What is a hedge and why does it makes sense to do it?

A hedge is always an investment which is negatively correlated to the main investment. When the main investment goes down, the hedge should go up and if the main investment goes up, then the hedge normally goes down. It is clear, that we like the first, which is to reduce the draw downs with a hedge, but not to reduce the gains.

If you have a stock portfolio, then the main hedge possibilities are:

  1. A VIX ETF like VXX or a VIX Future. These have nearly a -1 correlation.
  2. An inverse ETF on a index like SH which is the inverse of the S&P 500 SPY ETF
  3. Precious metals like GLD or SLV
  4. Treasuries

A lot of people use 1) and 2) to hedge their positions. This may probably make sense if you have a big stock portfolio, and you can not sell everything instantly in case of a market crash. These two must be perfectly timed. I do not think it makes sense to use them as a hedge for longer periods because the VXX ETF has an extremely strong down trend of about 5-10% per month. This is a very effective but also very expensive hedge. Such a hedge will ruin the performance of your portfolio if you keep it longer then one or two weeks. Same with SH. Because the S&P 500 has a long term up trend of about 8%, you will lose about these 8% per year if you use SH as a long term hedge.

Precious metals 3) are much better. They are a safe haven investment. They normally have an inverse correlation to the stock market in times of trouble and on the longer term they should go up at least because of inflation. Gold and Silver are today priced about at their production cost. Sure, it is possible that they go down below today’s prices for a short time, but the down potential is very limited versus the up potential. Mining costs are increasing quite fast and on the long term GLD and SLV will go up at least 5% per year. If you have a Forex trading account you can borrow GLD or SLV for about 0.5% interest today. So it is very cheap to hold these precious metals. I hold quite a big position in Silver and the last months have shown, that this is quite a good hedge. Always when the US market is down, then GLD or SLV goes up.

Treasuries 4) are also a good “safe haven” hedge, even if the Fed’s tapering process is still ongoing. At the moment treasuries are showing a very constant negative correlation with the stock market. If you add a treasury position to your stock market position, then you can reduce the draw-downs quite a lot. The good thing with Treasuries compared to an inverse S&P500 ETF or a VIX ETF is , that on the longer term they go up by about 4% per year. If you can invest in Treasuries by shorting an -3 inverse TMV ETF, then in addition to these 4% you profit of an additional time decay and the high management fees of this ETF. The TLT ETH is down 2.1% for the last 24 month. Our TMV ETF is down 19%. If you short it then it is up 19%. Because it is 3x leveraged compared to TLT you have to divide by 3. So, compared to TLT which is 2.1% down it is 6.3% up. This is a 8% difference to TLT.
So, overall the TMV hedge is really the best thing you can do. This ETF reduces your draw-downs and on the long term it should return about 10% per year.

I proposed to invest 25% (=80%+20%) of your stock market investment in such a hedge. Here is a comparison of a hedged SPY portfolio compared to only SPY.

Image1
As you can see, such a TMV short hedge is one of the best things you can do. Increased profit and much less volatility and this with the year 2013 included, which was one of the worst years for treasuries ever. One of the most important things is, that it will reduce the max. draw-down by about 50%.

If you can not short TMV, then you can also go long TMF.

Image2

The result is still much better then just a normal SPY investment in the stock market . The return is slightly smaller then SPY alone, but the risk (volatility) is reduced by 1/3rd.

In general it is quite easy to find out if it makes sense to hedge a portfolio. You just have to calculate the Return to Risk ratio (Sharpe Ratio) of the portfolio without and with hedge. If it is bigger with the hedge, then your hedge makes sense. In general only a hedge with Treasuries or precious metals will increase the Sharp ratio.

One of the biggest advantages of such a hedge is that it is always in place. Even if something really bad happens over the weekend, like now the Crimean/Ukrainian crisis and the next Monday the stock markets open with big losses, then you can be happy. A 20% hedge in TMV or TMF will cut your draw-down by 50%. If you are rather a risk adverse, then you can also increase such a hedge to 30%. This will nearly flatten out any bigger draw-down.

Posted in Bond Rotation Strategy, Global Market Rotation Enhanced Strategy, Global Market Rotation Strategy, Hedging, Maximum Yield Rotation Strategy | 3 Comments

Risk Management using Timed Hedging

As you perhaps know I have invested all my money in my own strategies, and I and my family (the best wife of all and 4 nice children) are living from the return of these investments. So, I just cannot afford to lose much money in market corrections. Therefore I always try to improve the strategies to lower the risk of major losses.

The new “Timed hedging” is a major improvement of the rotation strategies. It increases the Return to Risk ratio of all strategies a lot. Timed hedging allows you to reduce the downside risk or the volatility of your investment by about 1/3rd without affecting the performance of the strategies.

An excellent way to reduce the volatility or risk of your investment is hedging with Treasuries. Treasuries are most of the time negatively correlated to the stock market and still have a long term positive return. In my strategy emails, I will from now on always give an indication on how you can hedge the current strategy investment.

There is a good possibility that 2014 will be a more choppy market than 2013. The 32% performance of the US stock market is just crying for some corrections, even if the economy outlook is still very positive.

In a normal year like 2012 without tapering, the stock market (MDY – orange) and Treasuries (EDV – blue) have nearly perfectly mirrored charts.

Image

2013 was a special year with extremely fast rising treasury yields during the summer period. This had the effect, that long duration ETFs like EDV lost up to 20% for the whole year. Since the beginning of 2014 treasuries show again a normal negative correlation of about -0.5 to the stock market (SPY).

Since hedging with Treasuries is an extremely simple and effective way to reduce volatility I have added a hedging proposal to all my rotation strategies (except the Bond Rotation Strategy).

To show you the effect of hedging, here is a backtest of the S&P 400 midcap ETF MDY hedged with long duration Treasuries. The hedged portfolio is composed by an 80% MDY long and 20% TMV short position.

The green chart is the hedged MDY portfolio and the blue chart is the MDY only portfolio. You immediately see, that the volatility of the green chart is very much reduced. The Return to risk ratio goes up from 0.71 to 1.32 and the maximum drawdown is reduced from 26% to 12%. But there is not only reduced volatility, but also a much higher return of 70% compared to 47% for the non-hedged portfolio.

So in this case, even with the negative effect of tapering in 2013 which can be seen in the chart, it is absolutely clear, that hedging would have been very good for such a portfolio. In my strategy emails, I will however not always advise to hedge, but I will try to time the hedging, so that such drawdowns like in June-July 2013 should not happen.

Image

In order to hedge a portfolio, the best is to use long duration Treasury ETFs like EDV, because they make bigger moves. You can use EDV to hedge, but I prefer to short TMV. TMV is an inverse -3x leveraged +20 year duration ETF. If you short TMV, then you again have something like a positive acting +3x leveraged ETF.

I don’t like at all inverse stock market ETFs like SH as a hedge. Even worse are VIX ETFs like VXX. They both have very strong long term down trends. SH, the inverse S&P 500 ETF had a -15% down trend, and VXX a nearly -54% down trend during the last 3 years. Such strong down trends will wipe out most of the profits of your portfolio. Long duration Treasuries however make long term profits even with tapering.

There are several reasons, shorting TMV is the much better hedge then just buying a normal +20 year Treasury like TLT or EDV.

The most interesting reason is the huge time decay TMV shows. If you look at the chart below, then you see the blue chart which shows EDV for the last 7 month. The performance is nearly zero (-0.42%). It is the same for TLT for this time period. TMV however has a -12% performance due to the huge time decay which results of the continuous rebalancing. Now, the nice thing is, that if you short TMV, this -12% loss turns into a +12% gain. This gain adds to the normal positive yield of long term Treasuries.

Image

Another reason to use TMV is, that it is bad to use too much of your capital as a hedge, because normally you do not make money with the hedge, but with the other part of your investment. Here a 20% investment in TMV is sufficient to provide a good hedge. You have 80% left for your normal investment which may be a stock market ETF like MDY or even an inverse volatility ETF like ZIV.

I like also TMV, because it does not pay dividends, so you do also not need to pay taxes on these dividends.

If you cannot short TMV, you may buy TMF the +3x leveraged +20 years Treasury ETF or EDV to hedge your portfolio. Here you see the same backtest with portfolio composed of 80% MDY and 20% EDV. It is also much better than a 100% portfolio, but TMV just gives you stronger hedging and a better performance at the same 20% portfolio weight.

Image

Looking at our strategy rankings, you see that even with ongoing tapering, Treasuries had a strong comeback. They are again in the top ranks of our strategy ratings and the correlation to the S&P 500 index, which I show also in my ranking tables is negative again.

Examples on how to invest:

hedge table

You see that as long as you hedge, you always keep 20% of your capital in a short position of the -3x leveraged TMV Treasury. Timed hedge means that you stop hedging if the correlation of Treasuries to the stock market (SPY) gets positive.

To show you the effect of hedging, here is the January FEZ chart with the current market correction (blue) and the chart of the hedged portfolio (80% FEZ + 20% TMV short). The effect of the hedge is easy to see.

January chart

I consider this additional timed hedging as a major improvement of the strategies, but after all, you are free to decide if you want to hedge or not. All the strategies should also provide good positive long term returns without hedging. However you may sleep better with less volatility in your investments.

Frank Grossmann
http://www.logical-invest.com
January 2014

Posted in Global Market Rotation Enhanced Strategy, Global Market Rotation Strategy, Hedging, Inverse Volatility, Maximum Yield Rotation Strategy, Uncategorized | Tagged , , , , | 11 Comments

Strategies For Trading Inverse Volatility

In this paper, I present five different strategies you can use to trade inverse volatility. Why trade inverse volatility you ask?

Because since 2011, trading inverse volatility was probably the most rewarding investment an investor could make in the markets. Annual returns of between 40% – 100% have been possible which crushes any other strategy I know.

In modern markets, the best way to protect capital would be to rotate out of falling assets, like we do in our rotation strategies. This is relatively easy, if you are invested only in a few ETFs, but it is much more difficult, if you are invested in a lot of different shares. In such a situation an easy way to protect capital is to hedge it, going long VIX Futures, VIX call options or VIX ETFs VXX.

If you trade inverse volatility, which means going short VIX, you play the role of an insurer who sells worried investors an insurance policy to protect them from falling stock markets. To hedge a portfolio by 100% an investor needs to buy VXX ETFs for about 20% of the portfolio value. The VXX ETF loses up to 10% of it’s value per month, because of the VIX Futures contango, so this means that scared investors are willing to pay 1.5-2% of the portfolio value per month or around 25% per year for this insurance. Investing in inverse volatility means nothing more, than taking over the risk and collecting this insurance premium from worried investors and you can capitalize on this with a few simple strategies, which I will show you below.

Something seems afoot. Why do investors pay 25% per year to hedge 100% of an S&P 500 portfolio which traditionally has only achieved a return on average of around 8% in the last 10 years? I am sure many investors must have lost more money paying for this insurance than they would have lost from falling stock markets. But I guess, they are paying for their own peace of mind.

Traditionally, it has always been better to hedge a portfolio with US Treasury bonds. These normally have like VIX products a negative correlation of about -0.5 to -0.75 with the US stock market, but unlike VIX volatility products, they can achieve long term positive returns.

However, since June 2013, US Treasuries have lost their negative correlation to the stock market, and at the moment there is no other choice to hedge a portfolio than to buy these very expensive VIX products or inverse index ETFs.

This is good news for people like me, who like to trade inverse volatility. However, there is something you need to know. You should never ever trade inverse volatility without being 100% clear on your exit strategy!

Here, I want to present some strategies which may be new to you and will allow you to participate in these high return volatility markets.

The Basic “Contango Rule” Strategy for VIX

For this strategy, all you have to do a daily check of the VIX term curve. You can find this curve for example at www.vixcentral.com

1

As long as the front month is in contango (curve goes up from left to right), such as in the chart above, you can go short VXX or long XIV. Sometimes you will see the front part of the curve go up until the front month goes to backwardation.

Here in this graph you see the days of the last fiscal cliff fear spike.

2

If the two front month of the VIX term curve are in backwardation and the curve drops downwards, such as in the chart above on October 7.-8., this is a clear sign to exit VXX or XIV. From October 10, the curve returned to contango and you could have again shorted VXX or gone long XIV.

It is clear, that most of the time when you have to exit it is because of a short VIX fear spike (such as above) which is over after a few days. You will have to realize a loss, but, this is inconsequential. Normally, you need only a few days to cover these losses again as the normal VIX contango situation is restored. In the example above, the front month future was below 20, which is not that worrying, but in 2008, this value spiked to 70. This means that going short VXX would have meant the possibility of realizing 300% losses if you didn’t strictly follow any exit rules.

This “contango rule” strategy is not really a strategy, because it doesn’t give you a clear exit signal, however, if you invest in inverse volatility, you MUST know the VIX Futures term structure.

The Bollinger Band or Simple Moving Average Strategy

These are strategies which work well and which have the advantage that you can backtest the strategies, or you can even automate these strategies. I used to trade the Bollinger band strategy for quite some time automatically with Tradestation.

Here is the backtest of this strategy since Feb. 1, 2009 which was when the VXX started. The performance has delivered a 96.41% annualized return or 2370% in total if you reinvested all profits. If you invest always the same amount which is what I did, then you get 5.8% per month which is a very nice monthly income.

The SPY ETF has delivered only a 20% annualized return or 137% total return during the same period. This is also very good, but pales in comparison to the VXX strategy return.

3

The maximum drawdown of this strategy was 27.7% compared to 20% for the SPY ETF. The risk to return ratio of such a strategy is 3.27 compared to 0.99 for the SPY ETF. So, even if trading VXX is considered risky, with the right strategy you could have had a 3x better risk to return ratio than for the US equity investment (SPY).

The parameters for this strategy have been optimized in QuantShare. The Bollinger band period is 20 days and the upper line is at 1.4. If VXX crosses the upper line I will exit (cover) VXX the next day at open. If VXX goes below the middle line, then I go short VXX the next day at open.

You can also use two SMA lines with 15 and 5 days and sell or cover at the crossings. The return is more or less the same as for the Bollinger strategy.

You can also do such strategies with XIV which is the inverse of VXX. However, the maximum annual return which I could achieve is 84% per year, which is 12% less than with VXX. This lower performance is mainly due to time decay losses which are quite strong for such volatile ETFs.

So, this is quite a simple strategy. You can even set a stop at the level of the upper Bollinger band line + 1%, so that the exit is automatic in case something very bad happens.

The Cautious Investor Medium Term Inverse Volatility Strategy

The two strategies above are for traders willing to check their investments on a daily basis. If you do not want to do this because you like to go on long holidays or you just don’t like to look every day at your PC screen then it is better to invest in the medium term inverse volatility. You can do this by going long ZIV or going short VXZ. VXZ has higher volume than ZIV but the results are similar.

VXZ and ZIV have less than half the volatility (vola=25) than VXX or XIV (vola=55). Also, the contango structure is more stable than for the front month. Also, during the fiscal cliff crisis last month, the midterm futures never went into backwardation.

You can also use a Bollinger or SMA trading system for these ETFs. You will achieve about 44% annual return trading VXZ and you can do so with less than half of the volatility. This way you have about the same return to risk ratio as if you had traded the VXX.

However, because the volatility and behavior of ZIV or VXZ is very similar to the stock market, you can also include for example ZIV in a rotation strategy. In such a strategy it is a ranking mechanism which will tell you when to exit ZIV. This is normally better than using moving averages, because the switching points are much smoother.

Investing in Medium Term Inverse Volatility with the “Maximum Yield Rotation Strategy”

A strategy I employ which gets most of its return from inverse volatility is the “Maximum Yield Rotation Strategy” which I presented in Seeking Alpha around two months ago. With such a strategy you can outperform a simple ZIV or VXZ SMA strategy by up to 20% per year. The advantage is that you only need to check the ranking of the ETFs every two weeks. No need to check daily the VIX term structure or the ZIV charts. Rotation strategies are very sensitive to changing market environments.

In case of upcoming market troubles, US Treasuries will quite early outperform ZIV and the strategy will rotate out of ZIV into treasuries. The main advantage of such a strategy is that it not only exits ZIV during market corrections, but the strategy will then rotate into Treasuries which can produce very nice additional returns during market corrections.

4

The High Probability VIX Future Trade Strategy

Instead of investing in VIX ETFs, I prefer to sell the VIX Futures directly. Normally, somewhere during the third week of the month, the front VIX future expires and is removed from the VIX term structure chart (see chart below). Now the second month will move to the front month position and on the curve end a new Future will appear. I always go short a few of these Futures (red arrow) and then just let them slowly move down the curve until they arrive about at the green arrow position. At this point I cover my short position and collect the roll yield for the about 4.5 months. On this chart, this would mean going short at about 19.25$ and covering (buy) at around 17$. That means a profit of 2.25$. Sometimes I have to wait a little bit longer to sell, for example if there would be a VIX spike of some nature. But, for more than two years, I have never seen a loss.

So, this is a high probability trade. Once per month you go short the last or second last future and at the same time you enter a stop limit and a cover limit. For the July Future in the chart below, I for example go short at 19.25. I activate a stop loss limit at 21.50 (=+2.25) and I activate a take profit limit at 17.00 (=-2.25). Now I just wait about 4 months until one of these limit is executed. As long as the contango of the VIX futures is there, this will be a trade with a profit probability of 90%-100%.

5

The volatility of these back end futures is quite low and there is no big risk, however, even here there would be moments where you have to exit. The main reason to stop such trades is when the back end of the future curve gets completely flat or even goes into backwardation. However, this is relatively easy to check online at www.vixcentral.com.

Posted in Inverse Volatility | Tagged , , , , , | 28 Comments

The Sleep Well Bond Rotation Strategy with an annual performance of 15% since 2008

The “Bond Rotation Strategy” is another tool you can use alongside our “Global Market Rotation Strategy” (GMRE), to maximize returns. These two strategies form the core of our investment strategies.

We employ this strategy, because it outperforms the stock market by more than double and this with one third of the volatility or risk. This means that since 2008, the return to risk ratio is about six times higher than an investment in the SPY ETF which tracks the S&P 500. Even this year, when many investors are selling bonds due to increasing yields through FED tapering, the bond rotation strategy has delivered positive double digit returns.

The Bond Rotation Strategy (BRS)

The BRS Strategy invests in the top one or top two ETFs out of a selection of five bond ETFs which is then rebalanced on a monthly basis. The backtested returns of the strategy since 2008 is very impressive compared to a traditional “buy and hold” strategy. The data below refers to the returns for holding the top two ETFs in the strategy. The figures in brackets show the returns for holding the top ETF only. The top two ETF strategy has a slightly better return to risk ratio than the top one ETF strategy. So, for larger amounts of money (> 100’000$), I would advise investing in the top two ETFs rather than simply holding one.

  • Annual performance (CAGR) = 15.7% (19%) compared to S&P500=5.4%
  • Total performance since 2008 = 133% (175%) compared to S&P500=33.1%
  • Volatility (annualized) = 6.75% (9.45%) compared to S&P500=24.7%
  • Return to Risk Ratio (Sharpe Ratio) = 1.79 or 1.68 compared to S&P500=0.25
  • Alpha compared to AGG = 62%

Strategy performance 2008-2013

Bond Rotation Strategy Chart
Black – Top one Bond Rotation Strategy
Blue – Top two Bond Rotation Strategy
Green – AGG iShares Core Total US Bond (4-5yr)
Red – SPY SPDR S&P 500

The Bond strategy ETFs are:

  • AGG – iShares Core Total US Bond (4-5yr)
  • BOND - PIMCO Total Return ETF
  • CWB - SPDR Barclays Convertible Bond
  • JNK - SPDR Barclays High-Yield Junk Bond (4-7yr)
  • TLH - iShares Barclays 10-Year Treasury (9-11yr) U.S. Treasury Bonds
  • CASH or SHY - Barclays Low Duration Treasury (2-yr) U.S. Treasury Bonds

Why is it important to rotate the bonds rather than employing a “buy and hold” strategy?

In May 2013, the U.S. Federal Reserve Chairman, Ben Bernanke, stated in a testimony before Congress that the Fed may taper its bond-buying program known as Quantitative Easing in the coming months. Most bond investors see investing in Treasury bonds as the safe or risk-free option, however, in 2013 long term US Treasuries like TLT have been down more than 12%.

This has caused many investors to worry about the future of bonds and many of them have sold their US bond positions due to low yields and falling prices, preferring instead to invest in the rising US stock market.

However, one big advantage of the bond market as opposed to stock markets is that there are lots of different categories of bonds with very different correlations.

At the current time, there is no reason to rotate out of bonds into the stock market. Bonds are still a very safe and broad asset class to invest in with lower levels of volatility and higher levels of safety than investing in equities. I would advise everybody who is investing larger amounts of money to invest a portion in bonds. The amount would depend on an individual’s age and risk profile with a higher amount in bonds for older clients or those with a lower risk profile.

If you look back at the last 20 years, then you will see that there are always bond classes which have performed well in any market situation, especially during big financial crashes. The stock market is not as diversified. During the 2008 subprime mortgage crisis, almost all stocks went down globally, however, had you been invested in Treasury bonds, then you would have made very good profits.

But, it is crucial to choose the right bonds to invest in. Some bonds, like convertible bonds or high yield junk bonds, have a very high correlation to the stock market. At the moment, these bonds are rallying in tandem with the stock market, albeit with lower volatility. Some bonds, like US Treasuries, are “safe haven” investments and they are usually negatively correlated to the stock market. At the moment, with the US stock market rising, it is preferable to hold non-US government bonds such as junk bonds or convertible bonds.

A “Buy and Hold” Bond Diversification Strategy Vs. the Bond Rotation Strategy

If you hold a mix of all the various bond classes together, you get a very low volatility bond ETF like the AGG iShares Total Aggregate US Bonds ETF. Unfortunately, mixing all these classes together will result in quite poor returns. The AGG ETF has had an average return of 4.5% per year since 2008. If you subtract inflation of around 2% and a decent interest for your invested capital, you are left with nearly zero return on your investment. I do not think it makes sense to use a “buy and hold” strategy such as buying an aggregate bond ETF like AGG, unless you are happy with a return on your investment of around 2.5% above inflation. It makes much more sense to use a bond rotation strategy.

It is a little bit like mixing all the world stock markets together. In that case, you would get the ACWI iShares All World Index ETF which returned on average 3.9% per year over the last 10 years. However, if you rotate between different world stock markets using various region specific ETFs with a solid system like the “Global Market Rotation Strategy“, then you can rack up yearly returns of up to 40%.

Many advisers call this diversification though the mixing together of stocks or bonds through a “buy and hold” strategy as sound financial planning, but I think it’s hogwash. If you really want to accrue good returns, then you must rotate or adapt your investments from time to time according to momentum and world economic cycles.

This bond rotation strategy is a simple one. You can do it yourself quite easily. Just look at the end of every month to see which of the above 5 bond ETFs had the highest return and invest in that ETF. Using this method would have made you an average of 17% per year.

Here is an overview of different bond rotation techniques:

table1

As you can see, this simple do-it yourself rotation strategy has a three times better return to risk ratio than a “buy and hold” investment and requires only a minimum amount of work. In the table above, you can see that the return is not the only factor when deciding to employ a strategy. Keeping the risk low has equal importance to seeking a high annual performance. This is why I always judge a strategy by it’s return to risk ratio (the Sharpe ratio). Risk is calculated by looking at the volatility of a strategy. Low risk means low volatility or smaller rises and falls in ETF prices. You should be aiming for smaller rises and falls, as this will let you sleep well at night.

At logical-invest.com, we try to minimize risk in our rotation strategies by looking at the volatility of an ETF. Higher volatility will reduce the ranking of an ETF.

A second concept, which I have introduced recently is active money management. Without money management, you just reinvest all your capital at the beginning of each month in the top two ETFs. You can do this by investing 50% of your capital in each of the top two ETFs. This is strategy 3 in the table above.

Money management means, that you adjust your investment whilst taking current market and ETF volatility into consideration to lower risk. For example, on the last day of 2008, during the subprime crisis, the strategy would have invested 50% in cash, 17% in the TLH ETF (10-20yr US Treasuries) and 33% in the AGG ETF (US Total Bond Market). There was a higher investment in AGG to reflect the lower volatility or risk of as opposed to TLH. This type of money management allows you to reduce volatility and therefore the risk of the strategy by reducing the amount of money which is invested in turbulent market periods. It is clear, that if you are only 50% invested, you reduce volatility and risk by a factor of two.

At the moment, market volatility is low and the Bond Rotation Strategy is 100% invested with 50% in CWB Convertible Bonds and 50% in JNK Junk Bonds. No cash is held.

This is a sample of a monthly ETF ranking list (ranking as of Nov. 6, 2013)

table2

The additional risk and money management gives us about 2% additional return with a lower risk. This probably does not seem high to you, but it means for example that instead of using your own money, you can run this strategy with CFDs (contracts for difference). CFDs are more or less the same as the corresponding ETFs, the only difference is, that you borrow the money from the bank. The borrowing rate is normally about 2% per year. So, 2% more return and a quite low risk strategy means, that you can run this strategy with CFDs for free, or that you can for example buy CDFs for 3x your available capital which allows you to leverage your investment. Your capital is then used just as security margin to cover losses and the borrowing interest is paid by the higher return of the strategy.

Please visit our website www.logical-invest.com for additional information.

Happy trading and best regards from Switzerland
Frank Grossmann

Website: www.logical-invest.com
Email: mail@logical-invest.com
November 2013

Posted in Bond Rotation Strategy, Uncategorized | Tagged , , , , , , , , , | 4 Comments

Why work yourself, if Silver can work for you? (My silver strategy)

In the past 20 years I traded nearly everything you can trade, including commodities. Since about 10 years, I have gone from purely emotional trading to systematical rule based trading. Today, I don’t trade anything anymore, if I cannot reproduce a positive backtest of my trading strategies.

Today I stopped trading commodities, because it is very difficult to get good results with backtested strategies. My core investment strategy is the “Global Market Rotation Strategy”, which I presented in my first SeekingAlpha contribution. This is a very good and safe strategy and also this year the return is already 28.4%.

The only commodity I trade at the time is Silver (SLV). With Silver it is different. There is no way to include silver in a successful rotation strategy. Silver is much too volatile and it is much too easy for big investors or banks to influence the price.

However one thing I still think I understand, is the value of something. I do not like value investing with shares, because shares can go to 0. With commodities it is different. Today you can buy silver for 22$/ounce and we know that production costs are between 25$-30$. Even if there is no shortage of silver at the moment, I think for a longer term investment silver is extremely interesting. No commodity ever remained for long time below production cost. With such a constellation the downside risk of the silver price is much smaller than the possibility of higher prices.

The other interesting argument for a silver investment is, that it is extremely cheap to buy.

I am using a broker (Saxo-Bank) in Switzerland which allows you to trade silver like a Forex currency. I can buy nearly every amount of silver with extremely tight spreads and no initial margin is required. With Forex trading, the bank will lend me the US$ I need to finance my trades and all I have to do, is to pay some interest. At the moment I pay 0.4% of yearly interest (overnight swap rate) on my silver position. This is much less than the about 1.5% US inflation rate. This is important, because one thing you know, is that over the years the silver price should at least rise with the inflation rate. So, inflation will pay you 3x the interest on my US$ borrowings.

Another very important advantage of silver, compared to other commodities is, that I do not have to fight the strong contango of many other commodities. Just compare for example crude oil ETFs with the crude oil spot price and you see that on the long term you just lose money.

With silver it is different. You can just keep silver and wait. Sooner or later it will go back over the production cost again.

Now the nicest thing of silver is the high volatility.  Because of the low price below production cost, this time high volatility does not really mean higher risk. However it gives you the big advantage that you can make silver work for you.

And here, with the next screenshot, I can tell you that silver really works hard for me since quite some time.

Silver trades for the period (September 23-October 22)

silver trades

This screenshot (sorry, it is in German) shows you the silver trades of on month (September 23-October 22). I always buy 2000 ounces of silver if it goes 50 cent down and I sell it again if it is 50 cent up again. This is the very basic buy low sell high strategy. During last month for example, I made 8200 Swiss francs which is about 9100 US$ with 10 trades and this only because of the silver volatility. The silver price was exactly the same September 23 and October 22, so with a buy and hold strategy I would not have made any money at all.

So, you see it’s a dream. I bought nearly 40’000 ounces of silver at 19.50 US$. When the Silver price goes to 30$, I will have sold everything at a rate of 2000 ounces/50cent price increase.

So, now I hope that everybody will invest into silver so that the price goes up quickly with a lot of volatility.

Attention! If you invest at 2000 ounces per 50 cents, then you have 16000 ounces of silver when the price falls down to 18$. This would mean a book loss of 16’000 US$ in addition to the losses of your initial silver position. You should have enough money in your account to cover such book losses. If you really have to sell it, then this strategy would end with a big loss.

Frank Grossmann

Bertschikon, October 2013

Posted in Global Market Rotation Strategy, Silver strategy | Tagged , , , , , | 11 Comments

Why we invest in ZIV (inverse mid-term volatility) and not in XIV (inverse fronth month volatility)

Several times I have been asked why we invest in ZIV (inverse mid-term volatility) and not in XIV (inverse front month volatility) in our “Maximum Yield Rotation Strategy” and in the “Global Market Rotation Enhanced Strategy”.

After all, front month VIX Future contango is about 2-3x bigger then medium term contango. At the moment XIV profits from nearly 9% monthly VIX Futures contango. ZIV profits from about 3% monthly VIX Futures contango.

Normally you would think that XIV should have a far better performance than ZIV, but now look at this chart of the 1 year performance. ZIV has performed very well. With 64% annual performance it performs nearly 4% better than XIV and this with much less volatility.

XIV Chart

The main problem is that both of the ETFs are inverse ETFs. This means that underlying they are constructed by shorting VIX futures. These ETFs are rebalanced every day and this results in a quite big time decay. XIV has a very high volatility of about 55% compared to only 25% for ZIV. Higher volatility means also bigger time decay losses.

The 25% volatility of ZIV fits very well to the volatilities of our global market ETFs (MDY, FEZ, EEM, EPP, ILF). Rotation strategies work better, if the ETFs have more or less the same volatility.

Rotation Strategy backtests

If I backtest our “Maximum Yield Rotation Strategy” with XIV instead of ZIV, then I only get an annual performance of 31% with a volatility of 48% since 2011. With ZIV, I get 70% annual performance with only 27% volatility. This is a huge difference, which shows you, how important it is, that the ETFs of a rotation strategy fit well together.

Rotation Strategy annual return since 2011 volatility
MDY, ZIV, EDVSHY 70% 27%
MDY, XIV, EDV, SHY 31% 48%

Sharpe ratio check

Another way to check which ETF performs better is to calculate the Sharpe ratio. Never look only on the Return of an ETF, without also looking at volatility. Volatility means risk. With XIV you can have big losses in short time. The Sharpe ratio calculates the risk weighted return. Now you see, that ZIV had a Sharpe ratio of more than 2 (63,8%/25%) and XIV had only a Sharpe ratio of about 1 (59%/55%) for the last 12 month.

Conclusion

For longer term investments, ZIV is the far better ETF than XIV. But even for ZIV you need to have an exit strategy. The most basic exit rule, is that you exit ZIV as soon as the front month or the whole VIX term structure goes into backwardation. You can check this at http://vixcentral.com/.

However XIV can be interesting for short term investments if you buy it on VIX spikes and sell it some days later. XIV has a much higher volume than ZIV, but probably the main reason is, that short term investment ETFs which attract day-traders always have more volume then longer term investment ETFs.

The low volume of ZIV should not be a big problem, as this ETF is based on VIX Futures which have a much higher volume.

An alternative to ZIV or XIV investments is to short VXZ or VXX. However if you hold VXZ for a longer period you would also have to rebalance from time to time, because a VXZ short position will become smaller and smaller when at the same time a long ZIV position gets bigger and bigger.

Without rebalancing, you cannot make more than 100% profit if you short an ETF. You see this at the 3 year performance of ZIV which is +172% compared to +78% for the same VXZ short position.

http://www.logical-invest.com/

Posted in Global Market Rotation Enhanced Strategy, Maximum Yield Rotation Strategy, Uncategorized | Tagged , , , , , | Leave a comment

How To Build An ETF Rotation Strategy With More Than 50% Annualized Returns

In this paper I want to explain the readers how the  Maximum Yield Rotation Strategy of www.logical-invest.com is built. This Strategy achieves very high returns investing in inverse volatility. From 2011 to today the annual performance was more than 70% per year. Year to date the performance is 40.9%. The Sharpe Ratio (Return/Risk) of 2.12 is a “DREAM VALUE” and I doubt that someone can show me a strategy with a higher ratio.

The strategy invests in 4 different ETFs:

  • US Market (MDY – S&P MidCap 400 SPDRs)
  • U.S. Treasury Bonds - (EDV Vanguard Extended Duration Treasury 25+yr)
  • Volatility - (ZIV VelocityShares Inverse VIX Medium-Term)
  • cash – (SHY Barclays Low Duration Treasury) only if Treasury correlation to SPY > -0.25

The Maximum Yield Strategy switches semi-monthly between these 4 ETFs. For the switching I use a ranking system like the one I explained in my SeekingAlpha article of the Global Market Rotation Strategy. The ranking system is also using 3 month historical performance and 20 day volatility. Using also volatility is quite important, because it reduces the ranking of high volatile ETFs like ZIV.

However, if you want to play such a rotation strategy by yourself, then you can also just look at the 3 month historical performance.

In this strategy the ZIV ETF is the most important performance driver. ZIV can only be backtested since 2011, so that I cannot present a longer backtest for the whole strategy, but the way the strategy is built, you can backtest parts of it for more than 10 years.

The Maximum Yield Rotation Strategy is composed by several smaller sub-rotation strategies. Here is an overview of these different strategies:

Image

Here are some comments to the above strategies:

  1. I decided to use MDY (S&P400) instead of SPY (S&P500) because MDY performed better in the backtests.  SPY only performed 8.4% annually compared to 11.5% for MDY during the last 10 years. I normally prefer to buy the S&P400 COMEX futures instead of the MDY ETF, but MDY can also be easily replaced by other similar ETFs like RWK the return weighted midcap ETF which even performed a little bit better than MDY.
  2. Switching to cash during financial downturns does not increase the annual performance a lot, but it reduced the maximum drawdown of your investment during the 2008 Subprime Crisis from -55% to -16%. I think this reason alone should be enough to decide that from today you do not invest anymore without a clear exit strategy. Normally we enable cash switching only in our rotation strategies if Treasuries have a higher than -0.25 correlation to SPY. This is the case just now, but normally Treasuries have -0.5 to -0.75 negative correlation to SPY.
  3. Much better than a simple cash exit strategy is to switch to a negative correlated asset during financial downturns. During the last 10 years the best was to switch to Treasuries. In my strategy we switch to EDV during financial downturns. During the last 10 years we made nearly the same performance during down periods of the market as we made during up periods of the market. A MDY – EDV rotation strategy even had the best annual returns in the years 2008 and 2011 with the biggest market corrections in our 10 year period.
    Instead of EDV we normally invest in Comex Ultra T-Bonds futures, but we buy about 1.5x the normal investment volume, because EDV behaves like a 1.5x leveraged Ultra T-Bond or TLT ETF.
  4. The 54.6% annual performance of the ZIV buy and hold strategy shows you the return potential which is in such an inverse volatility ETF. The ZIV ETF itself is shorting midterm VIX futures. These futures are in a strong contango of about 3% per month since 2011. Because ZIV is shorting these futures, you profit directly from this contango. I do not want to write too much about investing in VIX volatility, because you can find a lot of good articles in SeekingAlpha.com.
    There is also the XIV ETF which is shorting front month VIX futures. XIV profits from about 10% VIX contango at this time, but the XIV future is very volatile which results in a much too high time decay. The Sharpe ratio (Return/Risk) of ZIV is 1.17 compared to 0.79 for XIV, so I prefer to invest in inverse midterm volatility (ZIV).
    Investing in VIX volatility is not so simple. You need to have a good exit strategy in place, because in case of a bigger market correction ZIV (and even more XIV) can lose most of its value in short time. There are several parameters I control nearly on a daily basis. The most important is the VIX future contango. Normally in case of a market correction the front month futures can temporarily go into backwardation and later also midterm futures go into backwardation. This should be the latest moment to exit your inverse volatility investment. Because volatility can change quite quickly, the Maximum Yield Strategy is updated every two weeks. The EDV and SHY exits work very efficiently together with the ZIF ETF and so the risk of losses is very much reduced.
  5. In our rotation strategy the EDV Treasury ETF makes sure that we exit our ZIV investment early enough in case of a market correction. During these corrections EDV can generate quite good returns. By switching ZIV – EDV you could achieve 54.6% annual performance. This even includes the recent strong Treasury correction because of rising yields. In our final 4 ETF strategy rising yields are not a big problem anymore, because we still have cash (SHY) as an exit for the case that treasuries do not have the normally negative correlation anymore.

Conclusion:

It is my absolute conviction, that it is much better to have a small portfolio with only a few ETFs then to buy a lot of different shares. If you have only a few ETFs in your portfolio, then you can react very quickly and with low costs to any market changes. However for this, it is very important to have a mandatory strategy with strict exit rules.

It needs quite some discipline to sell an ETF and buy another during a market correction. Most people would prefer to sit it out and wait for it to recover. However in this strategy it is really important to check your investment at these semi-monthly terms. If you do this, then this strategy is very safe. You can check the full list of semi-monthly returns of the Maximum Yield Rotation Strategy since 2003 on our web www.logical-invest.com site and you will see, that due to the very efficient EDV/SHY crash brake mechanism, the maximum drawdowns have been much smaller than using a classical buy and hold investment style.

If you think you have the discipline to check your investment regularly, then you can play this strategy yourself.

Good luck and happy investing!

Best regards from Switzerland

Frank Grossmann

September 17, 2013

Posted in Maximum Yield Rotation Strategy | Tagged , , , , , , , | 1 Comment