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Paul Allen has worked in the securities industry since 1998. Prior to his engagement with www.WallStreetCourier.com in 2009, he has been working for several top tier investment banks. Right now, Allen's position is Head of Quantitative/Technical Market Analysis. WallStreetCourier.com is an... More
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  • Large Institutional Investors Are Betting Against The Greenback!

    The Fed has caused a sell-off in the Power Shares DB US Dollar Index Bullish (UUP) recently, by announcing QE3. The Power Shares U.S. Dollar Index Bullish tracks the dollar against a weighted basket of the Euro, British Pound, Yen, Swedish Krona, Swiss Franc and the Canadian Dollar. This sell-off is a reaction to the open end asset purchases by the Fed and this current environment seems to be quite dollar-negative and carry-positive when we look at the anchor funding rates. In the past week, the dollar regained some of its big losses in the aftermath of QE3, cutting a losing streak of 4 weeks.

    Nevertheless, large institutional investors are betting heavily against the dollar, according to the Commitment of Traders Report, which was published last Tuesday (Chart 1). The Commodity Futures Trading Commission (CFTC) provides inside information about purchases and sales of different futures contracts. The largest players in each futures market are required to disclose their positions to the CFTC on a daily basis and this report is released on a weekly basis. These traders are separated into Commercial Hedgers and Large Traders. While Large Traders are commonly equated with hedge funds, they may also include Commodity Pool Operators and other managed accounts as well as large institutional investors.

    If we have a closer look at the chart 1, we can see that the net positions of all aggregated large traders have hit a new yearly low, indicating that they have reduced their dollar positions significantly. As the market is driven by supply and demand, it is definitely worth to take a regularly look what those big institutional investors are doing.

    (click to enlarge)Net Positions Large Traders

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Tags: UUP, forex
    Sep 23 1:13 PM | Link | Comment!
  • Why You Should Avoid Mutual Funds With A High Tracking Error!

    In general, all investment returns of actively managed mutual funds can be seen as a combination of alpha (excess returns) and beta (market returns). So investing in an actively managed mutual fund is a decision to get a blend of a possible alpha and beta.

    If an active managed fund has a high tracking error relative to its underlying index, the manager seeks to generate returns in excess of his benchmark. A tracking error is the difference between the performance of a fund and the performance of its underlying benchmark/index. For that reason, fund managers with a higher tracking error have the potential to outperform their benchmark in bull markets while achieving a degree of capital preservation relative to their benchmarks in declining markets. That is basically the main reason why retail investors are getting exposed to actively managed mutual funds.

    For example, according to Fidelity's website, the Fidelity Select Technology Fund (FSPTX) invests primarily in companies which processes products or services that will provide or will benefit significantly from technological advances and improvements. However, no benchmark was mentioned on their website. As this fund focuses on technology and is mainly invested in the U.S. we compare that mutual fund with the Technology Select Sector SPDR (XLK) and indeed it might be a suitable benchmark (Chart 1), since the correlation coefficient between the fund and the XLK is around 0.96! In other words, in 96 percent of all cases, the actively managed fund (FSPTX) as well as the Technology Select Sector SPDR are moving in the same direction.

    (click to enlarge)

    Benchmark XLE(Chart 1)

    If the mutual fund is outperforming its benchmark, investors would not mind to pay for the additional alpha, as the fund manager was able to pick the right stocks. However, measuring alpha can be quite tricky. For example, if a fund manager claims his benchmark is the S&P 500 (IVV), but he might mainly invest in higher-beta stocks within the Russell 2000 (IWM), he will mostly outperform the S&P 500 during good market conditions. In such a case, investors will only get expensive beta returns, although they are paying for alpha. However, since no benchmark was put on Fidelity's website, investors just can guess about the degree of pure alpha, the fund has delivered so far, although the fund was outperforming clearly our selected benchmark.

    Instead of investing in actively managed funds with a high tracking error, investors can easily get exposed to the underlying market through inexpensive and easily achievable exchange-traded funds. In addition, if they want to achieve an outperformance versus their market of choice, they can easily create a so called active beta core-satellite portfolio consisting of different exchange-traded-funds.

    The active beta core-satellite portfolio is a strategy, where the core of the portfolio consists of a passive investment that tracks the benchmark of choice. Additional positions, known as satellites, are added to the portfolio, to achieve a possible outperformance. Since a possible outperformance is generated by adding different beta markets, investors will not get any additional alpha, instead they will just purely benefit from the diversification effect, which should lead to the same results: to outperform the underlying benchmark in bull markets while achieving a degree of capital preservation relative to their benchmarks in times of market turbulences.

    In our article, we investigate if an active-beta portfolio with a similar tracking error relative to the Technology Select Sector SPDR will achieve better results than the actively managed fund.

    According to our calculation, the Fidelity Select Technology Fund (FSPTX) has an annualized tracking error of 9.4 percent relative to the Technology Select Sector SPDR (from 2003-05-05 until 2012-08-21). We have created an active-beta portfolio that has nearly a same annualized one year tracking error relative to the XLK like the Fidelity Fund.

    In our example this active-beta portfolio consists of following:

    • 50 percent in Technology Select Sector SPDR ,

    • 15 percent in iShares Barclays 20+ Yr Treasury Bond (TLT) and

    • 35 percent iShares MSCI Emerging Markets Index (EEM).

    • There is no allowance for transaction costs or brokerage fees.

    If we have a look at Chart 2 we can see, that the annualized one year rolling tracking error of the active-beta portfolio relative to the XLK is quite similar compared to the tracking error of the Fidelity Fund.

    (click to enlarge)

    Rolling Tracking Error(Chart 2)

    Table 1 presents the results of our back tests from 2003/05/05 until 2012/08/21. The active-beta portfolio has clearly outperformed both, the active managed fund as well as the underlying benchmark.

    Performance Ratios

    The active-beta portfolio has an annualized return of 10.8% while the Fidelity fund has only generated an annualized rate of return of 9.7%. More importantly, on a risk-adjusted basis (Sharpe Ratio), the active-beta portfolio is strongly outperforming both (Chart 3), the actively managed fund as well as the XLK.

    (click to enlarge)Historical Performance(Chart 3)

    If we have a closer look on draw down numbers, we can see that the active-beta portfolio has the lowest maximum draw down. The maximum loss for the active beta portfolio was only 49.2 percent compared to 61.2 percent for Fidelity Select Technology Fund. In total, the active-beta portfolio was reaching a new high after 183 days compared to 158 weeks for the actively managed fund.

    (click to enlarge)Drawdowns AB

    (click to enlarge)Drawdowns Fund

    (click to enlarge)Drawdowns BM

    The bottom line: The potential to outperform the benchmark is one main advantage that actively managed funds have over passive ETFs, and this might be the only reason why investors are getting exposed to them. Unfortunately, evidence that actively-managed funds can consistently outperform their relevant index is difficult to find. Fund managers are getting paid for creating alpha through stock picking and not for market timing skills. For that reason, they are often permanently fully invested, even in times of market turbulences. The problem is that only 30 percent of a typical stock's performance is determined by company specific issues while the remaining 70 percent are external factors, according to a Morgan Stanley research which was published in early May this year. For that reason, it might be better for retail investors, to create their own active beta core-satellite portfolio, instead of relying on the investment managers' stock picking skills.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Aug 23 3:25 PM | Link | Comment!
  • Behind The Myth Of The 10 Best Days!

    Last week, all major U.S. averages posted the biggest weekly gain of 2012, and this event has made headlines in the financial media. For sure, some investors who decided to stay at the sidelines during the European crisis, have missed out last week's performance, have fallen victim to the so called "Do not Miss the Ten Best Days"-theory, which has been promoted by the mutual fund industry for many years.

    The so called "Do not Miss the Ten Best" indicates that investors who just missed out the best 10 days, their return would be then dramatically reduced. The so called "Do not Miss the Ten Best" indicates that investors who just missed out the best 10 days, their returns would be then dramatically reduced.

    Looking back at the performance of the S&P 500 or the IVV, since 1950, an investor who missed out the best 10 best performing days would have ended up with a portfolio worth 53 percent less than one that had followed a buy and hold strategy. Investors, who missed out the worst 10 days, would have gained 146 percent more than the broad S&P 500 (Chart 1).

    (click to enlarge)Historical Performance

    (Chart 1)

    However, statistically those numbers do not look at the specific dates on those best/worst days appeared. The best days tend to be in close proximity to the worst days (Table 1). Investors who sold and remained out of the market (IVV) after it fell 20.5 percent on Black Monday (October 19, 1987), would have missed the 9.1 percent rally which would occurred just two days later. An investor who threw in the towel after the market declined 7.6 percent on October 9, 2008, would have missed the biggest one-day gain in history, when the S&P 500 rallied 11.6 percent.

    Days of Best/Worst Days IVV

    (Table 1)

    Theoretically, if an investor would have just stayed out of the market for the whole week, where one of those best days have had occurred, he would have had a great chance to miss one of the worst days as well (Chart 1). In total, such an investor would have ended up with a portfolio worth $23,057, compared to just $16,212 for the one that had followed a buy and hold strategy (Chart 1)!

    A possible reason for this outcome might be the fact that volatility tends to be higher when the market is in a longer lasting down-turn. This phenomenon is well described in "The Misbehavior of Markets" by Mandelbrot. He states, that high volatility within the market mostly appears in clusters and for that reason, returns remain high, in both directions.

    To prove this statement, we have used a simple 200 day moving average. The 200 day moving average is a very simple and well known technical market indicator. It helps to determine the overall market's health, since a market that is trading above its 200 day moving average is being considerate to be in a long term uptrend and the other way round. Interestingly, 9 out of 10 worst- and 10 out of 10 best days have occurred, when the S&P 500 has trades below its 200 day moving average.

    The bottom line: If you have missed the recent rally, it would not have been as tragic as some marketing prospects from mutual fund companies may state. More importantly, investors should stick to their chosen investment approach and should try to avoid emotional driven investing which is based on greed and fear caused by financial headlines.

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

    Jun 13 12:42 PM | Link | Comment!
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