Tag: optimal portfolio

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What are Model Portfolios?

Yesterday’s Wall Street Journal had a very interesting article about model portfolios. So, what are these, and why should an individual investor care about them?

A Wall Street Trend

This WSJ article stated that the use of model portfolios is a growing trend, since it helps take the emotion out of investing. So, these portfolios are based on scientific observations and analysis, rather than an investor’s “instincts” or emotional reaction to current market conditions. A growing number of financial advisors are embracing their use too.

Model portfolios take some of the human emotion out of investing. They provide the comfort of science.

Andrew Guillette, Research Director at Broadridge. source: WSJ, December 4, 2020

Thus, these model portfolios are ones that can “dynamically shift the funds it invests in as markets change”. We are advocates of this approach using commission-free ETFs. Our free and premium portfolios do exactly that, as we update them each month based on current market conditions. Please log in to see these portfolios now, which include the latest market shifts through Friday, December 4th. Premium subscribers also have access to a handy web calculator to assist in rebalancing their portfolio.

How have model portfolios performed this year?

Unfortunately, little is published about model portfolio performance. But, we report our model’s performance for ETFMathGuy portfolios on a regular basis. The image below shows the total returns from January through end of November from our investments at our Fidelity brokerage account.

Total returns from January through November of Stocks, Bonds and ETFMathGuy Portfolios

What about risk?

The performance over the last 11 months look very promising, suggesting a scientific approach to rebalancing an ETF portfolio can perform well in volatile markets. But, how much risk did we take with these investments? Using the monthly returns that led to the total returns shown above, the volatility of the stock market (ticker: IVV) was 26.9%. However, the volatility of the moderate risk ETFMathGuy portfolio was only 18.2%. Not surprisingly, the aggressive risk ETFMathGuy portfolio had a higher volatility of 19.0%, as expected for a portfolio seeking more risk. So, these portfolios continue to outperform the stock market, while also taking less risk as measured by volatility.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

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Market uncertainty prior to next week’s election

The stock market, measured by the S&P 500, lost about 2.5% in October. But, earlier in the month, the stock market was up over 5%. The chart below shows the roller coaster ride for two ETFs that track the stock and bond markets: iShares Core S&P 500 ETF (ticker IVV), Vanguard Total Bond Market ETF (ticker: BND) So, what’s going on with this market volatility?

Stock and bond returns in October, 2020. Source: finance.yahoo.com

Markets don’t like uncertainty

There are many opinions to describe what caused the financial markets to move like they did in October 2020. We think that the combination of the upcoming election and spike in coronavirus cases is adding to uncertainty. But, this uncertainty, as measured by stock market volatility, is still well below where it was earlier in the year. We used our daily volatility monitor in the plot below.

Stock market volatility as of October 30, 2020. Source: ETFMathGuy.com
Stock market volatility as of October 30, 2020. Source: ETFMathGuy.com

As this chart shows, volatility has crept a little higher in October. But, based on the long-term historical norm, this volatility is still slightly elevated in the 75% percentile. Of course, if you are a believer in efficient markets, then you simply don’t know what the future of the market will hold. In more positive news, the WSJ recently reported that the U.S. economy recovered significantly in the 3rd quarter of 2020. Consumer spending for online retail items continue to stay strong, while the travel sector still lags.

How about the ETFMathGuy portfolios and market uncertainty?

Thanks to wide diversification from over 2,000 ETFs we analyze each month, our portfolios continue to perform well. Consequently, the moderate risk portfolio lost 0.6% and the aggressive risk portfolio lost 0.5% in October. The year to date cumulative return of the ETFMathGuy aggressive risk portfolio appears below, along with the S&P 500 and Aggregate Bond Market total return.

ETFMathGuy year to date cumulative returns, versus the S&P 500 and Aggregate Bond Market returns.

Premium subscribers can now access the backtested portfolios for November 2020. Not a premium subscriber yet? Then, just visit the bottom of our “Join Us” page to upgrade your subscription and get immediate access!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Market Volatility is Back?

Market volatility returned in September 2020. In this post, we discuss this recent surge in the context of long-term historical volatility. We also show how our ETFMathGuy portfolio performed, and elaborate on a source of that performance.

Market Volatility returned, but will it persist?

Earlier this year, we developed an app to automatically measure stock market volatility. This app updates daily, and the figure below shows the latest result.

Stock Market Volatility was 19.7% on Friday, slightly above its long-term historical norm.
Stock Market Volatility was 19.7% on Friday, slightly above its long-term historical norm.

We also provided a table showing the distribution of long-term historical volatility, as observed over more than 20 years. Current volatility is 19.7% as of October 2nd, which corresponds to the upper limit of the third-quartile. So, while market volatility returned, it is still well below the volatility seen in early 2020.

Market Performance through the 3rd Quarter

The higher volatility occurring in September did indeed correspond to a loss in the stock and bond markets. The stock market lost 3.7% and the bond market lost 0.1%, based on the ETFs with ticker symbols IVV and AGG. The year to date return of these stock and bond index ETFs were 5.5% and 6.7%, respectively, including dividends. The year to date return of the ETFMathGuy Aggressive Risk Portfolio was 20.8%. This return is the result of trades conducted in a brokerage account at Fidelity Investments, and so includes the bid-ask spread.

Stock and Bond Market YTD Returns compared to the ETFMathGuy Aggressive Risk Portfolio
Stock and Bond Market YTD Returns compared to the ETFMathGuy Aggressive Risk Portfolio

Premium subscribers now have access to the October 2020 premium portfolios, as well as a handy rebalancing calculator. Free subscribers are welcome to log in to review older premium portfolios through May 2020, or upgrade their account to enable premium access.

Sources of Excess Performance

One ETF that our portfolios have consistently included throughout this year is the Aberdeen Standard Physical Palladium Shares ETF (ticker: PALL). Its 12 month return and volatility appear below next to the S&P 500 ETF (ticker IVV).

The Palladium ETF has higher volatility than the S&P 500, but also has a higher return over the last 12 months. Source: www.ETFreplay.com
The Palladium ETF has higher volatility than the S&P 500, but also has a higher return over the last 12 months. Source: www.ETFreplay.com

Examining these results for PALL confirms the expectation that higher risk can lead to a higher return. Our optimal portfolio construction process creates a portfolio that, along with PALL, finds other ETFs that maximize expected return. This process also keeps the portfolio’s expected risk between the stock and bond markets. Additionally, we backtested this process over a full market cycle. We hope you will consider upgrading your subscription to gain insights into a wider variety of ETFs that appear in our efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

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Can minimum volatility ETFs consistently perform well?

Last weekend, there was a fascinating article about minimum volatility ETFs. It was written by one of my favorite Wall Street Journal columnists, Jason Zweig. In this article, he shared a lot of wisdom, which I will highlight more here.

What is a minimum volatility ETF?

One of the most common ways to measure risk in an ETF is to track its volatility. So, investing in a minimum volatility ETF may make sense for investors seeking to reduce risk. One of the largest low volatility ETFs is the iShares MSCI USA Min Vol Factor ETF (ticker: USMV), with over $30B in assets. The chart below shows it performance since its inception in October 2011, which generally lagged the S&P 500 (ticker: IVV). However, its volatility was noticably lower.

Risk and Return of a large minimum volatility ETF compared to the S&P 500 . Source: www.ETFReplay.com
Risk and Return of a large minimum volatility ETF compared to the S&P 500 . Source: www.ETFReplay.com

Why did this ETF produce lower risk and lower return?

This ETF is able to lower risk through the use of optimization, much like the ETFMathGuy portfolios. However, we don’t limit our optimal portfolios to equities like minimum volatility ETFs. We consider bonds, commodities and other alternative investments too. ETFMathGuy also uses backtesting that includes transaction costs to build portfolios to maximize returns.

The fund’s index uses an optimization algorithm to build a “minimum variance” portfolio—one that considers correlation between stocks—rather than simply holding a basket of low-vol stocks…

USMV Factset Analytics Insight (https://www.etf.com/USMV)

So, this ETF consists of stocks which typically emphasize lower volatility sectors like financial, utilities and real estate. These sectors are often termed “value”, rather than “growth” investments, in part due their issuance of dividends. Consequently, optimization to produce a minimum volatility ETF removes some market risk, generating a beta of 0.87. But, as we can see in the economic cycle from 2011 – 2020, the return also lagged the market.

Recent performance of minimum volatility

This year’s pandemic has certainly affected the stock market in significant ways. Investments favored by minimum volatility ETFs (financials, utilities, and real estate) have been significantly impacted by coronavirus lockdowns. However, technology has done very well, as remote work has increased the demand for technology systems and services. Unfortunately, technology is typically more of a “growth” investment. So, minimum volatility ETFs often limit their exposure to growth stocks to reduce volatility. In the ETFMathGuy portfolios, technology has been a noticeable portion this year, and has led to encouraging year-to-date returns and performance statistics.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Alpha and Beta Portfolio Statistics

In this post, we will be diving deeper into two commonly used portfolio statistics. These terms are Alpha and Beta, are based on a statistical method called “Regression“, and are used in the Capital Asset Pricing Model (CAPM). They are calculated by fitting a “line” to a set of points.

“…alpha is the return on an investment that is not a result of general movement in the greater market”.

Description of “Alpha” from the Capital Asset Pricing Model (CAPM). Source: Investopedia

“Beta effectively describes the activity of a security’s returns as it responds to swings in the market”

Description of “Beta” from the Capital Asset Pricing Model (CAPM). Source: Investopedia

If we define the market as the S&P 500, then Beta is an indication on how sensitive a portfolio is to S&P 500 returns. Alpha indicates how returns occur independent of the S&P 500. The term Alpha is so important, that it has even spawned its own website. And, why not? It represents the return obtained without exposing an investor to (stock) market risk.

An Example of CAPM

To better illustrate how Alpha and Beta are determined, consider the last 8 months of returns for the the following data sets:

  1. ETFMathGuy Aggressive Portfolio Returns
  2. S&P 500 total returns (ticker: IVV) to represent the market
  3. Short-term U.S. Treasury bill returns (ticker: SHV) to represent the risk free rate

Since CAPM is based on the concept of “excess returns”, which are returns above the risk-free rate, we can visualize this relationship in a scatterplot. The horizontal axis is the “Market Returns – Risk Free Rate”, and the vertical axis is the return of our “ETFMathGuy Aggressive Risk Portfolio Returns – Risk Free Rate”.

The Capital Asset Pricing Model (CAPM) applied to 8 months of returns of ETFMathGuy Portfolios
The Capital Asset Pricing Model (CAPM) applied to 8 months of returns of ETFMathGuy Portfolios

These results look promising, with a value of Beta = 0.37 and Alpha = 2.1%. However, 8 observations are small, so analysts typically look to see if these values are “significantly different” than 0. Or, put another way, what is the chance that these value were obtained by skill, rather than luck?

Assessing Luck vs. Skill

More data or evidence is always helpful in supporting any claim using statistics. For the example we show above, we are claiming that Alpha and Beta are non-zero values. Using some fundamentals from statistics, we can determine p-values for our Alpha and Beta calculation above as 29% and 15%, respectively. (Yes, p-value is another statistical term.) These p-values are fairly easy to interpret. In this case, 29% is the probability that Alpha = 2.1% is due to random chance, and the 15% is the probability that Beta= 0.37 is due to random chance. Put another way, we can say that Alpha = 2.1% and Beta = 0.37, but there is a chance (29% and 15%) that, in fact, we are wrong and that these value should be zero. So, the smaller the p-values, the greater confidence we have that these are the correct values and have minimal estimation error.

So What?

These results show that the ETFMathGuy Aggressive Portfolio is generating positive Alpha, and isn’t overly sensitive to the market. However, more data is needed to provide stronger evidence that these results are not simply due to luck. We hope you will continue to check back to see how the ETFMathGuy portfolios perform for the rest of 2020. And, for those who are premium subscribers, the September portfolios are now available, which includes a new calculator at the bottom of the page to further aid in portfolio re-balancing decisions.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Will this stock market rally continue?

As recently discussed in this Wall Street Journal article, there is a deep suspicion on the future of this current stock market rally. In this article, we discuss what this rally looks like in various market segments. We will close on how our ETFMathGuy portfolios have performed so far this year.

The state of our economy

Most investors would agree that the economy is not doing well. Unemployment is high and our GDP (Gross Domestic Product) is shrinking at record levels. However, the Federal reserve has acted quickly and significantly. Also, congress has provided significant economic stimulus. Consequently, we have a stock market, as measured by the S&P 500 total return, up 3.5% year to date. But, not all segments of the market are behaving the same.

Below is a chart similar to the one we wrote about previously, where real estate was lagging the overall market. In that post, we also highlighted that the top 5 companies in the S&P 500 were focused on technology, helping the performance of the S&P 500.

Stock market total returns, year to date. Source: www.ETFreplay.com
Stock market total returns, year to date. Source: www.ETFreplay.com

As this chart shows, real estate is still down about 10% year to date, as measured by the iShares Dow Jones Real Estate REIT ETF. (ticker: IYR). However, the energy sector, as measured by U.S. Energy Sector SPDR ETF (ticker: XLE) is down nearly 38% for the year. Given few people are travelling much these days, we shouldn’t be surprised to see the energy sector prices behaving this way. Alternatively, the technology sector, as measured by the U.S. technology sector SPDR ETF (ticker: XLK) is doing very well, with a 21% total return year to date. Again, this is not surprising to many investors. The demand for many forms of technology is high in order to support workers in our economy working remotely.

ETFMathGuy Portfolios

We build ETFMathGuy portfolios to respond to market dynamics by analyzing daily price returns, variance and covariance over a historical period chosen from our backtesting. We build these portfolios from segments of the market not typically considered, but also exclude ETFs that are not sufficiently liquid. Our cumulative year to date total returns appear below.

Year to Date Total returns of ETFMathGuy Portfolios Through July 31, 2020.

As this chart shows total returns each month for this year, the ETFMathGuy portfolios are succeeding in reducing risk. These portfolios are also continuing to outperform the stock market. If you would like to see how this performance was possible, remember that we analyze over 2,000 ETFs to find assets that maximize returns for the levels of risk chosen. We encourage free subscribers to review the portfolios published earlier in the year, including April and May. Premium subscribers can now view the latest portfolios, based on market data through July 31, 2020.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

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2020 Mid-year Review by ETFMathGuy

The coronavirus pandemic has made for an interesting year so far in the financial markets. So, we chose to focus this post on a 2020 mid-year review of market volatility and returns.

Let’s begin by looking at the stock (equity) and bond (debt) markets. The time series below shows the significant volatility in both markets. The green line is the total return of the iShares Core S&P 500 ETF (ticker: IVV). The blue line is the total return of the iShares Core U.S. Aggregate Bond ETF (ticker: AGG). Notable, for the second quarter of the year, the S&P 500 had its biggest return since 1998. Unfortunately, the S&P 500 total return (including dividends) is still down for the year.

Year-to-Date Returns

The year-to-date total returns for the stock and bond market appear in the next figure. Alongside them, you can see the total returns of the ETFMathGuy Moderate and Aggressive portfolios. We found these portfolio returns by reviewing my account balances, so they represent returns that include portfolio turnover and the bid-ask spread from actual trades. However, they do not include the effect of taxes. Like many individual investors, I won’t file my 2020 returns until early next year.

Both portfolios continued to outperform the total return of the S&P 500. Premium subscribers can now access the July 2020 portfolios. Free subscribers are invited to review previous month portfolios. We also encourage free subscribers to upgrade their subscriptions to enable access to the portfolios built from the latest market dynamics.

Year-to-date returns through June 2020 for the stock market, bond market and ETFMathGuy Portfolios

Market Volatility

Stock market volatility continues to trend down, but is still higher than historical norms. Current volatility is 27.7% using our market volatility calculator that updates daily. Thus, over the last month, the volatility has come down from the 96th percentile to the 90th percentile, based on historical norms.

Stock market volatility continues to trend down, but still higher than historical norms.

We interpret this lower volatility as the markets reaction to less uncertainty about future economic growth. But, as the chart shows, we are still in a time of elevated uncertainty.

We hope you find this 2020 mid-year review educational as your consider your investments in the second-half of 2020.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Market Volatility Continues to Decline

Declining market volatility continued in the month of May. Also, the S&P 500 had a very good month, returning 4.8%. However, the broad-based index is still down 5.0% for the year, including dividends. The chart below updates the returns from last month for returns through May 29, 2020. As these results show, the ETFMathGuy Moderate and Aggressive portfolios continued to outperform the S&P 500. The premium portfolios for April and May 2020 are now available to all subscribers. The latest premium portfolios for June 2020 are available to paid subscribers.

Year-to-date returns through May 2020 for the stock market, bond market and ETFMathGuy Portfolios
Year-to-date returns through May 2020 for the stock market, bond market and ETFMathGuy Portfolios

Markets returning to normal?

The declining market volatility suggests that the fear in the markets continued to subside in May. However, they are still elevated above their long-term historical average. The image below shows the volatility from our daily monitor that tracks the S&P 500 ETF (ticker: IVV). We determine the standard deviation of daily returns over one, two and three month periods, and report an average to find a daily value. As of Friday, May 29th, volatility was 37.8%, as shown below.

Stock market volatility is still high, be is now well below its recent peak over 70%.
Stock market volatility is still high, be is now well below its recent peak over 70%.

Market Volatility Still Higher than Normal

Analyzing over 5,000 trading days since mid-June 2000, we can see how “out of the norm” current volatility really is. The table below shows the distribution of volatility over this nearly 20-year time period. As this table shows, we are still in the 96 percentile of volatility, meaning only 4% of the days since mid-June 2000 exhibited higher volatility then on May 29th, 2020.

Stock market volatility is still very high, by historical standards.

Stock markets returning to “normal” can be very subjective. The table above can provide a more objective perspective to such an assessment. However, if the downward trend continues, it may not take much longer before volatility returns to its long term historical norm.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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S&P 500 had a great month but market volatility remains

The S&P 500 had its best month since January 1987, returning 13%. However, investors in this stock index still have a long way to go before posting a gain for 2020 due to market volatility. Through the end of April, the year-to-date total return of the iShares Core S&P 500 ETF (ticker: IVV) is -9.4%. The portfolios from ETFMathGuy continued to outperform this index, as shown below. Free subscribers can now view both the April portfolios and the January through March portfolios. At this time, we only restrict current month portfolios to paid subscribers.

ETFMathGuy Moderate and Aggressive Portfolios continue to outperform total returns of the S&P 500
ETFMathGuy Moderate and Aggressive Portfolios continue to outperform total returns of the S&P 500

How is volatility doing?

This large return of the S&P 500 in April could be perceived as an indication of a new bull market. After all, the S&P 500 is up well over 20% from its lows in March. The chart below shows how a $100,000 investment in the S&P 500 would have performed since the beginning of the year. This chart clearly shows a “bounce”. But, it is not clear if this trend will lead to a recovery or more market volatility.

Year-to-date price changes of $100,000 investment in iShares Core S&P 500 ETF (ticker: IVV)
Year-to-date price changes of $100,000 investment in iShares Core S&P 500 ETF (ticker: IVV)

Updated Market Volatility

In a previous post, we discussed how market volatility is common during big market corrections, like the one we experienced this year. About a month ago, volatility was over 70%, and today it is 55.6%. You can keep track of volatility using our new market volatility monitor, which updates daily. Notice that while volatility is going down, it is still far from its long-term historical average of about 13%.

Market volatility remains high, relative to the long-term historical norm of 13%
Market volatility remains high, relative to the long-term historical norm of 13%

When will markets be “back to normal”?

What does this all this mean? We interpret this current high volatility, relative to historical norms, as an indication that markets are still struggling with the price discovery process. Consequently, we suspect it will take the markets more time to properly price the uncertainty of the economy recovering from the coronavirus. Ideally, we would like to see volatility below about the 95th percentile of those seen historically since 2001, which means a volatility below 40%. However, when that will occur is anyone’s best guess.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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S&P 500 down about 20% in the First Quarter of 2020

It was a difficult year so far for many investors. The total return of the iShares Core S&P 500 ETF (ticker: IVV) was -12.1% for the month of March. The total return of IVV in the first quarter 2020 was -19.6%. Such large losses often shake investor confidence. Also, the math is against you now. To recover from the 20% loss, a investor needs a 25% gain. If losses hit 40%, then an investor needs a 67% return to get back to where they started. And, if losses reach 50%, an investor needs a 100% return, or double their money, to recover all their losses. This is the unfortunate math behind compounded gains and losses.

The recovering from a large market loss can be challenging due to the effect of compounding
Recovering from a large market loss can be challenging due to the effect of compounding

How did the ETFMathGuy portfolios do in First Quarter 2020?

Using my account balances at the end of March, I measured my investment returns for the first quarter. For the Moderate Portfolio in my taxable account, my first quarter return was -5.0%. My Roth IRA used the Aggressive Portfolio and had a first quarter return of -2.1%. These returns far exceeded the S&P 500 in this first quarter. So, we are pleased with these results, which were supported by the backtesting we used to tune our optimization methodology.

Total Returns for the First Quarter Using Taxable and IRA Accounts
Total Returns for the First Quarter Using Taxable and IRA Accounts

Why is there such a large difference between the moderate and aggressive portfolios? The biggest driver was the moderate portfolio’s exposure to the municipal bond market. The aggressive portfolio did not include municipal bond ETFs, since it operated within an IRA. Please, look for yourself at the premium portfolios that produced these returns, which are now available to all free subscribers.

Measuring Volatility

We’ve added a new feature to the ETFMathGuy site to track the daily stock market volatility. Using the first ETF ever created, the SPDR S&P 500 ETF Trust, we developed an average of one, two and three month annualized volatility. At the end of this week, volatility was 70.6%, which is well above its median value of about 13% over the last 20 years.

Current stock market volatility hasn't been seen since the financial crisis of 2008.
Current stock market volatility hasn’t been seen since the financial crisis of 2008. Click this image to see the latest volatility, updated daily.

The last time volatility reached this level was the 2008 financial crisis. Then, volatility peaked at 77.8% on November 24, 2008.

In our next post, we will discuss using volatility to potentially detect market trends. Before then, you may want to read this article on on tips for investors in volatile markets.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.