April 22, 2020
Recently, I wrote a post endorsing the simple Bogleheads approach: invest in passive index ETFs. Everything else is just mumbo-jumbo, window-dressing and people not understanding the (mostly) efficient market nature of the stock market. In other words…
Simple (indexing) beats complicated active investing
Well, after unloading on some of the fancy complicated investing styles, I just like to point out the select few of them that indeed performed relatively well in 2020. At least better than the index. So, for the record, I’d also like to write about three examples where…
Complicated beats simple index investing
And most importantly, I’m not pulling some “Monday Morning Quarterback” nonsense telling you that if you could have sold your airline stocks in February and replaced them with stocks for video conferencing makers you could have done really well. Well, duh, very few people other than U.S. Senators had that kind of inside information back in February! Rather, I want to write about some of the deviations from simple indexing that were mentioned here on the blog in my posts and/or in the comments. Before the crisis!
Let’s take a look:
Let’s start with the one slightly less simple equity investing style I implement myself:
1: Equity Index Put Writing
I introduced the strategy in my option-writing series, see this article: “Passive income through option writing: Part 3” for the most recent update on exactly what I’m doing. The strategy involves selling downside insurance (put options) on the S&P 500 equity index and collecting a small but steady premium for that. It’s a great source of income in retirement, but just to be sure, it also involves the risk of some ugly losses once in a while when the market takes a sudden and sharp downturn.
How did we do in 2020? The actual put writing strategy is up by 2.6% year-to-date up to 4/21/2020. Not bad considering the crazy market moves and a loss of 14.8% YTD. The strategy lost a good chunk of money on February 24 but then rallied(!!!) in March with a +4% return, one of the best monthly results of the put writing strategy ever. I’ve had a 1.000 “betting average” i.e., I made the maximum premium on every single put option I sold since February 24. That includes the crazy days in March with a 12% daily drop. So, the strategy delivered exactly what I wrote about back in 2016:
“[T]he advantage of our strategy has been that if additional drawdowns occur after the initial event […], we actually make money. That’s because investors were in panic mode and drove the option premiums up so high that we sold puts at strike prices far out of the money: none of our short puts lost money even when the market dropped further in consequent weeks.”
Specifically, even at the height of the crisis, I was selling put options with strikes well below 2,000 points and since the market never fell enough I always earned the full premium
As with every derivatives/margin strategy you also have to decide what you do with your margin cash. I had really great success last year holdings most of that money in a) individual preferred shares (mostly financials, like Goldman Sachs, Wells Fargo, State Street, etc.), b) Muni Bond Closed-End Funds and c) Muni Bond mutual funds. Unfortunately, this year all three asset classes took a bit of a beating. They took my nice solid +2.6% Put Writing return and turned it into a -6.9% return in the portfolio overall. Well, you can’t win all the time! The Lord giveth, the Lord taketh. But it’s still better than the equity market overall (-14.8%). I’m still ahead of a 75/25 portfolio with corporate bonds (-10.7%) and even slightly ahead of a 75/25 with U.S. Treasurys (-8.5%). One drawback is that during April, when the S&P recovered quite substantially, the put writing only made around 0.5% and the fixed income portfolio is still not recovering.
So, it’s a bit ironic that I was caught in a bit of a downdraft, not because of the scary, risky leveraged derivates trading but because of the old-fashioned assets in ostensibly “safer” traditional vehicles like fixed income mutual funds and ETFs. It’s also ironic because I warned about the risks of squeezing out more yield.
But I made the conscious decision that I could afford to take a bit more risk with my margin cash because I felt that I’ve dialed in the risk model in the put writing strategy well enough. It also just so happened that in late 2018 I got a chance to pick up a lot of the Preferred Shares and leveraged Muni Bond Closed-End Funds at a great discounted price and I was sitting on a big pile of unrealized capital gains in early 2020 after the 2019 rally. Ideally, I should have liquidated them and shifted to safer bonds (e.g., 10Y Treasuries like in the IEF ETF) before the crash. I would have made a killing this year. But who knew that in February? And 20+% of the gains would have been taxed away, too.
So, long story short, this approach performed a bit better than a completely passive portfolio. Lower drawdowns, less volatility and a better return than a 100% equity fund. With more than 8 months left in the year, I’m hopeful that we’ll get above the zero line again.
Onto the next style:
2: Stocks+Bonds plus leverage, plus long-VIX-futures
OK, that’s a mouthful! A reader recently asked me about my opinion about his portfolio – a very simple 3 fund portfolio that would have done remarkably well during the most recent market meltdown:
- 47% UPRO (=3x leverage U.S. large-cap equities)
- 47% TMF (=3x leverage U.S. Treasurys with 20+ maturity)
- 6% VXX (long VIX futures)
This portfolio combines two styles that I’ve always found quite intriguing:
- Using the negative correlation between stocks and bonds, one could take a 50/50 portfolio of stocks+bonds and lever it up to the max. I’ve seen some Bogleheads posts where they recommend 50% UPRO and 50% TMF (some even going as high as 55% UPRO). It has a similar flavor to the post I wrote a long time ago in 2016: “Lower risk through leverage“, i.e., find the tangency point along the efficient frontier (likely closer to 40% stocks and 60% if you ask me) and then scale up the whole thing to a risk/return level you’re comfortable with.
- In October 2017, I published a post on why the short-VIX strategy as in the now infamous XIV ETF seems way too risky. Sure enough, the ETF blew up in February 2018 and lost 96% in one day nd then shut down. Since the short-VIX strategy had such unattractive risk-adjusted returns one could deduce that one should do the exact opposite: add a little bit of long-VIX as a diversifier into a highly-leveraged equity portfolio due to the reliable negative correlation with the S&P 500 (as I surmised in the comments below that post).
And it turns out, this combination of the two flavors worked quite well in 2020. I simulated the original 47/47/6 allocation but also the 50/50/0 version (as seen on discussed heavily on Bogleheads, i.e., without the long-VIX ETF) and a 40/54/6 allocation (slightly overweight the bonds vs. stocks because stocks have higher volatility). And then compare the three flavors to 100% equities invested in a passive fund, e.g., IVV.
In the table below, I display the simulated returns not just for 2020 YTD, but also for the 2019 blockbuster equity return year and the (partial) 2018 calendar year. I have to start in February because the VXX ETF didn’t start until then:
- The returns of the leveraged portfolios look pretty amazing this year: +11.1% for the 47/47/6. Without the diversification from the long-VIX you do a little worse, but you’re still up 0.3% for the year. And with a more cautious stock/bond allocation (40/54/6) you’d have made a killing: +21.3% during a bear market!
- This combination of funds would have also worked phenomenally well in 2019, but at the cost of slightly underperforming the S&P 500 in 2018.
- I also included the correlation matrix. Note the significant negative correlation between stocks and bonds (-0.36 UPRO vs. TMF) and the -0.93 (!!!) correlation between VXX and UPRO.
- The risk (measured as the annualized standard deviations) of the leveraged ETF strategy is substantial. That’s the #1 reason the strategy is probably not a good route for most investors. Even the 40/54/6 version still has a higher risk estimate than a 100% equity portfolio, but at least it’s in the same ballpark.
For full disclosure: this kind of strategy would not do very well in a “stagflation” environment when both stocks and bonds tank, think the 1970s and early 80s. But, knock on wood, the current crisis still looks like the stereotypical demand shock recession. If you don’t believe me, here’s a screenshot from April 20 when the crude oil futures turned negative!
3: Equity Index LEAPS
LEAPS stands for Long-Term Equity Anticipation Securities. And the LEAPS approach I found quite intriguing involves the exact opposite of the put writing strategy in #1. Very short-dated puts are often overpriced because myopic, overly risk-averse investors are scared about short-term fluctuations. But longer-dated options have comparatively low premiums. I never wrote a separate post about this but the topic came up in the discussions frequently, most recently after the Bear Market post last year (see here for the link to the comment).
The idea here is that since a call option premium is relatively low, one could buy a LEAPS-call with a strike at-the-money (i.e., near the current index value) and thus fully participate in all the upside potential of the S&P 500 index over the next, say, 2 years. But you wouldn’t lose your shirt if the index were to go down. You can never lose more than the premium no matter how far the index falls. Sweet! But, of course, you have to pay for this protection! 1) you pay the option premium and 2) you participate in the S&P500 price index only, i.e., you miss out on a roughly 2% annualized dividend yield.
So, let’s go through the following simulation exercise:
- On 12/31/2019, the S&P500 stood at 3,230.78 points. Let’s go to the next higher call option strike, 3,250. An investor with a $325,000 portfolio, buys a single SPX Call Option with a strike 3,250 and an expiration on 12/17/2021. The option has a 100x multiplier, so you have the upside potential of a $325,000 portfolio invested in the S&P 500.
- The cost of that option was about $27,300. I initially worked with an estimate of $30,000 but a reader was kind enough to look up the exact quote as of 12/31/2019 (from Bloomberg, I presume).
- The remaining $297,700 of the portfolio can go into some interest-bearing assets. I will look at four different alternatives:
- A money market account, paying 2% p.a. for January through March and 1.0% p.a. during April.
- Short-term Treasuries (1-3 years, e.g., the iShares ETF with ticker SHY)
- Intermediate-term Treasuries (7-10 years, e.g., the iShares ETF with ticker IEF)
- Long-term Treasuries (20+ years, e.g., the iShares ETF with ticker TLT)
Let’s see how this would have worked out in 2020. First of all, the Call option lost a lot of value. As of 4/21/2020, the value of the call option is down to $12,970. That sounds like a big loss, more than 50% of the premium we paid, but relative to the $325,000 portfolio it’s a loss of “only” 4.4%. In addition, your $297,700 margin cash would have stayed afloat and even gained a little during that period. It all depends on what you used for holding the margin cash.
- In all four scenarios, you’d have substantially been better off than with the plain 100% index fund.
- The more U.S. Treasury bond duration you added to the portfolio the better the outcome. Ideally, with a 20+-year Treasury fund you’d have beaten the index by about 30 percentage points. +15.9% instead of -15%.
The risk of this strategy is that if you had gotten too greedy and jacked up the yield of the margin cash portfolio with too much credit risk, going into corporate bonds or even high-yield bonds, you might have lost a big chunk of the margin cash.
Another drawback of the strategy: That low premium for LEAPS holds only during relatively calm periods. Currently, the premium for an at-the-money call is over 7%. So, one could argue that the time to implement this strategy when you’re at or close to the all-time-high when implied volatility is low and the premium for the call option is low. Once the house is on fire it’s too late to buy insurance! 🙂
Bonus: Some other variations
- One could combine methods 1+3: sell short-term out-of-the-money puts for income but also buy a long-dated protective put as downside protection.
- In method 3, if the 4.5% annualized premium seems too steep, one could also do a (vertical) spread-trade, i.e., sell a call with a higher strike to give up some of the upside in exchange for reducing the premium outlay.
- One could use the long-VIX futures strategy to hedge the downside of the put writing strategy.
- For large enough portfolios, say at least $300k, ideally $500k and more, one could easily implement method 2 without the high ETF expense ratios: simply use S&P 500, Treasury Bond and VIX futures at a small fraction of the cost.
What do all three flavors have in common? Everything is entirely based on index investing. No stock picking, no sector picking, no style picking, no dividend yield, small-cap, value, small-cap-value, tilt that might all be a hit or miss during a bear market (and probably mostly a “miss” during this current bear market as I pointed out recently). So, just like the Bogelheads and much of the FI community, I’m a fan of keeping it simple and working with a broad index, like the S&P 500.
But there are some active approaches that are still within the index universe. You simply do some finetuning on how you deploy that index. In one case you work with options to pick up a vol premium that you can’t capture with a bland old index fund alone. In one case you work with leverage to expand the efficient frontier. And in another case you do some simple market timing and hedge the market downside when the index is goes from one all-time-high to another and the premium for an at-the-money LEAPS call is low.
Hope you enjoyed today’s post! Looking forward to your comments and suggestions below!
Title Picture: pixabay.com