In building ETFalpha, we use various modern investment concepts and new research in the background.
We send signals on six different asset classes through six different Exchange Traded Funds and, in this way, we make use of thousands of securities in a very cost-effective manner.
The six ETFs cover
• US stocks, investing in the largest 1,000 US companies across all sectors of the economy
• US bonds, investing in US Government bonds and other investment-grade corporate and other bonds
• US real estate, investing across a range of Real Estate Investment Trusts (REITs)
• Developed countries’ stocks, investing in hundreds of stocks in Europe, Asia, the Far East, and Australia, across all economic sectors
• Emerging markets stocks, investing in large-cap and mid-cap stocks in emerging markets including China, South Korea, Brazil, India, Russia, South Africa and Mexico
• Commodities, investing across most major commodities including gold, silver, oil, wheat and copper
ETFalpha uses this enormous diversification across global markets so that your money is not invested in just one basket but spread across the continents.
If you want to diversify fully, you must follow all the six ETFs. If you want your diversification to be limited to the US, then you can invest in any or all three of the US ETFs.
If you invest in all six ETFs, you will never have more than one-sixth of your capital invested in any one asset class.
(Of course, if you like, you can over-ride this rule and invest all your money in one area when it comes up – say US stocks – or in only three areas – say all the US ETFs - but you will be increasing risk on that money.)
The main purpose of this wide diversification is to reduce risk.
The results can easily be seen in our Performance pages. ETFalpha’s objective is to get superior returns at lower risk.
• R.G. Ibbotson and P.D. Kaplan, (2000), “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” (Financial Analyst Journal)
Why does investing in a group of securities in different asset classes reduce risk?
The reason is that the different securities and the different asset classes do not move in the same way – at least most of the time.
This is often best explained by the example of the businessperson who sells ice cream and coffee – when the weather is warm, people will buy ice cream; when cold, they will buy coffee. Since sales of these two products come into their own under different conditions, the business person reduces his or her business risk.
Technically, we estimate the volatility of each asset class by measuring its standard deviation. We look at the long historical record, at a short historical record and at what option prices indicate volatility is likely to be.
If two asset classes, for example US stocks and US real estate, move in the same direction most of the time, it is said that they are highly correlated. The lower this correlation, the more one can reduce risk by investing in the two classes.
Sometimes, the volatilities of two asset classes may move up or down together. This also affects by how much investing in these two classes would reduce risk.
There have been many studies and research to demonstrate how diversification operates in financial markets and how it enhances portfolio performance.
Recent winners of the Nobel Prize for Economics have been active in this area of modern finance.
Studies in this area include:
• Harry Markowitz, (1952), “Portfolio Selection” (Journal of Finance) – Nobel Prize winner, 1990
• William Sharpe, (1964), “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance) – Nobel Prize winner, 1990
Asset Class Rotation
Today’s investment markets are global and money flows around the world in search of the best opportunities.
Money is like the tide – when money leaves a market, the prices of securities in that market fall. But money cannot stand still or disappear in a vacuum! It will go into a new market and, when it does, the prices of securities in that market will rise, like boats as the tide enters a harbour.
The idea behind ETFalpha is that by investing in the main asset classes around the world, we capture this movement of money.
Asset classes behave differently:
• Stocks give investors exposure to economic growth and this often leads to capital gains. Stocks also pay dividends and protect investors against inflation. Stocks, however, can be quite volatile.
• Bonds are more stable than stocks. They usually provide a high and stable level of income and have rather low volatility. Bonds have a low correlation with stocks and therefore provide diversification advantages.
• Real estate is a popular asset class. In terms of income and correlation, this asset class falls between bonds and stocks, and is also a good inflation hedge.
• Commodities usually rise in price with economic growth as demand for them grows. Their correlation varies – sometimes they move with stocks, at others they are very sluggish. Over the long-term, commodities can offer good protection against inflation.
By rotating between these four asset classes across the United States and other major countries around the world, we capture the increases in securities prices as money flows into them.
Once money starts to flow out, we bid them au revoir, and take our leave.
In this way, ETFalpha both makes money and protects it.
Goodbye Buy-and-Hold and Hello Buy-Hold-Sell.
Trends and Momentum Investing
As the tide of money flows from one area of the global market to another, trends are formed and the prices of securities in markets receiving money gather momentum. The same is true when money moves between sectors in the same market.
Recently, a lot of research is being produced about this behavior of markets. For a long time, though, this area of research was ignored.
And yet, one of the most popular investment books, first published in 1923, Edwin Lefevre’s "Reminiscences of a Stock Operator", based on the life of the securities trader Jesse Livermore, is primarily about taking opportunity of trends and detecting their imminent reversal. This book, however, was not a favorite in academic circles.
Once the money flow starts a trend, that trend gathers momentum, and continues for a period of time.
Trends are then likely to carry securities prices too far in one direction which makes investors starts selling securities in order to take profits. Money starts migrating from the once favorite market to other markets, previously neglected, where opportunities are deemed to be higher, and prices fall. A downward trend then takes hold.
ETFalpha captures these trends as they form and tells you when trends are getting tired.
Amongst the early pioneers of recent research on trends and momentum we find:
• N. Jegadeesh and S. Titman, (1993), “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency” (Journal of Finance)
Low Cost ETFs
ETFs are the major financial innovations of recent years.
They can be said to have evolved out of the highly popular mutual funds but, unlike mutual funds, they can be traded on the stock exchange, like any stock, and they are extremely low cost.
ETFs often follow a particular index, such as the S&P 500 or the EAFE (Europe, Australasia, Far East) index.
With one simple transaction via your stockbroker, you can invest in ETFs made up of stock from across the USA and the world, without incurring front or back-end charges, and usually paying a very low annual fee.
ETFs are such effective and investor-friendly securities that they are currently growing at an explosive rate.
According to Wikipedia:
An exchange traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features.
This descriptive definition of exchange traded funds captures the main characteristics of ETFs and is fine as a working definition.
ETFs invest not only in stocks and bonds but also in other financial instruments such as futures.
Exchange Traded Funds - Commodities
Many commodity ETFs do not hold commodities directly but often hold futures which represent rights on those commodities.
This has been the traditional way to establish a position in a particular commodity since futures come in a wide range of choices, from gold to bonds to pork bellies to butter to orange juice! Futures also allow a fund manager to move in and out of the commodity very quickly and easily.
A commodity future is a standardized contract on an exchange which obliges the buyer of the future to purchase an asset at a predetermined price at a future date. For every buyer there is a seller of the future.
Futures contracts are standardized and detail the exact quantity and quality of the underlying commodity or other asset. This standardization enables trading on a recognized exchange, such as the Chicago Merc, formally the Chicago Mercantile Exchange.
In order to buy a future, one needs only deposit a margin to act as a performance bond or good-faith deposit. This allows the use of high leverage in futures which is managed by the manager of the ETF.
In order to retain exposure to a commodity, the ETF must buy futures and keep rolling them into new ones before they expire. This is another duty of the ETF’s manager.
When it comes to investing in exchange traded funds, while understanding how things work is always a good thing, an investor would not be involved in any of the underlying management.
Some ETFs, particularly those investing in precious metals such as gold, silver and platinum, hold and store the actual physical metal in vaults. Part of the annual charges would cover the fees the vaults charge to store the metals.
Exchange Traded Funds - Bonds
ETFs investing in bonds – of which there is quite a list – usually hold the type of bonds specified in their investment policy statement.
Interestingly, many bond ETFs hold thousands of bonds and this provide for very large diversification.
ETFalpha uses a fund which invests in US bonds and carries more than 7,000 different bonds. Most are highly secure US Government bonds and some are corporate bonds of various credit ratings.
Exchange traded bonds funds lists are available on the internet by various providers but one must always read a fund’s prospectus before investing.
The great thing about good quality bond ETFs is that with one click of the mouse via your online stockbroker you can invest in thousands of bonds which in the old days would have been extremely difficult, if not impossible, to put together unless one was investing millions and had a lot of time to do so!
The ETF area is very exciting, and keeps developing daily.