Active Asset Allocation Strategies
Using ETFs
Marvin Appel, MD, PhD
CEO, Appel Asset Management Corp.
Great Neck, NY
mappel@appelasset.com
Outline
• Update relative strength strategies from my
2005 presentation to QWAFAFEW
– Growth vs value
– SPX vs EAFE—extended to include emerging
markets
• Covered call writing– Not all ETFs are created
equal.
Concept of relative strength
• Divide index1 by index2.
These indexes may reflect
price or total return.
• Rising ratio means index1
(numerator) is stronger.
• Falling ratio means index2
(denominator) is
stronger.
• Relative strength
leadership does not tell
you whether either or
both indexes are showing
profits or losses.
6
5.5
5
4.5
index 1
index 2
4
3.5
3
2.5
2
1.5
1
1
2
3
4
5
6
7
time period
1.1
Index 1 divided by index 2
1
Rising = index 1 stronger
Falling = index 2 stronger
0.9
0.8
0.7
Index 2 peak
relative strength
0.6
0.5
1
2
3
4
5
6
7
Hypothetical ideal
relative strength
switching model
9
index 1
index 2
ideal switch
8
7
6
5
4
3
2
1
1
2
3
4
5
6
7
time period
1.1
Index 1 divided by index 2
Index 2 peak
relative strength
1
Rising = index 1 stronger
Falling = index 2 stronger
0.9
0.8
0.7
model in index 1
model in index 2
0.6
0.5
1
2
3
4
5
6
7
Recognizing new trends in
relative strength
10
9
8
7
6
5
4
3
2
1
0
40% drop
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15
Growth versus value model
• Select value and growth benchmarks for
either large or small caps (eg: Russell 2000
value and growth indexes)
• Calculate the monthly total return indexes
and find the ratio as of the last day of each
month.
• Look for 10% reversals in the ratio to define
new long term trends.
Trend-following strategy:
large-cap value versus large-cap growth
Russell 1000 Indexes and
switching strategy, 1979-2010
(total returns)
1000
Russell 1000 Value Index:
12%/year, 56% drawdown
Russell 1000 Growth Index:
10.2%/year, 62% drawdown
Source: Mutual Fund Expert as of 5/31/2010
1/1/09
7/1/07
1/1/06
7/1/04
1/1/03
7/1/01
1/1/00
1/1/97
7/1/95
1/1/94
7/1/92
1/1/91
7/1/89
1/1/88
7/1/86
1/1/85
7/1/83
1/1/82
7/1/80
1/1/79
100
7/1/98
Switching strategy:
12.9%/year, 50% drawdown
History of value/growth model signals
for large cap (Russell 1000) Indexes
1.9
1.7
1.5
Russell 1000 Value / Growth
Rising = value stronger
Falling = growth stronger
1.3
1.1
0.9
0.7
0.5
1/31/79
Model in value
Model in growth
7/23/84
1/13/90
7/6/95
12/26/00
6/18/06
Trend-following strategy:
small-cap value versus small-cap growth
10000
Russell 2000 Value Index:
13.5%/year, 55% drawdown
Russell 2000 Growth Index:
8.9%/year, 63% drawdown
Switching strategy: 14.3%/year,
58% drawdown
1000
Source: Mutual Fund Expert as of 5/31/2010
5/4/09
10/4/07
3/4/06
8/4/04
1/4/03
5/3/01
10/3/99
3/3/98
8/3/96
1/3/95
5/2/93
3/2/90
8/2/88
1/2/87
5/1/85
10/1/83
3/1/82
8/1/80
1/1/79
100
10/2/91
Russell 2000 Indexes and
switching strategy, 1979-2010
(total returns)
History of value/growth model signals
for small-cap (Russell 2000) Indexes
4.5
4
3.5
3
Russell 2000 Value / Growth
Rising = value stronger
Falling = growth stronger
2.5
2
1.5
1
Model in value
0.5
Model in growth
0
1/31/79
7/23/84
1/13/90
7/6/95
12/26/00
6/18/06
Foreign (developed country) versus
U.S. stock model
• Use MSCI EAFE as the benchmark for foreign
stocks and S&P 500 as the U.S. benchmark.
• Calculate the ratio of EAFE / S&P 500 (priceonly data) on the last day of each month.
• A new trend is defined by a 15% reversal in
relative strength.
MSCI U.S. versus EAFE
7,500.000
750.000
Aug 02, 2009
Jul 02, 2007
Jun 02, 2005
May 02, 2003
Apr 02, 2001
Mar 02, 1999
Feb 02, 1997
Nov 01, 1992
Oct 01, 1990
Sep 01, 1988
Aug 01, 1986
Jul 01, 1984
Jun 01, 1982
May 01, 1980
Apr 01, 1978
Mar 01, 1976
Feb 01, 1974
Jan 01, 1972
Dec 01, 1969
75.000
Jan 02, 1995
MSCI EAFE: 9.8%/year, 56%
drawdown
MSCI US: 9.4%/year, 51%
drawdown
Switching model:
10.4%/year, 58% drawdown
Source: MSCI Barra
(http://www.mscibarra.com/products/indices/international_equity_indices/gimi/stdinde)x/performance.html)
History of EAFE / U.S. switch model
3.5
3
Rising = foreign
stocks stronger
Model in foreign stocks
Model in U.S. stocks
2.5
Falling = U.S.
stocks stronger
2
1.5
1
Apr-08
Nov-02
May-97
Nov-91
Jun-86
Dec-80
Jun-75
Dec-69
0.5
A Quarterly Asset
Allocation Strategy for
Foreign-Equity ETFs
FT Press 2008
Three distinct areas of the world’s
stock markets
Through 1989,
Japan strong
5000
2002-2007
EM strong
500
MSCI Europe total return
7/2/2008
10/2/2005
1/2/2003
4/2/2000
7/2/1997
1/2/1992
4/2/1989
7/2/1986
10/2/1983
1/2/1981
3/1/1978
6/1/1975
9/1/1972
12/1/1969
50
10/2/1994
1994-2001
EM weak,
Japan weak,
Europe strong
MSCI Emerging Markets total
return
MSCI Japan total return
Source: MSCI Barra
(http://www.mscibarra.com/products/indices/international_equity_indices/gimi/stdinde)x/performance.html)
Quarterly rotation among broad areas
of the foreign stock market
• Evaluate MSCI gross total return, US Dollar
indexes at the end of each quarter for Japan,
Emerging Markets and Europe
• Whichever area was strongest in the prior
quarter should be held in the current quarter.
• Can use ETF data instead:
– EWJ for Japan
– EEM or VWO for emerging markets
– IEV for Europe
Europe / Japan / Emerging Mkts
2500
MSCI Europe: 8.4%/year, 54% drawdown
MSCI Japan: -1.4%/year, 61% drawdown
2000
MSCI Emerging markets: 12.4%/year, 53%
drawdown
Quarterly switching model: 11.9%/year,
50% drawdown
1500
1000
500
Jan-10
Nov-08
Oct-07
Sep-06
Aug-05
Jul-04
Jun-03
May-02
Apr-01
Mar-00
Feb-99
Jan-98
Nov-96
Oct-95
Sep-94
Aug-93
Jul-92
Jun-91
May-90
Apr-89
Mar-88
0
Source: MSCI Barra
(http://www.mscibarra.com/products/indices/international_equity_indices/gimi/stdinde)x/performance.html)
Covered call writing
•
In return for a fixed payment up front, you agree to forego profits but bear losses
that may occur within a limited period of time on a stock or ETF.
•
Example: I will accept 1.2% to forego all profits and bear all losses in the S&P 500
SPDR (SPY) between now and March 19, 2010 (12 trading days).
– The maximum possible gain is the 1.2% of risk capital
– Losses can be as large as the amount by which the S&P 500 SPDR (SPY) can fall between now
and March 19.
– But any loss will be mitigated by the 1.2% I collected. (So if the market falls 5%, my loss on the
covered call position will be 3.8%.)
•
•
•
•
•
Not a “conservative” strategy
Good strategy for flat or slowly rising markets, like the second year of bull markets.
Important to choose the right ETFs or stocks
It has been possible historically to achieve a significant risk reduction without loss
of profitability
Need to watch transaction costs
10
8
6
Buy stock at $90
Sell covered call at $2
4
2
0
-2
-4
-6
-8
Profit / loss on covered call position
Profit / loss on ETF alone
-10
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
• Buy 100 shares of
stock and sell one
option on the stock.
• Gain is likely to occur,
but is limited.
• Losses are relatively
unlimited, but in a
losing month writing
a covered call always
reduces losses
compared to owning
the shares alone.
Profit / Loss on position at expiration
Covered call position
Share Price at Expiration
Sources: www.cboe.com, Investors FastTrack
1-Jun-2010
1-Jun-2009
1-Jun-2008
1-Jun-2007
1-Jun-2006
1-Jun-2005
BXM dd: -33%
S&P dd: -47%
1-Jun-2004
1-Jun-2003
1-Jun-2002
1-Jun-2001
1-Jun-2000
100
1-Jun-1999
200
1-Jun-1998
300
1-Jun-1997
1-Jun-1996
1-Jun-1995
1-Jun-1994
600
1-Jun-1993
700
1-Jun-1992
800
1-Jun-1991
900
1-Jun-1990
1-Jun-1989
1-Jun-1988
Covered call writing: S&P 500
1000
S&P 500 total return
(8.9%/year)
S&P 500 Buy-Write Index
(BXM, 9.4%/year)
500
400
BXM dd: -40%
S&P dd: -55%
0
Covered call writing: Dow Jones
Industrial Average
240
220
200
180
DJIA total return
(4.2%/year)
DJIA Buy-Write
(BXD, 4.8%/year)
160
140
120
100
DJIA dd: -35%
BXD dd: -30%
80
Sources: www.cboe.com, Investors FastTrack
DJIA dd: -52%
BXD dd: -36%
Covered call writing: NDX
1200
NDX total return (10.3%/year)
1000
NDX buy-write (BXN, 7.5%/year)
800
NDX dd: -83%
BXN dd: -57%
600
400
200
Sources: www.cboe.com, Investors FastTrack
30-Dec-2009
30-Dec-2008
30-Dec-2007
30-Dec-2006
30-Dec-2005
30-Dec-2004
30-Dec-2002
30-Dec-2001
30-Dec-2000
30-Dec-1999
30-Dec-1998
30-Dec-1997
30-Dec-1996
30-Dec-1995
30-Dec-1994
0
30-Dec-2003
NDX dd: -54%
BXN dd: -45%
Covered call writing: Russell 2000
190
170
150
Russell 2000 total
return (4.4%/year)
Russell 2000 Buy-Write
(BXR, 3.3%/year)
130
Ru2000 dd: -59%
BXR dd: -51%
110
90
70
Ru2000 dd: -37%
BXR dd: -29%
50
Sources: www.cboe.com, Investors FastTrack
Shorter-term ETF relative strength
rankings and trading strategies are
reported in my newsletter,
Systems and Forecasts
(www.systemsandforecasts.com)