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This will be our third consecutive year of picks for the Financial Uproar stock picking contest. Here’s a brief recap of our past performance… which is not impressive, considering the bull regime we’re currently living under.

  • 2012 Picks – 17.8% Return – S&P 500 Return: 16.0%
  • 2013 Picks – 9.7% Return – S&P 500 Return: 32.39%

A Change in Philosophy

I don’t want to say our strategy was wrong, per se… but, yes, it was wrong. Set aside the fact that we were willing to invest in companies we wouldn’t normally touch (we work in tech so our investing dollars stay clear of most things electronic), we only owned 2 stocks we selected in the contests at any point during the contest year. For the record, those stocks were PDLI in 2012 (still owned) and TTM in 2013 (sold some time back).

Considering we tried to approach our past stock picks from a value perspective with more risk that we usually undertake, this year we decided to go in a completely different direction. Instead of sitting on companies we feel “have a chance for appreciable upside gain in the next 5-10 years”, we’re going to try to force the issue with some different asset classes.

This is where I tell you: most investors would be horribly served by this strategy, especially if they used the same 25% * 4 allocation for their whole portfolio. I do not suggest you follow the DQYDJ strategy, however, for a contest it makes sense: we want to force our portfolio to react, whether to the upside or the downside. From our perspective, that means we should either win the contest … or lose by a long shot. The only thing we can’t really see happening is the Red Queen scenario – we won’t be running in the same place.

So, read our writeup but don’t hold us accountable for these (in the words of Warren Buffett) financial weapons of mass destruction. If you buy anything on this list, you’re on your own, pal – read the prospectuses, be safe, and win your own contests!

Alliance Resource Partners (ARLP)

We left one vanilla pick in the portfolio, because even though Mr. Uproar hasn’t fully explained the rules, we felt the spirit of the contest demanded that DQYDJ picked at least one individual company. So we picked something more esoteric than the companies your brother likes to DRIP into – a Master Limited Partnership. Specifically, one with steadily increasing dividends, solid earnings per share, in a non-sexy industry (coal).

Only issue? Market beating returns last year… so it’s not really a secret.

But, let’s be honest – even though it’s an interesting pick, it’s actually the least interesting on this list.

Barclays Long C Leveraged S&P 500 TR (NYSEARCA:BXUC) Quick overview: "Total Return" means dividends reinvested, my favorite. This one is an ETN, which means it has Barclay’s company credit risk priced into it somewhere. Also, it trades on low volume.

That’s the boring stuff. Long time readers know we’ve talked about the constant leverage trap before on this site – a phenomenon of the cost to borrow and re-leverage those 2x and 3x ETFs daily that spurred the SEC to warn investors some time back. BXUC is a leveraged ETN that doesn’t suffer from the phenomenon … because after it first started trading, it doesn’t attempt to releverage to hit a constant leverage, it just said “que sera, sera“. This particular note matures in November of this year.

Let’s determine the current leverage … the leverage started at 2x on November 17, 2009. Since then, the index was up around 65% to January 2nd (when we ‘bought’ in the contest). To determine the leverage:

  • factor = (Index Performance + 1) / (2*(Index Performance + 1) – 1) = .717
  • factor * original leverage = current (nominal) leverage = 1.43x

So, we’re getting around 1.43x leverage to November from the 2nd, not including financing. Read the Prospectus for more details. Oh, and seriously … understand what you’re buying (that advice always applies, but even more so with leveraged products).

VelocityShares Daily Inverse VIX ST ETN (NASDAQ:XIV)

ProShares Short VIX Short-Term ETF (NYSEARCA:SVXY)

So, you thought BXUC was an interesting choice? Maybe so – but now we’re in the major leagues of the ‘force something to happen’ scenario. On the surface, these are slightly different funds, but both do the same thing – go short volatility. One is an ETN exposed to VelocityShares credit risk, and the other an ETF… which, interestingly, also allows option writing for SVXY.

Since the index VIX is based upon implied volatility (think: changes) in the price levels of the S&P 500 and VIX tends to spike in a down market, at some level these are bullish bets – you’re talking correlations over .7 for up days. These two funds are nominally "short" volatility – so when VIX decreases, they will pay off immediately … usually increasing more than the S&P 500 as a whole (on the flip-side, they generally decrease faster).

Of course, this contest starts at a time of relatively low volatility, after a huge up year … so you’re probably thinking, “what’s the upside?”. Well, the beauty of these products is they can make money in many markets due to a phenomenon known as "contango".

Let me break it down. VIX is based on options trading around the S&P 500 index. Those options trades need to constantly be refreshed to roll into new months as options expire. Because the future is uncertain (I don’t need to prove that, right?), volatility generally is predicted (read: costs more to hedge) to be higher in months further from the present. So, to short volatility, as these funds are doing, you would BUY the shorter dated options while SELLING the distant contracts. Those sales are worth more, in general (I’ll do another post) than the buys.

There has been some chatter on Seeking Alpha about this structure’s benefits, and, no doubt, the rewards can be huge. However, anyone considering this in a real-life-non-Financial-Uproar-stock-picking-contest portfolio needs to recognize the huge risks, including that ProShares or VelocityShares calls the funds in a drawdown (read the prospectuses!). The drawdowns can be insane in these funds – of course, playing in a contest for bragging rights allows me to easily eat a ton of risk.

But yeah, with real money? You need to do some research before you sink your teeth into any funds of this class. In 2011, for example, XIV at one point was down 66%(!!). Can you stomach that?

And yes, I’ll revisit the volatility topic again soon to reframe this.

Risk/Reward/Winning!

So, value is mostly out the door and crazy risks are in vogue for this year’s contest. Follow along here or at Financial Uproar and find out if I win or get trounced!

Disclosure: I own nothing mentioned, except PDLI which I specifically called out. I’m always looking for an entrance on SVXY and XIV, but I’d prefer waiting for a VIX spike first. So, yes, it’s possible I buy either/or in the next week.

Source: Stock Picks For 2014