The Holy Grail Of Investing - A Barbell Approach

|
Includes: TMF, TQQQ, VXX, XIV
by: Serge d'Adesky

Summary

After a nine-year bull run, the market is overvalued.

Traditional balanced approaches will underperform in a rising rate environment.

A lopsided barbell approach can provide the Holy Grail: downside protection and high growth.

You've all heard the old adage: "You can't HAVE your cake and EAT it too." (For non-English language readers, a more accurate adage would be "You can't KEEP your cake and eat it too.") When it comes to the trade-off between risk and rewards in the investment arena, this adage is always accepted as gospel truth. One can stride for low volatility and consistent returns, but these returns will be very low. Or one can strive for high returns, but volatility and intermittent drawdowns must necessarily accompany that.

But what if I proposed a sacrilegious concept: that you can keep your steady returns (your proverbial cake) while indulging in mouth-watering growth rates along the way? If you are truly a conservative investor (I didn't say a smart one), you'll have already averted your eyes from such blasphemy, perhaps even performing the sign of the cross for good measure, and quickly clicked away from this page. But if you are still reading this, give yourself a pat on the back. It means you know that great results require unconventional thinking. You may NOT achieve the results with a different approach, but if you use the same approach you've always used, guess what? You'll get the same dismal trade-off. We're going to start our approach by learning from history. A simple glance at this historical chart of the S&P shows that stocks, over time, clearly go up.

Source: StockCharts.com

(If you want to know why stocks inevitably go up, be sure to check out my previous posting on this subject.)

Just as obvious is that sometimes, like in 1929 and 2008, things can go very, very wrong. And sometimes, waiting for the eventual recovery can take too long. The unlucky 1928 investor needed to patiently wait 24 years (possibly past his life span) to just get back to breakeven on his principal.

Given that the stock market has just risen 380% in a long bull market for the last 9 years, and that stock valuations are stretched to all-time historical extremes, a repeat of 1929 does not seem altogether unlikely.

Making things even worse, in the next stock market crash, it is quite likely both stocks and bonds could fall for a while in tandem. (See "Conservative Investors - The New Risk Takers"). So traditional safe approaches are likely to fail.

To avoid such a fate, we're going to use a tool that weightlifters will be very familiar with: the barbell. But not just any barbell. Ours is grotesquely lopsided, with its weights skewed heavily to one side.

We're going to put 97% of our money in the highest steady return we can find. This represents the fat side of the barbell. These are investments that will be sure to preserve value in the case of a stock market crash and worldwide financial doldrums.

The remaining 3 percent will be invested in a way intended to achieve maximum returns. But we're not just happy with any returns. We want fabulous returns. We can live with high drawdowns because it will be with only a miniscule portion of our portfolio, and we will strive to always keep our principal safe from those drawdowns.

Before I go into our ideal strategy, I want to clarify another point that escapes a lot of people: a complex strategy is not necessarily a good one, but a great strategy is necessarily complex. Why? If a strategy is simple and easy to do, everyone does it. When everyone does it, this lowers the returns. Take some great, earth-shattering tech stock with no competition and unlimited potential. If the investment case for it is so compelling and obvious, everyone will want to buy it. But if everyone tries to buy it, the stock will rapidly increase in price, which makes it less of a deal. At one point, the price rises so much that there are no more prospective buyers. What happens next is obvious to anyone who was involved with the US real estate market in 2006.

So, if an investment seems really simple and incredibly promising, I have one word of advice: run away from it. You'll be glad you did.

If, on the other hand, another investment is complex, requiring technical, legal or political knowledge that is hard to obtain and difficult to master, rather than abandoning it, roll up your sleeves, pour yourself a glass of your favorite brew (but limit it to one glass) and start learning about it. Don't give up until you've mastered enough of its intricacies to understand - or reject - its promise. That will take more than one examination.

The two components of our barbell strategy are not simple investments. If you want simple, accept mediocrity. In our ideal investment strategy, both our safe barbell and our risky one involve complexity, but the higher returns are worth it. A simple, relatively low-beta portfolio will invest in a mixture of 3-6-9 year bonds with predetermined maturities. That portfolio, in the rising rate environment we now face, is likely to generate about 4 percent a year over 20 years. Yet, adding a little complexity, we are going to target 6-7 percent over that same period. That extra 3 percent, compounded over 20 years, would dramatically improve our long-term results.

Similarly, your could fill the aggressive side of your strategy in a simple way by buying a handful exchange-traded funds (ETFs) involved in robotics, biotechnology, artificial intelligence and energy alternatives. Sit on them for the next 20 years, never selling in the inevitable dips, and you are highly likely to make a nice return. But we doubt you would see a return beyond 18% a year. You might be quite happy with an 18% compounded return, but with a more complex approach involving a lot more analysis and a lot higher frequency of adjustments, we hope to achieve a 70% compounded annual growth rate.

The spreadsheet below shows the results of an investment compounding at our "complex" and "simple" settings.

"Simple" Strategy

"Complex" Strategy

With the simple approach your $100k investment grows to $169k in 10 years for a decent, if uninspiring, 6% CAGR. With the complex approach, your $100k investment grows to $1.22 million, a 31% CAGR.

Let's see. Both approaches protect your principal if you leave it in for at least 6 years. Check. Both require long-term approaches. Check. The simple strategy grows your money 1.5 times, the complex strategy grows it 12 times.

If you're like me, you'll go for the jumbo investment, meaning the complex one.

Still with me? Great. Let's look at that complex investment for both the safe and the aggressive sides of our barbell approach.

The safe side invests in a bond sold by the big investment banks. It promises you a rate that fluctuates based on two other interest rates you probably don't understand too well: the 2-year and the 30-year swap rates. You may be more familiar with interest rates on 30-year Treasuries and 2-year Treasuries. Swap rates move in tandem with those, but are bit different. These products promise you an interest rate equal to a multiplication of the difference between the swap rates. (I warned you about complexity, right?)

To add insult to injury, the bonds will not pay you anything if the stock market drops drastically (say, 40% below today's levels) for as long as the market remains below that level. And if it stays below that level all the way to the time the bond matures (15-18 years away), you even risk getting only a fraction of your principal back!

These bonds face two major types of risk if held to term: 1) The risk that the stock market crashes and "stays" crashed for decades; and 2) the risk that the banks issuing the bonds go bankrupt and default.

We use stock options that must be renewed every 12-24 months to hedge out those risks. The costs, if done in the best manner, can be as low as 1.9%. The bonus is that if we ever do get a stock market crash, we are making our whole investment back in one fell swoop. Everything before and after that crash that is to be earned - and will likely be considerable - is just gravy.

Yes, it is complex. You have to renew the options each year. You also have to keep abreast of news on the banks issuing the bonds and follow their financials for any signs of impending bankruptcy. You have to reject steepeners offered by banking institutions with weak balance sheets. But the extra return - 2-3% more than a simple ETF bond laddering solution - makes the complexity worthwhile.

I've explained those bonds in a lot of depth in this previous Seeking Alpha article, so I won't repeat that here. Bottom line, you are likely to see an average return somewhere between 8% and 10% on those bonds, depending on how interest rates and the economy evolve. Subtract from that the 2-3% cost of insuring against stock market crashes or bank failures, and you are left with a real return in the range of 6-7%. (We used 5.7% in our spreadsheet shown above.)

Now to the aggressive side of our barbell, in which we place only 3 percent of our initial funds. This we invest using an in-house algorithmic program whose strategy we can only reveal in broad strokes. (This strategy, the result of years of development efforts, is run for the benefit of ourselves and clients of our investment advisory.)

The strategy invests in 5 broad ETF groups, along with two volatility indexes, the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) and the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), and two leverage ETFs, the ProShares UltraPro QQQ ETF (NASDAQ:TQQQ) and the Direxion Daily 30-Year Treasury Bull 3x Shares ETF (NYSEARCA:TMF). A portion of the portfolio is examined and reset on a daily basis, while the remainder is reallocated on a weekly basis so as to achieve the highest return with the least drawdown. For non-IRA accounts, the strategy significantly improves returns by using controlled leverage, but for retirement accounts, no leverage is used.

Our "Holy Grail" Strategy

Please note: The graph is based on backtesting and not real-world results. It does, however, account for trading fees, likely volume-related pricing discrepancies that do occur in real-world trading. Despite the lack of historical results, the graph is extremely compelling. Over the last six years, this strategy would have grown by a neck-snapping 25651% over a period of 6 years, in which the stock market grew by 114%. It accomplished this with drawdowns (distance from peak to trough) of 31% and volatility of 49%. That is 256 times your original investment.

We should caution you that these are based on backtesting methodologies. Real-world results can, and will, vary somewhat. The backtests are also based on our own very low transaction costs. Your own results can differ if your transaction fees are much higher. As always, we cannot guarantee that past results can be reproduced in the future.

In summary, you can see that by deploying a lopsided barbell approach to investing, we can achieve the Holy Grail of investing. You can have protection of principal and high returns.

Perhaps you are skeptical that the results of backtesting in our aggressive algorithm will prove out in the future. Perhaps they will, perhaps they won't. Even if we cut the returns by half, though, the results still dwarf most portfolio results. Feel free to replace the small side of the barbell with your own aggressive approach. The key to making money in the long term is to be able to wait out the bad times, knowing those will always come. By not risking your principal, you'll have the luxury of allowing your aggressive investments time to recover and flourish. This is the magic of the barbell approach.