Equities Plays - Explanation

[Phil Matta]

Nayab asked me to write up an explanation for the allocation plays we came up with in the weekend meeting.  I will do my best to address those quickly, without a lot of extra fluff.  

The overall feeling over our investment time period (the next three weeks) was bullish.  This comes from both the last month of so where the IVV has been up 5% and the optimism we saw given the next three weeks of economic indicators.  Our projection for the IVV over the next three weeks was an increase of 3-5%.  This set the table for the rest of our estimates.

Since we see the IVV continuing its positive progression we wanted to shift our portfolio to high Beta stocks with positive correlation coefficients.  The Beta essentially tells you the volatility of that stock with respect to the index is compared against.  If the Beta is 1, it means that particular ETF is as volatile as the index (SP500), if the Beta is less than 1 it means the ETF is less volatile than the index and Beta's greater than 1 indicate that a particular ETF is more volatile than the index.  High Beta stocks are a good thing if two conditions are satisfied: (1) The index the beta is calculated against is projected to go up and (2) The correlation coefficient between the index and stock is positive.  

The correlation coefficient is between -1 and 1.  It measures the linear dependence between two variables but all we need to know that is that if the correlation coefficient between the IVV and our ETF is positive, than when the IVV goes up it is likely that our ETF will go up too.  The closer that number is to 1 the more likely they move together.  If the correlation coefficient is 0 it means that 50% of the time the IVV goes up the ETF will go up and 50% of the time the IVV goes up the ETF will go down, in other words there is no correlation and the two appear to have no influence on one another.  If the correlation coefficient is negative it means that the two stocks will tend to move in oposite directions, think the strength of the US Dollar and Gold prices.

Going back to this statement, "High Beta stocks are a good thing if two conditions are satisfied: (1) The index the beta is calculated against is projected to go up and (2) The correlation coefficient between the index and stock is positive."  The index with which we measure is the S&P500 and thusly the IVV.  If you look at ishares you will see that the Beta of the IVV is 1.  That is because the IVV is reflective of the SP500 and if you calculate the correlation coefficient it will be 1, a perfect positive correlation because the IVV is designed to mimic the SP500.

So if we expect the IVV to go up we want high Beta stocks that tend to go up when the IVV goes up.  

IJR and IXC, are two biggest holdings in the Securities Allocation document are relatively higher beta stocks with very positive correlation coefficients.  We have had IXC so thats old news but IJR is a small cap fund that is been phenomenal over the last few weeks so we wanted to get in on that growth, although because it is small cap fund, it does carry risk along with it. 

Our next biggest holding was ICLN.  ICLN is trick to diagnose in terms of growth and direction but in this instance it is acting as a hedge on our bet that the IVV will go up.  Over the last 6 months the correlation coefficient between the ICLN and the IVV is negative (-0.38) so that means over the last 6 months if the IVV goes up ICLN tends to go down.  So if were wrong about the IVV going up, ICLN should help insulate us assuming it behaves the way it has over the last 6 months.  

Of the remaining  ETFs, SOXX and EEMS are the only ones we haven't held before.  SOXX is a semiconductor ETF and Capitol Goods (I think this is classified as capitol goods anyways) tend to do well at this point in the business cycle so we picked it up.  EEMS is another play with some inherent risk as its an emerging market small caps fund but its performed well recently so we picked it up as well.  

My allocation program essentially takes the expected returns on each individual ETF and takes into account the expected risk of each ETF to determine the optimum amount of weight for each holding to minimise risk and maximize return.  This is what was ran to come up with the allocation distribution that is in the Securities Allocation - 2/4/2012 document thats online.  

Let me know if you have any questions but I expect most of you gave up before reading all of this anyways because its quite long.

All the best,

Phil

[Nayab Khan]

Great explanation, Phil. Thanks so much.