Tag: risk tolerance

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Measuring cryptocurrency risk

Cryptocurrency risk is well known to be very high for many reasons. However, both individual and institutional investors continue to evaluate it as part of their investment portfolios. This post discusses recent cryptocurrency trends in a diversified portfolio and how the risks of this alternative investment compare to mainstream investments like stocks and bonds.

Volatility estimates

Volatility is one common way of assessing the risk of any investment. For the stock market, we provide a historical perspective, updated daily, to see how volatility changes over time for the stock market. But, how does this volatility compare to investments in cryptocurrency? The chart below shows a 3-month annualized volatility for the last several years of the stock market, measured with the ETF IVV, the bond market, measured by the ETF AGG, and the crypto market, measured by the Grayscale Bitcoin Trust  (GBTC). As this chart shows, bond volatility is the lowest, averaging between 3-4%. Stock volatility is higher, averaging between 15 – 20%. Cryptocurrency risk is about five times higher than stocks, with average volatility between 90-100%.

3-Month Annualized Volatility of the stock, bond, and cryptocurrency markets. Source: ETFMathGuy.com
3-Month annualized volatility of the stock, bond, and cryptocurrency markets. Source: ETFMathGuy.com

How much to allocate to cryptocurrency?

This recent WSJ article provided some guidance for individual investors interested in investing in cryptocurrency. While the answers to this question really depend on the individual’s risk tolerance, this article suggested between 1-2%. So, even if the value of the crypto investment hits $0, the investor limits their loss to this original investment amount. But, given the high levels of volatility, more frequent rebalancing may be prudent. Thus, if there is a substantial increase in the price of a crypto investment, the targeted 1-2% allocation would most likely require selling some of the crypto gains.

Unfortunately, selling short-term gains can be “expensive”, especially for those individual investors in a higher income tax bracket. In this case, the use of a Roth IRA may be the best approach. Why? An investor can realize Roth IRA gains tax-free if taken after age 59 1/2 from an account open for more than five years.

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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Recap of the first half of 2021

Greeting ETFMathGuy subscribers! This post is a reminder that the latest free and premium optimal portfolios are now available for your review. So, please log in and see how the latest market conditions have affected these ETF portfolios. To begin, we discuss value versus growth ETFs and recent trends in their returns.

Recent returns on value investing leveling off?

A few months ago, we wrote about how value-driven ETFs returned about 5% more in the first quarter than growth ETFs. Revisiting the returns of the ETFs IVV, VUG, and VTV for the first half of 2021 shows this gap has shrunk to 3% after growing to more than 10%. In fact, as the chart here shows, the value ETF is below its early May high, while the growth ETF appears to have begun a new upward trend.

Total returns of value and growth ETFs.
The total return of value and growth ETFs in the first half of 2021. Source: www.ETFReplay.com

Is the relationship between value and growth ETFs typical?

The relationship between two variables can be directly measured using correlation which varies between 1 and -1. So, a correlation of 1 between two investment returns indicates their returns are identical. Traditionally, the correlation between value and growth investments was around 75%. However, as this Wall Street Journal article highlights, the current correlation between growth and value is now below 25%.

Correlation between value and growth returns.
Source: Wall Street Journal, June 28, 2021, by James Mackintosh

Performance of the ETFMathGuy Premium Portfolios

Based on actual investment performance, the risk and return of the moderate and aggressive portfolios over the last 18 months appear below. Consequently, this period includes all of the calendar year 2020, and the first half of 2021.

ModerateAggressiveS&P 500 (IVV)
volatility (risk, annualized)19.5%22.5%21.2%
total return23.9%32.7%36.4%
Annualized risk and total return of the ETFMathGuy portfolios, 2020-2021 (18 months).

We will continue to update our ETFMathGuy portfolios with current market conditions using our updated backtesting calibration results. So, time will tell if value ETF investing continues to outperform growth ETF investing.

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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Upgrades to our Optimal Retirement Income Calculator

As promised, our free optimal retirement income calculator continues to improve based on your feedback. Thank you to everyone who has provided suggestions by contacting us! In this post, we highlight some of the most recent enhancements to this free online resource.

A Glide Path?

The term “Glide Path” is used to refer to shifting from one asset to another. Previously, our optimal retirement income calculator kept a retiree and their spouse’s asset allocation fixed. For example, our calculator previously maintained a fixed allocation (e.g. 60% stock and 40% bond) each year by drawing down accounts appropriately. Unfortunately, such an assumption is not entirely realistic. Instead, many retirees may wish to slowly reduce their “riskiness” in stocks and increase their “safety” of bonds during retirement.

A typical retirement glide path reduces portfolio risk each year. Photo by Pixabay on Pexels.com
A typical retirement glide path reduces portfolio risk each year. Photo by Pixabay on Pexels.com

One percent is a typical glide path, meaning that a retiree who is 60 years old starting with an asset allocation of 60/40 (stocks/bonds) will shift their asset allocation to 59/41 at 61 years old, 58/42 at 62 years old, and so forth.

Our optimal retirement income calculator now includes a glide path to transition from stocks to bonds during retirement.
Our optimal retirement income calculator now includes a glide path to transition from stocks to bonds during retirement.

Other updates to our optimal retirement income calculator

We also updated a number of the default values used to better reflect “typical” retiree demographics, as well as expected macroeconomics and capital market conditions. The list below summarizes these default changes.

  1. Retiree and spouse default ages changed to 65 and 62. This difference of three years is consistent with the average difference in retiree and spousal ages.
  2. The long-term rate of return of stocks and bonds set to 7.2% and 4%, based on the lifetime annualized returns for our stock and bond ETFs IVV and AGG.
  3. We set the retiree’s fraction of cost basis for stocks/bonds assuming a 10-year gain at their long-term rates. So, the cost basis for stocks stayed at 50%. But, the cost basis for bonds increased to 68%, since over 10 years, bond capital gains and reinvestment of dividends would yield a higher cost basis.
  4. Inflation rate set to 2.1%, based on an AR(1) stochastic process model and annual CPI (consumer price index) data from 1992-2020.

We hope you find these updates helpful as you plan for your financial future! Please stay tuned as there are still several suggestions we are still working on that will appear in the coming months.

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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Backtesting ETF portfolios

Backtesting ETF portfolios is a very important part of validating any investment strategy that uses them. At ETFMathGuy, we backtest our optimal portfolio construction strategy periodically. Doing so ensures that our quantitative methodology stays calibrated to the highest performing portfolios. Here, we discuss the key findings from this recent analysis.

Backtesting methodology

Our backtesting methodology follows the same approach we used in our previous backtesting analysis. The key distinction now is our time period begins in 2014 and runs through April of 2021. Also, we focused on one-month holding periods this time. Why? Based on our previous results, we found holding periods between 1-3 months had little impact on returns.

Backtesting ETF results over a longer-term

Firstly, the chart below shows the result of changing the duration of the sampling period on the out-of-sample returns. Note that there are two local maximums, with the first occurring and the 6-9 months, but a second more substantial maximum occurring at about 39 and 45 months.

Annualized returns from backtesting differing sample sizes. Source: ETFMathGuy.com
Annualized returns from backtesting differing sample sizes. Source: ETFMathGuy.com

However, when a risk-adjusted return is considered, we can improve this calibration. In the next figure, we show the annualized return divided by the annualized volatility. Thus, it’s clear that the 39 month sample period is superior with this measure for the moderate and aggressive portfolios. For the conservative portfolios, there is only a slight degradation in risk-adjusted return over these 7+ years of backtesting.

Annualized returns / volatility from backtesting differing sample sizes. Source: ETFMathGuy.com
Risk-adjusted returns from backtesting differing sample sizes. Source: ETFMathGuy.com

Backtesting ETF results over a shorter term

We also backtested our quantitative strategy over a shorter interval of the last 15 months, from January 2020, through April 2021. Ideally, our backtesting results over the long-term, shown above, should agree with this shorter time frame. And, in fact, they generally do.

Annualized returns and risk-adjusted returns from backtesting differing sample sizes. Source: ETFMathGuy.com
Annualized returns and risk-adjusted returns from backtesting differing sample sizes. Source: ETFMathGuy.com

Once again, with the slight exception of the conservative strategy, the 36-39 month sample size provided the largest annualized returns and risk-adjusted returns.

Key takeaways

  • Backtesting provides an estimate on how our quantitative strategy would have performed based on historical time periods.
  • The best calibration for the sample period occurs around 39 months based on both absolute return and risk-adjusted return.
  • Longer-term and shorter-term backtesting provided similar calibration results.
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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Risk-seeking investors and the first quarter of 2021

There was plenty of risk-seeking in the first quarter of 2021. So, how did the stock and bond market respond?

A Unique Quarter

This recent Wall Street Journal article summarized this first quarter well. The author identified the following contributors to recent market behavior due to risk-seeking investors.

  1. Meme stocks
  2. Interest rates
  3. Tech rotation

Meme stocks and the Fear Of Missing Out (FOMO)

The most popular “meme” stock was GameStop Corp. for risk-seeking investors. But, what is a meme stock? This source describes it as a stock that exhibits rapid price growth that is popular among millennials. Meme stocks can also be categorized by high volatility, fueled by the so-called Fear Of Missing Out (FOMO) and panic selling. Time will tell if this category of stocks becomes more formalized, as many in the workforce return to their offices, thereby limiting their trading time. Of course, the effect of social media on stock trading isn’t likely to go away anytime soon.

A new trend in interest rates?

The other big news in the first quarter was the increase in interest rates. Long-term bond yields increased in February and March, after starting the year at 0.917%.

U.S. 10 Year Treasury Note Yield in First Quarter of 2021. Source: MarketWatch.com
U.S. 10 Year Treasury Note Yield in First Quarter of 2021. Source: MarketWatch.com

By the end of the first quarter of 2021, the U.S. 10 Year Treasury Note yield rose to 1.745%. As we wrote about before, the price of a bond decreases when yields rise. Consequently, the iShares Core Total US Bond ETF fell, to a year-to-date loss of 3.4%.

Total Return of iShares Core Total US Bond ETF, First Quarter of 2021. Source: ETFReplay.com
Total Return of iShares Core Total US Bond ETF, First Quarter of 2021. Source: ETFReplay.com

Tech Rotation

The first quarter was also characterized by about a 5% return difference between the Dow and Nasdaq indices. For instance, Exxon Mobil Corp. is up 35% this year, while Amazon and Apple have lost 5% and 7.9%, respectively. Of course, no one knows if this rotation out of tech and into energy is a new trend or just a reaction to markets anticipating a future with more energy consumption due to increased commuting. But, these recent changes have been incorporated into our portfolio construction process to produce an update to our free and premium portfolios. We encourage you to log in to see how these ETF portfolios changed due to the latest market dynamics.

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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Optimal Portfolio Updates for February 2021

ETFMathGuy optimal portfolios are now available to free and premium subscribers. Please log-in to see them now. In this post, we will discuss how the recent GameStop stock prices influenced these portfolios and our portfolio construction process.

Markets in 2021

The 2021 year in the ETF marketplace is already shaping up to be very interesting. The big news recently was the impact of stocks like GameStop’s 500% gain from Jan. 25 through Jan.29. Fortunately, most diversified ETFs saw little impact of this extreme price move. However, this rapid price gain did have a noticeable impact on two ETFs.

What ETFs were impacted most by GameStop?

According to this ETF.com article, two ETFs had their holdings in GameStop jump into double-digits weights. They were the Wedbush ETFMG Video Game Tech ETF (ticker: GAMR) and the SPDR S&P Retail ETF (ticker XRT). In the case of GAMR, this ETF has the largest weighting of GameStop, currently at 26%. Notice, in the image below, that this holding is more than 10-times larger than the next largest one.

Top 10 Holding for the Wedbush ETFMG Video Game Tech ETF (ticker: GAMR). Source: etfmg.com/funds/gamr
Top 10 Holding for the Wedbush ETFMG Video Game Tech ETF (ticker: GAMR). Source: etfmg.com/funds/gamr

Less extreme is the SPDR S&P Retail ETF (ticker: XRT), which currently holds 12% of its assets in GameStop. So, these two ETFs are not as diversified as one might expect.

Did these ETFs impact the ETFMathGuy portfolios?

The short answer to this question is “no”, because of our portfolio construction process begins with a curated list of ETFs. For this month, we chose to intentionally exclude GAMR due to the excessive level of risk associated with holding large amounts of GameStop stock. Fortunately, there were still many ETFs to pick from to build our optimal portfolios, creating plenty of other opportunity for gains. And, gains for 2021 have been good so far. Below is an image showing total returns for stocks (ticker: IVV), bonds (ticker: AGG) and our three premium portfolios invested in real brokerage accounts at Schwab and Fidelity.

Total returns for ETFMathGuy premium portfolios in January, 2021
Total returns for ETFMathGuy premium portfolios in January, 2021

We were happy to see these returns in January, which continues the strong returns from 2020. Please watch for future posts where we will continue our discussion on ETFs, the economy and tax-efficient retirement income.

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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Concentrated exposure with thematic ETFs

In our recent post about thematic ETFs, we discussed the growth of so-called “thematic ETFs”. These are ETFs that follow a theme. One of our favorite writers at the WSJ is Jason Zweig, and he also wrote about these ETFs recently. Today, they represent some of the market’s hottest funds by using concentrated exposure.

“Often called thematic ETFs, these funds cut across industries, trying to capitalize on ideas like alternative energy, cloud computing or 3-D printing. Others buy stocks that could benefit as more people work from home, demand gender or racial diversity, or lavish money on their pets.”

Jason Zweig, The Intelligent Investor, Wall Street Journal, January 15, 2021

More Concentrated Exposure

By concentrating on a particular theme, like solar power, robotics or industrial innovation, many of these funds can have very high returns. For example, the Invesco Solar ETF (ticker: TAN) had a 234% return in 2020. Similarly, the ARK Innovation ETF (ticker: ARKK) returned 153%. Of course, these returns didn’t come without their own risks. The volatility of these two thematic ETFs were 55% and 49%, respectively. As a basis of comparison, our typical benchmark for stocks is the iShares Core S&P 500 ETF (ticker: IVV) and bonds is the iShares Core Total US Bond ETF (ticker: AGG). The 2020 return of these ETFs appears below at 18.4% and 7.5%, respectively. Also, note their lower volatility than the thematic ETFs mentioned here.

Risk and Return of Three popular thematic ETFs in 2020. Source: etfreplay.com/charts.aspx
Risk and return of three popular thematic ETFs and two broad-based ETFs in 2020. Source: etfreplay.com/charts.aspx

Higher expenses in thematic ETFs

Expense ratios are often much higher in thematic ETFs than broad-market ETFs like those that track the S&P 500. For instance, the three thematic ETFs from above have expense ratios of 0.69%, 0.95% and 0.75% according to ETF.com. In contrast, our stock and bond benchmark ETFs (tickers IVV and AGG) have expense ratios of 0.04% and 0.06%. So, investors must pay a premium to get unique exposure to these themes. And, until a thematic ETF grows sufficiently, the bid-ask spread on them could be much larger, further degrading returns when they are bought and sold frequently. Nevertheless, we found in 2020 that thematic ETFs, when built into a diversified portfolio, can both manage risk and boost returns.

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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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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Thematic ETFs continue to grow

Thematic ETFs continue to grow in popularity. But, how is this type of ETF different from the broad-based ETFs, like those that track the S&P 500? In this post, we discuss several points to consider when investing in thematic ETFs.

What is an ETF “theme”?

ETF themes can come from nearly anywhere in the investment world. As discussed in this recent WSJ article, themes are often found to hopefully align with “beliefs or interests” that investors may have. In the U.S., assets invested in thematic ETFs have doubled in the past three years. However, there have been quite a few closures along the way too. Closures are typically due to the ETF’s expense ratio failing to produce sufficient revenue to match the expense of running the ETF. This WSJ article suggests that ETFs without $50M in assets after three years are most vulnerable.

We agree. In fact, the initial evaluation of the ETFs we use in our portfolio construction process discards ETFs that haven’t existed for several years or have less than $50M under management. Our approach helps avoid the many issues associated with ETF closures.

Opportunities of Thematic ETFs

The obvious attraction of these ETFs is their opportunity to make more “concentrated” investments in companies within its theme. For example, investors interested in companies involved in automation could buy the ROBO Global Robotics and Automation Index ETF (ticker: ROBO). Or, if an investor wishes to make investments in solar companies, they can buy the Invesco Solar ETF (ticker: TAN). The image below shows the top ten holdings of this solar ETF.

Top 10 Holdings of the Invesco Solar ETF. Source: ETF.com
Top 10 Holdings of the Invesco Solar ETF. Source: ETF.com

However, theme-based ETFs also lack diversification inherent in broad-based ETFs like iShares Core S&P 500 ETF (ticker IVV). And, they are typically are less liquid. For instance, the average bid-ask spread of the Invesco Solar ETF was 0.11%. The iShares Core S&P 500 ETF bid-ask spread was much lower, at 0.01%, according to ETF.com.

Risks and Rewards of Thematic ETFs

Having more concentrated holdings than a broad-based index usually means higher risk. The chart below shows how the risk, measured by volatility, for the automation and solar ETFs compare to the S&P 500 ETF over the last three years. Clearly, these thematic ETFs exhibited greater risk. For the solar ETF, this higher risk level was compensated by a higher total return. However, the automation ETF’s higher risk levels didn’t produce returns higher than the S&P 500, lagging it by about 1% a year.

Three-year risk and return of the Invesco Solar ETF, ROBO Global Robotics and Automation Index ETF and the iShares Core S&P 500 ETF. source: www.etfreplay.com
Three-year risk and return of the Invesco Solar ETF, ROBO Global Robotics and Automation Index ETF and the iShares Core S&P 500 ETF. source: www.etfreplay.com
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.