Time-efficient, diversified investing in Quality stocks
The Dow-Jones 30 Index contains massive corporations with international market presences that have proven and demonstrated competitive survival and growth skills. Many of them typically are present in virtually all portfolios of sizable investment organizations, are actively traded, well researched, and closely watched, world-wide. Their stocks are long-term, low-risk, securities.
They can be actively invested in, as a diversified package, by the Exchange-Traded Funds known as the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), a.k.a. "Diamonds", and an ETF version that leverages the DIA's daily price changes by 3 times, the ProShares Ultra Pro Dow30 ETF (NYSEARCA:UDOW).
The leverage in UDOW is accomplished by that fund's investments in derivatives of the DJIA index that are rebalanced daily to maintain the 3:1 relationship. No debt financing is used to accomplish the leverage, avoiding the ability of outside entities to force the fund into self-detrimental actions, like margin calls.
Both DIA and UDOW are subject to the constructive arbitrage pressures of a very liquid, active, public exchange market, where financial gain or loss disciplines force close parallels in the prices of the funds to the values represented in the individual prices of the stocks in the underlying DJIA index. In street parlance, they "track" the index average well, almost perfectly.
That tracking prevents the long-leveraged UDOW from the systematic erosion over time that is incurred by "inverse" ETFs, effectively a "short" position in the subject. There, the derivative contracts those funds commit to, progressively consume parts of the fund's capital in the daily rebalancing process, making inverse ETFs poor "long" holdings over time in wealth-building portfolios.
Figure 1 pictures the last 5 years price histories of DJIA (the Dow30 index), DIA, and UDOW. The DIA, perfectly tracking the DJIA, obliterates the DJIA's path from view.
The intended price volatility of UDOW is evident, both in the progressively upward years into 2015, and the market fluctuation periods following, to the present.
Capital building by active investing
Active investing makes maximum productivity of the investor's capital by positioning it in securities most likely to gain in price during a foreseeable forecast period.
Passive investing with buy&hold long-term investments accepts the reality that the capital committed will sustain periods of decline, but is driven by the conviction that longer-term trends will persist, carrying the investment to a higher value. What is sacrificed by the passive B&H strategy is time.
Unfortunately, the investment scorecard that counts for the largest number of investors is driven most critically by the factor of time passage. The equation at issue is one of compound growth of value, where all of the elements except one are simple linear functions of addition and subtraction. That exception most impactful to the desired result is time, and in the CAGR equation it is a power function.
While B&H plods along typically at single-digit percentages of CAGR (compound annual growth rates), active investing has available to it equity investments that year after year contain price swings of double- to triple-digit percentage price swings. Further, the swings typically occur in periods shorter than a full year, amplifying their CAGR impact.
Those fluctuating equities include all but a few of the issues found in the market index averages of passive investment strategies. Stocks with placid, regular growth are rare.
The price swings are both of increases and decreases, and to build wealth, there needs to be an ability to discriminate between the two. That ability is most likely to be found in people who are long experienced in making such decisions frequently, are highly motivated to make correct and accurate evaluations, and have the support resources to do so.
We find that combination of circumstances exists in market-making professionals [MMs] whose every-day work is to create a balance between buyers and sellers in specific securities. It is especially true where large volumes of shares must be executed on all-or-none basis, under the pressures of time and uncertainty. In order to bring such trades off, they frequently must put firm capital at risk.
The block-trade desks of MM firms know they must not accept such risk, and need to find speculative interests willing to take on the prospective exposure, for a fee, in a hedging transaction. Often that role is taken on by the proprietary trading desks of Investment Banking firms.
The key element in such hedges is the price to be paid and the structure of the risk-transfer deal. Both buyer and seller of the price-protection insurance are typically well informed about the subject by each firm's own 24x7 world-wide information-gathering, research, and evaluation staffs.
Each deal reached contains the coinciding expectations of prospective price possibilities under the best and worst likely circumstances during the lives of the derivative securities contracts involved. We determine and publish daily what their actions reveal, as we have since Y2K turned out not to be the problem originally imagined.
All of the DJIA stocks are regularly and actively involved in such volume trades, so the forecasts of their coming price possibilities are well established and updated daily. For a fund of only 30-stocks, that makes the index's price expectations quite projectable. Figure 2 shows how their projections have evolved for UDOW over the past 6 months.
(used with permission)
The vertical lines of Figure 1 display the implied price ranges of the MMs hedging actions taken day by day in anticipation of what may be coming. They are forward-looking, not the backward-looking history of traditional "technical analysis" charts.
Those ranges are interrupted by a heavy dot of the then current market price, which separates the forecasts into upside and downside proportions. The balance of the two proportions has proven to be useful in determining the probabilities of price change directions.
Useful so much so that we long ago created a metric we named the Range Index [RI] which measures the percentage of the whole forecast range that lies below the current market quote. As a measure of cheapness or expense, Figure 1 shows it to be only 10 now for UDOW. The implication is that there is 9 times as much upside in prospect for UDOW as there is in down.
To provide perspective, the small blue thumbnail picture at the bottom of Figure 1 shows the frequency distribution of UDOW's RIs over the past 5 years. It is now extremely cheap, but on limited occasions has gotten even cheaper.
When, as a strategy, we take the closing market price for UDOW the day after such prior RIs occurred as a position entry cost, and use the top of that forecast range as a sell target, the data row of Figure 1 tells that in the past 5 years 33 such positions have occurred. It also tells that 91% of the 33, or 30, would have by 3 months after the forecast date either reached their targets or a price higher than the position's cost: Win odds of 91 out of 100.
The data row also tells that, including the other 9% of losses out of the 33 (3 of them), the net gains averaged 11.6%. Since it took an average capital commitment time (holding period) of only 28 market days to achieve the 11.6%, the CAGR of these positions was 171%.
While that seems exciting, it tones down the current forecast, which implies a larger upside target of +14.7%. The actual result of "only" +11.6% produces a credibility ratio of 0.8, (11.6/14.7).
An additional caution is provided by the recognition that during the average 28-day holding periods, an average worst-case price drawdown from the various position costs was -9.9%. Would you be enticed by an +11.6% gain to endure temporary (in 91% of the positions) losses as large as -10%? Maybe, if they lasted no longer than 3 months.
After all, you may have been tempted to endure a $2 near-certain loss if the payoff potential was measured in hundreds of $millions. Here we have much better odds, and +171% CAGR isn't chopped liver.
Perhaps a little more perspective may be useful. Figure 2 takes once a week forecasts from the likes of Figure 1 to provide a weekly look at the MMs' forecast history back over the past 2 years.
(used with permission)
These are Thursday readings of MM forecasts, so the most recent as yesterday's differs slightly from the Friday one shown in Figure 1. But while the experiences are episodic, their typical productivity is apparent.
This the objective in active investment management, exploiting the drama of the incident as opposed to its diminution in a longer-term, less productive theme. The importance of entry and exit timing becomes evident. As does the need for effective forecasting support.
Can it be done effectively?
An answer to that question is offered in Figure 3.
This table has columns of holding periods following the date each forecast was made, increasing cumulatively up to 16 weeks of five market days. It has rows showing the annual rates of change (CAGRs) in each of the holding periods, for the forecasts counted in the #BUYS column.
Those forecasts are a total in the blue 1:1 row, so they are the average of the 1258 daily UDOW positions of the 5 years. The row above the blue row includes about a quarter of the total sample, counting all forecasts where the upside prospect was twice the downside, or better. The next higher row includes only those forecasts where the upside was three times the downside. That process continues to the top row where only the forecasts that had huge positive upside balances, or had no downside at all, existed.
The bottom half of the table below the blue row is just the inverse of the top half. In some ways, it is the more interesting part of the table. It shows that for UDOW the MMs pretty well identified the points in time where price problems were upcoming.
Now, with a 10 RI, or a 9:1 RWD:RSK ratio, and absent any time discipline, the average price change for 162 forecasts at 10:1 forecasts in a 25 to 30 holding period has been at a CAGR of +106 to +83. It turns out (not shown) that ~75% of those experiences were a gain.
The fine tuning of our time-efficient risk-management discipline [TERMD] strategy outlined above boosted the CAGR potential well above the simple rule suggested in Figure 3 of "buy any time UDOW's RI is lower than 10". Both fewer commitments and more certain profit captures contributed to the difference.
But the question of "is this the best time to make an entry commitment to UDOW?" is not answered. The question of "is this a good time?" appears to draw a credible response of "Better than most". But good judgment and risk management suggests that added opportunities may also lie shortly ahead, so parsing the powder may be more optimal.
Disclosure: I/we 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.