to be expected to a degree -- people invest in what they know.  Moreover,  prior to the ETF movement it was somewhat difficult to find low-fee vehicles that access international markets.   But that has all changed.   It's now ultra low-cost (no purchase fees, low expense ratios and in some cases zero commission).

The rankings chart below demonstrates a shift in relative strength that have been picked up and reflected in our Allocations Board portfolios back when it was occurring -- in August.   If you were just following news on a set of specific U.S. companies, you probably weren't paying attention to things like this.


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Risk Parity Basics

Oct 15, 2012 in Volatility

Risk-parity is a weighting methodology.  Given a set of securities in a portfolio, risk-parity overweights lower-than-average volatility securities and underweights higher-than-average volatility securities. 

Q.  How does it work? 

One of the most commonly accepted ways is to start with equal-weight positions and then make adjustments based on the relative volatilities. 

Because volatility always embeds a specific time-period assumption, you must specify the time-period (or lookback) you want to use.  There is no universal definition on what time-period is correct. 

If you choose a shorter lookback period, then your portfolio will adjust more quickly to major changes in volatility.   If you choose a longer lookback, then you will have less trading and less whipsaw losses when corrections end quickly and recover.  

(for what its worth, we have observed that some index providers use 12-months for the lookback time period and then chooose to rebalance quarterly.  But keep in mind that given two different analysts using different assumptions, you will get two different results for the same list of securities within a risk-parity portfolio.   As noted, there is no single 'answer').

Q.  What is the purpose of all of this? 

To us, one of the more interesting problems facing investors are questions having to do with how we weight securities that are in totally different asset classes.  Some securities mature at par (bonds) and some are perpetual (stocks) --- some represent  paper securities with high yields (preferred stocks) and some can be physical securities that have zero yield (Gold).  So long as something is actively traded on an exchange with accurate TOTAL RETURN pricing, risk-parity principles can offer an idea on a weighting methodology that uses the same metric across all of these disparate secruities.

Q.  Does risk-parity give an optimal weight?

No.  There is no way to calculate an optimal weight for the forward period so risk-parity looks at recent experience and applies that to the future period.  

Problem --  if short or intermediate bonds are used, the risk-parity methodology will always very heavily weight bonds (especially lower duration bonds).   This is because bonds that have fixed maturity dates will (nearly) always be far less volatile than securities that are perpetual (like stocks).   Clearly, low-duration bonds don't have much return potential either so if you were to follow risk-parity, you would end up heavily overweighting bonds relative to something like a 60-40 mix.    

Q.  Is risk-parity better understood as a concept or as a formula?

While risk-parity sounds quite pleasing, our opinion is that like just about everything in investing, understanding the concept behind it is more important than solving a formula.   This goes back to the very basics of investing: given similar return expectations you should choose to more heavily weight the lower-volatility security.   This does NOT mean that high-volatility securities are not investable -- it just means that you must have higher return expectations for the high-volatile assets.   If your return expectations are indeed higher, then it will make sense to overweight the higher-volatile asset.

Risk-parity will tend to do very well in any period with significant bear markets for an obvious reason, its focus on bonds.   Risk-parity will generally (but not always) underperform in up markets for the same reason.  

In our view, the point of backtests -- including risk-parity backtesting -- should not be to determine a formulaic 'answer' --- the point is to let backtesting help you digest large amounts of data and be part of the research process that helps you come to a conclusion about what is the right portfolio - in that situation - for that client - at that time.  

There are many ways to use volatility to help think about your portfolio exposures and  it takes judgment at the end of the day.   Given that risk-parity does nothing to adjust for differing return expectations across securities, it should be viewed as simply another tool, not an entire strategy in itself.   



To understand the risk-parity calculation, it is important to realize how a risk-parity portfolio differs from an equal-weight version of a portfolio with the same holdings.  

This example will use ETFs from 2 different asset classes:  Gold (GLD) and Real Estate Investment Trusts (REITs).  Think of it as a way you might want to research how to weight your 'alternatives' allocation.  For round numbers, assume alternatives make up 10% of your total portfolio and you want to research how risk-parity handled the past 7 years.

Below would be the weight of GLD using 3-month risk-parity for the period:



Note that in 2006, the risk-parity methodology had Gold as an underweight vs real estate.  At the time, real estate was in the tail-end of a major bull market.   As 2007 began, the weightings equalized (signalling equal volatility) and then REITs went into a major bear market and Gold came to be about 75% of the mix for about a year.  Since the end of 2010, the weightings have been on average near equal. Note also that over that same time, the returns of REITs and Gold have been about the same.

The risk-parity module is embedded within the core-satellite application.  Here is a screenshot:



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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 Backtest | Bonds

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

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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