Active Asset Allocation Strategies Using ETFs

Marvin Appel, MD, PhDCEO, Appel Asset Management Corp.

Great Neck, NYmappel@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.

1

1.5

2

2.5

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3.5

4

4.5

5

5.5

6

1 2 3 4 5 6 7

index 1

index 2

time period

0.5

0.6

0.7

0.8

0.9

1

1.1

1 2 3 4 5 6 7

Index 1 divided by index 2

Rising = index 1 strongerFalling = index 2 stronger

Index 2 peak relative strength

1

2

3

4

5

6

7

8

9

1 2 3 4 5 6 7

index 1

index 2

ideal switch

time period

0.5

0.6

0.7

0.8

0.9

1

1.1

1 2 3 4 5 6 7

model in index 1

model in index 2

Index 1 divided by index 2

Rising = index 1 strongerFalling = index 2 stronger

Index 2 peak relative strength

Hypothetical ideal relative strength switching model

Recognizing new trends in relative strength

0123456789

10

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

40% drop

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

Source: Mutual Fund Expert as of 5/31/2010

100

1000

1/1/

79

7/1/

80

1/1/

82

7/1/

83

1/1/

85

7/1/

86

1/1/

88

7/1/

89

1/1/

91

7/1/

92

1/1/

94

7/1/

95

1/1/

97

7/1/

98

1/1/

00

7/1/

01

1/1/

03

7/1/

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1/1/

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7/1/

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1/1/

09

Russell 1000 Value Index: 12%/year, 56% drawdown

Russell 1000 Growth Index: 10.2%/year, 62% drawdown

Switching strategy: 12.9%/year, 50% drawdown

Russell 1000 Indexes and switching strategy, 1979-2010

(total returns)

History of value/growth model signals for large cap (Russell 1000) Indexes

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

1/31/79 7/23/84 1/13/90 7/6/95 12/26/00 6/18/06

Model in value

Model in growth

Russell 1000 Value / Growth Rising = value strongerFalling = growth stronger

Trend-following strategy: small-cap value versus small-cap growth

Source: Mutual Fund Expert as of 5/31/2010

100

1000

100001/

1/79

8/1/

80

3/1/

82

10/1

/83

5/1/

85

1/2/

87

8/2/

88

3/2/

90

10/2

/91

5/2/

93

1/3/

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8/3/

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3/3/

98

10/3

/99

5/3/

01

1/4/

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3/4/

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10/4

/07

5/4/

09

Russell 2000 Value Index: 13.5%/year, 55% drawdownRussell 2000 Growth Index: 8.9%/year, 63% drawdownSwitching strategy: 14.3%/year, 58% drawdown

Russell 2000 Indexes and switching strategy, 1979-2010

(total returns)

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1/31/79 7/23/84 1/13/90 7/6/95 12/26/00 6/18/06

Model in value

Model in growth

Russell 2000 Value / GrowthRising = value strongerFalling = growth stronger

History of value/growth model signals for small-cap (Russell 2000) Indexes

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 (price-only 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

75.000

750.000

7,500.000

Dec

01,

196

9

Jan

01, 1

972

Feb

01, 1

974

Mar

01,

197

6

Apr

01,

197

8

May

01,

198

0

Jun

01, 1

982

Jul 0

1, 1

984

Aug

01,

198

6

Sep

01, 1

988

Oct

01,

199

0

Nov

01,

199

2

Jan

02, 1

995

Feb

02, 1

997

Mar

02,

199

9

Apr

02,

200

1

May

02,

200

3

Jun

02, 2

005

Jul 0

2, 2

007

Aug

02,

200

9

MSCI EAFE: 9.8%/year, 56% drawdownMSCI US: 9.4%/year, 51% drawdownSwitching 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

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1

1.5

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3.5D

ec-6

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Jun-

75

Dec

-80

Jun-

86

Nov

-91

May

-97

Nov

-02

Apr

-08

Model in foreign stocksModel in U.S. stocks

Rising = foreign stocks stronger

Falling = U.S. stocks stronger

A Quarterly Asset Allocation Strategy for Foreign-Equity ETFs

FT Press 2008

Three distinct areas of the world’s stock markets

50

500

5000

12/1

/196

9

9/1/

1972

6/1/

1975

3/1/

1978

1/2/

1981

10/2

/198

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7/2/

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4/2/

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10/2

/199

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7/2/

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10/2

/200

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7/2/

2008

MSCI Europe total return

MSCI Emerging Markets total return

MSCI Japan total return

1994-2001EM weak,Japan weak,Europe strong

Through 1989,Japan strong

2002-2007EM strong

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

0

500

1000

1500

2000

2500M

ar-8

8

Apr

-89

May

-90

Jun-

91

Jul-9

2

Aug

-93

Sep-

94

Oct

-95

Nov

-96

Jan-

98

Feb-

99

Mar

-00

Apr

-01

May

-02

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Jul-0

4

Aug

-05

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-08

Jan-

10

MSCI Europe: 8.4%/year, 54% drawdown

MSCI Japan: -1.4%/year, 61% drawdown

MSCI Emerging markets: 12.4%/year, 53% drawdownQuarterly switching model: 11.9%/year, 50% drawdown

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

Covered call position• 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.

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80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100

Profi

t / L

oss

on p

ositi

on a

t ex

pira

tion

Share Price at Expiration

Profit / loss on covered call position

Profit / loss on ETF alone

Buy stock at $90Sell covered call at $2

Covered call writing: S&P 500

Sources: www.cboe.com, Investors FastTrack

0100200300400500600700800900

10001-

Jun-

1988

1-Ju

n-19

89

1-Ju

n-19

90

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n-19

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n-19

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n-19

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n-19

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n-20

10

S&P 500 total return (8.9%/year)

S&P 500 Buy-Write Index (BXM, 9.4%/year)

BXM dd: -33%S&P dd: -47%

BXM dd: -40%S&P dd: -55%

Covered call writing: Dow Jones Industrial Average

Sources: www.cboe.com, Investors FastTrack

80

100

120

140

160

180

200

220

240DJIA total return (4.2%/year)

DJIA Buy-Write (BXD, 4.8%/year)

DJIA dd: -52%BXD dd: -36%

DJIA dd: -35%BXD dd: -30%

Covered call writing: NDX

0

200

400

600

800

1000

120030

-Dec

-199

4

30-D

ec-1

995

30-D

ec-1

996

30-D

ec-1

997

30-D

ec-1

998

30-D

ec-1

999

30-D

ec-2

000

30-D

ec-2

001

30-D

ec-2

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30-D

ec-2

003

30-D

ec-2

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30-D

ec-2

005

30-D

ec-2

006

30-D

ec-2

007

30-D

ec-2

008

30-D

ec-2

009

NDX total return (10.3%/year)

NDX buy-write (BXN, 7.5%/year)

NDX dd: -83%BXN dd: -57%

NDX dd: -54%BXN dd: -45%

Sources: www.cboe.com, Investors FastTrack

Covered call writing: Russell 2000

50

70

90

110

130

150

170

190 Russell 2000 total return (4.4%/year)

Russell 2000 Buy-Write (BXR, 3.3%/year)

Ru2000 dd: -59%BXR dd: -51%

Ru2000 dd: -37%BXR dd: -29%

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)