Tag Archives: spy

Recession-Testing Your Portfolio

This article originally appeared in the October issue of REP. Magazine and online at Wealthmanagement.com There is correlation between economic phases and sector performance. Which funds will best ride the wave ? If you subscribe to common wisdom, the late-summer market selloff must have you thinking about the potential for a true recessionary slide. After all, the stock market looked like it had topped out after a stunning six-year run. Many investors and pundits subscribe to the notion that the stock market is a leading indicator of the economy’s direction. True believers assume that certain market sectors will price in improvements some six to nine months before their fundamentals actually perk up. They use these signals to overweight favored industries while paring exposure to those segments most likely to falter. The trick to this rotation business is, of course, correctly identifying the market’s current state. How do you, after all, spot ascendant sectors? And which ones fare best-or worst-at different points in the economic cycle? The second question’s pretty easy to answer. The first not so much, but we’ll get to that in a minute. Research has shown pretty strong correlations between sector performance and economic phases. Sam Stovall, chief equity strategist at S&P Capital IQ Equity Research, famously mapped the relationship when he authored “The S&P Guide to Sector Investing” in 1995 (see chart). If Stovall et al are to be believed, we could confirm a market top if we found bullish signals in the sectors that outperform during contractions, i.e., consumer staples (non-cyclicals), health care, utilities, financials and consumer discretionary (cyclicals). So let’s get back to that first question. Just how do we spot sectors poised for liftoff? Fundamental analysis won’t avail us for a timing decision like this. Here, technical indicators and trend analysis work better. But what indicator? And what trend? It’s best to look at a mix of near-term and longer-term signals rather than relying upon a single marker. After all, sector performance is time-dependent: some industries will do better in the early phase of a recession, others in the midphase. You can then weight each indicator according to your confidence in its predictive power. There’s a wide range of indicators you can employ, but a half dozen or so seems ideal and nondilutive. Try these as examples: Point & Figure Price Objective: A point and figure chart, by its nature, filters out a lot of market noise, making longer-term price objectives easier to see. On the basis of its predictive strength, we’ll assign it a 25 percent weight. Seasonality: Sector performance does, to a certain extent, depend on the calendar. Looking back over the past five years, we can rank final-quarter performance for each sector and ascribe a 20 percent weight. Relative Performance: Plotting each sector’s 200-day performance against the broad market, represented by the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), measures changes in the degree of investor interest. Let’s make this a 15-percent factor. 20-Day Volatility: Here, we’re rating low volatility more favorably because gains are more likely to be retained in a stable price trajectory. We gauge changes in 20-day volatility over a 12 month period. This, like all the subsequent metrics, earns a 10 percent weight. Relative Strength: Each sector ETF’s price strength is measured against the entire universe of ETFs over the past 12 months. Momentum: This indicator measures each sector ETF’s 6-month price trend versus its 12-month trend. A higher rank is assigned when the longer-term trend exceeds the shorter-term. Percentage Price Oscillator: Another momentum indicator, PPO often signals trend changes before price tops and bottoms are formed. To create a model sector array, we can employ the wildly popular universe of State Street SPDR Select Sector ETFs as proxies. We’ll weight the ETFs’ indicators, ranking each ‘1’ through ‘9,’ with ‘1’ representing the highest rank and ‘9’ the lowest. (click to enlarge) Four Sectors Likely to Outperform the Market Putting the indicators together, the four sectors now likely to outperform the overall market are consumer staples, financials, consumer discretionary, and utilities-all signposts on the recessionary trail. With a case made for recession, we have to wonder if the SPDR Select Sector products are the best vehicles to use in a portfolio overweight. Maybe they are, but it’s worth looking around to see if there are better alternatives. There are a half-dozen ETFs focused on the large-cap consumer staples sector, including the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ). From a reward-to-risk standpoint (i.e., the Sharpe ratio), the category leader is the Guggenheim S&P Equal Weight Consumer Staples ETF (NYSEARCA: RHS ). RHS holds the same number of consumer staples stocks as the S&P 500 but, by equally weighting them, gives more heft to the smaller issues. That tilt’s given RHS a performance edge over the rest of the field while keeping a lid on volatility. The iShares U.S. Consumer Goods ETF (NYSEARCA: IYK ), sporting the category’s highest beta coefficient, lags the other five funds. There’s less dispersion in the returns of financial sector ETFs, but a clear standout is the First Trust Financials AlphaDEX ETF (NYSEARCA: FXO ). FXO is the only product that earned a better-than-breakeven Sharpe ratio over the past five years. It’s also the ETF most highly correlated with the S&P 500 proxy portfolio. Among volatile financial ETFs, high correlation is a good thing, a fact confirmed by the low r-squared coefficient and high beta of the bottom-scraping RevenueShares Financials Sector ETF (NYSEARCA: RWW ). RWW earns the distinction because its portfolio is revenue-weighted, tilting it toward larger-cap financial institutions. The iShares U.S. Consumer Services ETF (NYSEARCA: IYC ) earned the best risk-adjusted return in its category, owing largely to its low beta. The high-beta product, the First Trust Consumer Discretionary AlphaDEX ETF (NYSEARCA: FXD ), is the worst performer. FXD’s multifactor index methodology and tiered equal-weighting scheme yield a risky tilt to the portfolio which hasn’t paid off in outsized gains. Among utility sector ETFs, the Guggenheim S&P Equal Weight Utilities ETF (NYSEARCA: RYU ) earns the only 1+ Sharpe ratio. RYU owes its high return-to-risk tilt to its telecom allocation, which also accounts for the fund’s exceptionally high dividend yield. In the cellar is the PowerShares DWA Utilities Momentum Portfolio ETF (NYSEARCA: PUI ), a fund that weights its portfolio on the basis of its components’ price momentum. Over the past five years, momentum added volatility without a commensurate enhancement to returns. If you’re going to gird your portfolio for a recessionary turn using sector rotation, it’ll pay for you to consider lower-beta ETFs. State Street’s (NYSE: STT ) ETFs may be category-killers in terms of size, but they’re a fairly volatile lot. As a class, better risk-adjusted returns are earned by the Guggenheim set of equal-weighted portfolios. No one’s obliged to use a single purveyor, of course, but commission-free ETF trading offered by some brokerages acts as a sort of loyalty program. Staying loyal to portfolio performance may require some careful picking and choosing.

Q3 ETF Asset Flow Roundup

The third-quarter of 2015 was teeming with economic shockers that bulldozed risky investments worldwide but showered gains on some safe bids. While a hard landing fear in China was the actual culprit, a long-standing guesswork on the Fed’s liftoff timeline was a partner in crime. Yet, we admit that nothing could stand against the China issues that include sudden currency devaluation, multi-year low manufacturing data and a massive crash in the Chinese market. The resultant shockwaves, swooning commodities and the return of deflationary fears in the Euro zone also set the dark stage for the third quarter’s investing activity. The combined impact of these events led the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) , to lose about 7.7%, the PowerShares QQQ Trust ETF (NASDAQ: QQQ ) to shed 5.7% and the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) to retreat about 8.4% in Q3. The iShares MSCI ACWI (All Country World Index) Index ETF (NASDAQ: ACWI ) was off about 9.8% in the quarter. Overall, the global market was quite disastrous for investors as most key indices endured the worst quarter in four years. In such a scenario, investors might thus want to check out the top and worst grossing ETFs of Q3 to see which products cashed in on the market crash and which lost out. Winners of Q3 The SPDR S&P 500 Trust ETF Though volatility rocked the show in the third quarter as China-led global growth fears and its ripples in the other emerging and developed economies muddled the market momentum, steady U.S. growth impressed investors. Also, the Fed’s reiteration of near zero interest rates at the end of the quarter resulted in strong inflows into the U.S. equity funds. The ultra-popular SPY led the way last month, gathering over $8.4 billion in capital. Not only SPY, another popular S&P 500 ETFs namely Vanguard S&P 500 ETF (NYSEARCA: VOO ) accumulated $4.45 billion in assets. U.S. Treasury Bonds – iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) With the Fed still hesitating to hike the benchmark interest rates even almost after a decade, bond investing prevailed in Q3. Though September was a chancy month for the lift-off, a global market rout in August, a choppy global market and a still-low inflation level in the U.S. held the Fed back from catapulting a lift-off. This gave a big-time boost to the short-term U.S. Treasury bond ETFs. As a result, SHY garnered about $4.05 billion in assets in Q3. The SPDR Barclays 1-3 Month T-Bill ETF (NYSEARCA: BIL ) also piled up $1.66 billion in assets and made it to the top-10 asset scorers’ list (read: Guide to Interest Rate Hikes and ETFs: 4 Ways to Play ). Since the global macroeconomic environment was tumultuous in Q3, investors sought refuse in safe haven bids like intermediate-to-long term treasury ETFs. These offer investors safety along with a decent level of current income. Thanks to this sentiment, the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) and the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) attracted about $2.40 billion and $1.65 billion of AUM during the quarter (read: ETF Winners & Losers Post Dovish Fed Meet ). Hedged Global – Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEARCA: DBEF ) The global economy may be lagging, but investors’ penchant for currency-hedged global equity ETF investing is not. The policy divergence stemmed from the looming Fed tightening and the easy money policies in most developed economies made hedged international investments a compelling opportunity for U.S. investors and led them to pour about $2.38 billion in assets in DBEF. Several other Europe-based ETFs including the iShares MSCI EMU ETF (NYSEARCA: EZU ) and the Vanguard FTSE Europe ETF (NYSEARCA: VGK ) hauled in respectively $1.7 billion and $1.6 billion assets in Q3. Top Losers Emerging Market – Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) Emerging markets were hard hit in Q3 thanks to the double whammy of China-induced worries and the Fed rate hike tensions. This clearly explains why two top-notch emerging market ETFs namely VWO and the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ) saw assets bleeding in the quarter. The funds, VWO and EEM saw outflows of about $3.44 billion and $2.79 billion respectively in the quarter. Un-hedged Global – iShares MSCI EAFE ETF (NYSEARCA: EFA ) Since sooner or later the Fed is due for a policy tightening, investors started to dump non currency-hedged international ETFs like EFA. The fund shed about $1.13 billion in assets in the quarter. Gold – SPDR Gold Trust ETF (NYSEARCA: GLD ) Gold has slipped to multi-year lows on a stronger dollar, a still-muted inflationary backdrop worldwide and the slowdown in China, which is one of the largest consumers of gold. Though the recent global market rout offered gold the much-needed respite for a brief session on the metal’s safe haven appeal, the underlying fundamentals are weak. So, investors abandoned this product in Q3, resulting in about $922 million in net outflows. Link to the original post on Zacks.com

A Simple SPY Top-Off Portfolio

Summary A one-third UPRO, two-thirds cash portfolio mimics SPY (with some small tracking error and a net 0.32% expense ratio). Putting the two-thirds cash allocation in a short-term bond ETF like BSV allows you to recoup the 0.32% expense ratio, plus earn a little extra. Since UPRO’s inception in 2009, not including trading costs, the UPRO/BSV top-off portfolio has generated a CAGR of 15.3%, compared to SPY’s 14.3%. Going back to 1994, a 3x SPY/short-term bond portfolio has beaten SPY in 21 out of 22 years, with an average 3.1% annual outperformance. For S&P 500 investors, I see little downside to implementing a UPRO/BSV portfolio to consistently beat SPY. Background I’ve written a few articles on combining leveraged ETFs with cash or the underlying index to realize portfolios with certain properties (see for example Build Your Own Leveraged ETF ). There are a few neat things you can accomplish: Achieve any leverage between 0 and the highest multiple leveraged ETF available. Achieve a leverage multiple of an existing ETF by combining cash with a higher multiple leveraged ETF, potentially reducing your net expense ratio. Achieve net leverage of 1 by holding for example one-third of your money in a 3x leveraged ETF, and the remaining two-thirds in cash. The last point leads to the natural question: If I can mimic the SPDR S&P 500 Trust ETF ( SPY) while tying up only 33% of my available balance, why not put the remaining 67% to work in a low-risk fund that generates a few extra percentage points in growth every year? One-Third UPRO, Two-Thirds BSV The ProShares UltraPro S&P 500 ETF (NYSEARCA: UPRO ) is a leveraged ETF that aims to multiply daily S&P 500 gains by a factor of 3. It has an expense ratio of 0.95%. The Vanguard Short-Term Bond ETF (NYSEARCA: BSV ) is a short-term bond fund with an expense ratio of 0.10%. Let’s take a look at how a one-third UPRO, two-thirds BSV portfolio would have performed over these funds’ mutual lifetimes. (click to enlarge) Sure enough we get a nice little top-off with the UPRO/BSV strategy. The compound annual growth rate was 14.3% for SPY, 15.3% for UPRO/BSV rebalanced daily with no fees, and 14.8% for UPRO/BSV rebalanced whenever the effective leverage went below 0.9 or above 1.1 (with a $7 trading fee). Sharpe ratios were 0.058, 0.063, and 0.061, respectively. Of course, the greater your portfolio’s balance, the more your growth would look like the blue curve rather than the red one, since you can rebalance very frequently without trading costs hurting you very much. I know, an extra 1% isn’t that much. But just like a 1% expense ratio can really hurt you over time, a 1% boost every year can really make a big difference. If you go year by year you see that UPRO/BSV tends to tack on an extra 1-2% to SPY’s annual growth, although it doesn’t always. Annual growth of SPY and UPRO/BSV portfolios. Year SPY BSV UPRO/BSV (no fees) UPRO/BSV (fees) 2009 22.3% 2.1% 23.7% 23.4% 2010 13.1% 3.8% 15.5% 14.0% 2011 0.9% 3.0% 2.3% 2.2% 2012 14.2% 1.5% 14.9% 14.2% 2013 29.0% 0.2% 28.3% 28.1% 2014 14.6% 1.4% 14.9% 14.9% 2015 -7.1% 1.4% -6.6% -7.2% One-Third 3x Leveraged ETF, Two-Thirds VBISX We can only look at UPRO/BSV back to 2009, but it’s easy enough to switch UPRO for a hypothetical 3x SPY ETF, and switch BSV for the Vanguard Short-Term Bond Index Fund Investor Shares (MUTF: VBISX ), so we can go back further. For the 3x SPY ETF, we’ll assume no tracking error and a 0.95% annual expense ratio, mimicking UPRO. The correlation between daily gains for the simulated 3x SPY ETF and UPRO since UPRO’s inception is 0.997. The correlation between monthly gains for BSV and VBISX since BSV’s inception is 0.963. Let’s see how one-third 3x SPY, two-thirds VBISX would have performed since 1994. (click to enlarge) The top-off portfolios achieved nearly double the balance of SPY over the 20.5-year period. Sharpe ratios were 0.033 for SPY, 0.043 for 3x SPY/VBISX with no fees, and 0.043 for 3x SPY/VBISX with fees. Of course it is important to note that VBISX has done really well since 1994, with a CAGR of 4.4%. Note that the top-off portfolio with fees beat SPY in 21 out of 22 years (all except 1994), and on average beat SPY by 3.1%. You can see the consistent annual outperformance below. (click to enlarge) Another way to visualize the outperformance of the top-off portfolio relative to SPY: (click to enlarge) A Portfolio Optimization View I came to the one-third 3x SPY, two-thirds short-term bonds portfolio from the perspective of mimicking SPY by combining a 3x leveraged ETF with cash, but then putting the cash to work to gain an extra few percentage points. But you can also view the strategy from a portfolio optimization perspective. A short-term bond fund like BSV has positive alpha simply from the fact that it yields a certain small percentage annually from maturing bonds of various durations. So in periods when SPY is flat, BSV still tends to grow (i.e. it has positive alpha). Indeed if you regress monthly VBISX gains vs. monthly SPY gains going back to 1994, VBISX has alpha of 0.0036 (p < 0.001), meaning it gains on average 0.36% in months when SPY is flat. Typical Stocks/Bonds Story? It is well-known that holding both stocks and bonds tends to improve risk-adjusted returns. But if you hold an S&P 500 index fund in addition to bonds, your net beta drops below 1 and you often sacrifice raw returns. The UPRO/BSV approach is unique in that it keeps beta at 1 (assuming BSV has no correlation with SPY), while increasing both risk-adjusted and raw returns. Something like a free lunch. Upping the Ante A natural extension of the UPRO/BSV top-off strategy is combining UPRO with a longer duration bond fund. For example I like one-third UPRO, two-thirds BND, for a bigger top-off. But BND is much more variable than BSV, and also much more sensitive to rising interest rates. Another way to "up the ante" so to speak is to aim for some leverage greater than 1, say 1.25 or 1.5. You can still combine UPRO with BSV to get some extra growth at any leverage below 3, but the greater your net leverage, the greater your allocation to UPRO has to be, and the less you have left over to grow in BSV. Risks Many investors may not be comfortable with a portfolio that requires a significant allocation to a leveraged fund. Indeed, there are risks associated with leveraged funds. In particular: If SPY ever experiences an intraday loss of one-third its opening price, you could lose the entire balance in the leveraged ETF. While leveraged S&P 500 ETFs like UPRO have historically had very little tracking error, daily gains may occasionally deviate from the target multiple. In between rebalancing periods, you may suffer some irrecoverable losses due to volatility decay. It is important to note that while the top-off strategy uses leveraged ETFs, the target net leverage for the portfolio is 1. In that sense, the portfolio is not prone to the greatly amplified volatility (and potentially catastrophic drawdowns) usually associated with leveraged ETFs. It is very important to understand these issues before implementing the SPY top-off strategy. Indeed, many investors may decide that the potential for slightly higher annual returns does not justify the added risks. I personally believe that the risk/reward for the strategy is favorable. Conclusions A one-third UPRO, two-thirds BSV portfolio should behave very similarly to a 100% SPY portfolio, but often generate an extra 1-4% annual return. You'll have to monitor your effective leverage (multiply your UPRO allocation by 3) and rebalance when it deviates much from 1, but for a reasonably sized portfolio this should not detract much from your extra gains relative to SPY. Of course, you don't have to use UPRO and BSV. Other 3x S&P 500 ETFs and short-term bond funds should perform similarly. And if you want an extra boost, consider pairing the leveraged ETF with an intermediate or long-term bond fund, or a total bond fund. But your annual gains will be more variable, and you may suffer losses as interest rates rise. I am currently implementing the SPY top-off strategy with UPRO and BND, but may switch to UPRO and BSV in the near future for a more consistent, albeit smaller, bonus. Ideally, I'll beat SPY by a little bit every year, and eventually be happy.