How To Beat Mutual Funds At Their Own Game

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Includes: EEM, GLD, IWM, SPY, TLT
by: SteadyOptions

In my previous article, I showed why buying Mutual Funds might be a bad idea. As a reminder, some of the reasons include:

  1. High fees
  2. Below average performance
  3. Too many restrictions
  4. Lack of incentive for the Fund Managers to produce absolute positive performance

In this article, I will present few alternatives to Mutual Funds.

Alternative #1: The "Lazy" way - Couch Potato Portfolio

Canadian magazine MoneySense introduced a few years ago an idea of Couch Potato Portfolio. Their portfolio is constructed for Canadian investors but it can be easily tailored for any investor. The idea is simple. You build a diversified portfolio of low cost index funds, check in on it once a year, and otherwise let your money thrive on benign neglect. A sample portfolio for the US investor might look like this:

  • 40% in SPDR S&P 500 Index ETF (SPY)
  • 20% in iShares MSCI Emerging Index Fun (EEM)
  • 30% in iShares Barclays 20 Year Treasure (TLT)
  • 10% in SPDR Gold Trust (GLD)

This is just an example of how to divide your assets between US stocks, international stocks, bonds and gold. You can change the mix, increase/decrease the stock exposure, add REITs, high dividend ETFs, etc. The main advantage of this approach compared to Mutual Funds is expenses. Typical management fees for many ETFs is 0.1-0.3% compared to 1.5-2.0% for most Mutual Funds.

Alternative #2: A portfolio of individual stocks - am I diversified?

The next alternative would be building a diversified stock portfolio. Fellow SA contributor Rocco Pendola discussed in one of his recent articles if you should put all your eggs in Apple's (NASDAQ:AAPL) basket. This strategy would have worked very well in the last few years, but I don't think it would be a good long term strategy. On the other hand, I personally don't think one should own 20 stocks either. I tend to think like Warren Buffett, who has said that diversification is for people who don't know what they're doing. My personal opinion is that an individual investor should own about 7-10 stocks. So the stock portfolio might look like this:

  • Technology: Google (GOOG)
  • Healthcare: Johnson & Johnson (JNJ)
  • Consumer Discretionary: Wal-Mart Stores (WMT)
  • Energy: Exxon Mobil (XOM)
  • Financials: Goldman Sachs (GS)
  • Industrials: Deere & Company (DE)

Of course this is only an example; you might replace any stock with your favorite stock.

Alternative #3: Spice it up with Options

Now we are moving to the next step. This approach requires more time and effort, but it also could be more profitable. There are tons of options when it comes to options. Here are some of them:

  • If you own the stock but are concerned about temporary pullback, you can write a covered call.
  • If you want to buy shares of your favorite stock below the current market value, you can sell naked puts. In fact, I think this should be the only way to buy your favorite stock. Why to pay a full price if you can buy it at discount?
  • You can construct a bullish credit spread like the one I shared here. The trade produced 30%+ gain in one month with less risk than owning the stock.
  • You can substitute the stock with Deep In The Money (DITM) call and sell calls against it every month, as I demonstrated here.
  • If you own shares of a beaten down stock like Bank of America (NYSE:BAC), you can check here how you can recover some of your losses at no additional cost.
  • If you own a stock but are concerned about a short-term pullback, you can buy a short-term protection using puts.

The first three alternatives are all directional. They will profit when the markets go up but lose money if the markets go down. Whatever alternative you choose, I recommend buying some kind of protection against market meltdown. The most straightforward way to do it is buying SPY puts. The strike and the expiration will determine how much protection you will get and for how long.

Alternative #4: The non-directional way

This is by far my favorite alternative, but again, it's not for everyone. Here are some of the ways to trade this strategy:

  • If you think the markets are trading in a range, there is a way to profit from it by constructing an Iron Condor or Butterfly trade on one of the indexes.
  • If you like trading earnings but don't want to predict the direction of the stock, check here how you can trade pre-earnings volatility of the options without taking directional risk.
  • You can construct complex multi-leg trades like calendar spreads to take advantage of Volatility Skew.

In my article 'My Investment Strategy For 2012' I described how you can construct a complete options portfolio without taking any directional risk. A typical portfolio might look like this:

  • 25-30% in the Russell 2000 Index, the Russell 2000 Index ETF (NYSEARCA:IWM), the S&P 500 index or S&P 500 index ETF Iron Condors or Butterflies
  • 25-30% in pre-earnings trades on volatile stocks like Netflix (NFLX) and Wynn Resorts (WYNN)
  • 20-25% in calendar spreads
  • 15-20% in cash

Conclusion: I believe that any of the above alternatives should easily outperform most Mutual Funds over the long term. Which one to choose depends on your risk appetite and the time you are ready to spend to learn the strategies and to maintain the portfolios.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.