Tag Archives: nysearcadbc

Modern Portfolio Theory: Introduce Allocation To ‘Alternatives’

Summary Modern Portfolio Theory (MPT) implies that total portfolio risk can be reduced by combining asset classes that have less-than-perfect positive correlation. MPT provides an explanation for historical and expected outperformance of ‘David Swensen’s portfolio’ compared to typical stock-only or stock-and-bond-only portfolio. MPT also provides us with tools to further augment ‘David Swensen’s portfolio’ by introducing alternative asset classes to improve risk-return profile of the portfolio. I recommend inclusion of commodities in your Core Portfolio. This is the second article in the series that aims to develop portfolio investment approach that ‘beats the market’, or at least ‘beats the average retail investor’. The goal is to equip readers both with knowledge about the path and confidence to stay on the path. In the first article, Efficient Market Hypothesis And Random Walk Theory: Buy ‘David Swensen’s Portfolio , the author recommended using ‘Swensen portfolio’. We did not dive into a detailed review of the performance of ‘Swensen portfolio’, as doing so is one of the topics of this second article. If you haven’t read the first article, I strongly recommend doing so. Why ‘David Swensen’s Portfolio’ beats conventional stock-only and stock-and-bond portfolios? Modern Portfolio Theory (MPT) implies that the total variance of the portfolio could be reduced by combining asset classes that have less-than-perfect positive correlation. The main premise is the use of diversification. Typically, a change in the value of various asset classes is not uniform. It follows that combining such assets will help smooth out periodic upward and downward spikes (or even short-term trends) to result in a smoother ride for investors. If you are interested in learning more about MPT, please refer to the last section where I provide the list of references. I reviewed total return of ‘David Swensen’s Portfolio’ and S&P 500 for the 1988 to 2014 period. Results are presented in the table and graph below. ‘David Swensen’s Portfolio’ has lower CAGR than S&P 500. However, you would notice that both volatility and a maximum drawdown of ‘David Swensen’s Portfolio’ is about 1.4x-1.6x lower. As a result, ‘David Swensen’s Portfolio’ achieves a higher risk-adjusted return (refer to Sharpe Ratio). What does this mean? If we leveraged up ‘David Swensen’s Portfolio’ by ~1.5x to match the risk level of S&P 500, leveraged ‘David Swensen’s Portfolio’ would have had a CAGR of close to 14% (back-of-the-envelope calculation: 9.28%*1.5x = 13.92%). Portfolio CAGR Std.Dev. Best Year Worst Year Max. Drawdown Sharpe Ratio David Swensen’s Portfolio 9.28% 11.57% 26.78% -26.78% -26.78% 0.55 S&P 500 Total Return 10.62% 17.99% 37.58% -37.00% -37.61% 0.49 Source: Portfolio Visualizer (click to enlarge) Source: Portfolio Visualizer Above mentioned result indicates that ‘David Swensen’s Portfolio’ beats S&P 500 on a risk-adjusted basis. At the end of the day, introducing more and more ‘less-than-perfectly correlated’ asset classes should help in diversifying away non-systematic risk and offer investor every increasing portion of ‘free lunch’. Viewed in this light, comparing the performance of better diversified ‘David Swensen’s portfolio’ to all-stock or even stock-and-bond portfolio is unfair. Better diversified portfolios, MPT implies, would perform better than a portfolio that involve a fewer number of asset classes. Does it mean that ‘David Swensen’s Portfolio’ generates alpha? And how much of alpha it generates? No, ‘David Swensen’s portfolio’ does not generate positive alpha ! Just because this portfolio has better risk-adjusted performance than S&P 500 does not mean that it generates alpha. When computing relative performance of any portfolio, we should be using the appropriate benchmark. In the case of ‘David Swensen’s portfolio’, the benchmark would include same asset classes and same allocations to each. Market practice would not subject benchmarks to management fee, trading costs (e.g. bid-ask spread, brokerage fees), and other externalities. As such, ‘David Swensen’s portfolio’ will underperform customized benchmark by a number of such externalities. In other words, alpha generated by ‘David Swensen’s portfolio’ will be negative of the sum of all fees and expenses. The same argument applies to any passive index ETF: index ETFs are expected to underperform their relevant benchmark by a number of management fees (and trading costs). However, I argue using a more appropriate yardstick… First of all, we should make it clear that benchmarks by not accounting for actual real-life expenses and costs are not actually appropriate yardsticks. Furthermore, I argue that relevant benchmark for the average retail investor should not be a well-diversified portfolio of indexes, but an actual average composite portfolio that average investors build and maintain. It’s not a secret that a number of research papers showed that average investors struggle to meet the performance of even broad market indexes (I would argue that on average active professional asset managers underperform passive indexes as well). This is partially due to various market timing efforts of the general public. The chart presented below shows that average retail investor would have achieved ~4x higher annual return by holding S&P 500 index during last decade. (click to enlarge) Source: JPMorgan In other, the average investor is better off holding S&P 500, and better yet ‘David Swensen’s Portfolio’, than utilizing market timing approaches. Is it possible to improve ‘David Swensen’s Portfolio’? Of course, it is! And I plan to take you step-by-step as I introduce various theories, research papers and practical recommendations to help you build superior portfolios. At this step, let’s just focus on the implications of MPT and suggest augmenting ‘ David Swensen’s Portfolio’ by introducing ‘alternative’ asset classes, such as commodities, MLPs (master limited partnerships), BDCs (business development companies), Hybrid (preferred stocks, convertibles), peer-to-peer loans, less liquid assets (Hedge Funds, Private Equity, and Venture Capital), and volatility. Some authors might argue that BDC stocks are not different from typical equity shares and, therefore, should not be treated as an independent asset class. I will leave this debate and discussion of other ‘alternatives’ to future articles, when we will start discussing ‘satellite portfolio’. At this stage, let’s focus on our ‘core portfolio’ and change ‘David Swensen’s Portfolio’ to include only one new asset class – commodities. (click to enlarge) Source: Portfolio Visualizer (portfolio 1 represents ‘David Swensen’s portfolio’; portfolio 2 represents portfolio that includes an allocation to commodities). As you can see from the chart above, the introduction of an even small amount of commodity exposure can make a meaningful impact. For the purposes of this exercise, I propose introducing 5% allocation to commodities, which will come at the expense of lower allocation to foreign developed equity. The return profile of commodities is comparable to equities (please, refer to a research paper by Bhardwaj, Gorton, and Rouwenhorst ); therefore, I decided to swap some of the equity exposure to commodity exposure. Asset Class David Swensen’s Portfolio Augmented Portfolio Domestic Equity 30% 30% Foreign Developed Equity 15% 10% Emerging Market Equity 5% 5% Real Estate 20% 20% Bonds 15% 15% TIPS 15% 15% Commodities 5% Source: David Swensen; augmented portfolio is based on my personal recommendation Historical return comparison portfolios is provided in the table below: Portfolio CAGR Std.Dev. Best Year Worst Year Max. Drawdown Sharpe Ratio David Swensen’s Portfolio 9.28% 11.57% 26.78% -26.78% -26.78% 0.55 Augmented Portfolio 9.44% 11.19% 26.33% -26.88% -26.88% 0.59 S&P 500 Total Return 10.62% 17.99% 37.58% -37.00% -37.61% 0.49 Source: Portfolio Visualizer As shown in the table above, the introduction of commodities improves Sharpe ratio. Using 1.6x leverage, augmented portfolio would have yielded closer to 15% per annum. Once again, we will discuss leveraging portfolios in the future articles. Potential criticism I will address two main groups of potential criticisms with this proposal: EMH, RWH, and MPT are flawed concepts Commodities are a poor investment choice EMH and RWH discussion is covered in the previous article and in the comments to that article. Simplifying assumptions used by MPT (refer to Appendix) are far from the real life. Some more elaborate models where created to allow for more realistic assumptions; the key takeaway from those models is in line with MPT framework: diversification remains to be ‘free lunch’. Commodities have recently been one of the asset classes that suffered. There are a number of Wall Street banks publishing research with a very bleak take on commodities, driven mainly by oversupply or decreasing demand by China. A group of investors might claim that recent historical performance and future expectations make commodities a poor investment choice. Another group might claim that it is actually a good time to buy commodities while they are on ‘sale’. I do not support the approach of either group. Price or short-term expectations should not cloud our long-term asset allocation decisions. Reminder: I’m recommending commodity exposure for ‘Core Portfolio’. I’m a strong advocate of not using market timing and any other ‘active’ approach for Core portfolio. Execution For Core Portfolio, I recommend using the following allocation to various ETFs: Asset Class ETFs David Swensen’s Portfolio Recommendation Augmented Portfolio Domestic Equity Vanguard Total Stock Market ETF ( VTI) 30% 30% Foreign Developed Equity Vanguard FTSE Developed Markets ETF ( VEA) 15% 10% Emerging Market Equity Vanguard FTSE Emerging Markets ETF ( VWO) 5% 5% Real Estate Vanguard REIT Index ETF ( VNQ) 20% 20% Bonds iShares 20+ Year Treasury Bond ETF ( TLT) 15% 15% TIPS iShares TIPS Bond ETF ( TIP) 15% 15% Commodities PowerShares DB Commodity Index Tracking ETF ( DBC) 5% Source: David Swensen; augmented portfolio is based on my personal recommendation Reminder: please note that above mentioned ‘augmented portfolio’ should be utilized for Core Portfolio. Recommendation for the Satellite Portfolio will be covered in the future articles. Disclaimer: I’m not a tax advisor, please consult your tax advisor for any tax related matters. Also, I would like to mention that this article is the second one in the series. In the next articles, we will continue exploring stock market theories and how they impact on the way I invest. Future Next stop will be Jeremy Siegel’s Noisy Market Hypothesis and proven ways of ‘beating the market’. This article will be followed by Andrew Lo’s Adaptive Market Hypothesis, which should provide a framework to bring some reconciliation between Efficient Market Hypothesis and Noisy Market Hypothesis advocate. As a reminder, the main goal of this series of articles is to introduce new stock investors to academic theories and help them develop their own approach to stock investing. The stock investing approach that they will have enough confidence in to be able to consistently executive their chosen investment strategy. As we will discuss in the next articles, consistency is one of the main friends of the stock investor. Appendix MPT suggests that diversification eliminates non-systematic risk. It argues that unsystematic risk is not associated with increased expected return, and, therefore, diversification is expected to decrease risk without compromising return. Hence, it’s not a surprise that diversification is considered one of the few “free lunches” available to investors. MPT implies that investors can invest in assets without analyzing their fundamentals as long as they keep their individual positions in line with the capitalization-weighted index. It takes very global view: as investor match market weights, they will not crease excessive demand for any one specific asset versus another, and, therefore, would not impact expected returns of the portfolio. MPT makes many explicit and implicit assumptions about markets and market participants. These assumptions do not reflect reality. Some of those assumptions are presented below: Investors are interested maximizing their return for a given level of risk, and they are rational and risk-averse . We will review this point in the future articles when discussing implications of behavioral economics. Asset returns are normally distributed random variables: in other words, price spikes, and price momentums should not exist. Correlations between assets are stable. However, as we know during times of financial crisis all assets tend to become positively correlated as they start moving down in tandem. There are no taxes or transaction costs. As you noticed, I’m paying a lot of attention of fees and taxes, that’s why I have a strong preference for low cost and tax efficient ETFs. There are many more other assumptions that are far from the real life. However, as a framework MPT offers yet another layer of knowledge that should help retail investor gain some incremental confidence in using a broader set of asset classes. References/Bibliography Efficient Market Hypothesis And Random Walk Theory: Buy ‘David Swensen’s Portfolio’ Linked previously in the text Facts and Fantasies about Commodity Guide to the Markets Yale U’s Unconventional David Swensen, Unconventional Success: A Fundamental Approach to Personal Investment, Free Press, 2005 Next article: Noisy Market Hypothesis: Tilt Your Portfolio to Achieve Superior Returns

Should You Invest In Market Neutral Funds?

By Ronald Delegge I was recently asked by a reader named M.M. about the benefits of investing in market neutral funds. Equity market neutral funds hold long/short stock positions and aim to capitalize on investment opportunities in a specific group of stocks while keeping neutral exposure to broader groups of stocks either by sector, market size, or country. Aside from stocks, some market neutral strategies invest in other asset classes like bonds, currencies, commodities, and even volatility. One of the primary selling points of market neutral strategies is their distinction for having the lowest correlation with other alternative investing strategies. How has the performance of market neutral funds been? ETFs linked to market neutral strategies haven’t been good performers. The IQ Hedge Market Neutral ETF ( QMN) has risen just +2.95% over the past 3 years compared to a +49.89% gain for the Vanguard Total Stock Market ETF ( VTI) and a gain of +48.36% for the SPDR S&P 500 Trust ETF ( SPY). Similarly, the HFRI Equity Market Neutral Index, one yardstick of hedge funds that employ a market neutral strategy, has gained just +3.18% annualized over the past five years through August 2015. The sponsor of QMN describes the fund this way: The IQ Hedge Market Neutral Index seeks to replicate the risk-adjusted return characteristics of the collective hedge funds using a market neutral hedge fund investment style. These strategies seek to have a zero “beta” (or “market”) exposure to one or more systematic risk factors including the overall market (as represented by the S&P 500 Index), economic sectors or industries, market cap, region and country. Market neutral strategies that effectively neutralize the market exposure are not impacted by directional moves in the market. QMN has just $13.5 million in assets and charges annual expenses of 0.90%. Personally, I’m not a big fan of market neutral funds. But if you’re going to buy them, they don’t belong inside your core portfolio but rather inside your non-core portfolio. The non-core portfolio is always much smaller in size compared to your core. In summary, if you want to be neutral on the stock market, own cash. It’s cheaper than buying a market neutral fund, it’s more liquid, and it’ll probably even perform better. Disclosure: No positions Link to the original post on ETFguide.com

3 Reasons Why Risk Is Exiting The Debate Stage

Investors tend to ignore financial markets until they really start to move significantly in one direction or the other. Ironically, investors who wait to buy undervalued securities when the technical backdrop is dramatically improving tend to miss out on sensible risk-taking opportunities. Don’t let the flatness fool you; risk-taking is subsiding and risk-aversion is gaining. More than a handful of people asked me if I would be watching the big debate. 10 candidates. One stage. Which politician will emerge as the clear-cut favorite to win the Republican party nomination? It may surprise some folks, but I have zero interest in the made-for-television event. Each individual will receive about as much air time as Bethe Correia earned in her UFC Title fight against Ronda Rousey. (America’s superstar dropped the Brazilian fighter in 34 seconds.) From my vantage point, a debate exists when two individuals (or two unique groups) express vastly different opinions. And I would be intrigued by an actual match-up with actual position distinctions. Scores of presidential hopefuls from one side of the aisle looking to land a sound byte? I’d rather watch multiple reruns of ESPN’s SportsCenter. In other words, I will tune in when it’s Walker v. Kasich and Hillary versus Joe. (I am name-dropping, not predicting.) In the same way that I might ignore political theater until it really starts to matter, investors tend to ignore financial markets until they really start to matter. And by really start to matter, I mean move significantly in one direction or the other. Ironically, investors who wait to buy undervalued securities when the technical backdrop is dramatically improving tend to miss out on sensible risk-taking opportunities. In the same vein, those who wait to reduce exposure to extremely overvalued stocks when the technical backdrop is weakening tend to miss out on sensible risk-reduction opportunities. What’s more, theoretical buy-n-holders shift to panicky sellers when the emotional pain of severe losses overwhelm them. Although the Dow is slightly negative in 2015, and the S&P 500 is slightly positive, risk has already been sneaking out the back door. Don’t let the flatness fool you; don’t be misled by ‘journalists’ with political agendas. Risk-taking is subsiding and risk-aversion is gaining. Here are three reasons why risk has been exiting the debate stage: 1. The Recovery Is Stalling . Bad news on the economy had been good news throughout the six-and-a-half year stock bull. The reason? The Fed maintained emergency level policies of quantitative easing (i.e., QE1, QE2, Operation Twist, QE3) as well as zero percent overnight lending rates. Today, however, the Fed desperately wants to flip the narrative such that committee members can claim the economy is healthy enough for rate tightening. The data suggest otherwise. For example, Wednesday’s ADP report of 185,000 jobs in July was 20% lower than July of 2014 a year earlier. It is also the lowest headline ADP number since Q1 2014 when an unusually rough winter shouldered the blame. This goes along with the worst wage growth since data have been kept (0.2%), U-6 unemployment between 10.8% ( BLS ) and 14.6% (Gallup), as well as the lowest percentage of employees participating in the working-aged labor pool (62.7%) since 1977. It gets worse. Factory orders have only experienced month-over-month growth in 3 of the last 12 months. Year-over-year, export activity is down 6.6%. Business spending via capital expenditures – dollars used to acquire or upgrade plants, equipment, property and other physical assets – has plummeted. Corporate revenue (sales) will be negative for the second consecutive quarter, perhaps contracting -3.8% in Q2 per FactSet. What’s more, the Conference Board’s Consumer Confidence sub-indexes are dismal; the future expectations gauge is falling at a faster month-over-month clip than the present situation measure. Consumer spending is sinking as well. In sum, risk aversion as well as outright bearish downturns are frequently associated with recessionary pressures. Is a recession imminent? Maybe not. Yet risk-off movement in the financial markets reflect understandable concerns that the U.S. economy may not be capable of absorbing multiple rounds of Federal Reserve tightening. 2. Commodities Are Tanking . One could easily wrap the commodities picture up into discussions about the U.S. economy. That said, I am pulling the topic out into a separate header because it reflects economic woes around the world. As it stands, the IMF’s most recent projections for global output in 2015 represent the slowest annual ‘expansion’ in four years. And the waning use of raw materials is a big part of the IMF’s anemic outlook as well as the collapse in commodity prices. For a year now, a wide variety of analysts have endeavored to explain the oil price decline in positive terms. They’ve been wrong. Consumers and businesses are not spending their energy savings. Meanwhile, energy companies are abandoning projects, laying off high-paying employees and witnessing a dramatic exodus from their stock shares. The Energy Select Sector SPDR ETF (NYSEARCA: XLE ) has depreciated by more than 30% already. Similarly, many of the world’s emerging markets (and some developed markets) depend upon the extraction of materials and natural resources. Granted, the U.S. stock market has been an island unto itself since 2011. However, no market is an island unto itself indefinitely. The Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) is reaching for 52-week lows. The PowerShares DB Commodity Index Tracking ETF (NYSEARCA: DBC ) is already there. And in the last two U.S. recessions, year-over-year commodity depreciation via the Core CRB Commodity Index led forward S&P earnings estimates significantly lower. 3. ‘Technicals’ Are Faltering . Overvalued equities can become even more overvalued, particularly when authorities are easing the rate reins and/or an economy is expanding at a brisk pace. In fact, expensive stocks often become even pricier before market participants typically become squeamish. Yet current technical data show that – across the entire risk spectrum – the smarter money may be seeking safer pastures. What’s more, authorities are talking about tightening at a time when the economy is not expanding briskly. In the bond market, the spread between the Composite Corporate Bond Rate (CCBR) and the 10-year yield is widening. That is a sign of risk aversion. Similarly, investment grade treasuries are witnessing higher highs and higher lows (bullish) whereas the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) has seen lower highs and lower lows (bearish). These developments are also signs of risk leaving the room before the elephant. In equities, more stocks in the S&P 500 are below their long-term moving average (200-day) than above them. This is coming form a place where 85% of the components had been in technical uptrends. Historically speaking, this kind of narrowing in market breadth is typically associated with an eventual stock benchmark correction. Additionally, as I had identified in my commentary one week ago , the New York Stock Exchange Advance Decline Line (A/D) has a strong track record as a leading indicator of corrections/bears. It recently crossed below its 200-day for the first time in four years (as it did prior to the euro-zone crisis in 2011). In addition, decliners have been pressuring and outpacing advancers regularly since the beginning of May. Granted, the Dow Jones Industrials (DJI) Average and the Dow Jones Transportations (DJT) Average may not be as important as the S&P 500 in identifying technical breakdowns. (Dow Theorists would disagree with me on that.) Nevertheless, when the DJI and DJT are both signalling the potential for longer-term downtrends, there’s something going on. What’s going on? Risk is quietly tip-toeing off the stage. I’ve been telling folks for several months to rethink partying like it’s 1999 . Otherwise, you may find that you overstayed your welcome and that the punch bowl is empty. Is it too late to ratchet down the risk? Hardly. When sky-high valuations meet with weakness in market internals, a 65% growth/35% income investor might make a strategic shift toward 50% large-cap and mid-cap equity/30% investment-grade income/20% cash. You’ve reduced equity risk by avoiding small companies; you’ve reduced income risk by exiting higher-yielding junk. And you’ve given yourself the cash that put you in the right frame of mind to be able to “buy lower” in the next correction. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.