Volatility Effects

Do differences in equity sector responses to stock market crashes (and associated volatility spikes) support an exploitably attractive sector rotation strategy? In the November 2020 update of his paper entitled “Actively Using Passive Sectors to Generate Alpha Using the VIX”, Michael Gayed examines a cyclical-defensive sector rotation strategy using the level of the CBOE S&P 500 Volatility Index (VIX) as trigger. Specifically, he iteratively favors defensive sectors (Utilities, Consumer Staples and Healthcare) when daily VIX is relatively low in anticipation of VIX increases and favors cyclical sectors (Technology, Industrials, Materials and Consumer Discretionary) to buy into high-VIX panics and benefit from VIX reversion. He considers:

• Three allocation schemes: (1) 100% long favored sectors and 100% short unfavored sectors; (2) 100% long favored sectors; and, (3) overweighting (underweighting) favored (unfavored) sectors by 5% to form a modified S&P 500 Index.
• Two weighting schemes for sets of defensive and cyclical sectors: (1) equal weighting, and (2) S&P 500 sector weighting.
• Two ways of applying the Nelder-Mead method to identify daily VIX levels that trigger defensive-to-cyclical and cyclical-to-defensive switches: (1) using only the first five years (1999-2004) of the full sample, and (2) using a 5-year rolling window throughout the sample period.

Using daily levels of VIX and the S&P 500 Index and daily prices of Select Sector SPDR Exchange Traded Funds (ETF) during January 1999 through October 2020, with strategy tests starting January 2005, he finds that: Keep Reading

In response to “Shorting VXX with Crash Protection”, which investigates shorting iPath S&P 500 VIX Short-Term Futures (VXX) to capture the equity volatility risk premium, a subscriber asked about instead using a long position in ProShares Short VIX Short-Term Futures (SVXY). To investigate, we consider two scenarios based on monthly measurements:

1. Buy and Hold – buying an initial amount of SVXY and letting this position ride indefinitely.
2. Monthly Skim – buying the same initial amount of SVXY and transferring to cash any month-end gains exceeding the initial investment (the beginning-of-month SVXY position may become smaller, but not larger, than the initial investment).

The offeror changed the SVXY investment objective at the end of February 2018 (when short VIX strategies crashed), targeting henceforth -0.5 times the daily performance of the S&P 500 VIX Short-Term Futures Index rather than -1.0 times as before. We therefore examine SVXY performance separately before and after that change. We assume switching frictions of 0.25% for movements of funds from SVXY to cash in scenario 2. We assume return on cash is the 3-month U.S. Treasury bill (T-bill) yield. Using monthly split-adjusted closing prices for SVXY and contemporaneous T-bill yield during October 2011 through August 2020, we find that: Keep Reading

Are equity multifactor strategies, as implemented by exchange-traded funds (ETF), attractive? To investigate, we consider seven ETFs, all currently available:

• iShares Edge MSCI Multifactor USA (LRGF) – holds large and mid-cap U.S. stocks with focus on quality, value, size and momentum, while maintaining a level of risk similar to that of the market.
• iShares Edge MSCI Multifactor International (INTF) – holds global developed market ex U.S. large and mid-cap stocks based on quality, value, size and momentum, while maintaining a level of risk similar to that of the market.
• Goldman Sachs ActiveBeta U.S. Large Cap Equity (GSLC) – holds large U.S. stocks based on good value, strong momentum, high quality and low volatility.
• John Hancock Multifactor Large Cap (JHML) – holds large U.S. stocks based on smaller capitalization, lower relative price and higher profitability, which academic research links to higher expected returns.
• John Hancock Multifactor Mid Cap (JHMM) – holds mid-cap U.S. stocks based on smaller capitalization, lower relative price and higher profitability, which academic research links to higher expected returns.
• JPMorgan Diversified Return U.S. Equity (JPUS) – holds U.S. stocks based on value, quality and momentum via a risk-weighting process that lowers exposure to historically volatile sectors and stocks.
• Xtrackers Russell 1000 Comprehensive Factor (DEUS) – seeks to track, before fees and expenses, the Russell 1000 Comprehensive Factor Index, which seeks exposure to quality, value, momentum, low volatility and size factors.

We focus on monthly return statistics, along with compound annual growth rates (CAGR) and maximum drawdowns (MaxDD). We use four benchmarks according to fund descriptions: SPDR S&P 500 (SPY), iShares MSCI ACWI ex US (ACWX), SPDR S&P MidCap 400 (MDY) and iShares Russell 1000 (IWB). Using monthly returns for the seven equity multifactor ETFs and benchmarks as available through August 2020, we find that: Keep Reading

How do mutual funds and hedge funds change their stock holdings in response to a sharp market crash? In their July 2020 paper entitled “Where Do Institutional Investors Seek Shelter when Disaster Strikes? Evidence from COVID-19”, Simon Glossner, Pedro Matos, Stefano Ramelli and Alexander Wagner analyze changes in institutional and retail stock holdings during the first quarter of 2020. Using a February-March 2020 snapshot of returns and firm accounting data for non-financial stocks in the Russell 3000 Index, institutional holdings of these stocks as percentages of shares outstanding during the fourth quarter of 2018 through the first quarter of 2020, and number of Robinhood clients (representing retail investors) holding these stocks on December 31, 2019 and March 31, 2020, they find that:

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How well did previously identified portfolio risk management strategies work during the COVID-19 market crash? In their July 2020 paper entitled “Strategic Risk Management: Out-of-Sample Evidence from the COVID-19 Equity Selloff”, Campbell Harvey, Edward Hoyle, Sandy Rattray and Otto Van Hemert extended analyses of risk management strategies they identified in a 2016-2019 series of papers with an out-of-sample test of the February-March 2020 stock market sell-off. These strategies include:

• Long put options, short credit risk, long bonds or long gold.
• Trend following based on time series/intrinsic momentum (past return divided by volatility of returns over a specified lookback interval) or on moving average crossovers.
• Holding defensive stocks (based on profitability, payout, growth, safety or quality).
• Volatility targeting (increasing/decreasing exposure when past volatility is relative low/high).
• Rebalancing a stocks-bonds portfolio only half way and only when recent (1, 3 or 12 months) portfolio return is above its historical average.

Extending analyses from their prior papers through March 2020 to capture the COVID-19 crash, they find that:

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How might an investor construct a portfolio of very risky assets? To investigate, we consider:

• First, diversifying with monthly rebalancing of:
  1. Bitcoin Investment Trust (GBTC), representing a very long-term option on Bitcoins.
  2. VanEck Vectors Junior Gold Miners ETF (GDXJ), representing a very long-term option on gold.
  3. ProShares Short VIX Short-Term Futures (SVXY), to capture part of the U.S. stock market volatility risk premium by shorting short-term S&P 500 Index implied volatility (VIX) futures. SVXY has a change in investment objective at the end of February 2018 (see “Using SVXY to Capture the Volatility Risk Premium”).
• Second, capturing upside volatility and managing drawdown of this portfolio via gain-skimming to a cash position.

We assume equal initial allocations of $10,000 to each of the three risky assets. We execute a monthly skim as follows: (1) if the risky assets have month-end combined value less than combined initial allocations ($30,000), we rebalance to equal weights for next month; or, (2) if the risky assets have combined month-end value greater than combined initial allocations, we rebalance to initial allocations and move the excess permanently (skim) to cash. We conservatively assume monthly portfolio reformation frictions of 1% of month-end combined value of risky assets. We assume accrued skimmed cash earns the 3-month U.S. Treasury bill (T-bill) yield. Using monthly prices of GBTC, GDXJ and SVXY adjusted for splits and dividends and contemporaneous T-bill yield during May 2015 (limited by GBTC) through June 2019, we find that:

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How should investors evaluate the effectiveness of a safe haven asset? In their July 2020 paper entitled “A Safe Haven Index”, Dirk Baur and Thomas Dimpfl devise and apply a safe haven index (SHI) to evaluate over 20 individual potential safe haven assets. SHI consists of seven equal-weighted assets: gold, Swiss franc, Japanese yen, 2-year, 10-year and 30-year U.S. Treasuries and 10-year German government bonds. For evaluations, they focus on four safe haven events: the October 1987 stock market crash, the September 2001 terrorist attacks, the September 2008 Lehman collapse and the March 2020 COVID-19 pandemic. Using daily data for index components and other potential safe haven assets as available during January 1985 through May 2020, they find that:

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Can investors use leveraged exchange-traded funds (ETF) to construct attractive versions of simple 60%/40% (60/40) and 40%/60% (40/60) stocks-bonds portfolios? In their March 2020 presentation package entitled “Robust Leveraged ETF Portfolios Extending Classic 40/60 Portfolios and Portfolio Insurance”, flagged by a subscriber, Mikhail Smirnov and Alexander Smirnov consider several variations of classic stocks/bonds portfolio as implemented with leveraged ETFs. They ultimately focus on a monthly rebalanced partially 3X-leveraged portfolio consisting of:

• 40% ProShares UltraPro QQQ (TQQQ)
• 20% Direxion Daily 20+ Year Treasury Bull 3X Shares (TMF)
• 40% iShares 20+ Year Treasury Bond ETF (TLT)

To verify findings, we consider this portfolio and several 60/40 and 40/60 stocks/bonds portfolios. We look at net monthly performance statistics, along with compound annual growth rate (CAGR), maximum drawdown (MaxDD) based on monthly data and annual Sharpe ratio. To estimate monthly rebalancing frictions, we use 0.5% of amount traded each month. We use average monthly 3-month U.S. Treasury bill yield during a year as the risk-free rate in Sharpe ratio calculations for that year. Using monthly adjusted prices for TQQQ, TMF, TLT and for SPDR S&P 500 ETF Trust (SPY) and Invesco QQQ Trust (QQQ) to construct benchmarks during February 2010 (limited by TQQQ inception) through June 2020, we find that: Keep Reading

A subscriber requested review of a strategy that seeks to exploit “Sell in May” by switching between risk-on assets during November-April and risk-off assets during May-October, with assets specified as follows:

• Risk-on – SPDR S&P 500 (SPY), iShares Russell 2000 Index (IWM) and PowerShares DWA Technical Leaders (PDP).
• Risk-off – iShares Barclays 20+ Year Treas Bond (TLT) and PowerShares S&P 500 Low Volatility (SPLV).

On each portfolio switch date, assets receive equal weight with 0.25% overall penalty for trading frictions. We focus on compound annual growth rate (CAGR), maximum drawdown (MaxDD) measured at 6-month intervals and Sharpe ratio measured at 6-month intervals as key performance statistics. As benchmarks, we consider buying and holding SPY, IWM or TLT and a 60%-40% SPY-TLT portfolio rebalanced frictionlessly at the ends of April and October (60-40). Using April and October dividend-adjusted closes of SPY, IWM, PDP, TLT and SPLV as available during October 2002 (first interval with at least one risk-on and one risk-off asset) through April 2020, and contemporaneous 6-month U.S. Treasury bill (T-bill) yield as the risk-free rate, we find that: Keep Reading

A subscriber requested evaluation of a strategy that seeks to exploit U.S stock market reversion after dips by temporarily applying margin. Specifically, the strategy:

• At all times holds the U.S. stock market.
• When the stock market closes down more than 7% from its high over the past year, augments stock market holdings by applying 50% margin.
• Closes each margin position after two months.

To investigate, we assume:

• The S&P 500 Index represents the U.S. stock market for calculating drawdown over the past year (252 trading days).
• SPDR S&P 500 (SPY) represents the market from a portfolio perspective.
• We start a margin augmentation at the same daily close as the drawdown signal by slightly anticipating the drawdown at the close.
• 50% margin is set at the opening of each augmentation and there is no rebalancing to maintain 50% margin during the two months (42 trading days) it is open.
• If S&P 500 Index drawdown over the past year is still greater than 7% after ending a margin augmentation, we start a new margin augmentation at the next close.
• Baseline margin interest is U.S. Treasury bill (T-bill) yield plus 1%, debited daily.
• Baseline one-way trading frictions for starting and ending margin augmentations are 0.1% of margin account value.
• There are no tax implications of trading.

We use buying and holding SPY without margin augmentation as a benchmark. Using daily levels of the S&P 500 Index, daily dividend-adjusted SPY prices and daily T-bill yields from the end of January 1993 (limited by SPY) through May 2020, we find that: Keep Reading