Use of ETFs in Active Investing

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1 Use of ETFs in Active Investing Hardik Patel QPLUM Disclosures: qplum LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and are never guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance. 1

2 Outline 1. Background: Dynamic Asset Allocation 2. Why ETFs are good for Dynamic Asset Allocation? 3. How to construct a dynamic portfolio using ETFs? 2

3 Background: Dynamic Asset Allocation 3

4 Dynamic Asset Allocation Asset Allocation Liquid Assets Dynamic Asset Allocation 4

5 Dynamic Asset Allocation vs Security Selection Dynamic Asset Allocation: - Views certain asset classes more favorable compared to others. - Attractiveness of asset classes and geographic regions change over time. Security Selection: - Views certain companies more favorable. - Asset classes and geographies don t play much part here. 5

6 A Simple Example Bonds (40%) Equities (60%) Bonds (50%) Equities (50%) 20% Equities (80%) 10% Equities (90%) 20% Equities (80%) 6

7 Why use ETFs? 7

8 ETFs easily map onto Asset Classes US Stocks -> VTI, SPY. US Real Estate -> VNQ, IYR. US Bonds -> BND. International Bonds -> BNDX. International Real Estate -> VNQI. This makes it easier to construct portfolios. 8

9 Return Attribution is easier with ETFs Since ETFs directly map to the asset classes, it s easier to understand where the return is coming from. This is necessary for us to trust the final portfolio. Return attribution is also useful in debugging portfolio issues. 11

10 Caveats It s best to stay away from some ETFs: Leveraged and inverse ETFs - they have high costs and various pricing caveats associated with them. If you really want to get leverage, just open a margin account somewhere and trade on margin. High expense ratio ETFs - Higher fees will catch up with you. Illiquid ETFs - they may be significantly mispriced compared to what they are actually tracking. 12

11 How to Use ETFs for Dynamic Asset Allocation? 13

12 Step 1: Start with a large basket of ETFs VTI, SPY, SCHB, ITOT, BND, AGG, SCHZ, VGLT, BLV, TLT, VNQ, IYR, SCHH, VEU, VEA, SCHF, VXUS, BNDX, VNQI, RWX, VGK, EZU, IEUR, VWO, SCHE, IEMG, VWOB, EMB, PCY, VAW, XLB, FMAT, IYM, VCR, XLY, FDIS, IYC, VDC, XLP, IYK, FSTA, VDE, XLE, FENY, IYE, VFH, XLF, FNCL, IYF, VGT, QQQ, FTEC, XLK, IYW, VHT, XLV, FHLC, IYH, and have detailed information on various ETFs. 14

13 Step 2: Map ETFs with Sectors US International Stocks VTI SPY Bonds BND AGG Long T Bond TLT BLV REIT VNQ IYR Stocks VEU VEA Bonds BNDX REIT VNQI RWX Europe Stocks VGK EZU EM US Sectors Stocks VWO SCHE Bonds VWOB EMB Materials VAW XLB Consumer Discretionary VCR XLY Consumer Staples VDC XLP Energy VDE XLE Financials VFH XLF Technology VGT QQQ Health Care VHT XLV Industrials VIS XLI Utility VPU XLU Select ETFs with high liquidity and low expense ratios. 15

14 Step 3: Process Data Get Data Process (Take care of splits and dividends) Backfill missing data using indexes Data can be costly sometimes. Many ETFs are recent. You may need to backfill using approximations for longer histories. 16

15 Step 4: Create Signals Signals Trend Data RNN Market Data Macro Data Text Data Bayesian Value Signal Signal output consist of normalized allocation weight series for each sector. For each day, you have weights that sum up to 1. Expected Yield Mean Reversion 17

16 Step 5: Combine Signals Signals Trend RNN Bayesian Value Signal Dynamic Allocation Portfolio Expected Yield Mean Reversion Portfolio output contains the allocation weights for each sector. For each day, you get weights that sum up to 1. Since each sector is represented by an ETF, you get weights for ETFs. 18

17 Keep an Eye on Common Biases Lookahead Bias This can creep in at multiple locations: signal construction, position sizing etc. Survivorship Bias 19

18 Avoid ML Fallacies in Signal Construction Changing Data Distributions Effects of High Noise To Signal Ratio 20

19 Additional Notes Keep the turnover low. Use a more realistic backtesting engine. Should penalize low volume, high bid-ask spread securities significantly. Good backtesting can give a reasonable idea of the portfolio capacity as well. 21

20 Summary ETFs provide an efficient and cost effective way to construct active investment portfolios. 22

21 Questions? Disclosures: qplum LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and are never guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance. 23

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