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I had written an article last week detailing a strategy that returns an average of 31% every year for the past 17 years, taking no more risk than the market average. This is the strategy:

  1. Invest in S&P MidCap 400 Index index (MDY)
  2. Use 3x leverage (UMDD)
  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

In essence, the strategy is a variant of the old saying, Sell in May and Go Away, using small caps, with leverage added in. This is the performance of the strategy, backtested from the launch of MDY in 1995 to date.

  • Average Annual Return: 31%
  • Sharpe Ratio: 0.85
  • Alpha: 22.3%
  • Beta: 0.99

This strategy has had positive returns every year from 1996 to 2012, except in 2008. That year, the S&P500 (SPY) was down 40.3%, while this strategy was down 41.4%, which means that even in that horrible year for the market, the strategy was almost at par with the market. The beta of 0.99 shows that the risk of this strategy is exactly the same as the market risk. However, over this period, S&P500 returned ~9%. So the excess return of this strategy is ~22%, as reflected by the alpha. Clearly, the extra return was not generated using extra risk.

This is of course a very good strategy. However, there is still substantial risk, equal to that of the market average. The market, as we all know, has had some wide gyrations lately. Is there any way to preserve the excess return while lowering the risk?

A reader had a great recommendation - replace the money market funds with a high yield bond fund, like the PIMCO High Yield Fund (PHIYX). After I ran that model, the results were stunning.

  • Average Annual Return: 31%
  • Sharpe Ratio: 1.06
  • Alpha: 27%
  • Beta: 0.4

The beta dropped by ~60% from 0.99 to 0.4. The alpha sharply increased by 5 points. The average annual return remained the same. Because of the significantly lower risk, the Sharpe Ratio skyrocketed to 1.06. This is means this is the Holy Grail, a low risk strategy with high alpha.

Here are the annual returns.

YearNew StrategyOld StrategyS&P
201270.2%62.20%12.50%
201127.9%29.60%2.20%
201041.0%87.10%20.20%
20094.9%26.30%30.60%
200834.2%-41.40%-40.30%
20075.7%4.70%-4.70%
20068.5%37.10%12.80%
200540.7%4.60%7.80%
20042.9%35.90%4.10%
200326.4%19.30%32.00%
20028.8%20.20%-24.80%
200126.1%26.80%-18.30%
200011.1%10.20%-2.80%
199937.9%41.10%8.50%
1998110.0%114.00%29.50%
199722.5%13.80%25.30%
199647.1%37.30%

22.90%

What the annual returns show is that you give up quite a bit of returns in good years for the S&P500, e.g., 2009. But what you get back in return is a very good return in bad years, like 2008. This is classic risk management. Overall, you do not give up any long term returns at all. This strategy doesn't have a single down year, and beats the S&P500 12 out of the 17 years in the backtest, just like the original strategy. So, the new strategy is every bit as good as the old strategy, but has substantially lower risk.

As I mentioned in the original article, 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 will, however, allocate about 5% of my portfolio to this strategy going forward.

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.

Source: A Better, Low Risk Strategy To Beat The Market