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5 Lessons From The S&P 500 Market Crash For ETF Portfolios

Summary ETFs tracking the S&P 500 index had down-side tracking error. Other ETFs based on value, low volatility, dividend payers or equal weight fell more than the S&P 500 Index. Gold, bond and exotic ETFs provided down-side protection during the sell-off. These lessons can be used to build better portfolios. Introduction We review the past few trading days and try to draw some lessons from the rapid expansion in volatility. Naturally, it is still very early, and this edition of the crash is yet to run its course, and more lessons surely wait in the wings. However, we can draw a few lessons about portfolio construction that this market stumble has revealed. S&P 500 ETFs had down-side tracking error We measure the decline in the S&P 500 Cash index (SPX) from the Wednesday, August 19, close to the Monday, August 24, low. We want to check how well the S&P 500 ETFs did in tracking this downdraft. In Figure 1, we show that amplitude of the move from the Wednesday close to the Monday low. There was significant tracking error, particularly for the IVV ETF, which seemed to lost its bearings altogether. Hence, in designing portfolios, one should recognize that the down-side risk could be greater than that experienced by the index itself. (click to enlarge) Figure 1: There was significant down-side tracking error among popular S&P 500 tracking funds. Value, Dividend, Equal Weight Alternatives to SPX Fared Worse One of the portfolio construction principles suggested to reduce volatility and give down-side protection is to use a value approach, or have high dividend payers or change the weighting scheme. We show in Figure 2 that none of these alternatives gave any meaningful down-side protection. So, from a portfolio design perspective, it might be better to just use a good SPX ETF. (click to enlarge) Figure 2: ETFs focused on value, dividends and alternate weights fared worse in the sell-off then the SPX. Data courtesy ETFmeter.com. Low Volatility Funds Were Volatile Low volatility funds were supposed to bounce around less than the typical market ETF. However, these funds crashed harder than the S&P 500 index itself (Figure 3) calling into question their benefit within a portfolio. (click to enlarge) Figure 3: Many ETFs designed with volatility screens were more volatile on the down-side than the S&P 500 index itself and might add little value in a crisis. Data courtesy ETFmeter.com. Long-term bond ETFs and Gold ETFs provide small offset The traditional way to offset weakness in equities is through diversification into long bonds. We show in Figure 4 that the large bond fund provided a small positive offset during this major decline. Since bonds are rising while equities are falling, we measure the performance from the Wednesday close to Monday’s high. . As a store of value in a crisis, some money flowed into gold funds, and gold ETFs provided good diversification during the equity sell-off (see Figure 4). So, the gold related funds could be a source of diversification when one is constructing portfolios, though their long-run trends could dictate the size of the position. (click to enlarge) Figure 4: The major bond and gold ETFs were positive, providing diversification, but the bond ETF amplitude of the move was small compared to the declines in the equity ETFs and the expansion in the VIX index ETFs. Data courtesy ETFmeter.com. Exotic ETFs such as Leveraged Inverse ETFs Provided Diversification Lastly, we look at exotic ETFs, such as leveraged inverse ETFs and long/short strategy ETFs. By design, such ETFs should rise when the market falls, though their leverage means they are probably not the preferred choice for all investors. These inverse ETFs provided excellent on-demand down-side protection as they should, by design. The long/short strategy ETF also did well. So, for those who understand these strategies and the perils of leverage, these may be alternatives to consider during portfolio construction. We emphasize that these ETFs may not be the best alternative for everyone due to the leverage involved. (click to enlarge) Figure 5: The more exotic ETF strategies, such as inverse SPX ETFs, provided much-needed on-demand down-side protection, but due to their leverage, and other complexities, may not be the best choice for all portfolios. Data courtesy ETFmeter.com. Summary A number of lessons could be drawn from the market action so far during this sell-off, and more will surely follow. Perhaps the most important are that all S&P 500-tracking ETFs are not created equal, and that value, dividend, alternate-weighting schemes and low-volatility ETFs fared worse than the index itself. Some of the tracking errors could be attributed to the weak opening in the market, and ETF prices could have fallen more than the prices of the underlying stocks, i.e. to poor quotes in a “fast market”. However, this is a significant risk that should be factored into the portfolio construction process. Reference [1] Tushar Chande, “Eight lessons from the S&P 500 stumble to build better portfolios”, www.etfmeter.com/blog.aspx?id=4425 Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Volatility Is An Asset Class That Can Be Sold As Well As Bought

By DailyAlts Staff The CBOE Volatility Index more than tripled during the course of trading on August 24, 2015 – an all-time record. On that same day, the S&P 500 fell nearly 4%, while the Barclays U.S. Aggregate Bond Index gained a miniscule 0.03%, demonstrating the ineffectiveness of the standard two asset class portfolio diversification model. Puny bond yields provide little cushion for broad market selloffs, which has led many investors to turn to alternative strategies and asset classes, including volatility itself. This is the subject of a new white paper from Allianz Global Investors (“Allianz GI”): Volatility as an Asset Class . Volatility: Realized vs. Implied The paper’s author, Dr. Bernhard Brunner, is Allianz GI’s Head of Analytics and Derivative. He begins by discussing the difference between realized volatility – the standard deviation of logarithmized returns; and implied volatility – that which is measured by the CBOE Volatility Index (VIX). Realized volatility is typically less than implied volatility, and this means buying implied volatility, such as through VIX futures, comes with a volatility risk premium . Thus, while the negative correlation between equities and equity volatility makes buying implied volatility seem like a good portfolio diversifier, the consistent volatility risk premium makes it even more attractive to sell volatility, according to Dr. Brunner. Variance Swaps In addition to taking short positions in VIX futures or ETPs that track volatility, investors can also sell volatility through so-called variance swaps . Variance swaps are traded “OTC” (“over the counter”), but swaps on equity indexes such as the S&P 500 and EuroStoxx 50 are highly liquid nonetheless. And while VIX futures may have considerable variance from realized volatility, variance swaps can be structured so their payoff is exactly equal to the difference between realized and implied variances, thereby constituting a more precise definition of the volatility risk premium. Allianz GI’s Approach Allianz GI has developed an index to earn the volatility risk premium by systematically selling variance swaps on the S&P 500 and EuroStoxx 50. Its investment approach is governed by specific rules and based on the following characteristics of volatility as an asset class: (click to enlarge) Volatility always reverts to its long-term mean; Volatility tends to bounce briefly when the stock market slumps, followed by lengthier downward trends; and Volatility forms volatility clusters. Volatility offers a lot of promise as an asset class, based on its portfolio-diversification advantages. Most notably, volatility has what Dr. Brunner describes as an “immunity to interest trends,” which makes it virtually unique among investible assets, and particularly attractive in the current investment environment. For more information, download a pdf copy of the white paper . Share this article with a colleague

Playing Defense With A Chance To Score

Recent historic declines in global markets begs the age old question of how to effectively manage risk/return exposure. Playing defense while still having upside exposure is key. Defined outcome strategies can provide the comfort and relative safety that financial professionals and their clients increasingly seek. The investing world got a rude awakening over the last several trading days. In response to the historic decline, investors will be subjected to a wide range of advice ranging from the banal to the brilliant, but most of it will overlook the simplest solution – choosing the right investment instruments at this juncture can enable investors to pass through difficult times with minimal damage to their wallet or their mind. Most investors have pressure to generate returns while simultaneously avoiding disasters. The problem is that without a crystal ball, the only way to generate returns is by taking on risk. There is simply no way around this. “High return, low risk” products brings out the skeptic in me – trust me, there is risk somewhere within the package that is applicable to the return. If the risk is not well understood or seems too good to be true it may be best to simply stay away. This begs the question: what is the best way to play defense while staying in the mix for gains? In a State Street survey of 420 institutional decision makers , a primary conclusion is that many participants are not protecting their portfolios enough against potential market downturns. Furthermore, when participants do seek out protection strategies, the study finds that they are not exploring the full range of downside protection strategies available to them. One interesting statistic from the study is that a majority of respondents are using dynamic asset allocation, which essentially relies on the strategy getting out of the way at the right moment (perhaps a crystal ball would be helpful here). Another interesting statistic is that approximately 25% of those polled had used hedge funds at some point but no longer do so, which sends a message that the CALPERS decision not to invest in hedge funds going forward may be a trend rather than an anomaly. In recent discussions on these topics, I have heard several advisors propose the use of alternatives to generate returns while protecting portfolios from a crash. A strategy a couple of advisors focused on is Managed Futures due to their low correlation with the market. However, at the same time, there was concern over historically inconsistent performance – so while the odds are high an investor would see increased diversification from them, there is less confidence in generating consistent returns. The quandary for investors becomes how to balance many competing factors. For instance, how should one balance the beneficial low correlation of Managed Futures with inconsistent and ultimately unpredictable performance? Additionally, identifying the right active Managed Future fund – i.e. a manager and approach you trust, is crucial. It seems like a lot of decisions need to be made just right (e.g. right manager, right strategy, right time) to have a shot at an effective solution. Along the same lines, State Street also expresses concerns over too much reliance on investing forecasting skills, particularly when it comes to tactical asset allocation. Defined outcome investing offers a simplified method to participate in equity markets while effectively playing defense. Perhaps I am jaded from 20 years in the industry but one simply cannot get reward without commensurate risk. Defined outcomes clearly define this balance upfront. For instance, our index based strategy looks to limit downside exposure on the S&P 500 to 12.5% on an annual basis. This comes at a cost. We cap the upside at around 15% annually, a healthy return, to pay for the limited exposure down. Thus, the risk/reward equation is clearly spelled out. If the market drops materially like in 2008, you are spared the heartache, taking a minimal relative loss and nicely outperforming. If the market moves up strongly like in 2013, you will underperform but still generate a respectable mid-teen return. It is clear, consistent and provides investors the clarity they deserve. With an increasing abundance of market uncertainty, we believe that defined outcome strategies can provide the comfort and relative safety that financial professionals and their clients increasingly seek. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.