How Volatile has the Stock Market been?

 

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After recovering from the March 2020 lows, the major indices (Dow, Nasdaq, and S&P) have been on a tear, reclaiming the earlier highs. 

On its way to retesting the old highs, the market did dip several times, offering better buying opportunities, especially in late May and mid-September. For example, after reaching 27,000 in late May, Dow quickly fell back to 25,000 and provided a similar opportunity again in late September.

Though the growth has not been a perfectly linear, the investors nonetheless fared very well who stayed on or bought the dips.

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The High-to-Low ratio is one of the quickest ways to understand market volatility. Obviously, the bigger the spread, the higher the volatility. In a stable market, this ratio will be range-bound between 101 and 103. When it spikes above 105, the market enters a phase of turbulence.

The above graph confirms that the market experienced a very high level of volatility in late May and early June; for example, from a low of 102.74 on 5/18, it dramatically climbed to 109.98 on 6/8, steadily retracing back to 103.03 on 7/56. 

Many quantitative funds and traders take advantage of this volatility via liquid derivatives like options on Indices, VIX, etc.  

Stay safe!

-Sid Som

homequant@gmail.com

How to Create a Statistically Significant Fund of Funds from Balanced Mutual Funds

 

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1. Screening Funds: It's important to select funds with very similar attributes, which, in turn, will enhance the collinearity of the portfolio. In selecting the above funds, the following set of criteria has been used: NAV > $7B; Morningstar Rating = 4 to 5; Track > 10 years; Yield = Positive; YTD Return > 8%.

2. Balanced Funds: Balanced Mutual Funds are inherently diversified (40-60% in stable/dividend stocks, 30-40% in fixed incomes, and balance in Cash, Precious metals, and other debt instruments). Since these funds are self-hedged by design, meaning stocks hedged by bonds, etc., no additional hedge component is needed.

3. Fund of Funds: Creating a statistically significant Fund of Funds from a group of Balanced Mutual Funds requires that they are drawn from a highly correlated group, as shown in the correlation matrix above. Thus, while reducing the number of funds, the "least" collinearity must be adhered to. For instance, since Dodge and Cox show lower collinearity than its peers, it must be removed first from this line-up.

4. Risk Mitigation: A Fund of Funds is more prudent from the investment point of view. It helps reduce the general risk embedded in a single balanced fund (risk scenarios: merger, change of ownership, departure of a veteran portfolio manager, etc.). 

Therefore, instead of investing $100K in one balanced fund, it's better to spread the sum over a group of highly correlated balanced funds (again, the highly correlated funds tend to project very similar attributes).

Disclaimer - The author does not advocate any of the funds listed here; instead, this is promoted as alternative research in creating a statistical fund of funds. Consult your Registered Rep, RIA, or Financial Planner for an appropriate asset allocation model and the suitability of mutual funds and other instruments.  

-Sid Som

homequant@gmail.com

Link to the Book

A Diversified REIT ETF may Proxy Physical Real Estates in an Asset Allocation Model

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The Correlation Matrix (top graphic) shows the correlation between the S&P 500 and five publicly traded Real Estate Investment Trust (REIT) ETFs. While MORT is a mortgage REIT, the other four are diversified equity (Real Estate) REITs. 

The Correlation Matrix shows almost negligible correlations between the S&P 500 and the REITs. This lack of correlation entices investors to own REITs as a separate asset class in their asset allocation model, proxying a portfolio of diversified real estates (residential, commercial, and industrial) without physically owning and managing them. 

To maintain the tax advantage status, REITs have to pay out at least 90% of their income as a dividend. Since REITs are designed to yield higher dividends, they tend to complement the fixed income (asset) class in the asset allocation model.

Correlation coefficients ranging between + 0.10 and -0.10 are considered uncorrelated. VNQ is the only one that falls outside of that range, showing a slightly negative correlation. Save MORT, the other four equity REITs are moving in lockstep, considering their top holdings (accounting for at least 35% of the portfolio) are virtually alike (e.g., American Tower, Simon Property, Crown Castle, Prologis, Public Storage, Avalon Bay, Equinix, Equity Residential, Digital Realty, etc.).

Though Mortgage REITs tend to generate much higher yields than their equity (real estate) counterparts, they are inherently more volatile as they are more prone to interest rate fluctuations. MORT currently has a yield of 7.77% compared to 3% to 4% for the equity ones.

   

The weekly graph (bottom graphic) is more telling. While the S&P 500 moved from 2,400 to 2,800 (between 8/1/17 and 7/31/18), both REITs (IYR and VNQ) remained range-bound between $74 and $82. As a result, the diversified equity REITs have low beta (usually between 0.5 and 0.7). 

Again, a diversified equity REIT ETF could be an excellent way to own this asset class (a wide variety of real estates) without physically owning and managing them.

Disclaimer - The author is not advocating any of the ETFs/indices listed here. Consult your Registered Rep, RIA, or Financial Planner for an appropriate asset allocation model and the suitability of stocks and other holdings for your portfolio.

- Sid Som

homequant@gmail.com

Link to the Book