ETF Primer

What is an ETF

Exchange traded funds (ETF's) are essentially mutual funds that trade during the day. The price you pay for a share in an ETF is determined by whatever price you agree to with the other person taking the opposite side of the trade. Just like trading an individual stock. The price you buy or sell a mutual fund is determined at the end of the day and by the “net asset value” of that share.

ETF's may hold hundreds or thousands of securities in a particular asset, such as stocks, bonds, currencies, metals, futures, and other strange animals. Much like a closed-end mutual fund, there is a set number of shares that trade, where each share represents a small fraction of the total assets in that fund. However unlike a closed-end fund, new shares are created as needed. Problems insue whenever a fund sponsor is unable to create new shares. When this happens, the ETF shares act more like a closed-end fund, and could deviate from the index they intend to track.

This Forbes article, The Godfather of ETFs describes in good detail how a market maker in ETFs operates. The three largest RTF trading firms are Goldman, Merrill Lynch and Knight Capital.

The market is large. According to the Blackrock's quarterly review of all exchange traded products, titled ETP Landscape – Industry Highlights – Q3 2012, total assets under management for all exchange traded products are in excess of 1.84 trillion dollars, spread over 4748 funds. The Forbes article pegged the assets under management for traditional mutual funds at over 10 trillion dollars.

	AssetType	Assets($Billions)	NumFunds
1	Equity	1290.2	2597
2	FixedIncome	321.4	618
3	Commodities	206.7	906
4	Alternative	6.8	124
5	Currency	5.7	139
6	Other	14.7	364

Largest ETF providers

The four largest fund providers by total assets under management are (ibid):

	Name	Assets($Billions)	Market Share(%
1	iShares	711.8	38.6
2	State Street Global Advisors	333.4	18.1
3	Vanguard	230.8	12.5
4	Powershares	76.4	4.1

What investments are in an ETF

Stocks Initially, ETFs replicated major indexes such as the S&P500. For instance, the State Street SPDR S&P500 is the largest of all ETFs at $118 Billion. There are ETFs that track almost any of the major known indexes. There are ETFs for sectors of the stock market (eg. Technology, Health, Utilities, etc…); style and size indexes (eg. Value, Growth, Small cap, Large Cap, etc…); international stock markets, (by region, by by country, by sectors, and combinations). These are meant to be passive in that the index is specified up front, and the investment manager attempts to adhere as close as possible to that index. Active investment management by the portfolio manager is new feature only recently made available in some ETFs. In this case, the portfolio manager has some leeway to make individual investment decisions.

Bonds Similarly, ETFs focused on bonds may be focused on tracking various indexes based duration (short-term 0-3 years, mid-term bonds 5-10 years, long-term over 10 years), source (governemt, corporate), country (US, or otherwise).

Commodities Usually, these are structured as Exchange Traded Notes, and use futures contracts to track an index. I'll say more about these at a later time. A few do hold physical metals, such as the State Street Gold ETF (GLD), which is actually structured as a trust.

REITs Real-estate investment trusts are securities that are committed to pass along 90% of their income as dividends to the share holder. REIT based ETFs hold shares in these companies.

Other There are ETFs for currencies, short equities, leveraged equities, short leveraged equities, volatility, and many other flavors of indexing.

Resources

Additional sources of information on ETF's. The general information websites all have varying degrees of free information and premium services. I usually go straight to the fund family websites, but probably should spend more time reading the reports and news items from the general sites.

General information sites

• Morningstar If your local library has a subscription, see if you can't possibly access Morningstar through the library's web site.
• SmartMoney Some free, some premium services.
• ETF Trends has many educational articles, and an ETF screener.
• ETFdb has more news and screeners.

Fund Family websites

• Ishares
• Vanguard
• State Street SPDRs
• Powershares

Getting Help in R

Problem

Where to find help when using R

Solution

This is a consolidation of many sources, in particular a talk given by Rob Hyndman, which is available as a video, and as a pdf. Although the information is pretty basic, there were a couple of tricks that were new to me.

If you know the function name

Simply key in ?function_name at the prompt. Eg. ?mean, or ?sd

If you know the function name, but not where to find it

??function_name will search within your installed packages. The output is a nicely formatted list of package names and descriptions. The help systems does a approximate string matching on a default set of fields contained in the help files. Here are some examnples:

??DEoptim
??"DEoptim"
help.search("DEoptim")  # same as ??DEoptim or ??"DEoptim"; the quotes are required
??stats::sd  # restricts the search to just the stats package

If you get the chance, check out ?help.search. There are many more options to the help.search function.

If you need to search on something other than a known function name

RSiteSearch("search string") will do the trick. This will open a window in your browser at the search.r-project.org. It searches mailing list archives, help pages, vignettes and task views.

RSiteSearch("differential evolution optimization") # returned 33 items that contained all three search words

Check out these search options for use in the RSiteSearch() function. Options include AND; OR; NOT; grouping with parantheses; * wildcard as a prefix, postfix, or both; regular expression matching with /.../ as delimiters; and lastly searches restricted to specified fields.

RSiteSearch("differential evolution optimization") # returned 1000+ matches
RSiteSearch("diff* evol* optim*") # returned 1500 matches
RSiteSearch("genetic algorithm not neural") # intially found 507, the NOT reduced final results to 476 matches
RSiteSearch("/svm/") # found 33 in task views and vignettes, too many in functions

The home page for http://search.r-project.org/ has lots of other links for searching R. Well worth taking a further look.

If you are looking for a particular function, but can't remember the name exactly, or what package it is in

The third-party package “sos” provides the findFn() function. This function uses RSiteSearch(string, "function") to search only the functions in packages for the specified string. The results are contained in a dataframe that is then displayed as html in the browser.

install.packages("sos") # if not installed already
library(sos)
findFn("psoptim") # displays an html page with 6 results, all in the pso package

Other search facilities

These are repeated from the http://www.r-project.org/search.html page.

• RSiteSearch as discussed above.
• Searchable mail archives
• Gmane's R-lists
• RSeek searches multiple R sites.
• R Nabble

If you want to see what packages are available in your subject area

• Task Views provide edited lists of related packages on various subjects.
• Announcements of package updates

What if you want to install every package mentioned in a Task View

Package ctv will do just that:

install.packages("ctv")  # only if not already installed
library(ctv)
available.views() # will display the names of each view, R is case-sensitive, so you need the exact name
install.views("MachineLearning") # careful, this will download and install every package in that Task View
update.views("MachineLearning")

Working with packages

library() at the prompt will list all the packages installed on your system, and the directories where the are installed.

installed.packages() returns the list of installed packages as a dataframe.

In Conclusion

That is enough for now. Thanks.
_

Introduction

To paraphrase an ironic curse: May you invest in interesting times.

This has indeed been true over the past ten years. An investment in a S&P500 index fund ten years ago has returned a total of 50% over the past ten years (including dividends), which works out to 6.2% annually. Not only that, but you suffered through a decline in value from the peak in October 2007 to the bottom in March 2009 of over 50%. Only now would your investment have fully recovered back to that peak.

For those who have a lifetime of earnings ahead of themselves, constant and disciplined periodic savings over many years may overcome the severities of the market. However for those of us much closer to retirement, capital preservation becomes an overriding concern.

Consequently, my investment goals now include:

• the need for greater diversification, beyond just a mix of stocks and bonds, into other types of assets;
• diversification within each of those asset types;
• the need to know when to overweight or underweight a particular asset, or to stay out of it entirely;
• a way to reduce the maximum loss of the portfolio;
• and maybe a way to squeeze out a couple of extra percentage points in the annual return.

That's not asking too much, is it?

Fortunately, what has become known as tactical asset allocation and the widespread use of exchange traded funds would seem to meet that need.

Over the rest of the winter, I will use this blog to discuss how I built such a portfolio. Keep in mind that this is just one investment strategy, and one approach. Learn from it if you wish.

Basically, I use exchange traded funds (ETF's), which are highly liquid, passively indexed, well diversified with respect to themselves. Limit the choices to a broad selection that covers many asset types. Select those that have performed the best amongst that small subset. Rebalance periodically. Adjust the size of the positions as to control volatility of the portfolio. I will also consider putting in a floor of some kind under each investment to control losses.

There are many choices at each step, avenues to research and experiment with, and decisions to be made. I will start by discussing the following questions in the next few posts:

• What is an ETF?
• Who are the largest providers?
• What assets are available in an ETF?
• Which assets should I invest in? Compare this to the institutions, endowments, and target date mutual funds.
• Of so many similar sounding ETF's, which ones to use?
• Risks of ETF's – there are some, believe it or not
• Biases – Hindsight and other animals
• Start with a simple equal weighted portfolio of say, 5 or 10 ETF's and see how that would have performed over the past ten years.

Preface

Intended Audience

Hopefully anyone can find something to take away from this discussion. I start from the simplest portfolios and add more sophisticated layers while building upon more advanced concepts. You may choose to incorporate any level that is compatible with your level of risk, understanding of the concepts, and how much time you choose to devote to managing your portfolios.

How is this different from other similar approaches

Tactical asset allocation has been a significant development over the past several years, although many aspects related to creating such a portfolio has been researched over the past twenty to thirty years.

The focus is strictly on building well-diversified portfolios of exchange traded funds. Starting with a variety of ETF’s that cover most asset types, I gradually add more sophisticated layers. Some easy to implement, and others maybe not so easy. I will explain each layer as I add them.

Some of the layers I investigate, may be found in the academic literature, under the such concepts as endowments, institutional management, sector rotation, global asset allocation, momentum trading, as well as Capital Asset Pricing Model, the efficient frontier, and mean-variance strategies.

In addition, I will track a real money portfolio at here at this website: mostlyquant.com. I have staked my retirement savings on these ideas discussed on this website.

Necessary Caveats

Let’s get the usual disclaimer out of the way.

As with any investment, there are risks. Any investment may fall in price at any time, seemingly for unfathomable reasons. Anything contained within must not be construed as individual advice. Only you can determine the appropriateness of any particular investment or strategy.

I may buy, sell, hold any security mentioned within, at any time.

Who am I

I have a BS in Math from University of Illinois at Urbana-Champaign, and a MBA from University of Illinois at Chicago. I’ve been a programmer, a systems analyst, a bookstore owner, and a lifelong investor.

I have been around long enough to watch the 1987 crash from the visitor gallery above the Mercantile Exchange floor; convert busted Savings and Loan institutions into a larger bank in the late 80’s; sold off stocks leading into the tech bubble in the late 90’s; and sat anxiously by as the housing bubble burst most recently, and three rounds of quantitative easing so far have kept that last shoe from dropping.

Securing a comfortable retirement should not depend upon getting lucky a few times in your life. Tactical asset allocation is a way to tweak a passive indexing approach while at the same time hopefully limiting the downside risks that has become such a part of life lately, and maybe adding a couple of percentage points extra return on top of a buy and hold strategy.

That is the goal. I hope to share what I have learned, and the decisions I have made to enhance a tactical asset allocation strategy.

Initial Portfolio post

I will be posting my portfolio holdings on  a regular basis. Starting with a portfolio of ETF’s based upon a tactical asset allocation strategy, similar to that of “The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets“, by Mebane Faber and Eric Richardson. I will go into what decisions I have made that may differ from the book, how I made those decisions, and alternatives.

I am still exploring the capabilities of the wordpress.com blog engine, so bear with me as I find the best way to show my updates on a regular basis.

Introduction

Welcome to my blog.  I hope to share code snippets, tutorials, and more as they relate to my investigations into quantitative investing. Thanks for visiting.