A Correlation Study between ETFs

In setting up either long only or pairs trades it is useful to perform a correlation study to determine what happens when correlation breaks down.

Below I present three charts the first is the five year performance of five key ETFs SPY(US), EWZ(Brazil), EWH(Hong Kong), EEM(Emerging Markets), FXI(Shanghai Composite).   The second is a specific chart of the ratio of EWZ (prices) divided by EEM (prices).   The third chart is a correlation matrix between these assets one a longer dated correlation matrix the second over one year.   Note the extremely high correlations between EWZ and EEM.   The correlations are applied to 2 month cumulative returns as opposed to intra-day to highlight the relation-ship.  Also observe that that in the second chart that correlation can hit some fairly extreme values it is at those extremes that potential trading opportunities exist to either set up a long only position or a relative value pairs trade between the etfs EWZ vs EEM.   Note that when correlation falls apart and the ratio of EWZ to EEM prices falls below 1.2 this signifies good entry points to purchase EWZ.
It is also significant that while there is fairly high correlation between all these ETF's that EWZ has by far outperformed the other ETFs.   Brazil has the commodities that other emerging markets require to fuel there industrialization and this can help explain the outperformance.  Right now the ratio of EWZ to EEM is around 1.6 and correlation is hovering close to 1 extremely high.  At this juncture I would adopt a neutral position and await a better entry point when correlation once more breaks down.  

Relationship between the VIX and key ETFs

I thought it would be interesting to plot a chart of the VIX vs key ETFs namely SPY's, EWZ (Brazil), EWH (Hong Kong), EEM (Emerging Market).   What is interesting is what happens at huge extremes in the period from Oct 2008 to April 2009.  The VIX itself adjusted close breached the 80 level twice within the month between 10/26/2008 and 11/20/2008.   Note that Lehman Brothers filed for bankruptcy on 09/15/2008 and several other major institutions would have faced the same fate if the US govt had not acted.  However it took a further month for the VIX to spike this was preceded by the collapse in all markets.    From 11/20/2008 through to mid January the market started to rally again and the air came out of the VIX only to breach the 50 level on 03/02/2009.   Notably SPY, EWZ, EWH and EEM hit there lows in early March.   This is telling us that when you have the VIX hits extreme levels.   From the perspective of an investor the most liquid volatility ETF product is the iPath short term futures VIX ETN (VXX). Specifically, the S&P 500 VIX Short-Term Futures™ Index TR offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500^® Index at various points along the volatility forward curve. The index futures roll continuously throughout each month from the first month VIX futures contract into the second month VIX futures contract. More details can be found at http://www.ipathetn.com/ . 

LongTermTrendSystemResultsthroughNov2010

                 Enhanced Probability Technical Trading  Strategy Summary

Strategy Methodology- The idea was to combine technical analysis with statistical methods (distribution theory) in order to identify long term trends and turning points in the market considered.   The idea is to create a strategy that both outperforms the underlying market with less volatility than the underlier.    Several proprietary technical indicators are considered and there statistical distributions analyzed to determine buy and sell levels which are incorporated into a signal generator.  

Trades are only entered only after confirmation of several statistical and technical factors (this leads to a higher probability of a successful trade).   The trades are long term in nature as they go with the trend.   The period of analysis uses data from the 1999 or the inception of the ETF whichever is available.  It considers several bear markets including the most recent one which help stress test the strategy and set acceptable risk levels.   The strategy deploys a framework that increases the likelihood of a successful trade; stops are used to exit losing trades.  The strategy is deployed in various markets where there are high volume ETFs available.

Asset Selection- The strategy focuses on identifying appropriate entry and exit points in the most liquid exchange traded funds (ETF’s).   The reason for this is for both liquidity and scalability (numerous strategies focus on asset selection but ignore the need to scale for commercial viability).   The ETF’s selected are as follows SP500 Spider, NASDAQ (QQQQ’s), Emerging Market Index (EEM), Gold (GLD), Silver (SLV) and Oil (OIH). Note that in this initial phase of development the asset markets selected are diverse in that they comprise NASDAQ, SP500, emerging markets and commodities.   The same methodology can also be applied to individual stocks however the results I present here are for major market indices in the form of ETF’s.

Results

In this document I post the results for the NASDAQ, SPY, EWZ and EEM ETF (see below).  The other models are available in the spreadsheet attached along with Trade Statistics. (See attached)

The data considers several periods of dislocation in analyzing the system.  Namely NASDAQ Bubble Bursting, 2001-2002 bear market, 2008 credit crisis.  For example the NASDAQ Model did well in 2000 and stayed out of the market during this period and stays out during 2008.  The best year dollar wise is 2009 for the NASDAQ Model.   $1million dollars invested in the NASDAQ Model would result in total balance of over $3.28million by Nov 2010 compared with a loss of over 40% over the same period if invested in the underlyer.  The SPY Model increases by almost 100% for this period vs a slightly negative performance in the SPY ETF.

Strategy Deployment-- The strategy is ideally suited for a wealth management firm, mutual fund, or long only hedge fund that would deploy client capital in accordance with the signals to establish  a “technical long fund or fund of fund (via allocation to multiple asset classes)”.    These strategies are also ideally suited to institutions/family offices/insurance companies/endowment funds who are tired of paying extremely high fees to fund of funds and hedge funds.