Archive for May, 2012

ETFs Versus Specific Risk – JP Morgan Chase

Saturday, May 12th, 2012

May 12, 2012

Lets assume you have a nest egg of $50,000 to invest in equities.

As a prudent investor, you are not willing to invest more than 5% of your $50,000 capital in any one equity.  This means you will carry 20 equity positions of $2,500 each = $50,000.

The next question is…which equities ?

Do you want to give up control to a stranger, or a family member such as an arrogant, smarty pants brother in law.  Or would you rather retain control and make all the decisions yourself ?

Do you have the time and financial background to sift through thousands of financial statements and reams of data to make your 20 selections ? And then,  the time to monitor the daily fundamental and technical information on your selections ?  …. No ?

Then lets work top down and start with the top 20 equities ( by market capital ) included in the S&P 500. ( AAPL, XOM, IBM, MSFT, CVX, GE, T, JNJ, PG, KO, WFC, PFE, GOOG, JPM, PM, BRK, INTC, MRK, VZ, ORCL. )   You know you are dealing with the ” cream ” of the USA equity market and you know you can probably stay on top of developments just by scanning the financial pages.

Think you are totally safe ?……No …..Still, you are exposed to ” Market Risk ” ( all the boats go out with the tide – market decline ) , Sector Risk ( know anyone who wanted to own airline stocks till recently ) and Specific Risk.. .. The additional unique risk you undertake by owning a specific security whose fortunes rise or fall more or less independently of all other equities.

Lets start there – Specific Risk – By selecting the largest 20 equities  in the S&P 500, you have included JPM ( #14 ) in your basket,  risking 5% of your capital…..$2,500.  I suppose almost anyone would have felt comforted to know they owned JPM instead of C and BAC…especially with all the praise and space Jamie Dimon and his bank have received recently.  Mr Dimon even stepped forward to chastise authorities for placing too many proprietary risk restraints on a bank’s ability to make money.

So yesterday when JPM lost 9.52% of its value, Jamie must have felt like he fell into a sink hole.   The London Risk Management Section of JPM had failed to recognise and avert  a loss of $2 billion in securities hedging derivitive risk,  with more news promised.  What’s a bank to do to earn money when it ONLY gets 19% interest from us with almost zero interest cost to them ?  Remember, lending to business to get the economy going  can be  a low margin business !!   What’s going to happen to the business model ? What’s going to happen to the ” in house quants ” ?  They may actually need that math skill   to help develop something useful !

By investing only 5% of your capital  in JPM you lost ( 9.52% ) -$238. Now that’s Specific Risk,  mitigated by the fact that you had 20 different positions of no more than 5% each.  What if you had invested your $50,000 in only 10 or 5 positions…..or 1 position ?  You do the math.

However, if instead you had invested your $2,500 in the Bank Sector ETF….KBE…you would have lost only $64.50 because JPM is only2.58% of the KBE portfolio of banks.  Incidently, KBE as a whole yesterday lost 0.52% ( $130 ) as the sector itself was under some selling pressure in sympathy ( and worry ) for JPM.   And that is Sector Risk in action . Investors ask “If that can happen to Chase, what about C , BAC and some of the other even  less well run institutions.  Maybe we should exit the banks for now ”

Still further, if SPY ( the entire 500 stock  S&P portfolio ) had been your $2,500 selection instead of JPM, yesterdays loss would have amounted to only $7.50.   That is well diversified specific risk converted to market risk…. in action.

When you talk about specific risk,  you also must talk about insider information leaks because the world isn’t perfect and some people would have paid a great deal for pre-release negative information relating to JPM.  So, when we are talking risk capital and specific risk we can’t close our eyes to criminal risk.  Insider information is the magic wand that converts risk capital to riskless capital. Its also the wand that makes me want to disappear as an investor in individual stocks. 

Now I’m not saying anyone benefited from JPM insider information.  But, if I were the SEC I’d be reviewing all recent purchases of  Put Options on JPM which are not a hedge ( insurance ) against a long JPM portfolio position.  Option people know that when you purchase a Put you are either insuring or gambling.  Buying naked Puts ( no corresponding long position ) is an extreme form of gambling because the seller has an important advantage over you,  the buyer.  Not only must the news be bad and market moving but it must hit the market  before the option you purchased expires worthless.  In this case, you would be betting that JPM would make the $2 billion loss  anouncement before the  specific  options expiry date you selected. Options normally expire the 3rd Friday of the month.  The rewards can be huge because you can purchase  one Put  option contract for a fraction of the market value of  the 100 shares in each contract.

What should you take away from this Post.

1)  That an ETF  is a basket that  reduces risk  for a private investor vis a vis individual stocks.  It also reduces reward by just  a bit. but it more than makes up for it by protecting you via  … Investing Rule # 1 – ” Preserve Investment  Capital ” ! 

2 ) You show me a purchaser of naked Put options  and I’ll show you a fool or a gambler or a probably the beneficiary of insider info. 

3)  If you must invest in specific equities, split your investments based on the 5% rule.That means 20 x 5% positions. Or. no more than 5% in any position if you carry less than 20 positions.

 4 )  That commercial banks should be forbidden to invest.  They should borrow deposits from the public to  lend money.  What that  will do is cause banks to lend more  because loan interest  and fees will  be the essence of  their business model and the only way  they  make money .  Its time our bankers returned from ” Las Vegas ” even though they will miss the comps and the exciting action of CDSs , CDOs and CMOs.  Its time they forget about the next  bonus windfall  and concentrate on freeing up speculative risk assets to push business loans.

5 ) That Paul Volcker is absolutely on the right track….No commercial bank investing in derivitives ! ! And, fortuitously, this week JPM gave him  all the cement he should need to close  every risk crack the big banks are famous for trying to squeeze through.

Richard ( Gore ) aka Rich, Dick, RMG, , Richie  from Throggs Neck. and  Smiley from Woodlawn.

Where is all that ETF Money Invested ?…..Why ?

Friday, May 4th, 2012

May 3, 2012

I use the S&P 500 ( SPY ) as the benchmark for  measuring  my ETF selection and timing  performance.

It has occured to me, if I could list  the top 10 ETFs,  ranked by dollar  assets ( funds invested in each ) I’d have a pretty good picture of how funds are allocated across the ETF universe ( because these ” BIG TEN are favored by pension funds, hedge funds, and major investors  due to the liquidity they offer ) …and the list could be used to develop  another ” norm ” for performance measurement purposes.

I pretty sure I remember obtaining  the BIG TEN asset breakdown from an article appearing  on the ” Seeking Alpha ” website.

Here it is;

SPY and IVV ( Vanguard ETF ) combined 34.1%

GLD  17.3%

EEM 9.9%

EFA  9.6%

QQQ  8.9%

TIP  5.6%

VTI  5.4%

LQD  5.0%

IWF  4.2% 

I took a hypothetical amount of money, ( $ 1 million ), divided it into the above percentages, and bought as many shares as I could with each percentage.

The result;  a BIG TEN  portfolio which reflects the present allocation proportionality of investments in each of the 10 largest ETFs.

And, how does the performance of this ” ETF fund of funds” back test against the SPY benchmark ? ….. The ” BIG  TEN portfolio is weighted by the actual percentage of investment in each symbol. 

The result – – – Going back a year, six months, three months and year to date – – SPY has outperformed  the asset allocation weighted BIG TEN portfolio by 3%.   SPY has out performed the BIG TEN portfolio in every period.

What this  says to me,  is that unless I can be certain I can  change the result of BIG TEN versus SPY  by  eliminating or re-weighting  some symbols, my time would be better invested  simply by concentrating  on when to own SPY, and when not to own SPY. If I know me, I’ll be tinkering with both methods.   Working on these mechanisms is my equivalent of fine tuning the timing of a 56 Chevy ! Lots of fun!

In the above tests,  SPY was held throughout the periods examined and its total return, including dividends for each period was  ( a ) 12 months 5.6%….(b ) ….6 months 13%….( c )…..3 months 6.4% and ( d ) ,year to date,  ( May 3 ) 12.3%…..                                                              

Going further,…now I can back test the chart performance of SPY to see which indicators would create buy / sells to beat the above  buy / hold performance of SPY at 5.6% held  for one year.

Lets start with  May 3, 2011 to May 3, 2012,  buying / selling every time SPY crosses its 100 day moving average.  We are trying to reduce number of trades. The result would have been 5 round trips losing a total of  6.2% and one buy, November 30,2011 which would still be open and ahead 12.6%… profit for the period ( unrealized ) 6.4% ( $64,000 on $1 million )versus buy and hold, 5.6% ( $56,000 on $1 million ) without taking trade commissions into consideration.  Of course if you are doing this with $1 million, the commission on 5 round trips, $70- is not very much of a consideration against the $8,000 differentiated profit resulting from trading.

And,  all of this  can be refined further using different rules such as starting dates,  different  moving averages , . 

Bottom line… I am certain there is money to be made by trading SPY.  But, my goal isn’t 6.4%, it is 9.0% when the 10 year Treasury yield is 2%.  So, I need to continue to tinker with my SPY timing variables and learn by trial and error.  And, I want to study how re-balancing the BIG TEN to conform to my specific market vision will fare against SPY.

Something tells me this will not be a short or un-eventful voyage of discovery ! 

I’ll keep you abreast of my progress.

Richard Gore…. aka  Rich, Dick , RMG and Smiley from Woodlawn