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Peter F. Way, Blockdesk (712 clicks)
ETF investing, CFA, portfolio strategy, long/short equity
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Maybe you were not alert to the fact that you were investing time, along with your capital?

It's not the time you spend on deciding what to do next. The issue under discussion is the time that is invested alongside each capital commitment. Efficient management of that time makes huge differences in your portfolio's performance.

Much of the "conventional wisdom" of investment portfolio management is circulated at so general a level that it is of trivial usefulness. The problem comes back to the lack of good measures of the two essential factors that need balancing, risk and reward. And to the reality that their tradeoff against one another is usually a highly individual, personal matter.

Let's start with the reward dimension first, since it is the easier of the two, then attack risk, and finally, examine a process to put them together in an adjustable, disciplined framework that can be suited to one's own persona.

First, the role of time in measuring investment returns

The scorecard of investing is kept in terms of rate of return. The largest part of the returns can come from price changes, rather than dividends, when the investor recognizes that time is the factor in the return equation that has the most muscle. That is because it is, in algebraic terms, a power element, while all the others are linear functions.

R=(1+(P2-P1+D)/P1)^(1/T)-1, where Ps are prices, D is dividend, and T is time.

Because "performance" is an essential convincer in marketing investment management services, proper computation of investment returns has become a well-defined and skilled practice. Following the CFA Institute's professionally-advocated procedures, time plays an integral role, along with cash, credit leverage, and other committed assets, in comparing performances of various entire portfolios - the GIPS standard.

While that complexity is essential in the context of portfolio measurement, performance comparison between candidates for incremental investment in a portfolio becomes much simpler. Candidates need to be put on a common footing of return achievement per unit of time invested. Typically the unit of time used is a day, which then is scaled up into annual rates because investors are used to thinking in those terms, rather than day-rates.

Time becomes one of the three essential elements of investment, besides Capital and Perspective. Truly, time is invested, along with capital, at the direction of perspective. Long-term investments, managed well, are simply a series of shorter time-length investments, actively adjusted as called for, by the perspective of the period.

So we want to utilize time to our best advantage. The most frequent and best chances to do that come from price changes, because the equity investment markets are inherently (and irregularly) "noisy." While theoretically markets may be striving to be "efficient," they are driven by humans being influenced by gross overdoses of information.

Human behavior conditions risk exposures

Only some of the information being offered is real and useful. The largest part of what passes for investment input is misinformation that often is irrelevant and distracting. Another part, unfortunately, is intentionally toxic disinformation. It all needs to be sorted out.

In our competitive eagerness to succeed, we each tend to overdo, both as to extent of beliefs, and persistence in following through on our beliefs. Inertia is one of life's more powerful forces, including inertia of the mind. What differentiates successful investors is their ability to adapt when they sense that the herd has once again overdone the popular misconceptions of the period.

Adaptors' opportunities arise not only because of overdone peer pressure, but also may be a product of true changes in the subject situation. That is where real and useful information and regular attention comes into play. Because advances in communication and in information technology often make opportunity's half-life quite brief, credibility of the information source and response timing become critical.

Perhaps the best legally-usable sources of information are the market-makers. Those firms have been in their roles of aiding big-money funds to reallocate assets from one specific investment to another for many decades. In that time they have built extensive and efficient world-wide information gathering and sifting processes, taking advantage of advances in communications and information technology along the way.

Market-making firms have used their advantages and the presence of huge volumes of activity to skim off enormous profits which are partly used to incentivize, educate, and support skilled teams of specialized trading professionals. Those folks are not gods, and they regularly live with recurring errors. It's part of their learning process.

But their errors tend to be tiny, in the overall scheme of reality. Highly motivated by financial rewards for being right most of the time, they are also driven by fear of their displacement by younger tigers on their team, should an error grow to be critically large and/or fail to be protected against.

So we look to the hedging actions of these key players, taken to ensure the continuity of their highly desirable and enviable positions. Fortunately, their fears, like all investors, are stronger than their greed, and that allows us to monitor the ways they protect themselves as they go about their business.

What they are willing to pay, at a cost reducing their possible trade spreads, to protect the firm's capital put at risk to complete thousands of volume block trades daily, tells just how far they think each subject's price is likely to go, both up and down.

Their judgments on those appraisals are conditioned by multiple daily conversations with their counterparts on the trading desks of the clients. Many of those relationships have been built over years. With experience, both ends of the conversations develop a sense of what the other is likely to do, to say, and to make possible.

The inescapable fact is that money in volume moves market prices. These players are at the focal point of those volumes and intentions.

Calibrating the risk component

Still, the market-makers make judgmental errors; inherent in a rapidly-changing, globally-competitive, technological world. To allow for that, we calculate how well subsequent market prices conform to the forecasts of market-makers, implied from their self-protective actions.

The extent of their errors is influenced by the degree of imbalance they see in upside vs. downside price change prospects. We keep actuarial tables, issue by issue, that monitor the currently updated history of those details, in both the extents and frequencies of successes and failures.

At least we know what has happened, over extended periods of time - including market booms and busts - given various levels of market-making community forecasts, for specific stocks and ETFs. There is no guarantee that the future will repeat, only the suggested odds, given human behavior, that it might.

How to use all this in running a portfolio

We think that the best use of our imperfect information is to run a portfolio of investments that are selected at time of commitment from among the most desirable of competing candidates, each with its own specific price close-out target, subject to an unchangeable holding period limit date. That limit is a key part of the time discipline.

Then, as liquidations occur, whether due to target achievement or the exhaustion of holding time patience, repeat the cycle endlessly, using the then-current appraisals of eligible candidates in selecting replacements. All of the capital resulting from the prior cycle is to be reinvested in the next cycle. The repetitions of being fully invested at all times are what produce the compounding, raising returns to highly productive annual rates.

Since there are bound to be losses, no matter how accomplished the market-makers have been in the past, it pays to use the most trusted and least-cost risk management tool: diversification.

Given the activity of the process, and the competitively-reduced cost of transactions, both in commissions and in trade spreads on actively-traded issues, the bite-size of any day's commitment should be as small as practical. A bite-size of <1% of assets is not too small. Forced replacements to keep fully invested diversifies the portfolio by time of commitment, as well as among the candidates of each date.

That implies a portfolio of over 100 holdings to monitor. In practice, several of these will be repeats of a given candidate, made at different dates - diversifying through time while competing with other candidates. A limit on any one candidate's commitments may be desirable. The specifics of sell-target prices and holding period date limits make management of such large numbers easier than it might seem.

Where wealth-building is the objective, this approach makes the odds for success in each candidate commitment a key decision variable. Where excitement and entertainment are the mission, then the scale of the potential payoffs may become increasingly important in the decision process. Every investor will have his or her own desired balance between the importance of odds vs. payoffs. Making both dimensions explicit, measured, and comparable among alternatives allows the investor to set and maintain that balance.

The investment industry's key dis-information buffer from the truth is the endlessly-repeated notion that "you can't time investments in stocks (or ETFs)" all the while the market-makers are doing exactly that for their own considerable gain.

Now, they don't do it perfectly, or even well, for all stocks. Just well enough for most big-volume issues. Here is an example of how such a suggested portfolio management system can work.

We can use our actual buy recommendations made over past years, as published in our investment letters on They focus on some 250 energy stocks and on about 250 of the diverse ETF world. All tend to be widely-held and actively traded by institutions.

Let's go back to the start of 2011. At that time, our ETF letter made six buy recommendations of TNA (TNA), AGQ (AGQ), FXP (FXP), EEB (EEB), FAS (FAS), and GDXJ (GDXJ) on January 6th. The next week, on January 12th, the Oil & Gold letter recommended buys in 18 energy and precious metals issues.

We now set up a hypothetical $100,000 portfolio for illustrative purposes. In it, we create ten equal-sized threads of one initial position in all six of the ETF buys, and four other Oil & Gold buys. The latter were not selected by any particular preference.

The letters provide sell targets for each buy. Part of the selection preferences in the letters is based on historical experiences in the 3 months subsequent to prior forecasts similar to the present ones implied by the market-makers' hedging actions, so we set a patience holding limit of 63 market days after each buy date.

For this illustrative exercise, we will rely on diversification among the ten investment threads to complement the sell targets and holding time limits as our risk management discipline. In practice, a high-water-mark price drawdown limit might usefully be invoked as an overlay.

Here is how this suggested process would have worked out during the year in details of transactions for one of the investment threads:

(click to enlarge)

The initial investment in the ETF TNA was sold on February 14th, as its end-of-day price first exceeded the sell target of $83.87 set at the time of purchase and recommendation in the ETF letter. Its +12.77% gain took 39 calendar days, each of which compounded at an average 31 basis-point (1/100ths of a percent) rate. On a 365-day year, that would be a +208% annual rate. For this exercise, accidentally received dividends and idle cash interest accruals are ignored, and transaction costs will be accounted for at the end.

The entire proceeds of $11,277 from the initial investment of $10,000 are then invested in a candidate presented as a buy recommendation in the next available investment letter, published on February 16th. BRF was chosen at random from some ten buy recommendations made then. Its sell target was $55.77, and its holding time limit was set (not shown) at 63 market days after the purchase date.

Some 43 days later, the BRF target was exceeded and the position closed out, at a gain of +6.16%. The three right-hand columns of this table cumulate the gains and the time investments (days) to track the ongoing annual rate of returns (AROR).

Following the next investment in GXD, the first experience with PXD, a loss of -12%, is recorded. The second PXD investment was drawn from candidates recommended in the next available investment letter. Its choice was not random, but made to illustrate the real-life experience that is often presented by price declines. The resulting +13.58% gain recouped the earlier loss. It's accomplishment in but 9 days illustrates the irregularities often experienced, but necessitated by the holding period patience limit. If PXD were not supported by continued forecast promise at this later publication date, some other stock (or ETF) would have been chosen to pursue the process.

But please note the impact on the cumulative AROR of the combined 95 calendar days consumed in profitless involvement. The AROR dropped from +146% to +55%, clearly illustrating the leverage role played by time on the return scorecard.

Subsequent reinvestment gains bring the year's results back to an impressive annual rate of +160%. In fact, a gain of +138% was achieved in this thread during the 331 days of time and capital employment. It is interesting to note that the use of investment letter recommendations as a source of reinvestment choices forced the capital to be idle some 10% of the year. A reliable source of investment guidance available on a daily basis could avoid this.

So, what happened in the other nine investment threads of our hypothetical portfolio?

Here is a recap, without trade-by-trade details, of the end points of each thread, and an aggregate of the whole, using the format of the above table.

(click to enlarge)

The column headings only have relevance to the right of "Days Held." There it can be seen that thread cumulative gains range from Thread #1 at 138% to Thread #7 at -4%. In addition to #1, there are two other doubles of capital invested, #4 and #9, with an overall average gain (geometrically) among all ten of nearly +58%.

Typically each thread had 8 ½ positions during the year, 85 in all. There were 15 bad experiences, where the holding time discipline forced closeouts at losses. Overall, the 82% rate of profitable commitments is far above the hedge fund average of 55% to 60%.

That win rate, and the 58% gain level are testaments to the investment letter selection process partly, but more importantly to the portfolio management strategy of keeping a tight discipline on targets and holding time limits. Poor time discipline can quickly lead to price round-trips and the inevitable single-digit "norms" attributed to "long-term investment" practices.

To handle the reasonable questions of "cherry-picking" selections to generate good return illustrations, we used the proposed portfolio management process on the best and worst investment letter recommendations. It creates a "ballpark" of extremes in portfolio results that might be encountered.

(click to enlarge)

The "best" portfolio consists of 16 buys, all winners, magnifying the initial capital more than 7.3 times in a year, at an annual rate of compound growth above 1000% a year, with idle time of 20% of the year.

In the "worst" portfolio, all 4 losers each consume 3 months of investment time and result in a loss of -82% of the capital.

A portfolio experience of just the two threads, one "best" and one "worst" would result in a gain for the year of 29.7%. The S&P 500 for the same time period was up +5.5%

In closing, transaction costs for the ten-thread portfolio at $10 a ticket on 85 ins and outs would total $1,700 or less than 1 ½% of the average capital committed in a +56% growth from $100,000 to $156,200, net of those costs.

Source: Time Investment Means More To Your Portfolio's Performance Than Capital Investment