Disparate ETFs Have Common Prospect Measures

by: Peter F. Way, CFA

Professional investment analysts have long (too long) categorized investments in arbitrary, artificial ways, when in fact they all must answer two common questions:

  1. What rate of return will this investment provide while my capital in it is at risk?
  2. How big a loss might have to be taken in the worst probable circumstances?

Neither of these questions is ever really answered by categorizing the investment as a blue-chip value stock, a mutual fund, a corporate bond, a preferred stock, a precious metal commodity pool, an ETF, or a Brazilian small-cap growth stock.

Yet the desirability of all of those types can be measured by answers to the two key questions. And the answers make it possible to compare all kinds of investments on a common footing.

To illustrate, we can pose answers on a number of Exchange Traded Funds that address widely divergent investment media through their holdings. We can ease into the question by looking at just one section of ETFs that have a common description, but pose an array of prospects and exposures - Global and International (ex-US) stocks.

All of these ETFs, about 40 of them, are actively traded on major US stock exchanges. Market-makers in these issues daily are called upon to provide liquidity to complete volume trade orders by big investment funds. With capital temporarily at risk, these market pros hedge their positions to minimize or eliminate their exposures.

What they are willing to pay for the protection, and how it is structured, directly reflects just how far they believe the ETFs' prices could reasonably move. The cost of the hedges comes out of their trade spread profit, so they buy protection carefully, trying to never overspend.

They may have to be either long or short on one trade after another, so their hedging tells both upside and downside price change possibilities, often of different sizes in the same issue, at the same point in time.

Here is a picture of what those forecasts currently look like for the International & Global ETFs.

Access to their forecasts daily over several years allows the collection of experiences across the array of imbalances between upside and downside prospects, stock by stock. The subsequent price history following each level of imbalance tells how well the market pros, collectively, have been able to foresee what may happen next, in stock after stock, under present forecast circumstances.

The "how well" is measured in two dimensions - the ODDS for a profitable outcome, and the size of a likely PAYOFF. A key part of the payoff picture is a sense of what might be expected as the likely worst price move. That payoff part, along with the average size of losses, provides a (quantitatively measured) quality dimension to the #2 question above, concerning RISK.

By combining the history of odds-weighted positive payoffs with the negative ones, simple direct comparisons of question #1, RETURN opportunity, can be made. Here is such a set of comparisons for the International and Global ETFs previously mentioned.

The ETFs now having large upside forecasts relative to downside or drawdown exposure are at the left side of this picture, while the opposite are on the right. The vertical bars measure how the forecasts have carried through to price change opportunities in the 3 months following such prior forecasts.

Where the results are contrary to pattern, as in ProShares UltraShort MSCI Brazil (BZQ), iShares MSCI Mexico Investable Mkt Idx (EWW), Vanguard MSCI Emerging Markets ETF (VWO), and Market Vectors Agribusiness ETF (MOO), the implication is that the forecasters often missed on their outlooks in the past, and may again in the future.

To sharpen comparative evaluations between all these alternatives and focus on rate of returns instead of simple size of return, a further, time disciplined test usually is helpful.

By using the top of each issue's prior forecasts as a sell target, and by limiting all holding periods to 3 months after the forecast date with arbitrary closeouts at that point if targets not previously reached, a scorecard (of 1+% price change) can be cumulated, geometrically. This, coupled with the average length of each holding (some shorter due to an early reach of the target), provides an average daily rate (as the nth root), and its expansion into the more recognizable annual rate.

The data for the top-rated Odds&Payoffs ETFs in the group are as follows:

ProShares UltraShort MSCI Europe (EPV),Market Vectors Brazil Small-Cap ETF (BRF), iShares MSCI Chile Investable Mkt Idx (ECH)

Cumulative Average Annual Maximum
1 + Gain Days Held Rate Drawdown
EPV 1.141 53 87% -8%
BRF 1.050 33 45% -9%
ECH 1.028 36 21% -7%
And for other popular issues:
AAPL 1.068 27 76% -2%
PCLN 1.100 31 115% -4%
EDC 1.117 51 54% -16%

In the above table, the days held are market days, of which there are 252 in a year. And the maximum drawdowns are the average experienced only subsequent to forecasts like their current appraisals.

EPV is an ETF tracking the MSCI Europe index, but INVERSELY. Here is a picture of the market-makers price-range forecasts for EPV over the past 6 months. This not a high-low-close chart; the vertical bars are forecasts of prices yet to come.

Please note how similar EPV's current price in relation to its present forecast range is in comparison to its March, 2012 situation. In late May the ETF's price clearly rose above the $45-46 top-of-forecast-range sell targets set in mid-March. These are +30% gains.

Market-makers now seem to have a strong suspicion that despite a lot of strong ECB talk, much of the current-day whistling past the Euro's open-graveyard-plot is likely to get really scary.

Taking the analysis back to the original two questions, BRF is an ETF holding Brazilian small-cap stocks. Maybe its imputed appeal for market-makers is its absence from Europe. In any event, ECH, an ETF holding Chilean stocks is not all that different from BRF in geography, but seems to be substantially less promising in terms of its past performance.

Driving home the point of comparability, despite conventional categorizations, all the following have separate appeals and promised attractions: Apple (AAPL) and Priceline (PCLN) stocks, and Direxion Daily Emrg Mkts Bull 3X Shares (EDC), an ETF tracking long holdings of the MSCI Emerging Markets Index with a (3x) price leverage built into the investment's structure (operationally, not by borrowing).

EDC illustrates the risk-return tradeoff by its big average maximum drawdowns experienced in the pursuit of profits from prior forecasts like the present.

The ability to compare even more diverse ETF investment prospects may be demonstrated in another coming article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.