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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.

Low Blow – Why Low-Volatility ETFs Could Prove Anything But When You Really Need Them To Be

By Ian Kelly Just as nobody buys a parachute primarily for its colour – well, certainly not twice – presumably the main reason investors choose to buy low-volatility exchange-traded funds (ETFs) is safety-related. If they really were looking for a smoother ride from the share prices of their underlying holdings, though, events in global markets over the last few days may well have come as a considerable shock. Low-volatility stocks have enjoyed a good run in recent years, and as is often the way with investment, the better an asset or sector performs, the more people want a piece of the action. The low-volatility ETF market is now considerable – to pick out one example, the PowerShares offering that tracks the S&P 500 Low Volatility Index (NYSEARCA: SPLV ) has attracted almost £3bn from investors since its launch in May 2011. If pushed on why low-volatility stocks have done so well, here on The Value Perspective, we would raise the possibility they were priced very cheaply at the start of their run. In a previous article, ” Lost and pounds “, for example, we reminded you how lowly valued tobacco stocks used to be as the market fretted over, among other things, huge threats of litigation. Then, as those fears largely receded, the shares re-rated. Once a group of stocks reach “fair value”, however, the only way they can continue to outperform the rest of the market is if they grow their earnings more quickly. Where we would take some convincing then is that there is any reason why a business would be able to grow its earnings faster over the longer term just because its share price happens to bounce around a little less than the wider market does. In other words, while a low-volatility strategy has worked in the past, we have our doubts as to whether it will to continue to do so. Where we have few doubts, however, is that many people will have been shocked over the last few days by just how volatile their low-volatility ETFs have proved since the global markets went into free fall over concerns about China. The following chart shows how the aforementioned S&P 500 Low Volatility ETF traded versus the whole S&P 500 on Friday, August 21. While we would not normally focus on intra-day pricing on The Value Perspective, when a low-volatility ETF at one point plummets 46% as its wider benchmark drops just 7% – while trading real volumes on those numbers – we are prepared to make an exception. (click to enlarge) (Source: Bloomberg, August 2015) (click to enlarge) (Source: Bloomberg, August 2015) A good lesson to take from this is the importance of, as it were, looking under the bonnet of any collective investment so you are comfortable with the sort of businesses you own through it. Anyone “popping the hood” of the S&P 500 Low Volatility Index, for example, would find an allocation of almost 15% to insurance companies and a further 13% to real estate investment trusts. Is there any great reason why the valuations of these stocks should not be volatile over time, or in the case of insurance, the businesses themselves should not be volatile? If you accept that the valuations of these businesses and their earnings are likely to be volatile, you might ask what are they doing making up more than a quarter of a low-volatility benchmark? The answer lies in the fact that these kinds of indices, and the funds that track them, are mechanistic in nature. Thus, the S&P 500 Low Volatility Index is set up to measure the performance of the 100 least volatile stocks of the S&P 500, with volatility defined as “the standard deviation of the security computed using the daily price returns over 252 trading days”. It may seem odd for the index to have a 15% allocation to insurance companies today, but over time, ideas such as low volatility can become self-fulfilling. There will be times when this sort of strategy works and times when it does not. But you only ever get what the market is willing to pay, and at one point on August 21, for low volatility, that was half what it was the day before. To our minds, owning a low-volatility investment that fails to provide it when it is really needed is akin to a pretty-coloured parachute which doesn’t open when you pull the cord.

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