Friday Mailbag

Teresa, May 9, 2008 @ 10:42AM ET | Link | RSS | Read via Email | 7 Comments  

Our client Daniel took the time to send in questions about a number of things people want to know, but were afraid to ask. ;-)

Daniel
I have a question to know if it is possible. If one wants to “catch” a peak although you would not recommend on it how would I know what the band would be on the upside. I mean I have the band on the lower side obviously because it would still be a long position, but what I have seen in the charts it does not seem simply a matter of reversing the difference from the Close or Open to the band.

Teresa
If you wish to ‘pick tops”, there are two types mentioned in The Ultimate Trading Course: the spike top (after a parabolic rise) and the test of top (Trader Vic 2B). These are anti-trend hit and run trade setups, and generally, the InVivo.Stops would still be UNDER the price action.

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WYNN was a particularly elegant Trader Vic 2B Test of Top

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WM was a particularly elegant spike bottom

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Portfolio Size, Rebalancing and Weighting

Teresa, May 5, 2008 @ 10:58AM ET | Link | RSS | Read via Email | Start a Discussion  

There are two questions in the mailbag this morning:

Doug
I am questioning the updates in the strategic portfolio, etc. I just started with it 2 - 3 weeks ago. Was looking at the change in the % using $10,000 as a test amount. It looks to me that the changes week to week are very small +/- 1 to 3 shares and maybe less which is not possible; it seems the commissions will kill you. I pay very small commission rates too but would still have to pay a $1.00 per change. How I am clear with my thoughts.

Teresa
Yes, the percent changes are small. For a portfolio under $20,000 — even with $1.00 per trade commissions — the transaction costs would not justify rebalancing it once per week. You might consider rebalancing it once per month, but the performance will not be quite the same. The risk profile will also not be the same.

As usual, there is an economy of scale. The larger the account, the more efficient it will be, and the more money it will make because it can rebalance often. David Swensen states in his book, Unconventional Success:

As a matter of course, every trading day, Yale estimates the value of each of the components of the endowment. When marketable securities asset classes (domestic equity, foreign developed equity, emerging market equity, and fixed income) deviate from target allocation levels, the university’s investments office takes steps to restore allocations to target levels. In fiscal year 2003, Yale executed approximately $3.8 billion in rebalancing trades, roughly evenly split between purchases and sales. Net profits from rebalancing amounted to approximately $26 million, representing 1.6 percent incremental return on the $1.6 billion domestic equity portfolio.

Even though rebalancing profits represent a nice bonus for investors, the fundamental motivation for rebalancing concerns adherance to long-term policy targets. In the context of a carefuly considered policy portfolio, rebalancing maintains the desired risk level. Generating profit while controlling risk represents an unbeatable combination.

Few institutions and even fewer individuals possess the resources to conduct daily rebalancing of investment portfolios. Yet, regardless of the frequency of rebalancing, fidelity to asset-allocation targets proves important as a means of risk control and valuable as a tool for return enhancement. Thoughtful investors employ rebalancing strategies to meet policy asset-allocation targets.

Daniel
To what I have seen much of the success of the Strategic Performance Portfolio can be accounted for the right combination of ETFs.

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Daniel’s Chart

As a matter of fact yesterday I did a quick chart showing the Buy & Hold from the same start date (equal weight - no leverage). The results were a graph more or less with the same peaks and troughs, with less draw down but with less profit also. I am not stating that it is right or wrong, only that the right combination accounts for much of the success.

Rebalancing is like straightening the graphs cutting the peaks and troughs. If only one could just cut the troughs…..

Teresa
Exactly. I have a TradeStation strategy written so that I can quickly check to see what happens to an equal weight portfolio. And as you have seen for yourself, it is no way to go because it’s still a big roller coaster: the volatility of returns is too high. That’s the reason I had to do the R&D to come up with a better way to allocate my own assets.

Side note: people freak out when they see “too much bonds” or “too much cash” but they help toward the goal of proper portfolio construction, which is to smooth out the peaks and troughs — and then use appropriate leverage to boost returns. This concept might not be familiar to traders because their answer to smoothing the equity curve is to time the market. Same objective; different approach.

Choosing the “right” ETFs is simple because the success of a portfolio requires diversification amongst broad asset classes. For small accounts that need to save on transaction costs, we basically choose the one ETF that best embodies the qualities of that asset class.

Abdul
The percentage returns are based on the opening price and if one were to invest a large amount in the the etfs , the volume is not very large so what is your advice? Buy at the open or close.

Teresa
Ideally, one would be able to sell at the close to take advantage of any calendar effect and then rebalance at the open. I had to build the model with a price somehow, and the open was a logical point. Do your best to rebalance near the open, but if you cannot do it, I have observed (from trading S&P futures) that prices tend to settle down after the first 30- to 45-minutes and it’s quite often close to where it opened.