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5 Lessons From The S&P 500 Market Crash For ETF Portfolios

Summary ETFs tracking the S&P 500 index had down-side tracking error. Other ETFs based on value, low volatility, dividend payers or equal weight fell more than the S&P 500 Index. Gold, bond and exotic ETFs provided down-side protection during the sell-off. These lessons can be used to build better portfolios. Introduction We review the past few trading days and try to draw some lessons from the rapid expansion in volatility. Naturally, it is still very early, and this edition of the crash is yet to run its course, and more lessons surely wait in the wings. However, we can draw a few lessons about portfolio construction that this market stumble has revealed. S&P 500 ETFs had down-side tracking error We measure the decline in the S&P 500 Cash index (SPX) from the Wednesday, August 19, close to the Monday, August 24, low. We want to check how well the S&P 500 ETFs did in tracking this downdraft. In Figure 1, we show that amplitude of the move from the Wednesday close to the Monday low. There was significant tracking error, particularly for the IVV ETF, which seemed to lost its bearings altogether. Hence, in designing portfolios, one should recognize that the down-side risk could be greater than that experienced by the index itself. (click to enlarge) Figure 1: There was significant down-side tracking error among popular S&P 500 tracking funds. Value, Dividend, Equal Weight Alternatives to SPX Fared Worse One of the portfolio construction principles suggested to reduce volatility and give down-side protection is to use a value approach, or have high dividend payers or change the weighting scheme. We show in Figure 2 that none of these alternatives gave any meaningful down-side protection. So, from a portfolio design perspective, it might be better to just use a good SPX ETF. (click to enlarge) Figure 2: ETFs focused on value, dividends and alternate weights fared worse in the sell-off then the SPX. Data courtesy ETFmeter.com. Low Volatility Funds Were Volatile Low volatility funds were supposed to bounce around less than the typical market ETF. However, these funds crashed harder than the S&P 500 index itself (Figure 3) calling into question their benefit within a portfolio. (click to enlarge) Figure 3: Many ETFs designed with volatility screens were more volatile on the down-side than the S&P 500 index itself and might add little value in a crisis. Data courtesy ETFmeter.com. Long-term bond ETFs and Gold ETFs provide small offset The traditional way to offset weakness in equities is through diversification into long bonds. We show in Figure 4 that the large bond fund provided a small positive offset during this major decline. Since bonds are rising while equities are falling, we measure the performance from the Wednesday close to Monday’s high. . As a store of value in a crisis, some money flowed into gold funds, and gold ETFs provided good diversification during the equity sell-off (see Figure 4). So, the gold related funds could be a source of diversification when one is constructing portfolios, though their long-run trends could dictate the size of the position. (click to enlarge) Figure 4: The major bond and gold ETFs were positive, providing diversification, but the bond ETF amplitude of the move was small compared to the declines in the equity ETFs and the expansion in the VIX index ETFs. Data courtesy ETFmeter.com. Exotic ETFs such as Leveraged Inverse ETFs Provided Diversification Lastly, we look at exotic ETFs, such as leveraged inverse ETFs and long/short strategy ETFs. By design, such ETFs should rise when the market falls, though their leverage means they are probably not the preferred choice for all investors. These inverse ETFs provided excellent on-demand down-side protection as they should, by design. The long/short strategy ETF also did well. So, for those who understand these strategies and the perils of leverage, these may be alternatives to consider during portfolio construction. We emphasize that these ETFs may not be the best alternative for everyone due to the leverage involved. (click to enlarge) Figure 5: The more exotic ETF strategies, such as inverse SPX ETFs, provided much-needed on-demand down-side protection, but due to their leverage, and other complexities, may not be the best choice for all portfolios. Data courtesy ETFmeter.com. Summary A number of lessons could be drawn from the market action so far during this sell-off, and more will surely follow. Perhaps the most important are that all S&P 500-tracking ETFs are not created equal, and that value, dividend, alternate-weighting schemes and low-volatility ETFs fared worse than the index itself. Some of the tracking errors could be attributed to the weak opening in the market, and ETF prices could have fallen more than the prices of the underlying stocks, i.e. to poor quotes in a “fast market”. However, this is a significant risk that should be factored into the portfolio construction process. Reference [1] Tushar Chande, “Eight lessons from the S&P 500 stumble to build better portfolios”, www.etfmeter.com/blog.aspx?id=4425 Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.

How Do You Manage Risk?

By Andy Hyer That is the question that has been top of mind for many investors over the past several weeks as the markets have done their best imitation of the Twisted Colossus at 6-Flags. As it relates to our family of separately managed accounts, the answer really differs by portfolio. Here is the overview of the approach to risk management for our 7 Systematic Relative Strength portfolios: Aggressive Owns 20-25 U.S. mid and large cap stocks. Buys stocks out of the top decile of our ranks, and sells them when they fall out of the top quartile of our ranks. Overweights sectors up to approximately 2x the weight of that sector in the broad universe; no minimum required sector exposure, so if a sector is weak, it is possible that we have zero exposure to that sector. Fully invested at all times. Core Owns 20-25 U.S. mid and large cap stocks. Buys stocks out of the top quartile of our ranks, and sells them when they fall out of the top half of our ranks. Overweights sectors up to approximately 2x the weight of that sector in the broad universe; no minimum required sector exposure, so if a sector is weak, it is possible that we have zero exposure to that sector. Fully invested at all times. Growth Owns up to 25 U.S. mid and large cap stocks. Buys highly ranked stocks, and sells when they fall out of the top half of our ranks or have sufficient trend or technical attribute deterioration. Overweights sectors up to approximately 2x the weight of that sector in the broad universe; no minimum required sector exposure, so if a sector is weak, it is possible that we have zero exposure to that sector. Can raise up to 50% cash as dictated by market conditions. International Owns 30-40 small, mid, and large cap ADRs from both developed and emerging markets. Buys stocks out of the top quartile of our ranks, and sells them when they fall out of the top half of our ranks. Overweights sectors up to approximately 2x the weight of that sector in the broad universe; no minimum required sector exposure, so if a sector is weak, it is possible that we have zero exposure to that sector. Fully invested at all times. Balanced Owns 20-25 U.S. mid and large cap stocks and U.S. Treasurys in an approximately 60% equities / 40 % fixed income weight. Buys stocks out of the top quartile of our ranks, and sells them when they fall out of the top half of our ranks. Fixed income exposure to intermediate U.S. Treasurys. Overweights sectors up to approximately 2x the weight of that sector in the broad universe; no minimum required sector exposure, so if a sector is weak, it is possible that we have zero exposure to that sector. Fully invested at all times. Global Macro Owns 10 ETFs from a broad range of asset classes, including U.S. equities, International equities, Inverse equities, Currencies, Commodities, Real Estate, and Fixed Income. No minimum constraints in asset class exposure, so that if an asset class is weak, it is possible for us to have zero exposure to that asset class. Strict buy and sell discipline based on relative strength. Tactical Fixed Income Owns 2-6 Fixed Income ETFs from a broad range of sectors of Fixed Income, including U.S. Treasurys, TIPs, Corporate Bonds, Emerging Market Bonds, High Yield, and Convertible Bonds. 40% of the portfolio will always remain invested in some form of U.S. Treasurys (Short-Term, Long-Term or TIPs). Strict buy and sell discipline based on relative strength. The chart below is based on Dorsey Wright’s opinion of the likely relationship between volatility and return in each of the different strategies over a long period of time. The actual results may differ from these expectations. Greater volatility may result in greater gains and greater losses. (click to enlarge) Life is full of trade-offs, and the financial markets are no different. Good results are likely to be achieved when a caring financial advisor takes the time to understand their clients’ needs and risk tolerance, and then to build the right allocation for that client. For those advisors using our SMAs as part of that allocation, they will find that these 7 portfolios have very different approaches to risk management. All of them employ some form of risk management. Even the fully invested portfolios are managing risk through individual position management (i.e., cutting them back when they become too large a percentage of the portfolio, or completely selling them when dictated by relative strength rank) and through sector exposure. Others, like “Growth”, can raise up to 50% cash to seek to mitigate some of the downside risk. “Balanced” benefits from the time-tested benefits of combining equities and fixed income. “Global Macro” is our “go anywhere” portfolio that can completely shift away from weak asset classes if needed. Share this article with a colleague

Fidelity Equity Dividend Income: I’d Rather Own A CEF

FEQTX changed managers in 2011 looking to spruce up performance. Although there has been improvement, the results have been middling. If you are looking for income, you might be better off with a CEF. Mutual funds are generally the top-of-mind way for investors to quickly gain access to professional management. However, the Fidelity Equity Dividend Income (MUTF: FEQTX ) shows why you need to be cautious when you go down this route. In the end, if you are looking for dividend income, there are better options out there. Turning to a new leader FEQTX changed managers in late 2011 with the goal of shaking things up at a fund that had been lagging and, generally, not living up to its name. That means that 2011 and part of 2012 were really a transition period as new manager Scott Offen put his mark on the fund. So he’s got about three years of performance under his belt with a portfolio he created. The fund’s objective is reasonable income and capital appreciation. Reasonable income is defined as a yield above that of the S&P 500 Index. FEQTX’s trailing yield is roughly 2%. For comparison, the SPDR S&P 500 ETF Trust’s (NYSEARCA: SPY ) yield is about 1.9%. So I guess it lives up to its definition of reasonable yield, but that may not be your definition. Searching for stocks, Offen looks for , “…companies that deliver attractive, above-market dividend income and provide exposure to conservative earnings-growth potential with relatively low volatility.” He likes companies with, “…high or improving returns on capital and companies with strong balance sheets, including cash on hand…” As a shareholder, these are the types of things you’d like a manager to look for. The fund tilts toward value stocks, which isn’t surprising since Offen’s last gig was at a value fund. The interesting thing here is that the manager cautions that focusing too much on yield is dangerous. He highlights the banking sector during the 2007 to 2009 recession as a cautionary tale. And while that’s a worthy warning, 2% isn’t a material yield and it certainly isn’t much more than an index is offering, so income investors looking at, or in, this fund have a right to wonder if they are getting their money’s worth. Performance is so-so The problem is that performance relative to the S&P isn’t all that great. Over the trailing three years through July, FEQTX’s annualized return, which includes reinvested distributions, is around 14.7%. The SPY’s annualized return over that span is nearly 17.6%. Both have roughly similar standard deviations and FEQTX’s Beta is nearly 0.95, meaning it moves roughly in line with the S&P. (SPY, as you might expect, moves in lock step with the S&P.) So there’s little yield advantage, no performance advantage, and the same amount of risk. Although the expense ratio of around 0.60% is low for a mutual fund, the extra expense isn’t worth it when you could by SPY, get better performance and a similar yield, and pay just 10 basis points or so in expenses. A better alternative? This is why you shouldn’t get sucked in by a fund name. I’m not suggesting that FEQTX is a bad fund, per se, just that it isn’t compelling enough compared to other options. That said, I don’t believe it lives up to the words “dividend income,” which are found in its name. If you own the fund or are looking at it, you’ll basically be getting something on an index clone at greater cost. Why not shift gears and look at a completely different space? For example, you might consider the Nuveen S&P 500 Buy-Write Income Fund (NYSE: BXMX ). This fund was created through the merger of two older Nuveen closed-end funds late last year and now has the goal of tracking the S&P while writing index options to generate current income. It doesn’t have a long track record, to be sure, but it has put up decent results so far. First off, the distribution is around 7.6%, well above that offered by the index and FEQTX. And year to date through July, BXMX’s return is nearly 6.2% while SPY is about 3.4% and FEQTX is just 1.3%. A big difference, however, is in the expense ratio, which is just under 1%. But based on performance so far under the new investment strategy, you are being rewarded for that. The biggest risk, of course, is that the new strategy is untested. Which is a legitimate concern. That said, writing options should mute downside risk since in a falling market option income will offset capital losses. At least that’s the theory, anyway. Time will be the true test of this, meaning that you’ll need a little faith if you choose to own BXMX. But with a discount of nearly 7%, you are getting a little protection built in by buying below the actual value of the portfolio. Looking at that a little closer at recent performance, since the last few months have been pretty rough, BXMX’s trailing daily return over the last three months through August 26th was a loss of almost 4.2%. The S&P over that same span fell just under 7.3%. Over the trailing month through August 26th, BXMX was down about 5.1% and the index was down nearly 6.5%. So, through the current turmoil anyway, BXMX seems to be holding its own. Note, too, that upside performance should be muted in a roaring bull market because of the use of options. This year’s sideways market is really a good space for option writing. So the strong out of the gate performance really shouldn’t be taken as an indication of future performance. But income should always be notable. Not the only option That said, BXMX is just one option. It seems like a compelling one compared to FEQTX, but there are other closed-end funds with compelling yields and performance histories. That said, the real point here is to make sure you understand what you own. That’s particularly true of mutual funds where a fund may not be living up to its name. If you find you are an income-oriented investor stuck in such a fund, consider shifting to closed-end funds. You might find you are willing to pay a little more for a higher level of income-that’s especially true when the fund you own is simply tracking a broader index. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.