During the first part of the year, we created an ETF list for the ETF screener page we called ‘Primary Indexes’ – which was just meant as a sample of a few different important markets.

Rather than grow the pre-packaged ETF lists on the ETF screener page ever longer, we instead are updating the primary indexes list (now called 'Tactical Indexes') to reflect some thoughts we have on the broadest ETFs in existence (some of which made up the old primary indexes list).  

Most active managers have generally low enthusiasm for the big, broad ETFs that try to represent everything.   ETFs like Vanguard Total Market (VTI), MSCI Total World Index (ACWI), MSCI EAFE (EFA) index, Vanguard World Ex-US (VEU)  --  these are not very interesting indexes.  They just represent the broadest indexes possible and are dominated by the largest companies in the world.    

It is unlikely these types of ETFs are ever going to have very good relative long-term returns and yet they are not immune from significant drawdowns.   So we are presenting a new list with the idea of looking with a little more detail at market segments and just ignoring these mega-cap indexes for this particular list.    

Early in December, we will talk more about using a ‘core-satellite’ type of approach to ETFs when we add an exciting new application to the site.   A portfolio can be managed as multiple pieces --- one piece could be a relatively conservative allocation that draws on traditional indexing methods (with or without those broad mega-cap indexes).  The second piece can be a ‘return-enhancement’ portfolio allocation that utilizes some active management techniques that we have on the site -- such as relative strength.   

The important thing here is thoughtfully balancing return and risk.  The more you can simulate this with historical market relationships – the better you can estimate how your portfolio may act in the future.  We don't know of too many sources that attempt this specific core-satellite backtesting aspect to portfolio management. We doubt it exists except inside the walls of a few buyside firms. 

Up until now, the site has been presenting modules that might better be thought of as ‘components’ to a bigger strategy.  Shortly, we will begin the move to taking these components and building something that goes up one more level  ---- combining component strategies into a greater whole.

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A typical buyside analyst looks at the world in terms of business fundamentals, earnings estimates, quality of management, competitive position, competitive advantage, return on invested capital, P/E multiples and so forth.  

You will often hear analysts talk about P/E’s being low relative to growth rates or low vs 10-year bond yields or low vs a group of comparable companies or the overall market etc.

Is the price/earnings (P/E) multiple a good indicator for future performance?   One interpretation of this fundamental valuation measure is rather than thinking in terms of the current valuation vs ‘fair value’ --- is simply to observe whether the valuation is expanding or contracting and decide if you believe this will continue.

If a P/E has just gone from 14x to 12x, its cheaper – but is that bullish?  How do we know its not headed lower?  We should probably test this and see if it works and then create some guidelines for portfolio strategy based on this.   Wouldn’t that make sense rather than just blindly believing that a lower multiple is bullish?

Relative strength can actually be thought of as fundamental analysis if you wish to think about it like that.   It would not be unusual for a fundamental analyst to say during a rally “the P/E multiple is still too low at 12x next years earnings” -- even though it’s up from a low of 9x and you bought the stock at 10x.  But this is not any different than watching relative strength and buying at the same price and looking for further valuation expansion.

Good relative strength analysis captures when a market segment is experiencing valuation expansion.  A low P/E is not actually bullish unless its low and then expands higher.  This is the crucial aspect – not the absolute level of valuation. 

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In old-school financial theory, ‘the market’ was often assumed to be the S&P 500.   Many people in the financial industry grew up on defining things (like Beta –> and therefore Alpha) relative to the S&P 500.   This wasn’t the correct interpretation from Modern Portfolio Theory --- but as the 1990’s bull market raged, the question was not about U.S. equities vs bonds vs international investing or anything else --- it was more a discussion of simply ‘which US equities?’ – and the popularization of ‘style boxes’ that carved up the U.S. market according to size (small , mid or large cap) and style (value vs core vs growth).

In 1998, the S&P 500 rallied 25%+ while small cap U.S. stocks were essentially flat.   The dispersions between picking segments of the U.S. were very important then.   Much discussion was also whether you were overweight technology – or underweight sector XYZ – all along assuming that of course your universe was U.S. equities.   The economy was robust and it was not unusual for companies to grow 5-10%+ every 90 days (sequential quarterly growth).

Those days of course are long gone.   The companies growing 5-10%+ every 90 days now are more likely located in Brazil or India etc…  Still, the dispersions between market segments can be very large.    The conversation doesn’t end at --- overweight bonds --- but which bonds?  Long-duration corporates or intermediate high-yield  -- or preferred stocks for that matter?   Overweight international stocks?   Which international stocks – what regions, which countries?

One very interesting aspect of ETFs is that they allow allocations to be adjusted not just easily – but with such precision and at essentially no cost.   Expense ratios are in the 0.40% zone and are already accounted for in market prices.   With free trading now available --- it just gets better.  

But ETF investing doesn’t have to end at allocation decisions.   ETF rotation involves rotating beta exposures over time.    Its not just about picking a low-cost allocation and sticking to it.   Surely you have some view on some market segment in some region of the world?   

Importantly, expressing this view can be done as a satellite rotation strategy against a core portfolio of conservative investments  –  or on its own.   Its up to you and your risk tolerance and any other constraints you impose.    

The point is that there is tremendous value to be added that has nothing to do with stock-picking.   ETF's allow us to operate at a level that is above stock-picking – and picking market segments has and always will be more important than stock-picking. 

Even with all the ‘insider networks’ of professional money managers --- hedge fund indexes have shown very mediocre net performance, with any benefits of outperforming funds accruing primarily to the hedge fund manager -- and not to the investor.  Moreover, the data to fully risk-adjust these performances just isn’t available without a daily NAV – something hedge funds do not report.

So here we have transparent, ultra low expense ratio, free trading vehicles that operate at a level far more important than adding (or subtracting) 2.00% in stock-picking. 

To quote a recent line I heard from a high-profile CEO: “Get on the bus.”

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We have received this question a number of times in email and so we wanted to clarify something.

R.S.I. (known as the Relative Strength Index) and the way we at ETFreplay.com discuss ‘Relative Strength’ are not the same thing.   We wanted to briefly explain this.

R.S.I. is a technical analysis tool that involves only a single security  --  it measures the average amount of up closes vs the average down closes over a given period of time.   The most important distinction here is that R.S.I. only looks at the closing values of one security.  There is nothing in the calculation of R.S.I. that involves anything but the historical prices of this SINGLE security.

The way ETFreplay uses relative strength has nothing to do with R.S.I.   We use relative strength as a way to determine which among multiple market segments is relatively strong.

Many of you are probably familiar with Investors Business Daily.   The paper has for a long period of time used a ‘RS Rank’ --- this is more like what we use.   Note that IBD certainly did not invent the concept of relative strength  --  but they built a database of securities and then ranked everything relative to each other.   Institutional-oriented software programs do the same thing.  A RS Rank of 90 in IBDs method means that a stock has outperformed 90% of the other securities in their database over a given period of time.  High-end institutional software does something similar – except they proceed more mathematically by instead expressing the strength of the security as the distance from the average of a group  --- and this is usually stated in terms of the # of standard deviations away from the mean (think z-score).

This is all similar to what we have done – except we do it with ETFs and then allow you to backtest it yourself rather than just saying ‘you should buy relative strength because it works.’   We also allow the user to define relative strength themselves – using easy browser controls like drop-down menus and text boxes.   So for example you could simulate IBD’s method by using 12-month performance and ranking ETFs in a given universe like this:

ETFreplay Screener

Then you could go the ETFreplay.com backtesting module and see how 12-month relative strength has been holding up over the past 10+ years and see what kind of drawdowns its had.  

This is all a research process – its just that we are performing research that comes in a very practical form.   We aren’t researching stocks, we are researching strategies --- strategies based on baskets of stocks.   Backtesting is not the only thing that matters --- but its pretty darn good information for you to factor into your decision-making process.   Without some historical testing, you could easily go a lifetime of doing things that you thought worked – but actually don’t -- and never really did.

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ETFreplay.com has developed some new pages that we think better enable users to observe what is occurring across global market segments. 

The first app is the 'Relative Strength Reader' and it works seamlessly with any ETF portfolio list you have already created. Its been designed to show ETF relative strength changes that are occurring presently - as well as some easy controls to replay past changes. It combines charting with some advanced database queries and delivers a unique, easy-to-use product.

The product is in free trial-mode and you can give it a try here:
http://www.etfreplay.com/tools.aspx


A second announcement is that while a significant portion of the site will always remain free, we will be initiating a subscription service for certain applications in coming weeks. Along with this change we will concurrently be releasing another strong new application that is currently in final beta testing. 

We look forward to 2011 and the opportunities to further develop unique functionality for the site. We appreciate your support and feedback.

Sincerely,
The ETFreplay team

Just a note to new users that we updated the home page introduction video with a short example.  We have also added an About Us tab for those that happen to be interested.  Send us a message sometime through the contact tab if you would like to reach us.  

In the original introduction video, recorded late in February --- a simple example was shown that combined bonds and emerging markets.   Here is the update of that portfolio since then.  Note the low drawdown and strong Sharpe Ratio.   There is a pretty good relationship between portfolio volatility and subsequent drawdowns so we think its always good to review basic concepts like this:

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We showed where the S&P 500 ranked relative to an adjusted Ameritrade 100 ETF list recently.   This shows the S&P 500 vs the primary country funds as defined by weightings within the world index.  Note that other than Brazil, the smaller countries have done generally better.    And developed Europe has obviously been an area of weakness -- though Sweden is the exception, up +30% on the year.    Greetings to all our users in Stockholm.

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Source: Blackrock

At first view, the # of global ETF products might seem like a lot at 3,257.   But consider that there are greater than 69,000 mutual funds in existence (globally).

Moreover, ETF assets total about $1.3 trillion vs over $22 trillion for the global mutual fund industry. In fact, the $1.3 trillion in global ETF assets is actually just a fraction of the amount of assets that the mutual fund industry has lost in recent years when it peaked in 2007. That makes for roughly -$4 trillion in change versus the $26 trillion in assets of a few years ago.

I have spoken to a number of professional money managers regarding ETF’s. My impression is that the market has enormous room to grow as many managers I speak with are still not using ETF’s in any way. 

In the cases where they are, why are they doing so?

1. A particular market segment is attractive but there is no information edge to justify individual security-selection. Especially relevant in international and/or emerging markets.

2. Liquid access to non-correlating asset class exposure (Gold, Aggregate Bond Index, TIPS, Commodities)

3. Add Yield to portfolio (preferred stocks, inv-grade/ high-yield bonds, emerging market bonds, MLPs, high-dividend ETFs, and/or high-dividend sector ETFs, etc)

4. Alter portfolio beta to enhance return

5. Diversify with some non-correlating indexes that complement an otherwise concentrated list of best ideas

6. Reduce administrative burden of smaller separate accounts – rolling cash from maturing bonds across long lists of accounts is time-consuming and very low in terms of possible alpha from this task.

7. Macro Calls – express tactical views based on changes in the marco outlook for various market segments (global or domestic).

8. Hedging late in the calendar year with a short (or inverse) position – rather than selling longs --- in order to avoid taxable gains in the current year.

9. Liquidity – try selling individual muni or corporate bonds through a broker and see the bid/ask spreads you are quoted.

10. Pair Trading. Shorting a sector within a list of long individual stocks.

11. Shorting very low yielding long-duration treasuries

Interesting note:

Hedge funds generally wouldn't be caught dead owning a mutual fund in their portfolios.   However, while still a small percentage in terms of penetration -- many hedge funds have rationalized using ETFs (long and short) in some way.

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An email came in with an interesting idea to take a look at what the Federal Reserve portfolio of bonds might look like. We gave it a shot and compared it to the t-bill ETF return.  

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