A Look at SPY´s Value at Risk

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Feb 27, 2015

In this article, let´s take a look at The SPDR S&P 500 ETF Trust (SPY, Financial). An ETF is a special type of fund that invests in a portfolio of stocks or bonds. The aim is to mimic the performance of a specified index. As well as the shares, they are traded in the secondary market at any time (market hours) and investors can sell short. The advantages of this investment vehicle are that they provide an efficient method of diversification because investors gain exposure to an index or a particular sector. Second, investors know the composition of the fund at all times. Moreover, as they are a passive managed fund, they have good operating expense ratios.

The SPY ETF

This ETF seeks to track the price performance of the underlying holdings in the S&P 500 Index. The S&P 500 Index measures the performance of the large capitalization sector of the US equity market. The Index is a capitalization-weighted index from a broad range of industries chosen for market size, liquidity and industry group representation. The S&P 500 is a popular proxy for the U.S. market and as an indicator of the economic health of the U.S. It is best suited for investors looking for diversification across sectors at a low cost.

The top holding list includes companies such as Apple Inc (AAPL, Financial), Exxon Mobil Corp (XOM, Financial), Microsoft Corp (MSFT, Financial) and Johnson & Johnson (JNJ, Financial).

Value at risk

Value at Risk (VaR) is a probabilistic method of measuring the potential loss in portfolio value over a given time period and for a given distribution of historical returns. VaR is the dollar or percentage loss in portfolio value that will be equaled or exceeded only X percent of the time.

So there is an X probability that the loss in portfolio value will be equal to or greater than the VaR measure.

The analyst must select the X percent probability and the time period over which VaR will be measured. Generally, it is used for a one-day period.

We can obtain from Bloomberg the calculation of this measure. Although there are various methods, now we are going to concentrate on the Monte Carlo Simulation. This method generates hundreds, thousands or even millions of possible outcomes from the distributions of inputs specified by the user.

We are now assuming you are a risk manager and calculate the daily 1% VaR. The VaR (1%) indicates that there is a 1% chance that on any given day, the portfolio will experience a loss of $4,157,810,432 or more. We could also say that there is a 99% chance that on any given day the portfolio will experience either a loss less than $4,157,810,432 or a gain.

The loss represents 2.15% of the portfolio value, then on any given day there is a 1% chance that the portfolio will experience a loss of 2.15% or greater, but there is a 99% chance that the loss will be less than 2.15% or a percentage gain greater than zero.

Final comment

Value at Risk was developed as an efficient method to determine the risk exposure of banks with complex assets. As outlined in the article, the Monte Carlo simulation approach revalues a portfolio for a large number of risk factor values, randomly selected from a normal distribution.

The fund has generated a total return of 15.89% in the last five years, 17.79% in the last three years, and 16.97% in the last year. So for those investors seeking to invest their money in an ETF with exposure to large cap U.S. equities, the SPY ETF is a good option because it offers diversification and has a total return that ranks very high in comparison with peers over the last three years. Investors looking to complement this fund with smaller-cap stocks might look at Vanguard Extended Market Index ETF (VXF, Financial).

Hedge fund gurus have also been active in the ETF. John Buckingham (Trades, Portfolio), Eric Mindich (Trades, Portfolio), Donald Yacktman (Trades, Portfolio), Daniel Loeb (Trades, Portfolio), Steven Cohen (Trades, Portfolio), Frank Sands (Trades, Portfolio), Murray Stahl (Trades, Portfolio), Ken Fisher (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio), George Soros (Trades, Portfolio) and Bill Frels (Trades, Portfolio) have taken long positions in the last quarter of 2014, as well as Diamond Hill Capital (Trades, Portfolio).

Disclosure: Omar Venerio holds no position in any stocks or funds mentioned.