ETF Complete Portfolio Strategy Insights: Smart Traders Treat Volatility as an Asset Class

James Kimball | September 26, 2016

The ETF Complete model closed the week up +2.4% compared to the SPY which closed up +1.2%. Year-to-date, the Complete Portfolio is now leading the SPY by about 12%.

The SPY closed the week towards the high end of the September 9th wide measuring bar day, but has failed to reclaim new highs, something the QQQ’s did on Thursday. The FED’s decision to keep rates unchanged seems to have had its effect, pushing the market off its lows, but it remains to be seen if it will be enough to push to new highs or if this move is just a temporary stimulus high.

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This Week’s Strategy Lesson:  Smart Traders Treat Volatility as an Asset Class

Traders and investors have been increasingly warming to the idea of treating volatility as an asset class. Recently, the total volume in VXX and XIV, the two leading volatility-related ETFs, has been surging and now equals about 70% of the volume of SPY, the most widely traded ETF. Our ETF Complete model has been successfully trading both of these ETFs for years—the most recent example of that was during the “Brexit.”

The world survived the “Brexit.” At the time, this seemed far from certain. Most prognosticators thought there was little chance of the vote succeeding and when the surprise outcome was announced, it rocked the markets. The SPY dropped nearly 6% to the lows over the next two days (and at times it looked even more dicey in the overnight futures markets). It of course had a big impact on a number of currencies and EWU (United Kingdom ETF) still has not fully recovered. This week we are going to take a look at how that whole scenario played out and how the ETF models were able to navigate the volatility.

Brexit Run-up and Aftermath

Markets don’t like uncertainty, particularly the kind that could really shake-up the status quo. No country, let alone a major one like the United Kingdom, had ever left the European Union. After years and years of anemic growth (GDP still significantly lower than the 2008 high), debt crisis after deb crisis, and the growing discontent about the endless bureaucracy in Brussels, there were major concerns that if the United Kingdom exited it could set off a series of dominoes that would lead to completely unraveling the European Union.

These fears helped stoke the market volatility in the immediate aftermath of the vote but proved to be short-lived. While it is still possible that other countries could follow suit and exit, there seems to be more optimism that this will serve as a catalyst for reforms. And if Europe can return to a steady growth path it will help to put the debt issues in a number of these countries onto a sustainable path.

These sudden market shocks can play havoc on any portfolio. Our ETF strategies aren’t immune, especially to very sudden shocks where the portfolio does not have time to adjust its exposure. In the correction of August 2015, we fared a little worse than the market, due in part to hitting a couple stops and not being able to participate as much in the rebound that followed. This was not the case throughout the “Brexit.”

The ETF Complete model is a blend of three separate models that focus on different asset classes. Our Sector Moderate holds and rotates in and out of the leading U.S. sector ETFs. The County S&T model uses the same rules applied a group country ETFs, and likewise for the Global Macro model which looks for leading trends in regional stock markets, currencies, commodities, and alternative investment ETFs. The Global Macro model has the most exposure to volatility plays, both long volatility (VXX) and its inverse (XIV) and performed the best of the three component models over this period.

Overall, the ETF Complete had a slightly smaller drawdown and a stronger recovery than the broader U.S. market (SPY shown above). The Global Macro model had the highest volatility of the three models, dropping and closing the next day down -5.1% compared to the SPY down -3.6%. However, all of that drop was just retracing the tremendous run-up it had in the few days before the vote and it would go on to swiftly make up that lost ground.

A big reason for both the added volatility and return over this period was an unusual trade we put in XIV, the inverse volatility ETF. With volatility in its name, it should be of no surprise that this can be a wild ETF. We rotated into it on June 14th after it moved sufficiently into our top ranking to prompt the position change. At the time, we knew the vote was coming up and were both surprised at its strength and a little concerned about the potential fallout but we stuck with the signal.

You could say we got a little lucky in that we just barely reached our first target and was able to take profits at that level and minimize the loss on the remaining after it opened the next day a little below our no loss stop, however, it’s possible the damage wouldn’t have been significantly worse if we had missed that target entirely and just exited the full position after the drop.

Net-net, we made a profit on that XIV trade and then we re-entered the XIV after the dust settled in early July and that new trade is up nearly 30%.
When the markets enter these, usually short-lived, manic periods of fear and panic, it can be very difficult to navigate. Often the whole market moves down and a few minutes on a trade can mean the difference between profit and loss. Even typical safe haven investments can be affected. While it is not possible to avoid all of these risks, with the proper use of volatility-based assets, you can mitigate the effects or even profit from these short-term events.

The Current Condition of the Model

Stay tuned to the daily emails for any position changes and updates.

Best wishes for your trading,

James Kimball