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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.

Market Lab Report – Premarket Pulse 8/28/15

Major averages rose yesterday on lower volume, closing near the top of their respective trading ranges. Virtually all formerly leading stocks are sitting within broken chart patterns, and over the past two days have merely rallied back up into areas of potential overhead resistance. Thus the long side of this market remains questionable. The US economy grew at a faster 3.7% annual pace in the second quarter, up from the initial estimate of 2.3%. Oil soared 10%, its largest gain since 2009. The Fed may now have more room to hike rates at its next meeting, but the global economy remains in a quagmire with the recent global turmoil in China’s markets, thus the Fed may postpone the hike. Indeed, futures telegraph the probability of a rate hike in September at just 24%, down from 51% a few weeks ago. Expect a continuation of elevated volatility in the near term.

VGSH: For The Investor That Wants Reduced Exposure To A Hot Equity Market

Summary The Vanguard Short-Term Government Bond Index ETF is an intelligent holding within a portfolio, especially when the equity market is hot. The ETF has low volatility and low correlation with other important investments. The credit quality is excellent and the expense ratio is reasonable. The big weakness is a very weak yield. The fund is relatively similar to simply holding cash within the account. Within a diversified portfolio almost all of the risk (volatility) attributed to VGSH is eliminated. The Vanguard Short-Term Government Bond Index ETF (NASDAQ: VGSH ) is a very solid choice for investors trying to limit volatility in an equity market that has been trading at fairly high levels over the summer. By many fundamental measures, such as P/E, the equity market is feeling expensive enough that investors may want to consider increasing their bond exposure. Unfortunately, the yields on debt have been very low, contributing to higher valuations in the equity market. For investors wanting to see their portfolio risk reduced, VGSH is a great tool to get there. Duration The following chart breaks down the duration of the funds. Holdings are all less than 3 years and usually more than 1 year. Again, this is a solid choice. It shouldn’t be surprising that such short-term debt is unlikely to have any meaningful volatility since this is high quality government debt and the short duration limits any volatility from shifts in the yield curve. Of course, there is one major weakness, which is the fund having a yield of .56%. That is a pretty severe weakness for the ETF, but it is a cost of acquiring such low volatility. Some investors may point out that they might as well just deposit their cash in the bank. If the investor has that as an option, that is a fine choice. However, if the investor is working with funds in retirement accounts, that may not be an option. If the account is a 401k and the exposure needs to be accomplished through mutual funds, VGSH also trades as a mutual fund under the ticker (MUTF: VSBSX ). A Hypothetical Portfolio I put together a very simple sample portfolio using Invest Spy. Due to some of the ETFs being newer, the sample period is limited to a little over two years. (click to enlarge) This hypothetical portfolio is weighted to 60% equity and 40% bonds. To break that down, the weights from the equity section are 30% total market index (NYSEARCA: VTI ), 10% equity REITs (NYSEARCA: VNQ ), 5% Utilities, 5% Consumer Staples (NYSEARCA: VDC ), 10% International Equity. The bond section is holding 10% in junk bonds (NYSEARCA: JNK ), 5% in extended duration treasuries (NYSEARCA: EDV ), 5% in emerging market government bonds (NASDAQ: VWOB ), 5% short term corporate debt (NASDAQ: VCSH ), 5% in short term government debt , 5% in mortgage backed securities (NASDAQ: VMBS ), and 5% in intermediate-term corporate bonds (NYSEARCA: BIV ). This portfolio won’t be perfect for hitting the efficient frontier, but it should beat the vast majority of real portfolios investors are using on a risk-adjusted basis. If long-term rates were higher, I would have used a higher weighting for long duration bonds due to their exceptional correlation to major equity classes. My disclosure already states it, but I’ll reiterate that I am long VTI and VNQ. Annualized Volatility When measuring risk-adjusted returns for a portfolio, the most efficient method is usually to use the Sharpe ratio. For that ratio, we are taking the total return annualized return and subtracting the risk free rate. Then we divide the resulting number by the annualized volatility. The problem is that this metric is only really known after the fact. Predicting the level of returns in advance is problematic, but correlations and relative volatility are more reliable over time than returns. Within the chart investors can see the annualized volatility of each holding as well as the resulting annualized volatility for the portfolio. While some holdings have higher annualized volatility scores, such as EDV, the ETF makes up for that by having negative correlation to a few of the equity holdings. As a result, the ETF only contributes .6% of the total risk in the portfolio. VGSH has an annualized volatility of .9%, which is extremely low. Once we adjust for correlation, the risk contribution to the portfolio is only .1% of the total. That means VGSH fits extremely well in this kind of hypothetical portfolio. This is fairly similar to using cash as part of the portfolio value except the returns over time here should be positive. I wouldn’t bother using VGSH outside of a retirement account, but it is a fine holding to use within the retirement account if the investor is concerned about the high valuations in the market. Correlation I want to dive a little deeper into the correlation statistics. The table below provides the correlation across each of those ETFs, which should make it very quick to see which ones are work very well together. When a correlation is shown in the tan color, it indicates a negative correlation which is very attractive for reaching the efficient frontier. You’ll notice that quite a few of the bond funds have negative correlations to VTI and the S&P 500 (NYSEARCA: SPY ). Since VTI and SPY have a correlation ranging between 99% and 99.9%, depending on the measurement period, it should not be surprising that those two funds have very similar correlations to other holdings. Here is the correlation table: (click to enlarge) Conclusion The expected returns on VGSH will regularly be weak when yields are already very low. On the other hand, with high valuations throughout the equity market, there is a solid argument for keeping part of the portfolio protected from the fluctuations in equity valuations. Disclosure: I am/we are long VTI,VNQ. (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. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.