ETFOptimize subscribers should be aware that with our more aggressive equity-based strategies, sharp paper losses can sometimes occur during rapid market corrections (as took place in February and March 2018). These paper-losses can occur because the models are often holding 2x leveraged-equity ETFs when underlying conditions are robustly bullish, but the market has experienced a sharp pullback nevertheless as temporary over-enthusiasm is adjusted back to normal (called a 'correction').
This occurrence can cause a great deal of anxiety for some strategy subscribers, and we want to arm you with some facts that allow you to understand better what is taking place and why you needn't worry that 'something is wrong' with your strategy's selections.
QUANTITATIVE STRATEGIES vs. DISCRETIONARY DECISIONS
This consistent focus on the critical drivers of investment performance is one of the many ways a quantitative strategy is superior to classic, discretionary approaches. Our quantitative investment approaches are designed to maintain constant attention to the underlying drivers of the market, and they do not try to react every time there is a minor convulsion of prices. These temporary, volatile market gyrations are usually the result of investor's emotional response to a troubling news item (in this case, ostensibly the new 'Trump tariffs' on China and the prospect of a trade war).
Usually, these types of stories pose some perceived 'threat' to the US economy that some investors believe will drive down profits. These economic horror stories are almost always empty noise, and if they ultimately do come to fruition, it occurs months or years later. For this reason, you shouldn't panic and sell investments today, even if those stories do turn out to be true.
However, when these type of news items break, a particular variety of skittish investors will begin selling, while a second wave, seeing the selling and resulting decline of prices - and not wanting to get caught without a chair when the music stops, respond with even more selling. These knee-jerk, emotional reactions by 'weak hand' investors frequently result in decision errors that can compound and usually cause financial loss - the exact result these panicky people were trying to avoid in the first place.
These scenarios occur because inherently, investing is incredibly difficult for the average person – and even for the not-so-average super-person. Not only do we need to understand and weigh dozens of rapidly changing economic factors, understand the interplay between different market sectors, determine the significance of various product categories rising while others are falling, assess the impact of corporate officers coming and going in their jobs, the financial implications of mergers and acquisitions, valuation considerations, growth prospects, corporate insider trading activity – it's a very complicated undertaking potentially millions of bits of information affecting the price of a stock's!
Investors realize they can't stay in touch with - or even wholly understand - all of these dynamic factors and their entanglements, so they often panic when they see rapid selling take place. They think – seemingly logical at the time – that if others are selling, they should also sell. Investing is, in a significant way in short-term time frames, a product of crowd dynamics (some would say 'crowd hysteria').
On the other hand, quantitative investment strategies, such as those offered by ETFOptimize, are able to consistently collect and process this multitude of interrelated factors and can assess how they affect the markets and various categories of investments. Quantitative investing strategies allow a savvy you to ignore all of the nonsense in the news. Instead of spending time monitoring cable business channels, diligently reading the Wall Street Journal or your favorite market website, trying to anticipate what's next for stocks – you can instead focus on what's essential in your life – your family, your career, and your peace of mind.
Meanwhile, your quantitative investment strategy will always be focused – keeping its attention 24-hours-a-day on the critical drivers of the prices of the ETFs in its portfolios, measuring the pertinent aspects and correlations, then consistently choosing the security that has the highest probability of providing the most profit with the least drawdown in the context of the strategy's investment approach. Your quantitative strategy consistently weighs all of these different factors and makes clear-cut decisions, never forgets, never gets tired, and never has a bad day.
POTENTIAL PSYCHOLOGICAL TOLL
However, for some investors who are inexperienced with systematic investing, allowing a strategy to make all decisions is analogous to forcing yourself to sit alone in the backseat for your first experience in a self-driving car – during heavy traffic. Feeling 'out of control,' you begin to see life-threatening dangers lurking at every intersection, and your heart begins to race when you think the car isn't putting on its brakes soon enough to stop. Something similar happens to investors when they 'take their hands off the wheel' of a quantitative investment strategy for the first time and commit to allowing it to make all the decisions.
There is no doubt that when a sharp market correction occurs, it has the potential to take an emotional and psychological toll on less-experienced investors when using one of our more aggressive strategies that include leveraged equity ETFs. Those leveraged ETFs perform incredibly well when the market is rising, but are a two-edged sword when the situation reverses. However, behind the scenes of your quantitative strategy, there are some hidden protections - of which you should be aware and which should give you more confidence in its decisions.
ANALYZING A TYPICAL CORRECTION
We will get to those protections in a moment. But first, let's examine corrections and what causes them. The widely accepted definition of a market correction is a decline between -10% to -20% from the most recent high. Sometimes that decline comes in short span of a week or two, which can cause the most psychological damage if the strategy is holding a leveraged ETF.
Because some of our more aggressive strategies might be holding a 2x leveraged ETF when a correction occurs, that quick downturn can result in a paper loss that can be double that of comparable non-leveraged security. Conceivably, holding a leveraged ETF when a correction occurs could potentially turn that -10% drawdown into a drop of -20%, and it can happen very quickly.
As shown in the Chart 1 below, the S&P 500 2x Leveraged ETF (SSO) used in our S&P 500-Aggressive strategy fell -11.48% last week (March 19-23) alone, while the standard S&P 500 ETF fell half that amount, -5.24%.
Chart 1: While a 2x leveraged ETF is highly coveted when a bull market rules the roost, volatility (like we've seen recently) makes investors run from them.
With sharp drawdowns like this sometimes occurring in a matter of just a few days, by the time a strategy has the chance to switch positions (if it is appropriate) some real psychological stress can take place for those investors who are holding leveraged positions that temporarily go in the wrong direction. Assuming these investors don't have longer-term experience with the strategy, they can immediately begin to losing confidence in it. The real danger that investors bring upon themselves is selling in reaction to a temporary loss.
Individual investors often make this mistake when a single leveraged ETF in their portfolio takes a temporary, corrective dive. As the investor becomes stressed and their innate, fight-or-flight animal response takes over, many investors sell their positions rather than risk further stress over additional paper losses, thereby locking-in and making permanent a temporary loss.
While not a substitute for real-time experience with a strategy, some pertinent facts about the ETFOptimize strategies may help you stick with them when sharp, temporary drawdowns occur.
IMPORTANT FACTS YOU SHOULD KNOW
We don't want you to have undue stress over the paper performance of the positions in your portfolio and we certainly don't want you to come to regard the ETFOptimize strategies as potentially dangerous. That's not the case at all – in fact, objective evidence shows the exact opposite, and we want to offer instantiationabout how our strategies work for you over the long-term to provide far less risk than virtually all other type of investments. Yes, even the ETFOptimize strategies that use leveraged ETFs have less risk than investments like individual stocks, mutual funds, commodities, individual ETFs, and many bonds.
Frequently, users new to a strategy do not have confidence in the approach – confidence that sometimes can only come from the experience of seeing their strategy perform well through challenging occasions. When subscribers don't have this positive experience, we find they will often pull the plug and abandon the strategy (often at the worst possible moment – at the bottom of a decline). To continue the earlier analogy, these investors will get out of their self-driving car when it stops at an intersection. Of course, this locks in those losses, just as occurred during the Financial Crisis panic selling.
1) PATIENCE IS REQUIRED...
Many investors, focused on their immediate, personal 'crisis' at hand related to one troubling position, don't realize that if they simply have patience they are highly likely to see strong positive performance morph from those temporary drawdowns.
When being introduced to investing, many newbies are told that the stock market offers an annual return of around 10%. While that's true, a performance of 10% is actually rare in any given year. But it is accurate over longer time frames of 20-years and more.
Every few years, J.P. Morgan Asset Management has been doing a study of investor returns in stocks, bonds, and a 50-50 blend of the two over one-year, five-years, 10-years and 20-years of rolling investment performance. Their study shows the average range of annualized returns for each timeframe an investor stayed invested in the asset class.
Chart 2 below shows the results of this J.P. Morgan study, from 1950 through 2016 (66 years). On the far left, you can see that the performance of stocks in any one year can range from a high of 47% to a low of -39%. For bonds, that range is 43% to -8% and for a blend of the two, 33% to -15%. However, the further one goes out in steadily sticking with a strategy, the more narrow that range and the more predictable and typical your annualized returns become.
For an investor with a minimum five-year commitment to stocks (or a strategy), the range of performance over rolling 5-year periods would've been no worse than -3% while producing an return of up to 28% annualized. Think about that for a moment: in any given year there is the potential for a -39% loss, but if you stick invested in your positions for a minimum of five years, the most you are likely to lose is -3% on an annualized basis.
The range of likely high annualized return and low annualized return steadily narrows as investment periods grow longer – until at 20 years the investor has the potential for a minimum of a 7% annual return - and up to 17% annualized. At 10 years, the maximum you can lose is -1%. The implications of that last sentence are profound – if you hold onto your investments and stick with the program, you have zero chance of losing money in periods over 10 years! At 20 years, the least return you are likely to get is 7% annualized.
The ETFOptimize strategies, which minimize drawdowns by rotating to defensive positions when conditions are contractionary and maximize profits by rotating to positions that are most productive – including leveraged ETFs – when conditions are expansionary, could produce a multiple of the J.P. Morgan study results. While we don't yet have 20-year performance record for our strategies, we believe that there is also 0% chance of losses in longer timeframes, and those time frames without the risk of a loss can probably be quite short. meanwhile, there is the potential for very high average annualized returns when using a systematic rotation strategy. The only thing you need to attain these surefire gains is patience – and the discipline to follow your strategy's recommendations through thick and thin.
While we can provide investors with our best, most professionally crafted quantitative investment strategies, we can't force them to have the proper investment mindset and diligently follow their strategy's decisions – which is all that's necessary for investment success with the ETFOptimize models. All we can do is point out that the strategies are consistently working in your favor in the background and that over the longer term, they should perform far better than your discretionary alternatives.
2) OUR ALGORITHMS ALWAYS FOCUS ON UNDERLYING CONDITIONS...
Keep in mind that the algorithms driving our strategies are doing continuous real-time analysis of underlying economic conditions, market internals, and stock fundamentals for their selection criteria. The strategies rotate into defensive positions when the underlying conditions become challenging and select the most advantageous ETFs during expansionary market periods, which can include 2x-leveraged ETFs.
When those underlying conditions have not changed, the ETFOptimize strategies are designed to ride out temporary market turbulence without a change of positions. The reason for this is that periods of investor over-exuberance and the inevitable corrections that follow are notoriously difficult to measure and time.
While we can certainly measure times when market indices are becoming stretched, and times when market indices have moved too far too fast, the point when that over-exuberance quickly changes into negativity can literally happen in a matter of hours. Most overextended market conditions that enter into parabolic patterns are notorious for stopping at a peak and reversing course downward.
A COMMON, BUT ERRONEOUS RESPONSE
The error that many investors make is switching to a defensive position (or cash) when temporary, corrective market action occurs. Corrections occur to resolve over-speculation in prices that have moved upward too far, too fast. Corrections are technical, price-centered responses to overextended prices that reposition shares back into equilibrium from overbought conditions. Overbought conditions were happening in January 2018 as investor enthusiasm about the December 2017 tax reform got out of hand. Stock prices had moved too far above their long-term mean. The resulting corrective action in February and March was likely not the beginning of a bear market. It was just a temporary price adjustment, without a change in underlying conditions, which does not call for defensive action.
Often, because potentially millions of investors are involved, the corrective price response initially overshoots to the downside. Of course, this can frighten investors when it appears prices are headed further afield, below the mean. Fear can set in and visions of a bear market play out in the mind.
However, in the following weeks, equilibrium is ultimately re-attained and the underlying dynamics of the economy and the market return to being the drivers of price action. Our strategies always focus on those drivers of share prices and disregard short-term overbought, corrective, and oversold conditions. That means followers of the ETFOptimize strategies (or any other systematic investment approach) will need to learn to ignore temporary corrective price action while your strategy remains focused on the underlying drivers of performance.
If you do not yet have the confidence to hold steady with one of our more high-performance, aggressive strategies through periods of market volatility – without overriding its recommendations with your own decisions – we suggest that you choose one of our more conservative models. Our most conservative approach is the Adaptive Fixed Income Rotation Strategy, which has an annual return of about 14% (including a 4% dividend).
While not as exciting or profitable as our strategies that include leveraged equity ETFs, the Adaptive Fixed Income Rotation Strategy produces a return that is more than double the long-term return of the S&P 500, and it has an equity curve that is nearly a straight 45-degree line upwards. The maximum drawdown (peak-to-trough decline) is just -9.17% since inception, so no one is going to lose sleep over temporarily volatile declines from this investment system.
COMING SOON: NON-LEVERED EQUITY ETF STRATEGY
For those wanting a more conservative approach that doesn't include leveraged ETF's ,we will be adding a new strategy soon that will provide you with another alternative. In the next few weeks, we will be announcing a new non-levered equity strategy. This strategy will not include any 2x-leveraged ETFs, and if you are concerned about rapid paper declines in leveraged positions, this new strategy may provide you with more peace of mind as a result of lower drawdowns when the market becomes temporarily turbulent.
Note that we expect the investment markets to be significantly more volatile in 2018 than they were over the last few years, which is a common characteristic as the economy enters into its final phase of expansion. The current expansion is nine years old, which is more than double the average length. While economic expansions coming out of deep financial crises are always long and slow, they cannot last forever, and this one will also come to an end.
We believe many signs are pointing to a downturn later this year. Therefore, the experience that subscribers have had recently with the February-March market turbulence may be repeated several times in the coming months (volatility is a common calling-card of market turns). We will notify all subscribers of this new, more conservative equity strategy's availability as soon as we have finished with construction of the pages and supporting materials.
In the meantime, we hope you will stick with your strategy's current ETF selections. Always keep in mind that your strategy is ignoring the empty noise in the foreground and assessing the overall economic and market situation in the background, then selecting the most profitable ETFs to hold for the current underlying conditions. If you can steel yourself to ignore the noise and volatility, your strategy will provide you with excellent results over the intermediate- and longer-term!