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More ETF Magic

About the only joyous thing about Christmas is that there is a marked slowdown in the amount of junk  mail that hits my inbox. And to be honest I do miss the emails telling me that people have the ideal job for or that Svetlana from Kokshetau in Kazakhstan is desperate to send me pictures of her recently shorn yak. Paradoxically I have not seen a slowdown in the number of emails extolling the virtues; nay magic of index ETF’s. This got me thinking about the nature of indices and their construction. In simplest terms an index is simply an aggregation of stocks design to represent a sector of the market. However, stocks are not simply lumped into a group and passed off as an index, an index can be either price weighted such as the Dow or market value weighted index such as the S&P500.  With the Dow the weighting of each component is a function of its price whereas with the S&P500 components are weighted according to total value of their outstanding shares. Each method of construction results in a different end product.

Because we have two mechanisms of solving the same problem we can compare and contrast what each solution looks like when plotted against one another. This might seem to be a somewhat academic problem and in many ways it is is except when you consider that when being told to buy an international ETF investors are directed towards SPY which is a representation of the S&P500 –  a market weighted index. You might think so what but remember this is not the only way to measure an index and that the folks who create ETFs are nothing if not inventive. As such there is a price weighted version of the S&P500  known as the Guggenheim S&P 500® Equal Weight ETF or RSP

It is therefore easy to compare the performance of these two instruments –

etf

For the period being considered it appears as if the equal weighted version has given the market weighted ETF a bit of a belting. This raises the question as to why do dislocations occur between the performance of two indices constructed using different methodologies and the blindingly obvious answer is that it is the different methodologies account for the different performance. Granted they hold the same stocks but they hold them in different ratios. For example SPY’s largest holding is Apple which makes up 3.12% of its portfolio whereas its holding in RSP is capped at 0.21%. This means that when Apple does well SPY will do well but when it does poorly it will drag the performance down. Equal weighted indices are to some extent insulated against the travails of a single stock.

The existence of instruments such as RSP introduce a layer of complexity for ETF traders since they offer a variation on the theme of index investing that may or may not suit them. Unfortunately, for those who pump magic index ETF systems the world is a little more nuanced than they think it is.

 

The Pot-Belly of Ignorance

What you allow to leak into your head is immensely important.

Increasingly, we’re filling our heads with soundbites, the mental equivalent of junk. Over a day or even a week, the changes, like those to our belly, are barely noticeable. However, if we extend the timeline to months and years, we face a worrying reality and may find ourselves looking down at the pot-belly of ignorance.

More here – Farnham Street

A Metric For Success

One of the joys of experience is experience – you get to see all manner of things and from these these observations you can generalise a series of rules about life in general. A subset of these observations naturally relate to trading and what they have enabled me to do is to with a high degree of accuracy spot people who will and will not make. With any set of markers you have benchmarks that trigger alarms and for me it is relatively simple – if you email me asking what is the cheapest online broker or where can you get free charts then I am certain you will not make it in trading. In fact I am so cocky and arrogant that I will suggest that you wont make it at anything you try. My arrogance stems from a  simple observation. If you send me an email with any of these questions or a variation of these questions it shows that you are lazy and couldn’t be bothered doing the work yourself and lets be honest typing into Google the phrase online broker comparison is not really work.

Lazy people go nowhere.

It Was Going So Well

As followers of the blog will know I have been using my copious free time to experiment with building a new system from the ground up and then testing it live. There is no point testing new theories and ideas within the electronic purity of a computer program unless you are going to put actual money into them and see how you and the system perform under live conditions.  This system contains a mix of long and short time frames and I have been experimenting with the mix of instruments that I bring into the portfolio and I recently added Natural Gas. Interestingly the first trade was a winner, catching the move up from early November. This was interesting because my experience of such things is that the first trade is usually pretty much a dud.  The energy part of this portfolio of which Natural Gas is a part is a true long/short system so it takes every signal that the system generates – in some ways it is a generalised stop and reverse system. So when the system generated a signal in the opposite direction I naturally took it and it looked to be doing well until it was hit by a large intra-day reversal.  This generated another signal in the opposite direction which I took – and here is the rub. The power for this part of the system comes not from its entry signals but rather from its aggressive money management, as such this reversal signal was also stopped out.

NG

Since this is a new system I review the decision making behind each trade to make certain that the rules were followed and whether there is anything that can be learnt from the trade. I am a firm believer that this form of post trade analysis should be part of everyone’s routine but only up to a point. This is in reality a limited amount of information that can be gained from the majority of trades. If you have followed the rules then it is a process of simply accepting the result and moving on. Endless cogitation about what you should have done is largely unhelpful.

When I first started experimenting with stop and reverse systems way back in the day I used to get enormously frustrated at this sport of scenario – I liked the notion of stop and reverse in markets that had a tendency to swing in sentiment such as energy markets but lacked the emotional maturity to deal with inevitable consequences of such an approach. Nowadays I couldn’t give a flying f$5k about the trades. It is mildly annoying when you wake up and see that you have been stopped out for the second time in 24 hours and I dont think that ever goes away. You do need some emotional investment in your own success or failure – to think otherwise is pointless.

The Year In Money

Bloomberg have been busy – click the image below to be taken to the full infographic.

2016

Perception Versus Reality

TableI was digging through my archive of data related junk when I came across the regular (yearly) series called Perils of Perception by Ipsos MORI I was going to include one of the slides from the 2016 deck but the resolution was quite low so I decided to reformat it to make it clearer. The slide I picked related to public perceptions of health spending as a function of GDP versus the actual level of expenditure. Making the data a little clearer yielded the following table.

As you can see there is a staggering difference between what people think their governments spends on health versus what they actually spend – everyone thinks that their government spends more on health than it actually does. What is interesting is that this the sample set covers countries of all levels of economic development and political persuasions and everyone gets it wrong. One might forgive the level headed Scandinavians for thinking their government spends more on health care than they actually do because of their extremely generous and well funded health care network. But everyone got it wrong. Perceptions are crap and are completely inadequate for dealing with the world in a sensible way.

The issue here is that humans are perceptual filters not data crunchers our thinking is often more about what we perceive and feel rather than what we observe and analyse. As such our thinking is easily swayed by not only our internal own bias but also by anything that confirms that bias. This is a feature keenly exploited by politicians who are all too aware that the majority of people lack the skills necessary to think critically about issues. This is enhanced by the echo chamber that is social media and the fact that we seem to be living a new form of Dark Age where data is irrelevant.

The implication for traders should be obvious but it often isn’t. Consider the notion of prediction – prediction is a guess and at this time of the year markets are awash with predictions for next year. These predictions are based largely upon perception and narrative – not data. For example all analysts err on the bullish side when predicting the trajectory of market but experience and common sense tells us that markets also go sideways and down not just up. If analysts were basing their predictions on anything approaching data then the prediction would be a range value that was book ended by error bars. Not good for the mass media but accurate.

In trading the only mechanism we have for combating our tendency to perceive and feel rather than to think is to generate a rules based trading system but even here we run into trouble. Over the years I have seen countless trading plans from investors of all levels of experience. The good ones have clearly defined terms and parameters – they are mechanistic in nature. The bad ones operate more on a sensory level will ill defined terms that could not be followed by anyone other than the plans originator and even then they probably couldn’t follow their own plan because it is too loose.

The harsh reality is that if you cannot separate perception from reality as defined by data then yo will find trading very difficult.

EVO Car Of The Year


 

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