You Must Be Crazy! - A Leveraged Portfolio

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Includes: BCRH, BDCL, DVHL, EFF, MORL, SDYL, SMHD, XES, YMLP
by: Darren McCammon

Summary

A 13 quarter review of a high yield portfolio of ETFs and ETNs which has beat the market.

Income generation, price volatility, and total return are discussed.

A key integrated money management strategy and it's effects on the portfolio are also covered.

"Since you have many attachments, you are only a little crazy. This is not crazy enough. You must become completely crazy before you can begin to understand."

- Seungsahn

Intro:

The YMBC (You Must Be Crazy) High Yield Portfolio utilizes primarily UBS leveraged 2x ETNs and sector ETFs in order to formulate an easily managed, reasonably diversified, very high yield portfolio. The portfolio typically only does one transaction per quarter, re-investing dividends in whichever holding seems the cheapest and has now existed and been reported on in articles on Seeking Alpha for over three years. In this article I will go over some history and learning's over the years, as well as giving the latest returns, of this real live portfolio.

Goals:

First however, one needs to understand how I could come up with such a crazy idea. This portfolio was specifically designed to meet the goals, parameters, and motivations of a small inherited IRA I received from my father. As such it must take an annual Required Minimum Distribution (RMD) into consideration. I wanted to create a very easy to manage, reasonably diversified, and sustainable income focused portfolio so in effect my father could be sending me a check every year from beyond the grave.

I however am not particularly risk adverse, short term price volatility of the portfolio is not a primary concern; long term sustainable cash flow is. While the majority of the rest of my assets tend to be invested in individual small cap value equities, more like the Search for Value portfolio, here I wanted something different. Here I wanted a present from my dad, every year, for the rest of my life.

Pass-Through Securities:

I decided to create a diversified portfolio of predominately pass-through securities utilizing 2x leveraged UBS ETNs.

Source: Economist Magazine

Pass-through securities have tax advantages which allow them to throw off more income than the typical C-corp. Historically, they exhibit all the volatility in price that the market usually does and are probably most closely benchmarked against a small cap value index. They are not less risky than the market. They do however throw off significant income which itself shows less volatility. Here is a chart showing a pass-through centric portfolio designed by Trust and Fiduciary Management, these are the same people who brought investors the HIPS ETF:

Source: Trust and Fiduciary Management Services White Paper

The idea here is to accept market like price volatility (pink line above) in return for an ongoing and more stable flow of income (blue line above).

The YMBC Portfolio:

As such, the YMBC portfolio was initiated in January, 2014 with primary holdings: BDCL, MORL, SDYL, DVHL, and EFF (black arrow on left in price only chart below).

Source: YahooFinance.com and Author; the little light blue and dark blue arrows show dividend re-investment.

As you can see in the price only graphic above however, my timing was not particularly opportune. Most of the YMBC portfolio holdings proceeded to fall in price for the next two years, hitting a low in January of 2016. There is a reason for this.

The YMBC portfolio is fairly well diversified. Some investments do better when interest rates climb (BDCL, EFF) others provide leavening when they fall (MORL, and the bonds and REITs in DVHL). Some tend to do better when the economy is improving (BDCL, SDYL) others provide stability when it is not (MORL, EFF). What they do have in common however is they are all predominately spread investments.

Most of the underlying companies borrow at short term rates, to buy some longer lived asset which collects interest or rent. the most familiar spread investment for most investors would be a REIT. It borrows money, buys real estate, and rents it out to tenants. BDCL companies typically borrow in order to lend to small and mid-cap companies. MORL companies typically borrow in order to buy mortgages which pay interest. DVHL leverages a combination of BDCs, mREITS, MLPs, REITs, and bonds (the most diversified of the bunch).

Drivers:

Thus, the spread between short term and long term rates (the 2/10 Spread), is an important common ingredient for most holdings in the YMBC portfolio. This is the portfolio's greatest weakness, and unfortunately, the 2/10 Spread plummeted immediately following the YMBC portfolio's inception:

Source: Federal Reserve

As you can see above, the YMBC portfolio initiation (January, 2014) was particularly poor timing. The 2/10 Spread plummeted by about 70% over the next two and a half years following inception (from 2.6 in January 2014 to 0.8 in August 2016). This in effect is a crash for the spread investments in YMBC. A crash which the spread has only started to recover from. And make no mistake, the word crash is used purposely. This crash in the interest rate spread world, is comparable to the crash in the equity world we now call the Great Recession. On a percentage basis, it represents an even greater fall than the Great Recession; it was very much a test of the portfolio.

One cannot however jump ahead and assume that means the portfolio was a failure, nor even that overall total returns on the YMBC portfolio are bad. As you will see, that is not the case. Indeed, it is this test of the portfolio, successfully survived, which makes me more confident of the combination portfolio and its money management strategy's usefulness.

Money Management Strategy:

Key to understanding how the portfolio survived is first understanding that the combination of holdings routinely throw off income yields in the mid-teens (typically greater than 3% per quarter). One quarter worth of distributions each year goes to fund the RMD; the other three quarters are re-invested. Re-invested at lower and lower prices as it turns out.

During the first year, as the primary 2x ETNs continued to fall in price, distributions were re-invested in whichever ETN I felt was cheapest at the time. This was generally whichever ETN had been doing the worst recently. In the second year, I also started using the distribution to add in some other smaller secondary sector holdings which I felt further improved the overall portfolio diversification: SMHD, BCRH, YMLP, XES (price only chart below)

Source: Yahoo Finance and Author; Please Note: All trades are typically disclosed same day in the comments section of that quarters article with the heading "trade disclosure". This allows any reader who has followed me to see trades the same day they are made.

It is this re-investment of distributions, a money management strategy purposely designed to work in conjunction with this portfolio's unique characteristics (leveraged, high yield, pass-through securities), which ultimately creates the resilience of the portfolio.

Medium-term Returns:

The total return including dividend re-investment for the YMBC portfolio over the last 13 quarters is 45.9%. This compares favorably to the Russell 2000, its primary benchmark, which returned 18.5% over the same 13 quarter period. It also outperforms the S&P 500 at 27.8% for those who are more interested in that benchmark. As we have seen already however this return is not due to fortunate timing. The first 10 quarters of this 13 quarters period were a distinctly poor period for spread investments. Nor is the strong return despite price volatility; rather, it is because of it! The YMBC portfolio tries to turn volatility on its head; turning it into an advantage instead of something to be feared.

You have heard the phrase buy low, sell high. That is exactly what the YMBC portfolio attempts to do in an efficient and systematic manner. Each quarter significant distributions from each holding are thrown off into cash. How much is thrown off in distributions by each holding is dependent on how well that particular sector has been doing recently, sell high. These distributions are then re-invested in whichever single holding appears to be the cheapest, typically the one that has done the worst recently. Buy low. YMBC was built not just to be diversified and throw off lots of income, it was built to sell high and buy low, thus creating a sustainable long term funding of the RMD.

Another alternative way to think of this is a lot more shares tend to be bought with the distribution when prices are low, than are purchased when prices are high. Moreover, there is usually some sector which is currently out of favor, and YMBC tends to buy that sector.

To recap, despite one of the worst periods in history for spread betting pass-through securities, the YMBC portfolio has continued to survive and thrive. I consider it a success.

2017 YTD Returns:

YMBC returned 6.4% for the quarter vs. the Russell 2000 at 2.1%. I suspect the sharp dip in return showing just after March is reporting error. This is likely caused by the very high quarterly distributions causing the holdings to fall in price, but the actual resulting cash not being credited to the account yet. It graphically shows that most, if not all, of the returns in this portfolio come in the form of high distributions.

As usual the income produced by this portfolio just keeps chugging along:

Quarterly Changes:

During Q1 the YMBC portfolio changed as follows:

There were no transactions in Q1 for the YMBC portfolio. The changes in allocations percentages are merely price changes and the buildup of cash from distributions. I need to re-invest those distributions, but nothing looks particularly cheap right now. I have not decided yet whether I will, or just keep letting the cash build.

Alternate Money Management Strategy:

This brings up another potential money management strategy for those more conservative than myself. There is nothing requiring one to re-invest the cash produced every quarter. An alternative option for those retired or more conservative would be to just let it build until the market had declined 20% and then re-invest. While I suspect, this might lower overall returns a bit, it should also significantly lower risk. As the market goes up, so too your cash balance would build. The higher the market, the more cash is going to become a significant percentage of your portfolio. After the market has crashed, you would be then do what you probably should, re-investing all cash back into a now lower priced market. This alternative money management strategy produces another more drastic example of sell high, buy low.

Conclusion:

  • Volatility can be your friend.
  • Buy low, sell high, doesn't just happen, it requires a strategy.

I look forward to and encourage your comments, including criticisms. If you find this article interesting, or would like to get notification of trades, please click the follow button above.

Disclosure: I am/we are long EVERY EQUITY MENTIONED.

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.

Additional disclosure: I say right there in the name, if you follow this portfolio YOU MUST BE CRAZY! I don't know who you are, nor your particular situation; therefore, I cannot recommend this portfolio or for that matter any investment to you. Don't follow a crazy person, do your own due diligence.