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, Blockdesk (1,461 clicks)
ETF investing, CFA, portfolio strategy, long/short equity
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Summary

  • The price of investment reward is endured risk, in the form of (hopefully) temporary encounters of loss of capital.
  • Investor values pit forecast (expected) profit against the prospects of emotional stress of such experienced risk.
  • Only the individual can say what makes for him a good value in units of profit per unit of risk. Equity investing is shopping in the market.
  • But he/she needs to know how much of each condition is likely in all the viable investment candidates that may be chosen from.
  • And both dimensions – profit and risk – are constantly changing as market prices change.

Start by recognizing risk isn't what you've constantly been told it is

Uncertainty may (and does) contain risk, but it also contains reward as part of the noise being measured by "standard deviation of 'returns'". Risk has to do with getting hurt, not by encountering pleasant surprises. Price drawdowns are the risk part of uncertainty that must be separated and measured.

The likelihood of a price drawdown is never a constant through time. It depends importantly on today's price, relative to a lot of things, only a few of which can be suggested by looking back at the past. Risk only lives in the present and in the future. We need to appraise it that way. As of today, not yesterday or months ago.

Our response to that challenge is to find experienced, informed, motivated folks who make such decisions every day under compelling incentives to be as right as is humanly possible. The best candidates we can find, after decades of active investment management, are the people of the market-making community. They can be found on the block-trade desks and proprietary trading desks of the major (formerly brokerage, now "investment banking") firms.

Those pros have no desire to be helpful to potential competitors or unintentional interferers impeding their ability to service their big-money-fund clients. Clients with the money muscle to actually move prices. Clients they talk with dozens of times a day, as they have for years, and whose habits they know quite well.

Fortunately, though, to do their jobs, they make market capacities flex by putting firm capital at risk temporarily. But never without risk protection (which the client ultimately pays for). It is the size and type of protection and its cost that the block desk, prop-desk, and client demand and agree to that tells what price limits are likely to be tested in coming days for the volume trade being filled in each stock or ETF.

Those price range limits are often asymmetrically arrayed around today's market quote. Upside and downside potentials differ from day to day, and so do risk prospects. True risk perceptions are not a constant, but choices between alternatives involving them must be made at specific times of portfolio management decisions. So comparative data needs to be available at those times.

Today's example of best ETF reward-risk comparisons

Here is how the top ten most interesting ETFs (out of 337 with forecasts currently made today) compare among themselves, and with the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) as a market proxy, and against the background of that large population of actively traded ETFs and the even larger population including them and some 2500+ equities.

The ETFs have been screened to ensure forecast histories of at least 3-5 years, daily, with upside prospects of at least 8%+ and odds of profitable test results of at least 6 out of 8 from every prior like forecast. Then, they have been ranked in the table based on the reward-to-risk ratios of column (14), where the true risk cost (6) per unit of reward expected (5) is compared.

The "top ten" contain both leveraged and unleveraged ETFs, short-structured and conventional "long" posture ETFs to underscore the notion that with the right descriptions, comparisons can be made between even the most dissimilar investments.

(click to enlarge)

A quick explanation of the less-obvious numbered columns: (5) is the % change between (4) and (2). (12) tells, out of the total number of forecast days available, that sample number of those days with Range Indexes like the present. The Range Index (7) is the percentage of the forecast range (2 to 3) that lies below the forecast day market price (4). Using the prior sample in (12) to follow a standard, simple, time-efficient holding discipline, (8) indicates the percentage of them that were profitable, (9) the average net gain on all such holdings, (10) tells how long, on average, the samples were held, and (11) the rate created by (9) and (10). (13) measures the credibility of (5) given (9), and (14) compares (5) to (6).

Please invest the time and effort it may take to understand the dose that is inflicted by all of those ( )s in the prior paragraph. The data does provide a useful way to compare some not-so-simple, but realistic, investment considerations.

For example, the critical starting point in each is the benefit being offered by each forecast in (5), largest for the Direxion Emerging Markets Bear 3X Shares ETF (NYSEARCA:EDZ), smallest for ProShares UltraPro MidCap 400 ETF (NYSEARCA:UMDD). Past experiences of (9) say ProShares UltraPro Russell 2000 ETF (NYSEARCA:URTY)'s 14.0%+ is most credible of the group, and those of EDZ are the least believable.

Where investment policy comes in

What is the investment mission? The purpose of the ongoing exercise? For many investors these days, it is an effort to build personal wealth resources for future hard-to define needs of retirement or family interim needs provisions for housing or offspring's education.

What reasonable risk prices can be paid to acquire wealth increments? For a younger family, the advantage of a longer time horizon moderates the need for large return increments, but the shared domestic responsibilities constrains the scale of acceptable loss that could be endured by a single near-retirement or recently unemployed individual in pursuit of more urgent accomplishments.

The test results of prior forecasts are simply aids to perspective of what may be more or less likely capable of being accomplished; they have no guarantee of being repeated. But they may be helpful in guiding preferences as getting whichever job is at hand best done.

Conclusion

The young family may sensibly favor the unleveraged iShares Nasdaq Biotechnology ETF (NASDAQ:IBB), the SPDR S&P Biotech ETF (NYSEARCA:XBI), and the iShares China Large-Cap ETF (NYSEARCA:FXI) with past drawdowns of only -2% over the far higher-risk, high-return, 3X-leveraged URTY that may logically appeal to the near-retiree or unemployed individual with pressures of a shorter time horizon.

But none of these are validated for long-term holds. Instead, they can be advantageous buys at these prices, to be sold at rewarding gains when reaching their forecast tops.

All may do well to avoid the siren song of the big-promise, small -fulfillment, short-posture EDZ and the Direxion Daily Gold Miners Bear 3x Shares ETF (NYSEARCA:DUST), or the Direxion Russell 2000 Bullish 3X ETF (NYSEARCA:TNA) whose payoffs are likely to turn out to be a poor reward for big drawdown ordeals.

The prospects of a market-proxy SPDR S&P 500 Trust ETF offering a less-than 6%+ payoff, with actual achievements of little more than half of that, are a warning that market pros see some tough times ahead in the near future for broad market indexes. It is evident that selectivity is an essential, currently.

That message is reinforced when looking at the population averages for equities at large, with achieved payoffs at present Range Index forecasts of only 4.6%+, while promising 3 times as much at 13.5%+. And ETFs at large are even worse at these prices, whispering hopes for 8-9% average gains, while having delivered barely more than 1%. Shades of past mutual fund delusions.

Source: ETF Best Buys Today, On A Wealth-Builder's Value Scale