Even the casual investor couldn't have missed this year's financial news focus on "Increased Volatility" and "Split Markets." Exchange Traded Funds ("ETFs") provide us with an easy tool to take a deeper look into these headlines across both Sectors & Styles alike.
In this regard, the table below catalogues total returns and historic volatility across 14 Select Spider-Sectors and six PowerShares-Style category ETFs, as ranked by their respective Sharpe ratios:
As a brief reminder, William Sharpe's ratio is one of the simplest measures of the historic risk/reward characteristics of a security's return series, as follows: (Total Return - Risk Free Rate)/ Standard Deviation of Returns. Yes, there are fancier, better measures than this out there these days, but the table above tells our two stories quite nicely on its own; thank you very much!
Looking across the select ETF categories, the two headline saws become most apparent. First, volatility increased dramatically in almost every ETF category, in some cases nearly doubling between the first and second halves of the trading year.
Second and equally dramatic was the much ballyhooed split-nature of returns. Not surprisingly, Energy (XLE) and Metals (XME) led the pack here, with Financials (XLF) and Homebuilders (XHB) bringing up the proverbial caboose. Similarly, Large- & Mid-Cap Growth ETFs (PWB/PWJ) ranked the leader board throughout the year, with the Small- & Mid-Cap Value ETFs (PWY/PWP) generally taking it on the chin. In case the increased volatility wasn't a strong enough "tell" for you, split returns like these are not characteristic of a healthy bull market!
The scatter plot chart below takes our analysis up a notch, showing a slight inverse linear (albeit dispersive) relationship between positive total returns and relatively lower historic volatility:
Note: Volatility is presented highest to lowest.
The Metals & Miners (XME) complex located in the upper-left hand quadrant above was a bit of an outlier last year, posting both strong returns and relatively higher volatility.
As you develop your investment allocation plans for 2008, perhaps you will consider the persistence of these risk-reward characteristics through time, as well as the possible linear relationship between the two elements of Mr. Sharpe's equation.