The ETF Sector models took a small hit this week, in large part due to Semiconductors continuing to cool off from their recent all-time highs. The Sector Conservative is up marginally on the SPY year-to-date, the Moderate is lagging by a small margin, while the Aggressive remains negative.
The U.S. markets, bolstered midweek on positive Eurozone news, were unable to follow-thru on the rally which stalled as more mixed news trickled in about Greece on Friday. SPY and DIA are just under their 50 DMAs, while QQQs, which were down half a percent on the week, are just sitting on its 50 DMA and IWM, which managed to put in a positive week, it above all there of its major moving averages.
We made one position change this week, moving to a full-size position in TAN in the Sector Conservative and Sector Moderate models as that ETF appears to have rebalanced and stabilized after reducing its weight in Hanergy Thin Film (A Chinese solar firm with on-going financial and trading irregularities).
We recently made a number of significant changes to the Sector models, including adding two new models and renaming an old one. Please see last week’s strategy article for more information.
Summary of the Sector Models' Performance
This Week’s Strategy Lesson: Stops and Targets Analysis (Part 2)
With the recent rollout of some additional trading options for our trend strength-based ETF models, particularly the Sector variants, we are going to continue our series looking at the Sector Moderate, its overall risk/reward characteristics and specifically how the Stops and Targets affect this model.
Last week, we looked at one instance where taking profits during a volatile period significantly reduced the equity swing and ended up locking in a higher level of profit.
There is no guarantee that this will always be the case. Profit taking reduces your future exposure, which is good when the stock or ETF goes back down and not as good when it keeps going up. But even if you miss some upside, taking profits and reducing overall risk is often the right thing to do.
This week we are going to compare two different versions of the Sector Moderate, one with stops and targets and one without, and see how the volatility is affected by the addition of stops and targets. This is a good apples and to apples comparison because both models end up with very similar total return, but fairly different performance profiles in other respects.
Volatility
Volatility isn’t always necessarily a bad thing. Still, wild swings can spook us out of a trade, and all other things being equal, if two stocks or ETFs both go up by 10%, the one that goes up that much on the lower volatility should almost always be preferred.
In the chart above, we compare rolling average returns that have been smoothed to better demonstrate the relationships. We can see that the orange line (with stops and targets) tends to have smaller extremes. Both lines move tend to move together, but the overall volatility of the stops and targets line is smaller on both the up and down moves.
Our stops and targets are on the passive side, meaning they are set fairly wide and fewer than half of the trades reach either a stop or a target. More aggressive stops and targets could further reduce the volatility, but depending on the nature of the trades, they can also start cutting into total performance.
We have tried to find the happy medium between the two (volatility and returns), but no one system or settings is going to be perfect for every market condition.
On a per-unit-of-return basis, the stops and targets on the moderate model reduce weekly volatility by 24%. In a hypothetical example, this roughly means that if both variants ended the week up 2%, the model with the stops and targets might have had a weekly trading range of 4% and the model without stops and targets might have had a weekly trading range of 5%.
Volatility relative to returns is a very important component of the Sharpe ratio. The Sharpe Ratio is often used to contrast the risk and volatility between two similar strategies. The ratio compares average annual return to the average annual volatility as measured by standard deviation. The Sharpe ratio output is in constant “volatility-per-unit-of-return” terms, so you can use it to compare any type of instrument or strategy, but the comparison is often most apt between two instruments or strategies with similar overall return.
We have that similar comparison between the two variants we are looking at. The Sharpe ratio for the version without stops and targets is 1.3 (a very respectable score) while the Sharpe ratio for the version with stops and targets is 1.95 (a very high overall score).
The Sharpe ratio is not perfect. Its annual granularity can sometimes hide important or drastic swings and it penalizes a model equally for upside and downside volatility (investors might not care as much about upside volatility). However, it is a good measure here because of the similar overall performance levels and if we weren’t already convinced one variant was superior, this should go a long way to tipping us in that direction.
Next week we will wrap up this series looking at one final important factor in comparing the risk and reward characteristics of the two models: drawdowns.
The Current Condition of the Model
Please visit the Model Portfolio section of the member area to see the ETF ranking for each of the three Sector models.
Stay tuned to the daily emails for any position changes and updates.
Best wishes for your trading,
James Kimball
