New Global Tactical Model Series added…

For the convenience of those interested in tracking Mebane Faber’s popular Global Tactical Asset-Allocation model that he originally featured in his 2006 paper, I have added that model among our tactical ETF models. As I discussed in a Seeking Alpha article, I have replaced the original 10 period moving average with the 8 period…it just seems to work better. Overall though, readers will find this tracks pretty close to what Meb has on his own site.

As some of you are probably aware, Meb has published some updates to his original paper, the most recent being February 2013.  In the latest update, Meb introduced 8 additional asset-classes for a total of 13.   He also discussed several alternative methods of allocating funds, one which included the discussion of combining a momentum-based ranking system along with the original use of the trend following moving average.  (Links to both the original and the updated paper can be found on the Reference page.)

This inspired me to conduct some research of my own given the tremendous success I have had with applying momentum across a variety of asset-classes.  After testing many combinations of factors, the finished model ranks the 13 ETFs using a ranking system that combines both momentum and volatility.  Any ETF that is not above the 8 period moving average is eliminated.  Finally, instead of selecting  the top five ETFs as Meb does in his paper, I settled on buying the top three in equal weight as the best choice. Below in the table are my test results.

Number of ETFsCAGRSharpe RatioMaximum DrawdownTotal Return (dividends reinvested)

To summarize, less than three and the portfolio volatility reached unacceptable levels and more than three, the portfolio returns quickly diminish.   Thus, I have aptly named the new model, GTAA – Focus Three.

For some who may think that owning just three ETFs each month is too limited, remember that each ETF is in itself extremely diverse.  For example, the iShares Russell 1000 Growth ETF, a current model holding, is diversified with 625 separate securities.

I personally really like the stability of this model and how well it navigated the the 2007-2009 period.   Unlike some of my other models, this model does not include an inverse fund but never the less, the inclusion of fixed-income ETFs provided enough opportunity to keep downside risk contained to acceptable levels.

For individual investors looking for a single model that covers most all of the major asset-classes, I believe this could be a good choice.  And for financial advisors who want a simple but effective way to managed their client book, I would have to think this model could serve them well and provide the ability to build a very scaleable practice.

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U.S. Style Box ETF Rotation – Introducing Portfolio Cafe’s newest ETF model.

In 1992 Morningstar introduced their now famous “style box” as a way to classify  mutual funds into distinct categories based upon market capitalization and growth and value characteristics.   In this article I will introduce Portfolio Cafe’s newest ETF model which is based upon the observable performance differential between investment styles.  But first, some quick background.

How it Works – Quantitative Ranking

The vertical axis of the Style Box defines three size categories, or capitalization bands-small, mid-size, and large. The horizontal axis defines three style categories. Two of these categories, “value” and “growth,” are common to both stocks and funds. However, for stocks, the central column of the style box represents the core style (those stocks for which neither value or growth characteristics dominate); for funds, it represents the blend style (a mixture of growth and value stocks or mostly core stocks).

Style Box assignments begin at the individual stock level. Morningstar determines the investment style of each individual stock in its database. Stocks are evaluated against other stocks in the same geographic area (United States, Latin America, Canada, Europe, Japan, Asia ex-Japan, Australia/New Zealand). The style attributes of individual stocks are then used to determine the style classification of stock mutual funds.

The Horizontal Axis

  • The scores for a stock’s value and growth characteristics determine its horizontal placement:
  • Value Score Components and Weights
  • Forward looking measures 50.0%
  • Price/Prospective Earnings.
  • Historical based measures 50.0%
  • Price/book 12.5% Price/sales 12.5% Price/cash flow 12.5% Dividend yield 12.5%
  • Growth Score Components and Weights
  • Forward looking measures 50.0%
  • Long-term projected earnings growth
  • Historical-based measures 50.0%
  • Historical earnings growth 12.5% Sales growth 12.5% Cash flow growth 12.5% Book value growth 12.5%

The Vertical Axis

Rather than a fixed number of “large cap”or “small cap” stocks, Morningstar uses a flexible system that isn’t adversely affected by overall movements in the market. Large-cap stocks are defined as the group that accounts for the top 70% of the capitalization of each geographic area; mid-cap stocks represent the next 20%; and small-cap stocks represent the balance.

Style Boxes as Factors

While style boxes have served usefulness in classifying mutual funds, I would pose that they also represent another example of where “rotation” is observable and where rotation strategies can produce excess returns.  Since each style box represents a concentration of stocks of similar characteristics, it’s fair to treat  each style box as a factor.

The financial literature is filled with numerous examples of where momentum strategies have been used to produces excess returns in virtually every asset class and their respective parts. (sectors, industries, countries).   Momentum strategies are equally applicable to equity styles.

In 2008, Tibbs, Eakins, and DeShurko published  “Using Style Index Momentum to Generate Alpha” which examined the effect of momentum using Russell style box classification.  The results indicated that momentum does indeed persists when applied to equity styles, just the same as when applied to other forms of classification.  That is, the performance of the top-ranked equity style tends to persist.  The top-performing style typically displayed the best performance and the bottom performing style continued to display the worst performance.

For investors, this is good news as the use of Russell style box ETFs represents a very easy and low-cost means to gain diversified access to the U.S. stock market.  For example, the iShares Russell 1000 Value ETF (IWD) presently holds 669 stocks classified as large-cap value.  Names like Exxon-Mobile, AT&T, Chevron, Procter & Gamble, and Berkshire Hathaway, Inc. are among its top holdings.

Building a Better Model

The addition of the style-based momentum model to the Portfolio Cafe lineup provides investors with a very affordable and effective means to invest in the U.S. market.  In addition to including an ETF representing each of the Russell primary style boxes, I have added a handful of other ETFs including the iShares DJ Select Dividend Index (DVY), the PowerShares Nasdaq 100 Index (QQQ), and the iShares MSCI USA Minimum Volatility Index (USMV).  My reason for doing so is that I believe each also represents a “style” of investing that the market displays tendencies to favor at various times.

As is customary to all of my ETF models, I have built in rules that will protect investors during periods of protracted market declines.  As such, the model may hold cash or short-term bonds when there are no attractive opportunities available in the equity markets.

While the full details for the new model can be found on the models page, here is a look at the summary page.

Model Inception Date:12/31/2002Data as of 01/31/2017
Total Return:589.3%240.9%
Compound Annual Growth (CAGR):14.7%9.1%
Sharpe Ratio:0.900.44
MAR Ratio: 0.910.16
Correlation to benchmark:0.30
Volatility: 14.2% 18.8%
Maximum Drawdown:-16.3%-55.2%
Winning Period %:66.9%
Best Monthly Period:10.20%
Worst Monthly Period:-7.98%

For Charter subscribers, the new model is available at no additional cost.

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$1 Trillion and counting…

Last week the ETF industry reached a major milestone as ETF assets reached  $1 Trillion.  Now, on a comparative basis, that is still well shy of the $11.5 Trillion held in mutual funds (Investment Company Institute), but many industry experts think that ETFs have just begun to scratch the service.

 Much has changed since SPY was launched in 1993 when the goal was simply to provide institutional investors a simple way to mimic the biggest U.S. equity benchmarks.  Today, ETFs include everything from domestic, international, emerging, fixed income, commodities, currency, active and passive.  

In addition to the number of asset classes now represented by ETFs, there is equally important a variety of different methodologies being applied to the construction  of ETFs.   These methods include capitalization weighting, equal weighting, fundamental weighting as well as a variety of quantitative  and technical overlays.  Future posts will explore each of these topics separately as they all play an important part to investor returns.  Here are some reasons why ETFs have become so popular.

  • Instant Diversification

    The purchase of a single ETF gives investors exposure to a basket of stocks creating diversification and eliminating company-specific risk.

  • Tax Efficiency

    Due to low turnover, most ETF’s do not have large capital gains that need to be paid out to investors which result in “phantom income”. Mutual funds on the other hand are known for paying out year-end capital gains even if the mutual fund has lost value.

  • Intraday Pricing

    An ETF can be bought and sold throughout the regular trading session in the same manner as a stock. A mutual fund can only be bought or sold at the Net Asset Value, which is computed at the end of the trading session.

  • Low Expense Ratios

    The annual expense ratio of ETF’s is lower than that of mutual funds. For example the Vanguard Emerging Markets ETF (VWO) has a low annual expense ratio of 0.3%. The category average for an emerging markets mutual fund is 1.83%. Over time this will eat into your profits.

  • Low Fees

    The cost of buying and selling an ETF is the same as an individual stock. Some mutual funds charge loads that can be as high as 5% of the initial investment.  A number of brokers now offer commission free trading of select ETFs.

  • Passive Investment Vehicles

    ETF’s are passive investments that track a set index and the composition is only changed a couple times per year. Most mutual funds are actively managed and therefore trades are taking place daily. The chance of your mutual fund outperforming the market by trading is approximately 20%.

  • Ability to short and buy on margin

    Traders that would like to bet against a specific ETF moving higher can “short sell” the ETF. Investors also have the ability to leverage their account with margin when buying ETF’s.  For accounts where shorting may not be possible, such as IRA accounts, "inverse" ETFs can provide the equivalent of a short exposure.  

  • Convenience

    ETF’s can be purchased the same way as a stock through an online brokerage firm. When it is time to sell it can also be done online with the mere cost of making a stock transaction.

  • Exposure to niche sectors

    A new advantage of ETF’s is exposure to niche areas in the market that mutual funds do not offer. For example, there is a water infrastructure ETF, an ETF that concentrates solely on Singapore, or an ETF that moves with the price of natural gas futures.

  • Transparency

    Nearly all ETF’s track an index that is reallocated wither every quarter or twice per year. Therefore, on any given day you can determine what stocks make up your ETF’s.  Of the growing number of ETFs which use an active strategy, most typically rebalance no more frequently than monthly, again making it possible to know exactly what you own.   

As mentioned in a previous post, there are now over 1,000 different ETFs to choose from and this number will continue to increase.  Currently, the SEC pipeline is full of registrations for new ETFs, many with actively managed strategies.  Investors can expect to see a number of new offerings in 2011 and the line between mutual funds and ETFs begin to blur.    

 Recent studies conducted by Schwab and Ameritrade concluded that only 15% of all retail investors presently use ETFs, suggesting that there is significant room for the industry to grow.  In the 1970's there was a major transition toward mutual funds which lasted roughly 25 years.  Today we sit in the early innings of a major transition away from mutual funds and toward ETFs.  This is very likely a long term shift as ETF assets are growing at rates usually only applicable to nascent markets poised to become much larger.  

Come join the revolution.

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The Paradox of Choice…Can Having Too Many ETFs Make You Unhappy?

Social scientist Barry Schwartz makes the case in his book "Paradox of Choice – Can Having Too Many Choices Make You Unhappy" that unlimited choices produces genuine suffering.  The more choices we have to make, the less certainty we seem to have. Let's apply this to investing.

Today, there are over 1,000 Exchange Traded Funds (ETFs), representing one of the fastest growing segments of the investment industry.  ETFs first became popular back in the early 1990s with the introduction of  "SPY", or Standard & Poor's Depository Receipts.  Also known as SPDR or Spider, this ETF has gone on to become the largest in the world. Initially designed to provide a fast and affordable way to mimic popular stock market indices and sectors, today ETFs have proliferated to represent an array of regions, sectors, commodities, futures, and other asset classes.  

So, according to Schwartz, when faced with seemingly unlimited choices that have significant consequences, such as investing, people will relentlessly search for the best option.  These people spend a great deal of time and energy on choices that will never satisfy them.  Which brings me to the main point of this post and to why I created PortfolioCafe.

Relative Strength investing and mechanical stock screening approaches have the ability to quickly and easily cut through the many choices presented to investors.  With Relative Strength we can quickly and easily reduce the universe of ETFs to only those that matter at this moment.  The best performing investment opportunities naturally present themselves to us.  With mechanical, multi-factor models, investors can screen through thousands of stocks and find the small handful that meet a given criteria.  By following such approaches, investors can reduce their choices and apply their limited time and energy in a meaningful way.

I am not against choice or the many new ETFs which have been constructed.  Quite to the contrary, I think investors have never had it so good.  For much of my career as a broker, the only way to hedge a portfolio against downside risk was buy purchasing put options or shorting stocks.  Today, investors can easily hedge a portfolio or actually profit from market declines through inverse ETFs.  Also, it has never been so easy to build a well diversified portfolio with exposure to a variety of asset classes.  So choice is good.

What I think is missing for many investors is the means to filter the many choices.  Too much information and too many choices causes paralysis. Investors are constantly bombarded with "tips" and "market news" which in reality is nothing more than "noise".   

PortfolioCafe was designed around systematic and mechanical approaches to investing which reduce the time and energy spent on decision making.  The systems and models presented within this site are well grounded upon research and historical evidence.  The "Paradox of Choice" has been greatly reduced to a handful of well thought out and carefully researched systematic approaches to investing. 

In my next post, I will discuss "The Art of Becoming an Investor Minimalist".

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