Jul 02, 2014
Volatility
When you study finance, you have to first learn the basic fundamentals of portfolio theory. When you eventually move to real life, you quickly realize how theory is only a starting point. Nevertheless, it is useful to know the "book theory" because it provides something of a very basic framework. That said, in the words of the great investor Mike Tyson "Everyone has a plan 'till they get punched in the mouth." First, here is the look of a list of ETFs that climb up the risk curve.
Note that this was posted on this given date covering this very specific time period. Using those precise assumptions, the book theory held up nearly perfectly -- a line going from lower left to upper right --- more return for more risk. But you have to remember --- that was using some very careful selections. Here is an example of a different time period where equity investors were punched in the mouth, Tyson-style:
The point is that the volatile ETFs that are towards the right side of the chart will be the ones to have large intermediate-term drawdowns and large intermediate-term returns. The ETFs on the left side will have low drawdowns and low returns. These are very generic ETFs. Where this gets much more interesting is when you use other ETFs that track more interesting indices.
Watch our backtesting videos.
Dec 01, 2012
Ratio
Quick mini-analysis of an ETF we are long in our Allocations Board models (EPP).
Here is a summary of the rationale:
We went long EPP on an Allocations Board portfolio during a small pullback in late August. (members can see allocation board for details). Why EPP and why then?
First, EPP is a regional ETF covering developed markets in the Pacific ex-Japan region. This means companies based in Australia, Hong Kong & to a lesser extent Singapore and New Zealand. Note that none of these are considered emerging markets --- though all are clearly closely tied to the growth of Eastern Asia, which in turn are all emerging Markets (ex-Japan).
EPP began by performing well on a relative strength basis during the summer of 2012 vs various lists we keep on constant monitor.
EPP is very volatile -- so we wanted to expose the model to strong relative strength -- but also be sure to plan ahead in case things went adversely against us. This can be a tricky situation because you absolutely must give yourself a chance to participate in the uptrend by giving it some room in the short-run ---- but we wanted also to have a plan in place to avoid large portfolio drawdowns. Below is a snapshot using the Ratio MA module to manage the individual position. Also included are some pullbacks which are normal for a volatile security like this. These would be buying opportunities within a perceived uptrend. This is not meant to be how anyone else should choose to manage a position. This is just a snapshot of how we were thinking about it.
The exact parameter settings should not be the focus here. Investing is not a pure science, in our view. It is much more like a game of poker, partly mathematical and partly behavioral/psychological. Good poker players don't take wild risks with no plan in place if things go adversely. They start out with a plan for each part of the hand and then make adjustments and often have to make some tough decisions as more information is revealed that is adverse to their position. Sometimes they make a mistake and fold the best hand (like a trading whipsaw) --- but over time, good long-term decision-making is what makes a good investor (and a good poker player). PLAN YOUR HAND.
Note that the ETF in discussion here (EPP) was not chosen in the first place because of this ratio MA analysis -- that is just a second more detailed view of how we planned to manage the position. EPP was instead originally chosen because we like what the ETF represents on a fundamental basis (companies based in Australia, Hong Kong & Singapore) AND it also was showing strong signs of a new uptrend beginning (this is what good relative strength analysis does -- it locates particular strength in the market that over time suggests continuation rather than reversal).
Oct 15, 2012
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.
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Example:
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:
Aug 31, 2012
Ratio
Credit markets don't appear to be too concerned about recession in United States. Junk Bonds have been outperforming Treasury Bonds lately.
May 30, 2012
Volatility
A new book in the Market Wizards series by author Jack Schwager has come out this month. While these books are a collection of interviews of great money managers -- Schwager himself also does a nice job of summarizing some of the themes he personally has gleaned by incorporating his decades of experience into a series of observations.
He also recently summarized a few of these observations on his twitter account (@jackschwager)
A few of his takeaways from interviewing top money managers:
- It is not about predicting what will happen -- but rather recognizing what is happening
- Many go wrong by failing to adjust exposures to changing market volatility
This all conveniently ties into ETFreplay, using Relative Strength to help recognize what is happening is foremost. But on the second point, we recently added a module to help think about how to adjust exposures to changing market volatility. Let's look at one example of the latter.
Let's think about the Russell 2000 Index, the most popular index for small cap U.S. stocks, which is one of many important market segments we can access at ultra low-cost (never any redemption fees or lock-ups with ETFs) and it of course has total transparency and is deeply liquid.
Let's look back at 2010 for an interesting example of how this segment has traded.
2010 was a very good year -- but you wouldn't have said that during the summer of 2010 when there was a large drawdown following a flash crash in May and yes, continual negative newsflow from... drumroll... Europe. The final IWM return was very strong +27% but masks the mid-year washout and pain many investors felt.
Here is 2010 as full year snapshot.
Go forward one year to 2011, the IWM final return of -4% for IWM also greatly masks the 'path-taken.' Another large drawdown, this time -29% and about the same actually as the European index loss (VGK was off -30% from peak to trough).
This is very important and something that investors must study a great deal --- the long-term return of the markets is not all that great in relation to the often wild path taken to get that return. That is, a long-term return of say +7% might have huge drawdowns along the way that cause investors to actually end up losing money if they don't learn how to deal with this.
(In modern portfolio theory terms, you describe this situation (low return relative to high volatility) by saying simply that the Sharpe Ratio is not very good.)
If the short-term S&P 500 sharpe ratio gets really high, just wait -- it's coming back in at some point. This is what happened in Q1 2012 when the S&P 500 YTD sharpe ratio was over 3.00 at one point. We noted this as an unsustainable figure on our Allocations board timeline. And now we see the inevitable washout that occurs with assets that don't have good long-term sharpe ratios. If you want a more efficient equity curve, then don't buy and hold stocks --- unless its part of a well thought-out allocation that adjusts to prevailing conditions.
On the ETF Tools page is a new module 'Volatility Target Test.' This module executes a convenient, clean performance backtesting report for you complete with detailed period-by-period weightings and return.
It combines any ETF of your choosing (such as IWM) with a cash-like ETF (SHY) and allows you to therefore approximate a level of volatility for the combination based on changing (dynamic) market conditions. It continually adapts to the current environment and records the performance of such a mechanical targeting approach.
It should be clear that if you target low volatility and the market goes up a lot -- then obviously it will underperform. But if you target lower volatility and the market goes down a lot, it will obviously then outperform. The point of the application is not to be an optimal weighting, it is to help us all understand how volatility targeting is working and how to avoid one of Schwagers main points repeated here
* Many go wrong by failing to adjust exposures to changing market volatility
Below is a single view screenshot of the new Volatility Target Backtest:
