Tag Archives: seeking-alpha

How To Design A Market Neutral Portfolio – Part 2

Summary Sector diversification is a key in market neutral investing. Two examples. Questions to solve for IRA compatibility. My previous article described the investor profile to hold a market neutral portfolio and some characteristics of this investing style illustrated by examples. I also explained why I prefer using an index ETF for the short side of the portfolio. In the next step, I want to focus on the benefit of sector diversification in market neutral investing. Sector diversification is especially important when the objective is to beat the benchmark in all market conditions, that is to say in all phases of the expansion-contraction cycle. The reality is more complicated than the figure. Cycles of different and variable periods may be in play, and macro trends can freeze the cycle for some sectors (like oil price does for energy and materials). In fact, it is sometimes quite difficult to figure out where we are and on which time frame when various cycles are combined. This is why, if an index ETF is on the short side, the long side of the portfolio must be diversified, not necessarily in all sectors, but at least in a few cyclical and defensive sectors. Since the return of such a Market Neutral Portfolio is the alpha of the long side, diversification in defensive and cyclical stocks is a key to keeping drawdowns acceptable in duration. In my opinion, the historical maximum duration in drawdown of an investing strategy is a parameter as important as the return and volatility. Examples I have performed a simulation of a portfolio mixing all the S&P 500 strategies of my book «The Lazy Fundamental Analyst» (Harriman House 2014). There are 9 strategies, one for each sector of the GICS classification, except Telecommunication (which is very small to elaborate statistical models). Each strategy selects 10 S&P 500 companies using a simple ranking process based on 2 fundamental factors. The factors are sector-dependent, chosen using historical statistics. The result is an equal-weighted portfolio of 90 stocks in a universe or 500, updated and rebalanced every 4 weeks. It is quite a big set (18% of the S&P 500 index) with various logics mixed, so the performance can hardly be suspected of being curve-fitted or random. Of course, past performance, real or simulated, is not a guarantee for future returns. But on such a portfolio it gives a good clue on the risk. The next chart shows the simulation of the 90-stock S&P 500 Lazy Portfolio (long side only) since 1999, with a 0.1% transaction cost and a 4-week rebalancing: (click to enlarge) The next table gives statistics of the excess return of the portfolio over the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) by 4-week periods, which corresponds to the market neutral portfolio with a leveraging factor 2, without the margin and carry cost for the “short half”. Average 4week return Average Annual return Max Drawdown Depth Max Drawdown Duration Avg gain / Avg loss 4week gain probability Kelly criterion Kelly crit. 95% confidence 0.94% 12.9% 20.5% 19 months 1.52 67% 0.46 0.35 Holding 90 stocks is a lot. In my real market neutral portfolio, I have reduced the number by: Excluding the most sensitive sectors to macroeconomic and geopolitical concerns: finance, energy and materials. My aim is not to get the best possible return, but a good return with a risk as low as possible. Optimizing the models to keep only 24 stocks with a diversification pattern, including at least 2 defensive sectors, 2 cyclical sectors and a minimum number of stocks in each of them. Optimizing to a lower number of stocks incurs a risk of curve fitting. However, with 24 holdings and various ranking logics, the risk remains quite low. The biggest danger of optimizing is not over-rating the possible return, but under-rating the real risk. In a diversified market neutral portfolio, the risk is limited by design. The next chart shows the simulation of my 24-stock portfolio (long side only) since 1999, with a 0.3% transaction cost and a 2-week rebalancing: (click to enlarge) This portfolio is more dynamic (rebalanced twice more often). It is also focused on large caps, but may hold a limited number of liquid small caps from the Russell 3000 index. Even if I use volume filters, I use a higher transaction cost to model a higher spread and slippage. The next table gives statistics of the excess return of the portfolio over SPY by 2-week periods, which corresponds to the market neutral portfolio leveraged twice, without the margin and carry cost. Average 2week return Average Annual return Max Drawdown Depth Max Drawdown Duration Avg gain/Avg loss 2week gain probability Kelly criterion Kelly crit. 95% confidence 0.79% 22% 11% 13 months 1.69 64.2% 0.43 0.36 These are examples. Ideas and steps can be reused with other quantitative models, or with a stock picking based on due diligence. The main idea here is to formalize and follow a sector-based diversification pattern. A next article will explain how to use leveraged ETFs to implement this strategy with a lower or no leverage (ProShares Ultra S&P 500 ETF (NYSEARCA: SSO ), ProShares UltraPro S&P 500 ETF (NYSEARCA: UPRO )), and the consequences of using inverse ETFs to avoid short selling (ProShares Short S&P 500 ETF (NYSEARCA: SH ), ProShares UltraShort S&P 500 ETF (NYSEARCA: SDS ), ProShares UltraPro Short S&P 500 ETF (NYSEARCA: SPXU )). Indeed market neutral investing can be implemented in an IRA account. Feel free to follow me if you don’t want to miss it. Data and charts: Portfolio123 Additional disclosure: Long SPXU as a hedge. Past performance is not a guarantee of future returns.

What’s Hot, What’s Not: SPY And Select Sector SPDRs At The Dawn Of 2015

Summary The SPDR S&P 500 ETF has not had a happy new year thus far, shedding 1.90 percent in the first 11 trading days of 2015. During this period, the Utilities exchange-traded fund was first by return among the Select Sector SPDRs, rising 2.96 percent. Over the same time frame, the Financial ETF was last by return among the sector SPDRs, falling -5.01 percent. The U.S. equity market’s large-capitalization segment has been characterized by the relative overperformance of low-beta Select Sector SPDRs and the relative underperformance of high-beta sector Select Sector SPDRs in 2015 year to date, just as it was in 2014. Meanwhile, their parent proxy, the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) has struggled this year, as it dipped to $201.63 from $205.54, a drop of -$3.91, or -1.90 percent. This long-term sector rotation appears important for multiple reasons at this late stage of the economic/market cycle. With respect to economic matters, the International Monetary Fund cut its forecast Tuesday for global growth this year, to 3.5 percent from 3.8 percent, and the World Bank Group did likewise Jan. 13, to 3.0 percent from 3.4 percent. With respect to market matters, the S&P 500’s cyclically adjusted price-to-earnings ratio is at the historically lofty level of 26.77, according to 2013 Nobel Prize-winning economist Robert J. Shiller . Appearing below are comparisons of changes by percentages in SPY and all nine sector SPDRs in 2015 year to date, last month, last quarter and last year. Figure 1: XLU No. 1 Among Select Sector SPDRs This Year (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing daily share prices at Yahoo Finance . In 2015, the Utilities Select Sector SPDR ETF ( XLU ), Health Care Select Sector SPDR ETF (NYSEARCA: XLV ) and Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) have been not only the best behaved but also the only ones with positive returns among the sector SPDRs that break the S&P 500 into nine chunks. Elsewhere, I indicated it is an article of faith (and statistical interpretation) hereabouts that so-called PUV analysis is better than psychoanalysis in determining Mr. Market’s state of mind. What is PUV analysis? It is basically the study of the behaviors of XLP, XLU and XLV in comparison with their sibling sector SPDRs. If the PUV cluster of ETFs ranks in or near the top third of the sector SPDRs by return during a given period, then I believe market participants are in risk-off mode; if the PUV cluster of ETFs ranks in or near the bottom third of the sector SPDRs by return over a given period, then I think market participants are in risk-on mode. Given the relative performances of XLP, XLU and XLV that have them in the top three spots among the sector SPDRs this year, I believe market participants are in risk-off mode. And I think they will continue to be so, with changes in policy at the U.S. Federal Reserve the biggest reason why. In this context, I note the Fed announced the conclusion of purchases under its latest QE program Oct. 29 and that the ends of purchases under its previous two formal QE programs are associated with both a correction and a bear market in large-cap stocks, as evidenced by SPY’s dipping -17.19 percent in 2010 and dropping -21.69 percent in 2011. Figure 2: XLU No. 1 Among Select Sector SPDRs In December (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing daily share prices at Yahoo Finance. XLU also was the big winner among the Select Sector SPDRs last month, when the Technology Select Sector SPDR ETF (NYSEARCA: XLK ) was the big loser in the group. I suspect XLK may continue to struggle this year, with one large reason being the bias divergence in monetary policy at major central banks around the world. On the one hand, the U.S. Federal Reserve is oriented toward tightening; on the other hand, the Bank of Japan, European Central Bank and People’s Bank of China are oriented toward loosening. This divergence has led to significant movements in exchange rates, such as in the euro and U.S. dollar currency pair, or EUR/USD. The EUR/USD cross fell from as high as $1.3992 May 8 to as low as $1.1459 Jan. 16, a tumble of -$0.2533, or -18.10 percent, based on data at StockCharts.com. The change in EUR/USD and similar moves in other currency pairs indicate a strengthening greenback and a weakening everything else could pressure earnings of U.S. companies in sectors with substantial international businesses, which most likely will be a headwind for many of XLK’s components. Anyone doubting the effects of central-bank policy on financial markets should take a close look at the impacts associated with the Swiss National Bank’s surprise decision to discontinue its fixing of the minimum exchange rate between the Swiss franc and the euro last week, which I briefly covered in a piece at the International Business Times . Figure 3: XLU No. 1 Among Select Sector SPDRs In Q4 (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing daily share prices at Yahoo Finance. XLU also ranked No. 1 among the Select Sector SPDRs last quarter, while the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) ranked No. 9 in the group. Recently, I argued lockstep movements of the EUR/USD currency pair, the commodity price of crude oil and the share price of XLE appear likely to continue unless the Federal Open Market Committee makes clear it will delay the anticipated announcement of its interest-rate hikes April 29 and that it is preparing to carry out asset purchases under its fourth formal quantitative-easing program of the 21st century, aka QE4. I also argued the FOMC may be hard-pressed to present a convincing rationale for those actions, given the conditions described in “SPY Slips And U.S. Economic Index Slides In December” and that, without them, XLE might continue to be the equivalent of a canary in coal mine where things are looking darker by the day. These arguments still make sense to me. Meanwhile, I anticipate being underwhelmed by the ECB action or inaction on its own QE to come Thursday, and I expect Mr. Market will be so, too, except on a short-term trading basis, with plenty of sound and fury, signifying (nearly) nothing. Figure 4: XLU No. 1 Among Select Sector SPDRs In 2014 (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing daily share prices at Yahoo Finance. I am detecting a pattern here: XLU also led the way among the Select Sector SPDRs last year, when XLE lagged the rest of its siblings. Consistent with the above discussion of PUV analysis, I consider XLU key to the assessment of market sentiment based on the comparative behaviors of the sector SPDRs. If XLU ranks near No. 1 by return during a given period, then I believe market participants are in risk-off mode; if XLU ranks near No. 9 by return over a given period, then I think market participants are in risk-on mode. In the current environment, I therefore would be completely unsurprised should XLU continue to behave well this quarter and this year, not on an absolute basis but on a relative basis (i.e., in comparison with the other sector SPDRs and with SPY). The ETF may not produce gains, but it might produce losses smaller than those of its siblings, which is another way of saying SPY looks vulnerable, right here, right now. (Unless, of course, the Federal Reserve comes riding to the rescue, as it did in 2010, 2011 and 2012.) Disclaimer: The opinions expressed herein by the author do not constitute an investment recommendation, and they are unsuitable for employment in the making of investment decisions. The opinions expressed herein address only certain aspects of potential investment in any securities and cannot substitute for comprehensive investment analysis. The opinions expressed herein are based on an incomplete set of information, illustrative in nature, and limited in scope. In addition, the opinions expressed herein reflect the author’s best judgment as of the date of publication, and they are subject to change without notice.

State Of Disunion: Safer Haven Investments Diverge From Stocks

The appetite for risk has been changing before our eyes. Large-cap U.S. stocks in the S&P 500 still rocketed mightily. Safer haven assets were every bit as desirable as the Dow and the S&P 500 in 2014. Is that uncommon for a late-stage bull market? Not particularly. On the other hand, the landscape may be changing. The S&P 500 soared 29.6% and 11.4% in 2013 and 2014 respectively, pushing the broad market benchmark to unimaginable heights. Net inflows into U.S. stock funds, including ETFs, also set records. Unfortunately, that is not always a positive sign for the asset class. The increased participation by the world’s investors in U.S. stocks may not be inordinately alarming. What might be far more ominous? The remarkable performance of safer haven assets over “stuck-in-place” stock assets since the Federal Reserve ended its third round of quantitative easing (QE3) on October 31. Specifically, the 30-year treasury yield has plummeted from roughly 3.0% to 2.4%, sending a proxy like the PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) up more than 20%. Similarly, the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) has pocketed nearly 14%, while the SPDR Gold Trust ETF (NYSEARCA: GLD ) has rallied about 10%. The appetite for risk has been changing before our eyes. Remember the success of riskier equities in 2013, as investors ran from treasury bonds and gold? Indeed, 2013 was only one of two negative years for total bond returns across two decades. Equally staggering, gold appeared to many as if it might collapse altogether. The nature of risk shifted in 2014. Large-cap U.S. stocks in the S&P 500 still rocketed mightily. Yet the clear preference of stocks over safer holdings evaporated; treasuries rallied throughout the year, in spite of the near-unanimous sentiment that interest rates would fall. (Note: I am not opposed to tooting my own horn on this one – I recommended pairing large-cap stock ETFs with long duration treasury ETFs like the Vanguard Extended Duration Treasury ETF (NYSEARCA: EDV ) and ZROZ 13 months earlier.) Safer haven assets were every bit as desirable as the Dow and the S&P 500 in 2014. Some of them like TLT and ZROZ were more desirable. At least for a calendar round-trip, the ownership of historically divergent asset classes produced harmony and indivisibility. Is that uncommon for a late-stage bull market? Not particularly. On the other hand, the landscape may be changing. The perceived need for safety has risen appreciably since the Federal Reserve ended its electronic money printing in October. For example, in 2015, each of the 10 components of the FTSE Custom Multi-Asset Stock Hedge Index has gained ground, whereas the S&P 500 has drifted lower. Those component assets include long-maturity treasuries, zero-coupon bonds, munis, inflation-protected securities, German bunds, Japanese government bonds, gold, the Swiss franc, the yen and the dollar. Granted, the European Central Bank (ECB) intention to create $50 billion euros monthly for a year could reward risk-taking in the same manner that the Federal Reserve’s $85 billion per month had. On the flip side, the $600 billion euro figure that is floating on newswires may come off as underwhelming, as the Fed’s QE3 had been open-ended upon its announcement. Moreover, the “stimulus” amount ran beyond the trillion-and-a-half level. Keep in mind, you do not need to run from stock risk if you have a plan to minimize the severe capital depreciation associated with bear markets. My approach in latter stage bull markets involves pairing lower volatility stock ETFs like the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) and the iShares S&P 100 ETF (NYSEARCA: OEF ) with safer haven ETFs like the Vanguard Long-Term Bond ETF (NYSEARCA: BLV ) and EDV. If popular stock benchmarks breach 200-day trendlines, I reduce equity exposure and/or employ multi-asset stock hedging by investing in those assets with a history of performing well in moderate-to-severe stock downturns. Click here for Gary’s latest podcast. 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.