MDY: Long-Term, Moderate-Risk, Passive Strategy To Beat The Market

| About: SPDR S&P (MDY)

I had recently written an article on how simply buying and holding the S&P mid cap 400 index beats Warren Buffett over 17 years. After writing that article, I started to think what the results would have been if one were to use a leveraged ETF on this index.

I wanted to create a completely mechanical strategy, one that is rules based and requires no rebalancing based on market performance. It is essentially a fire-and-forget strategy. You invest $100 in this strategy and forget about it. You wake up in 35 years and have a million dollars. This is the gist of the strategy:

  1. Invest in S&P MidCap 400 Index index
  2. Use 3x leverage
  3. Invest 100% on November 1st
  4. Sell 100% on April 30th
  5. Between May 1st and October 31st invest in money market funds, estimated at 1% annual yield

The SPDR S&P MidCap 400 ETF Trust ETF (NYSEARCA:MDY) has returned ~3x since inception. This period has covered two market crashes, so this is not a case of the ETF doing well in just a bull market. I chose this period for back testing of returns from this strategy.

MDY Total Return Price Chart

What is the performance since inception of its leveraged cousin, the ProShares UltraPro S&P MidCap 400 ETF (NYSEARCA:UMDD)? Since inception, UMDD has returned ~132%. In the same period, MDY has returned ~55%. so there is considerable erosion from the leverage, as a straight 3x leverage should have returned ~165%. It will be interesting to check how this impacts our strategy.

UMDD Total Return Price Chart

While the UMDD is new and returns for it are not available for 2009 or before, it is very easy to simulate UMDD's performance going back to the start of MDY. As the prospectus of UMDD says

ProShares UltraPro MidCap400 seeks daily investment results, before fees and expenses, that correspond to triple (300%) the daily performance of the S&P MidCap 400 Index.

So, we can use the historical daily returns of MDY, multiply by 3, and synthetically reconstruct the UMDD for the period when MDY was available. However, we still need to choose the right months to invest in.

As the above chart shows, MDY returns are most concentrated in a few months. In particular, November through April generates the bulk of the returns. So, I decided to modify my synthetic UMDD to be 100% invested in these 6 months, and go on cash for the remaining 6 months. This, incidentally, is variation on the old adage, Sell in May and Go Away. This is something that has been true for a long time for all the major indices and is getting stronger by the year as IRA money pores into ETFs in specific months.

This is the performance of this strategy, back tested for the past 17 years.

Year Strategy S&P
2012 62.2% 12.5%
2011 29.6% 2.2%
2010 87.1% 20.2%
2009 26.3% 30.6%
2008 -41.4% -40.3%
2007 4.7% -4.7%
2006 37.1% 12.8%
2005 4.6% 7.8%
2004 35.9% 4.1%
2003 19.3% 32.0%
2002 20.2% -24.8%
2001 26.8% -18.3%
2000 10.2% -2.8%
1999 41.1% 8.5%
1998 114.0% 29.5%
1997 13.8% 25.3%
1996 37.3% 22.9%

Average Annual Return: 31%

Sharpe Ratio: 0.85

Alpha: 22.3%

Beta: 0.99

The comparable S&P 500 (NYSEARCA:SPY) return during this same period is ~9%, and the Sharpe Ratio is 0.34. This strategy returns 3x the S&P 500 for the same time period with the almost exact same risk (beta ~1). Hence, risk-adjusted, this beats the S&P 500 hands down, and doesn't take on more risk to generate 3x returns.

Now that, I would say, is Seeking Alpha.

Note that this strategy has only 1 down year from 1996 to 2012, the infamous 2008 crash. But 16 out of 17 years it is positive. It also beat the S&P 500 12 out of the 17 years.

I do not know if this behavior will persist in the future. I am not going to follow this myself blindly, as I do not like 100% of my assets tied down to one ETF. I do follow the month by month investing, as I always sell in May, and buy back in October, but perhaps I will now change that to buy back in November. I will, however, allocate about 5% of my portfolio to the UMDD going forward, and hold it for the 6 key months as mentioned in the article.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.