Author Topic: Using short ETF instead of Bond to reduce volatility  (Read 6989 times)

Grog

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Using short ETF instead of Bond to reduce volatility
« on: June 24, 2014, 06:48:55 AM »
Hi everyone
I'm actually 100% stocks and I'm fine with it. But everywhere I read about investing, they counsel people that want a smoother ride, less up/downs etc, to reduce volatility by diversifiying and using not-so-correlated asset classes, like bond.

But why I never find any indication about short-index ETF? Aren't this the only true perfectly uncorrelated product?

The investor in broad index believe that the market always goes up, let's say at about 8% annually.

So if my portfolio looks like this:
75% long S&P500 ETF
25% short S&P500 ETF

I'll have following expected return: 75% x 8% - 25% x 8% = 4%
with a far smoother ride that bond and with a certainty of 100% that for every crash my short ETF will go up.

Hell, you could even use a 60% long - 40% short index allocation as "Saving accounts/emergency fund" with an expected average return of 1.6%.

What do I understand wrong? These short ETF are truly the inverse, right? So I don't see any problem.
Thanks to all you gurus for the enlightment :)

matchewed

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #1 on: June 24, 2014, 08:33:30 AM »
So someone better at this can correct me if I'm wrong, but I think you're making the mistake that your plan has assets with no correlation. Your plan still has assets which have correlation. They're directly correlated, whether positively or negatively I don't know, but they're the same assets just betting on them to behave differently.

The why on counseling people to go for further rides is generally to combat basic human psychology. Can you ride that volatility it will exhibit in the short term? If your answer is yes then you have no real reason to want that smoother ride unless you're seeking opportunities in other types of investments; international, bond markets...etc.

And your statement here -
I'm actually 100% stocks and I'm fine with it.

doesn't jive with the rest of your post. If you're fine with it and have accepted the various risks and returns associated with that asset allocation, then why seek to change it?

Grog

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #2 on: June 24, 2014, 08:44:59 AM »

doesn't jive with the rest of your post. If you're fine with it and have accepted the various risks and returns associated with that asset allocation, then why seek to change it?

I'm far away from FIRE, but that doesn't mean I'm projecting myself up there when I'll be probably not able to stomach a 100% stock allocation.
Me in the accumulation phase-> fine with 100% stocks
in the retirement phase? I don't know, I presume no. Is a gedankenexperiment

Since many of the text treat the maintaining/FIRE phase and counsel 75%/25% or something differently I was just wondering why not use a truly inversely correlated asset, which is what you are looking for to reduce volatility, risk and therefore returns.

matchewed

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #3 on: June 24, 2014, 08:50:04 AM »

doesn't jive with the rest of your post. If you're fine with it and have accepted the various risks and returns associated with that asset allocation, then why seek to change it?

I'm far away from FIRE, but that doesn't mean I'm projecting myself up there when I'll be probably not able to stomach a 100% stock allocation.
Me in the accumulation phase-> fine with 100% stocks
in the retirement phase? I don't know, I presume no. Is a gedankenexperiment

Since many of the text treat the maintaining/FIRE phase and counsel 75%/25% or something differently I was just wondering why not use a truly inversely correlated asset, which is what you are looking for to reduce volatility, risk and therefore returns.

Bolded for emphasis. But the advice you're reading isn't asking for inversely correlated assets but non-correlated assets. Equities will have a stronger correlation with other equities. That is why when you see someone say something like 75/25 what they generally mean is equity/bond or other fixed income not equity/other type of equity.

Grog

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #4 on: June 24, 2014, 09:43:27 AM »

Bolded for emphasis. But the advice you're reading isn't asking for inversely correlated assets but non-correlated assets. Equities will have a stronger correlation with other equities. That is why when you see someone say something like 75/25 what they generally mean is equity/bond or other fixed income not equity/other type of equity.

Of course, I see it now. If equity are doing meh (+/-1% for 10 year), then the truly inversely correlated will not provide some sort of growth, just inversely reflecting the "meh" period, while an uncorrelated asset maybe will, like bond.

Now I'm just wondering if there are strategy that use this information of the true inversely correlated aspect of short etf.

hodedofome

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #5 on: June 24, 2014, 09:51:57 AM »
If you can't stomach the volatility then just have less of your portfolio in stocks. Put more in a savings account or something. The reason why people diversify into bonds is that bonds still offer a positive return over time while being generally uncorrelated with the stock market. Having money in a short selling strategy that is most likely going to lose money over the long term is the wrong way to do it.

This is why short biased hedge funds (that actually make money) are in such high demand. If the short fund makes the market return over time, but is uncorrelated with the market, then you can combine it with a long-only market fund to make the same or better returns with lower volatility.

nordlead

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #6 on: June 24, 2014, 09:54:32 AM »
In a perfect world (think frictionless pulley's from physics class), 25% short S&P500, will essentially cancel out 25% S&P500.

So, 75% S&P500 + 25% Short S&P500 is exactly the same as 50% S&P500 + 50% cash. This is because they are perfectly inversely correlated. In the real world though, there are fees, and that 25% Short S&P500 portfolio will actually do worse than the cash portfolio even if the cash earns 0%.

Inversely correlated is different than uncorrelated though. Stocks and CD's and are uncorrelated. How stocks perform has no bearing on how CD's perform. If your CD's are throwing off 3%, and the stocks expected return is 7%, then with a 75/25 stock/CD portfolio you'll have an expected return of 6%.

As further emphisis, a 50/50 split of inversely correlated investments will return 0% (S&P500 and shorting S&P500), where as a 50/50 split of uncorrelated investments theoretically will return some positive results (according to vanguard, stocks/bonds is historically 8.3%).

warfreak2

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #7 on: June 24, 2014, 11:21:08 AM »
So, 75% S&P500 + 25% Short S&P500 is exactly the same as 50% S&P500 + 50% cash.

Taking a long position means you profit when the index goes up, taking a short position means you profit when the same index goes down. This is like betting on every horse.

The point of diversification is to get the same returns at lower risk. If you want lower returns for lower risk, just invest less of your money!

ivyhedge

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #8 on: June 24, 2014, 12:28:52 PM »
Short ETFs are designed for daily holding periods or less only. ProShares and Direxion, et al, print that language all over their literature; how did you miss it? The time decay exhibited by even the broadest products is *not* your friend and will work against the products' intent the longer each is held (and it scales based on the multiple - like a 2x or 3x short). The products are aimed at, and chiefly used by, institutional traders as hourly/reversal hedges; that they have been co-opted by retail investors is sickening: but you're free to do as you wish, though: it's what makes a market ... PM me if you have specific questions.

Grog

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #9 on: June 24, 2014, 03:33:40 PM »
Short ETFs are designed for daily holding periods or less only. ProShares and Direxion, et al, print that language all over their literature; how did you miss it? The time decay exhibited by even the broadest products is *not* your friend and will work against the products' intent the longer each is held (and it scales based on the multiple - like a 2x or 3x short). The products are aimed at, and chiefly used by, institutional traders as hourly/reversal hedges; that they have been co-opted by retail investors is sickening: but you're free to do as you wish, though: it's what makes a market ... PM me if you have specific questions.

I won't do anything I've just confused uncorrelated with reversely correlated. Thanks for the reply and all the others, after the third post I immediately saw my error that I didn't quite get in my thoughts experiments before posting.

rmendpara

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #10 on: June 24, 2014, 06:13:43 PM »
Hi everyone
I'm actually 100% stocks and I'm fine with it. But everywhere I read about investing, they counsel people that want a smoother ride, less up/downs etc, to reduce volatility by diversifiying and using not-so-correlated asset classes, like bond.

But why I never find any indication about short-index ETF? Aren't this the only true perfectly uncorrelated product?

The investor in broad index believe that the market always goes up, let's say at about 8% annually.

So if my portfolio looks like this:
75% long S&P500 ETF
25% short S&P500 ETF

I'll have following expected return: 75% x 8% - 25% x 8% = 4%
with a far smoother ride that bond and with a certainty of 100% that for every crash my short ETF will go up.

Hell, you could even use a 60% long - 40% short index allocation as "Saving accounts/emergency fund" with an expected average return of 1.6%.

What do I understand wrong? These short ETF are truly the inverse, right? So I don't see any problem.
Thanks to all you gurus for the enlightment :)

I'll try to keep this light, as we all don't have a statistics background.

Positive correlation (+1) means two stocks (or any two securities) move in perfect sync, in the same direction. For every $1 A goes up, B also goes up $1.

Negative correlation (-1) means two stocks (or any two securities) move in perfect sync, in the opposite direction. For every $1 A goes up, B goes down $1.

Buying an inverse ETF has a -1 correlation to a long ETF (not perfect -1, but pretty darn close).

The purpose of diversification is to purchase assets which are uncorrelated (0). That is, the movement in A is unrelated to the movement in B. Most likely it's between -0.3 and +0.3, as few assets have a correlation of 0, but you get the idea. For every $1 A goes up, there is no statistically significant movement in B (i.e. if you drew a scatter plot of the returns, it would appear to be all over the place and you couldn't draw a line and get very close to both).

A common example of an uncorrelated asset to stocks is real estate, as it has its own booms/busts and other issues and doesn't follow the stock pattern very closely over a long period of time.
« Last Edit: June 24, 2014, 06:24:57 PM by rmendpara »

Grog

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #11 on: June 24, 2014, 11:19:41 PM »
Yeah I see it clearly now, thanks for the explanation :)

here on this forum I've already seen advertised a momentum strategy based on putting all the fund in the top ETF with the best X-month trailing return (usually 5 months).
Could it be that there is an use for this short ETF for a momentum strategy, always switching back and forth between long and short? probably it doesn't make sense, since investing in short means you are putting your money on something that is bound to lose value over time.

matchewed

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #12 on: June 25, 2014, 05:17:07 AM »
Yeah I see it clearly now, thanks for the explanation :)

here on this forum I've already seen advertised a momentum strategy based on putting all the fund in the top ETF with the best X-month trailing return (usually 5 months).
Could it be that there is an use for this short ETF for a momentum strategy, always switching back and forth between long and short? probably it doesn't make sense, since investing in short means you are putting your money on something that is bound to lose value over time.

There would probably be strategies that would follow that method. There are strategies for all sorts of things. That isn't the right question. The right question would be how successful would that strategy have been? When would be the triggers to switch between? Odds are if you're just guessing you'll do poorly with your portfolio. I'd recommend (of course) just sticking with index funds and educating yourself on more complex investment options if that's your thing.

hodedofome

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #13 on: June 25, 2014, 08:17:56 AM »
Yeah I see it clearly now, thanks for the explanation :)

here on this forum I've already seen advertised a momentum strategy based on putting all the fund in the top ETF with the best X-month trailing return (usually 5 months).
Could it be that there is an use for this short ETF for a momentum strategy, always switching back and forth between long and short? probably it doesn't make sense, since investing in short means you are putting your money on something that is bound to lose value over time.

You can test this out yourself on etfreplay.com.  I have seen momentum strategies that utilize short ETFs for this reason. However, in my own testing using an uncorrelated asset that is a 'flight to safety' like treasury bonds works better than an inversely correlated asset like a short index fund.

During strongly trending up or down periods, just using SPY and SH (as an example) will give you the best return. However, during choppy periods where there is no sustained trend, you'll get whipsawed heavily. The market will start to go up, so your momentum system will say buy SPY. You buy SPY and then the market starts to go down. So you lost money on that trade. Then your system says to buy SH because the market is going down. You buy SH and then the market starts to go back up so you lose money again. If this happens several times in a row you could be looking at a pretty good loss. Most likely the losses during these periods will be great enough that you'll give up on the system...just as the market starts to trend and the system makes money again. :)

Play around with a subscription to etfreplay and read stuff from Mebane Faber and Gary Antonnacci if you are interested in momentum systems. But realize that strategies are easy, it's sticking to them when they suck, is the hard part.

YoungInvestor

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #14 on: June 25, 2014, 09:20:43 AM »
If you're gonna be doing that, why don't you just put 50% in an ETF and 50% in a savings account?

You'd get the same returns with less fees. Heck, you might get interest on the 50% in the savings account.

People generally want to add diversification to their portfolio. Other options would be a REIT, bonds and international equity. This way, if the US stock market crashes, your other investments may (or may not, in the case of the REIT and international equity) remain more stable.

RaymondG

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #15 on: June 26, 2014, 02:23:17 PM »
Here is a article about "Correlation Analysis for Asset Allocation". The web site includes basics about diversification and investing in mutual funds.
http://www.investing-in-mutual-funds.com/correlation.html
« Last Edit: June 26, 2014, 02:36:58 PM by RaymondG »

warfreak2

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #16 on: June 26, 2014, 02:28:43 PM »
If there are perfectly negative correlated two assets and they have a mean growth rate,
If two things are perfectly negatively correlated and one of them grows, the other one shrinks. They can't both grow.

RaymondG

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #17 on: June 26, 2014, 02:33:51 PM »
If there are perfectly negative correlated two assets and they have a mean growth rate,
If two things are perfectly negatively correlated and one of them grows, the other one shrinks. They can't both grow.

Yes, you are right. I updated my last reply.

RaymondG

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #18 on: June 26, 2014, 06:39:41 PM »
If there are perfectly negative correlated two assets and they have a mean growth rate,
If two things are perfectly negatively correlated and one of them grows, the other one shrinks. They can't both grow.

Yes, you are right. I updated my last reply.

Thought about it again. I thought the correlation between two stocks is the the correlation of their (daily) price changes when I wrote my last reply. Such as SPY and TLT in some periods, both have positive total return in long run but their prices often change in different direction though  not in the same amplitude. In a portfolio, we include most assets for their growth while choosing them by not-so-correlated, better if negative correlated, to reduce volatility.
« Last Edit: June 26, 2014, 07:07:04 PM by RaymondG »

warfreak2

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #19 on: June 26, 2014, 07:13:25 PM »
If there are perfectly negative correlated two assets and they have a mean growth rate,
If two things are perfectly negatively correlated and one of them grows, the other one shrinks. They can't both grow.

Yes, you are right. I updated my last reply.

Thought about it again. I thought the correlation between two stocks is the the correlation of their (daily) price changes when I wrote my last reply. Such as SPY and TLT in some periods, both have positive total return in long run but their prices often change in different direction though  not in the same amplitude.
OK. Yes, it's mathematically possible for the rates of change of two variables to be perfectly negatively correlated, without their actual values necessarily being negatively correlated, and this would imply that some combination of the two would be non-random without necessarily being constant. That is a good point.

However, in mathematical finance, the no-arbitrage assumption implies that you'd get the same riskless interest rate by buying a conventional riskless asset, and hence one of the assets must be a short position in the other*. So it's "mathematical-financially impossible" rather than "mathematically impossible", which is somewhere between "mathematically impossible" and "we didn't see it yet", but I'd say a lot closer to the former.

*Actually, this still doesn't quite mean that they don't both grow in nominal terms, but it does mean that one of them is worse than holding "cash", so it shrinks in practical terms.

RaymondG

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #20 on: June 26, 2014, 08:05:45 PM »
If there are perfectly negative correlated two assets and they have a mean growth rate,
If two things are perfectly negatively correlated and one of them grows, the other one shrinks. They can't both grow.

Yes, you are right. I updated my last reply.

Thought about it again. I thought the correlation between two stocks is the the correlation of their (daily) price changes when I wrote my last reply. Such as SPY and TLT in some periods, both have positive total return in long run but their prices often change in different direction though  not in the same amplitude.
OK. Yes, it's mathematically possible for the rates of change of two variables to be perfectly negatively correlated, without their actual values necessarily being negatively correlated, and this would imply that some combination of the two would be non-random without necessarily being constant. That is a good point.

However, in mathematical finance, the no-arbitrage assumption implies that you'd get the same riskless interest rate by buying a conventional riskless asset, and hence one of the assets must be a short position in the other*. So it's "mathematical-financially impossible" rather than "mathematically impossible", which is somewhere between "mathematically impossible" and "we didn't see it yet", but I'd say a lot closer to the former.

*Actually, this still doesn't quite mean that they don't both grow in nominal terms, but it does mean that one of them is worse than holding "cash", so it shrinks in practical terms.

Thank you very much. I understand it better now.
« Last Edit: June 26, 2014, 08:07:16 PM by RaymondG »

DaKini

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #21 on: June 27, 2014, 03:15:20 AM »
But wouldnt rebalancing kick in?
In a bear market i would pourmore fresh funds into the long position whereas in a bull market i would fund the short one more. This should helph growth when the market rebounds OR peaks (and would loose in flat markets), shouldnt it?
When i reach the withdrawal phase i would pull money out reversed, eg from the long position in bull markets. In addition i would rebalance manually, eg selling short position to buy long ones in a bear market.

The problem i see with this is the short decay usually involved.
« Last Edit: June 27, 2014, 03:17:20 AM by DaKini »

warfreak2

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #22 on: June 27, 2014, 05:21:47 AM »
But wouldnt rebalancing kick in?
Let's treat a 75% long/25% short position as 50% long/50% mixed. Now let's just examine the mixed portion. We'll also ignore fees.

Suppose you have $100, so you go $50 long and $50 short. Say the market grows by 10%: then your long holdings are now $55 and your short holdings are $45. Still $100. You rebalance by selling $5 of long holdings, and buying $5 more short. Next the market goes down 2%, and your holdings are now $49 long, $51 short. Still $100.

aclarridge

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #23 on: June 27, 2014, 09:14:32 AM »
Yeah I don't know why anybody would do this strategy, as you could simply invest less money instead, and avoid paying the close to 1% fees that these types of funds usually charge. Fees will always be higher because of the extra work required to run them.

Grog

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Re: Using short ETF instead of Bond to reduce volatility
« Reply #24 on: June 27, 2014, 09:50:07 AM »
Yeah I don't know why anybody would do this strategy, as you could simply invest less money instead, and avoid paying the close to 1% fees that these types of funds usually charge. Fees will always be higher because of the extra work required to run them.

absolutely right. I was blinded by the reverse correlation (growing in bear market) but forgot that in the end, the still cancel out because of the almost perfect inverse correlation.