Achieving Outperformance in a Low Return World

I recently re-read "Mission Possible", a book by Michael J. Oyster, CFA. Here are some key tools one can employ to outperform the market averages:

1. Asset Allocation - (not good in a bear market)

2. Indexing – Replicate performance of a particular market or asset class. It solves the main problem of active management: security selection.

3. Enhanced Indexing:
- Stock Selector (over or underweight certain names)
- Synthetic (using futures or swaps)

4. Small Cap and Value Bias (buy low and sell high) *

5. Protected Leverage – 1 S&P Futures Contract and 1 S&P 500 Put Option (long-term)

6. Costless Collar – Shorting a Call and Buying a Put

7. Covered Call Writing – Need for current income (short-term)

8. Buy 1 S&P 500 Futures Contract and 1 S&P 500 Covered Call. Spend 10% of the Option Income and reinvest the balance.

*Here are some fascinating statistics that can help one asset allocate by style:

• Small Cap Value returns from 1927-2004: 14.7%
• Micro Cap returns from 1927-2004: 13.0%
• Large Cap Value returns from 1927-2004 : 11.7%
• Large Cap Growth returns from 1927-2004: 9.5%

This tells us that Large Cap Growth companies are too large and too mature. Next, the risk premiums, over the long term, to achieve a better rate of return, goes down when you invest in value funds within the Small Cap Sectors. Next, a portfolio of 60% S&P 500 index and 40% Lehman Bond index from 1973-2004 will return an annual return of 10.4%. If you change the mix to 30% S&P 500 index, 40% Short-term Bonds and 30% US Micro Cap the return goes up to 11.8% per year. Now, if you further diversify into 30% to International (small and large and emerging), and 30% into US (small value and large value and S&P 500) the return goes to 13.1% per year with less risk than the first two portfolios.

Now look at the S&P 500 from a seasonal standpoint since 1950:

click to enlarge

Historically, you would be rewarded for being long the market in November, December & January. You could achieve this with the purchase of S&P Index options or double long S&P market funds. Conversely, you might reduce holdings prior to Labor Day or at least put on 2 month hedges for September & October.

TickerSense looks at The Good, the Bad, and the Beautiful of a $1 investment in the S&P 500 under three different strategies back to 1966.

We are born brave, trusting and greedy – and most of us remain greedy.
– Muriel Strode.

Comments

[Fred Swartz:]

Thanks for mentioning "Mission Impossible", but it might also be interesting to tell us what you thought about it (good, bad, ...).

2008 Apr 28 02:14 PM