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Take The Long-Term View To Manage Volatility

By Tom Lee, Managing Director, Investment Strategy and Research, Parametric Volatility today is not materially above the long-term average. If we use the CBOE Volatility Index as a reference, volatility since the end of 2015 averaged a little over 21 ½. Long-term VIX averages in the high 19s. The reality is people think we are in a higher-volatility environment because we came from, historically, a relatively low-volatility environment. Volatility tends to cluster into regimes. The volatility environment we’re in now is more normal. What caused volatility to elevate? There are a lot of contributors to volatility. There are the experimental and divergent monetary policies that are being pursued across the globe, including negative interest rates. And there’s also an intuitive understanding that the longer we are in this experimental monetary policy phase, the higher the risk is of some unintended consequence. We’re going to have this uncertainty for a while. Asset allocation Having said that, I don’t think that volatility should drive changes in asset allocation. Volatility tends to cluster in regimes and it would be very hard for an investor to time an upward or downward move. I think investors should structure their portfolios for the long term. I would say that now is a very prudent time for investors to closely observe their portfolio and make sure they have transparency into all the risks they’re taking and address unintended risks. As an example, recently investors have become very interested in hedging their currency exposure – after the strong rally in the dollar. They’re hedging only after they’ve experienced the risk. We are advocates of investors trying to get ahead of the curve with respect to risk. Investors need to show fortitude as volatility picks up and not overreact to events in the market. Staying the course What can investment managers do? First and foremost, investment managers can come up with ways that help the client to stick to their policy portfolio. So, as an example, they can offer seamless rebalancing methodologies. Investment managers can be more transparent about their strategies. By this I mean every strategy has periods when the wind is at its back and periods where you’re running into the wind. Overall it’s helpful to be more transparent about what environments will be challenging for a strategy. And if managers are forthright with the client about this, it’s less likely the client is going to terminate them during a challenging period. Frequently, in hindsight, we see that these challenging periods were absolutely the wrong time to terminate a strategy. Low-volatility strategies Low-volatility strategies are always worthy of consideration but investors need to be conscious of what they’re getting into. Most strategies are constructed around two general themes, a risk metric construction process and a min-variance process. Risk metric just involves sorting the index by various volatility metrics. Minimum variance looks beyond risk metrics and incorporates correlations among securities. All low-volatility factor construction uses some type of concentration limits. You need to understand that these strategies don’t outperform in every situation, namely a down market. For example, the S&P 500 Low [Volatility] Index has underperformed the S&P approximately 15% of the time when the market was negative. So investors have to understand that they can have these downward surprises. If investors want to avoid these types of surprises, either asset allocation or diversification through the introduction of other risk premiums will provide them with greater certainty of low volatility when they most want it, and that’s in a negative market environment. Holding cash In regard to holding cash, I think it’s challenging for an investor in the long term. They are holding risk assets to fund future liabilities, which are growing faster than cash. Investors holding cash also struggle to realize when the market is bottoming so they can time their move out of cash into risk assets. If you are really thinking about holding cash as a modest form of protection, there are other strategies available. A very simple one is a disciplined covered-call selling program that will generate cash in a stressful environment and dampen some of the downside volatility. That, to us, would be more prudent than parking money in cash. Derivatives Derivatives can and have been used to control portfolio volatility. Historically investors have used long puts or put spreads to control downside risk in portfolios. I am generally not an advocate of this approach. It needs to be highly customized to the particular investor and it can lead to a lot of challenging decisions. How do you pay for the downside protection? Do you sell away upside? Experience shows that most investors become fatigued with the expense and tend to terminate programs, often right before a market experiences challenges. Options An alternative approach is to sell fully collateralized options. This approach seeks to capture the volatility risk premium, which is embedded in options. It often makes more sense to de-risk the portfolio and consider being a seller, rather than a buyer of the hedge. The first adopters of this type of strategy were endowments and foundations. More recently there is increased interest from Taft-Hartley funds that are dealing with particular pension funds and mark-to-market issues, as well as public fund investors. There are benefits of selling volatility in a transparent, liquid and fully collateralized manner. One preferred way of doing that is through index options and trying to capture what academic and market research has identified as the volatility risk premium. The result is that this premium can be captured in a transparent, liquid manner and it shows diversification benefits versus traditional assets. It can have a material and positive impact on a portfolio over time. Focus on the long term Many investors look at volatility and are fearful. They intuitively understand that rising volatility generally means more stressful market environments. Investors need to take a step back and focus on the long term, and not become reactionary or fall into short-term pitfalls and try to shuffle their portfolio to follow some latest fad. As markets evolve there may be better approaches available to them that allow them to achieve their ultimate objectives. So be open to new ideas. There’s a lot of really creative thought going on right now in different areas that maybe in a couple years will become more mainstream. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Best And Worst Q2’16: Financials ETFs, Mutual Funds And Key Holdings

The Financials sector ranks sixth out of the ten sectors as detailed in our Q2’16 Sector Ratings for ETFs and Mutual Funds report. Last quarter , the Financials sector ranked seventh. It gets our Neutral rating, which is based on aggregation of ratings of 38 ETFs and 249 mutual funds in the Financials. See a recap of our Q1’16 Sector Ratings here . Figures 1 and 2 show the five best and worst rated ETFs and mutual funds in the sector. Not all Financials sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 21 to 572). This variation creates drastically different investment implications and, therefore, ratings. Investors seeking exposure to the Financials sector should buy one of the Attractive-or-better rated ETFs or mutual funds from Figures 1 and 2. Figure 1: ETFs with the Best & Worst Ratings – Top 5 Click to enlarge * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings PowerShares KBW Property & Casualty Insurance Portfolio (NYSEARCA: KBWP ) is excluded from Figure 1 because its total net assets (NYSEARCA: TNA ) are below $100 million and do not meet our liquidity minimums. Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 Click to enlarge * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Schwab Financial Services Fund (MUTF: SWFFX ) is excluded from Figure 2 because its total net assets are below $100 million and do not meet our liquidity minimums. iShares U.S. Financials Services ETF (NYSEARCA: IYG ) is the top-rated Financials ETF and Fidelity Select Banking Portfolio (MUTF: FSRBX ) is the top-rated Financials mutual fund. Both earn a Very Attractive rating. iShares Residential Real Estate Capped ETF (NYSEARCA: REZ ) is the worst rated Financials ETF and Rydex Series Real Estate Fund (MUTF: RYREX ) is the worst rated Financials mutual fund. REZ earns a Dangerous rating and RYREX earns a Very Dangerous rating. 595 stocks of the 3000+ we cover are classified as Financials stocks. American Express (NYSE: AXP ) is one of our favorite stocks held by IYG and earns a Very Attractive rating. We previously published a case study outlining how AXP could boost its value by $50 billion by making strategic decisions to boost return on invested capital ( ROIC ). Over the past six years, American Express has grown after-tax profit ( NOPAT ) by 6% compounded annually. At the same time, the company has improved its ROIC from 12% in 2005 to a top-quintile 20% in 2015. However, some short-term issues, which we identify in our case study have left AXP undervalued. At its current price of $62/share, American Express has a price-to-economic book value ( PEBV ) ratio of 0.9. This ratio means that the market expects American Express’ NOPAT to permanently decline by 10%. If AXP can, instead, grow NOPAT by 6% compounded annually for the next decade , the stock is worth $98/share today – a 58% upside. Essex Property Trust (NYSE: ESS ) is one of our least favorite stocks held by REZ and earns a Very Dangerous rating. Essex earns its rating in large part to its misleading earnings. Over the past decade, GAAP net income has grown by 11% compounded annually. However, Essex’s economic earnings , its true cash flows, have declined from $7 million to -$249 million over the same time period. Further highlighting the deterioration of Essex’s operations, the company’s ROIC has halved from 8% in 2005 to a bottom-quintile 4% in 2015. GAAP earnings have propped up shares for too long, and ESS remains overvalued. In order to justify its current price of $225/share, Essex must grow NOPAT by 12% compounded annually for the next 11 years . After a decade of shareholder value destruction, the expectations baked in ESS remain too high. Figures 3 and 4 show the rating landscape of all Financials ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst ETFs Click to enlarge Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Mutual Funds Click to enlarge Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Exits: Know When To Hold ’em, Know When To Fold ’em

Originally published March 29, 2016 We all focus a lot of attention, perhaps too much attention, on where to buy and sell a market, on where to enter trades. Today, let’s spend some time looking at the other side: where are you getting out? Some categories are useful here, and they are not complicated. First, we have exiting at a loss, or at a profit. (This is not necessarily the same as saying exiting on a stop or at a profit, because a (trailing) stop can often be a profit-taking technique.) Both of these can then be divided into two more categories: Exiting at the initial loss or a reduced loss, and profit taking against a stop or at a limit. Let’s spend a few moments thinking about each of these. Initial stops The most important think about initial stops is that you have one. Though so many trading axioms and sayings do not apply universally, one that does is “know where you’re getting out before you get in.” For every trade, you should have a clearly defined maximum loss, and you should work hard to make sure that loss is never exceeded. In practice, bad things will happen. You will have the (hopefully rare) experience of a nasty gap beyond your stop, and sometimes will see losses that are whole number multiples of your initial trade risk. (I remember one lovely -4.5x loss in Yahoo (NASDAQ: YHOO ) years ago. Though these events are rare, they are also a good reminder of we do not, for instance, risk 10% of our accounts on a trade. A 45% loss on a single trade would be a disaster, but 4.5x a reasonable risk (1%-2%) is merely annoying.) Initial stop placement is an art in itself, but, in general, I think too much of the material on the internet probably uses stops that are too tight. I’ve never seen anyone trade successfully with stops that are a few ticks wide. For me, initial stops usually end up somewhere around 3-4 ATRs from the entry. These stops are wide enough that many traders find them uncomfortable, but simply reducing position size to manage the nominal loss is an obvious solution. Taking losses is perhaps the most important thing you will do as a trader, so do it well and do it properly. Click to enlarge Reduced stops We have defined that initial “never to be exceeded” (ideally) stop at trade entry, but many traders find it effective to move that stop rather quickly. Another possibility to consider is the time stop, in which we take steps to limit the position risk if the trade does not move in some defined time. There are many possibilities here, ranging from tightening the stop, to reducing the position, to exiting completely. I have made a good case for not reducing the position at a loss because it effectively “deleverages” your P&L in the “loss space.” (See the chart above, which is drawn from pages 242 and 243 of my book.) Personally, I’ve found that simply taking whole, but smaller than initial, losses is more effective, but your experience may be different. A key point here is that all of this – entry, exit, position size, moving stops, taking targets, re-entries, adding to positions, partial exits, etc. – all of this must work together. You change one piece, and the whole system will change. This is why some techniques may be effective in some settings but not in others. To simplify, think of reduced stops as being moved when the trade does not immediately go far enough in your favor, and consider the use of time stops. Profit targets Profit targets are usually limit orders, as opposed to stops (which, not surprisingly, are usually stop orders). In general, I find that it makes sense to have profit taking limit orders working in 24-hour markets, though we may not wish to work stops in the same after-hours environments. People sometimes make mistakes or do silly things in after-hours, and I’m always happy to provide liquidity at the right prices. There is a school of thought that says that all trades should simply be exited at profit targets, while there is a conflicting school that says we must let our winners run. How to reconcile these two approaches? I think the answer lies in trading style. For trend traders, we must let our profits run. As countertrend traders, we must take quick profits, usually at pre-defined areas. I have not found chart patterns or points to be any more effective than simply setting a target 1x my initial risk on the “other side” of the entry. Many people like to use pivots or trendlines, but I’ve executed well tens of thousands of trades (one of the advantages of spending years as short-term trader) and have simply not found these to be that effective. (For intraday traders, highs and lows of the day do deserve respect.) Consider the tradeoffs in simplifying your approach. Trailing stops Trailing stops can be managed in many ways, and I have found these to be very effective in many types of trading. We can trail at some volatility-adjusted measure, and there are even times we trail a very tight stop, effectively hoping to be taken out of the trade. This is a good problem to have: sometimes you may trail a stop at yesterday’s low, and be shocked as the trade grinds in your favor week after week – there’s nothing to be done in these cases but be forced to stay in the trade and make more money, but guard against hubris: many of the times this has happened to me; I have been properly positioned into a climax move. When these moves end, they often end dramatically, so simply ring the register and step away from the market. Putting it all together This is certainly not an exhaustive list of all the possible ways to exit trades, but it will get you started in the right direction. I find that combining these techniques, using a pre-defined target for part of the trade, trailing the stop on the rest, and moving quickly to reduce initial risk on my rather wide initial stops, this works very well for swing trading the markets I follow. Consistency certainly matters, but consistently doing something that works will, not surprisingly, lead to consistently losing money. Make sure you have a well-designed system with an edge, and that the system is one you can follow in actual trading. Make sure you trade with appropriate size and risk, and that you monitor your performance accordingly. With these guidelines, you can be a few steps closer to developing your own system and approach to trading.