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, Blockdesk (2,113 clicks)
ETF investing, CFA, portfolio strategy, long/short equity
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Investors may have a variety of reasons for putting capital at risk. They may be seeking additional income outside of employment; accumulating capital against known, scheduled expenses (like college costs for offspring); building financial reserves against unknown hazards; preparing for a comfortable retirement; or even as a means of excitement and amusement.

We focus in this article on wealth-building by capital appreciation in equity investments. Special attention is given to the efficient use (and investment) of time in the process. Our reasons for these concerns are outlined in this previous article.

Income investors and pure defensive capital-protecting investors will likely find a more productive and comforting expenditure of their time and attention elsewhere.

What's Important in Wealth-Building

The four key issues are the same as they have always been: 1) Selection, 2) Timing, 3) Risk, and 4) Reward. We offer for consideration an integrated approach to dealing with all of these in a flexible, adaptable framework that can be easily understood and tailored to individual preferences. But many folks find it runs counter to what is traditionally held to be "acceptable, conservative, proper, and conventional" ways to manage one's investment capital.

The justification for this approach is that we bring to the table both a perspective that is not generally recognized, embraced or utilized, and well-established evidence of the effectiveness of that perspective. In short, we play the game in a very different way.

We see the investment arena and activities within it as an extremely serious game, where players vary widely in the resources of capital, intelligence, information, and perspective that they can command. Styles and intensity of competition are constantly evolving, and the surrounding environment is very complex and changing. Challenges are everywhere.

Overlaid on all this is an uncomfortable reality. Most equity investing takes place in a secondary market for existing securities, and is largely a zero-sum game where the winner takes from the loser. Every outcome depends upon the subsequent actions of other participating players.

Over 50 years of active involvement in these markets in a variety of roles, dealing with capital in eight- and nine-figure amounts, has led us to the realization that no static "mechanical" or relationship-rules-based model can provide much help in appraising "value." Nor, more importantly, as to indicating where prices of specific securities are likely to be in the future, relative to where they are now.

So is it all a futile, pure-chance, self-deception activity?

Insight into future prices has to be an essential objective in the mission of wealth-building. It need not be without purpose, plan, or strategy, simply because others do it poorly. Indeed, that provides us with a significant advantage.

We recognize our own disadvantages, in competition with other players in the game. To be effective competitors, we need to have help from those who are well-endowed with the resources most likely to support and ensure success. We also recognize that such players justifiably desire to protect their advantages and resist the actions of others to encroach on their empires.

Since our interest principally focuses on future price movement of securities, rather than any promised compensation for the use of capital (dividends or interest), our attention is drawn to those who may be most likely to cause price changes, and those who maintain informed opinions about the potentials for such change.

Markets respond to the pressures of money seeking employment and money seeking relief from perceived risk exposure. Money moves markets, and the bigger the money being applied, the more likely is there to be significant movement.

Big money presence typically is the result of capital collected from large numbers of investors by a limited number of professional investment managers. Such assignments may be either temporary -- as in Mutual Funds, Hedge Funds, Investment Counselors, Financial consultants and planners -- or on a more permanent basis, as in retirement funds, endowments of not-for-profit organizations, and trusts set up for a variety of purposes.

Those professional managers recognize the need to actively manage the assets under their control because of the continuously changing environment. They seek future improvements in price for specific holdings by making tactical changes. Because of the scale of assets involved, changes in emphasis among holdings frequently tax the availability in equity markets to accommodate desired transactions. The fund managers regularly seek the help of market-making "block-trade" organizations to bring about a sufficient volume of willing participants to take "the other side of the trade" to get the proposed deal "filled." Often those facilitators find it necessary to temporarily commit their own firm's capital to the stub end of the trade that the market will not accommodate.

Thousands of such trades occur each day, and are a major cause of price changes, due to the "lumpy" nature of their presence in the marketplace. The oft-described presence of apparent major transaction volume from "High-Frequency Trading" [HFT], deals in relatively small orders, in great frequency, seeking tiny price changes in most cases. They are more likely to be a price-stabilizing influence than a sizable price-moving presence most of the time. Attention to them occurs most when some rare, infrequent but near-catastrophic, accidental event requires correction.

Fortunately for our interests, the market-making operations of the major "investment banking" organizations that facilitate block trades seek to minimize the risk exposures of their capital that are necessary in doing their job. That maximizes their capital available for such tasks. They hedge, or buy protective insurance against unwanted price moves, in the course of "providing market liquidity" that gets the big-money trades accomplished. The ones that frequently move prices.

Sellers of the insurance are typically the proprietary-trading (prop) desks of other market-making firms.

It turns out that what the market-makers [MMs] will pay for protection, and the way they structure it, tells just how far they believe their big-money clients are likely to push prices, both up and down, in the near future. So we conduct an analysis of the informed, rational, and intelligent behavior of these market professionals. That lets us monitor their expectations of what is likely to be seen in the future prices of over 2,000 stocks and Exchange Traded Funds [ETFs].

So, now we have reliable price forecasts?

Not necessarily. The MMs get a lot more exercise in some stocks than others. Some stocks are easier to understand and anticipate than others. Conditions change. Uncertainty is present everywhere, all the time. Everything becomes a matter of probability or odds, not certainty.

So we maintain a daily updated record of how well the MMs' past guesses about future prices were actually borne out in subsequent market experience. Besides there being differences in forecast ability between stocks, there are important reliability differences within each stock's forecasts, depending upon the balance seen between upside and downside prospects. Every stock is different, and has its own character of perceptions by the MMs.

These complications provide welcome assistance in guiding choices between alternatives when it comes to putting capital at risk. We have explicit comparative metrics of damaging risk exposure, not the fuzzy, imprecise notions of statistical uncertainty that are baked into investment theories like CAPM. That problem is part of the theory's growing sense of rejection by investment professionals.

To provide a better sense of how this information deals with those four key concerns of selection, timing, risk and reward, let's look at an array of how a group of ETFs are currently being appraised by the MM community, and how those evaluations differ in dealing with the various investor concerns.

To begin with, the basic information metric for each security is a range of prices that is being held likely enough to occur that the MM community is willing to commit some of what could be a trade-spread profit to protect against its possible happening. The extremes of each possible price range, in comparison with the current market quote provide separate (and often unequal) upside and downside price change prospects.

Here is a map of those dimensions for the example group of ETFs we are to use as illustrations.

(click to enlarge)

(used with permission)

In this plot, ETFs with the most upside vs. downside are in the green lower-right area, and the scary ones with lots more downside and little upside are in the yellow, upper left. ETFs with equal upside and downside are along the diagonal.

The ETF at [15] is Direxion Daily Emerging Markets Bull shares (NYSEARCA:EDC), a (3x) structurally leveraged tracker of the MSCI index of stocks in emerging markets. The one at [9] is ProShares Ultra FTSE China 25 (NYSEARCA:XPP), a (2x) leveraged ETF tracking an index of the 25 most liquid and active Chinese stocks on the Hong Kong exchange.

In contrast, [23] is a (2x) leveraged ETF by ProShares Ultra (NYSEARCA:USD) that tracks an index of semiconductor stocks. The (2x) leveraged ETF at [21] tracks the S&P 400 index of mid-cap stocks, and goes by the name of ProShares Ultra Midcap 400 (NYSEARCA:MVV).

Please note the advantage of being able to directly compare the prospects for a specific industry's investments with international investments of both a general theme (economic emergence) and a specific country [China], with an index based on capitalization size of the index's components. These are hardly apples-to-apples comparisons as to subject matter, but very much so as to the ultimate objectives being sought.

While investors should want to have diversification of interests in their portfolios, they need the means of selecting at any time those areas with the best available prospects. That avoids overlooking productive alternatives, but requires restraint in overloading currently "hot" topics.

If this Reward~Risk map were sufficient to guide capital commitment choices, then we could execute desirable changes, if any, and go off fishing. Unfortunately, it's not quite that simple.

Beauty and value are in the eye of the beholder

These forecasts are the perceptions of knowledgeable, informed, market professionals, honed to a common denominator by protection money spent, negotiated by similarly-resourced buyers and sellers of the insurance, each attempting to avoid likely problems, at a best price possible. But the future is a treacherous place, and some estimations may be easier to make correctly than others.

So it is important to have a sense of how well this market-making community has fared in the past after making forecasts similar to those appearing today. Our experience is that the balance between upside payoff prospects and likely drawdown price risk exposures is an important consideration in evaluating their prior achievements.

To simplify subsequent comparisons, we have a metric called the Range Index [RI]. It reports the percentage of the price range being forecast that lies below the current market quote. So a low or negative RI offers a larger reward potential, and a high RI poses a possibly large risk exposure. Since few investors are willing to expose capital to risk without the possibility of a reward advantage, experience has shown RIs over time average numbers in the low 40s. Corollary: You want willing coin-flippers at your regular poker game.

Here, for the ETFs mapped above, is a table of meaningful dimensions stemming from actual market experiences where all prior RIs not higher than the present forecast have been considered. The right-most columns indicate how many market days of forecasts in the last 5 years are available, and the number of days of that total meeting the RI test.

(click to enlarge)(click to enlarge)

The table has been ranked by the size of upside percentage price change between the "price now" at date of analysis and the upper end of the forecast range, often taken as a sell target. The quality of those forecast offerings may be conditioned by a number of considerations. The first one may need to involve the length of time forecasts have been available, and the adequacy in number of the qualifying RI sample from which several dimensions have been calculated.

Making tradeoffs to fit personal preferences

For example, the only 9 RI experiences that EDC has had prior to today's, while small, may be acceptable given its fairly extreme RI of 8. That RI implies an upside 11-12 times, larger than its downside, likely to be an uncommon occurrence, even during four years.

In contrast, the mere 3 prior instances of BOIL's current RI of 18 are far less comforting, particularly given its limited background of only 297 forecasts, not a lot more than one year's 252 market days.

The upsides prospects for both UVXY and NUGT exceed both BOIL and EDC, but do so with much larger risk exposure experiences. The numbers in the column to the right of the sell target column are not just the downside price change forecast. Instead, they reveal the worst emotional pressures experienced at any point before closeout, on average, of hypothetical holdings from the qualifying RIs. Clearly, UVXY and NUGT have taken holders on many a thrill ride.

Now let's look at the "bright" side, the payoff averages. Those same thrill rides when ended, produced average gains for UVXY of less than +1%, and for NUGT an average loss of -16%. Does that make NUGT a bad investment? At this time, yes. But not at all times. Different forecast RIs logically produce different odds and payoff histories.

Now NUGT's RI is 50, meaning as much downside in prospect as up. In comparison, UVXY at a RI of 35 has about twice as much upside as down, in the eyes (and guts) of the MM community. But is that a fair comparison?

One of my more memorable college professors would respond to such fairness complaints with the rejoinder: "30 days hath September, April, June, and November; all the rest have 31 except for February, and it has 28. Now, is that fair?" His meaning, of course is that some things are the way they are and little can be done about it. The world is not always a fair place.

The market at this point of comparison offers UVXY, NUGT, BOIL, and EDC the way that they are now perceived. Tomorrow will probably bring a different view, but decisions may need to be made now with what we have now.

An appraisal of how attractive may be each of the possible alternatives in this table may also be colored by other considerations. Like how the forecast upside to a sell target compares in size with prior average accomplishments, and what the frequency of losses has been. A BOIL upside of +21% looks quite doable in light of priors of +33%. And its win ratio of 100 out of 100 is exciting! That is, until we reflect on the wins being really 3 out of 3, in about only one year's market exposure. The fact that BOIL's 33% gains happened in less than a month's average holding periods, generating huge annual rates adds to the credibility question of: Can they be repeated?

But for EDC, the near +20% upside seen seems much more reasonable, given priors of +25%. While not numerous, its prior experiences occurred during a 4+ year period, when forecasts suggested quite a favorable balance between wins and losses. Indeed, EDC won in all those outings, and it took some seven weeks on average to accomplish those feats.

The candidates next in line, from an upside prospect ranking, have less sizable payoff histories and much poorer win-loss ratios. Further down, RUSL has a 7 out of 8 (or 88 of 100) win ratio, but experienced maximum drawdowns 1 1/2 times its upside forecast, over a shorter market history. TNA's forecast upside is not strongly supported by its average payoff experience, and the RI of 53 has more downside in view than upside. There might be peculiar portfolio considerations making them superior to an EDC, but here at least the differentials are spelled out.

The fourth consideration -- timing

Selection, conditioned by the reward and risk dimensions as presented, may lead one to a particular preference -- for now. But is "now" the time to commit capital to any selection? We offer no perfect answer for that issue, except that capital is only productive while it is working. When it is not, its role is simply defensive. Maybe in some circumstances that may be the best defense possible.

But most of the time employed capital is the better answer. Even in periods of stress and general despair, there are usually equity investments that are rewarding, without undue trauma. Sometimes it is because they have already been through the worst of the difficulties and their price reflects it.

The other dimension of the timing question is more thoroughly explored in the articles on timing and on the need for sell targets. The availability of how price range forecasts have trended over time sometimes may contribute to this matter. Here is the past 2-year history of USD's daily real-time forecasts (vertical-line future price range forecasts and contemporary actual price dots), displayed once a week:

(click to enlarge)

(click to enlarge)

(used with permission)

Our standard performance test would probably have closed out any recent buys of USD since its current price is above the tops of most forecasts (sell targets) in the past two months. But for longer-intentioned holdings, an artistic visual evaluation of this history picture suggests that continued holding now at this point may invite losses that could become troublesome.

Wealth-building disciplines should avoid losses where possible, or at least seek their minimization. One of the ways to do this is by the maintenance of an end-of-day check of current holdings' market prices against their cost prices. Drawdowns beyond some personally set standard, kept private to one's self, (not posted as "stop" orders) should cause at least some concern as a warning, if not a next-day closeout.

Such liquidated capital should immediately be put back to work in the most desirable alternative present at the time. Unless, of course, a major strategic decision has been made to be more defensive by increasing the portfolio's allocation to cash.

Conclusions

Our experience in monitoring over a decade of market-maker forecasts made daily is that there are, with rare exceptions, usually profitable opportunities available to put capital to productive (wealth-building) work within disciplined procedures. That takes daily attention, patience, clear goal-setting, clear thinking and emotional restraint.

For most investors this requires and becomes a second job. So don't quit the "day job," even if it looks like the second one might be better than the first. If you're in that position, it may mean that the day job has given the emotional support needed frequently to withstand the inevitable strains of investing.

If investing is the only "job," be sure to find an emotional support from some other source -- family, partner, hobby, travel, or other healthy recreational diversions. An important part of success in this endeavor is to avoid making big "dumb" decisions under stress.

"Saving" is a good characteristic to encourage, if you are enamored of "pennies," but the "dollars" will not take care of themselves to the extent that many folks in this day and age need.

Diligent, deliberate and disciplined programs centered in equity price appreciation are the most likely means to build the capital to meet the needs that most ambitious people are bound to encounter across their life spans. Seek help in the process wherever it makes sense to you and is compatible with your objectives and resources. Good luck, and best wishes in developing skill at your pursuit of the mission.

Source: Wealth-Building From ETFs With Good Odds, Big Payoffs