2017 In Review

by: Darren McCammon

In 2017, the trend was your friend.

Growth did well.

High-dividend, pass-through securities did poorly.

Investments that benefited from tax reform did the best.

Stay diversified, use allocation and trading rules, and remember no hedge is perfect.

2017 was a year I would like to forget, at least the latter part of it. However, I believe in full disclosure and hope others can learn from my mistakes, so instead of glossing over them, I'm going to point them out.

But before we get started, let me state all returns are total weighted average returns of live real money accounts. The numbers are calculated the same way the SEC suggests funds do it, and in this case, are actually calculated and provided by a third party, E-Trade. No games, gimmicks, or shortcuts here. To make clear the difference from what you may see elsewhere, they are not:

  • Closed positions only. How hard is it to not close losing positions so you don't have to include them in your reporting? In my opinion, using only closed positions is not only misrepresentative but also purposely disingenuous. I am aware there are other providers who still do that. Shame on them.
  • An average, median, or mode of positions. A simple example may best show why that can be misleading. Notice the difference between average return and weighted average return for the exact same portfolio.


Source: Author

Using an average return however is more forgivable in my mind. In most cases, it is probably done out of necessity, rather than any attempt to purposely hide anything. Frankly calculating weighted average returns of a portfolio would be extremely time consuming and prone to error. Even with a relatively simply portfolio holding no more than 20 positions, with all the buys, sells, partial sells, dividends being reinvested, etc., one can easily get up to over a thousand different individual holdings each of which would have to be calculated and weighted into the overall return for the time period held, and only the time period held. It would be an absolute nightmare. If E-Trade didn't do it for me, I would probably default to an average of individual returns also.

Search For Value (now called Income) and You Must Be Crazy (YMBC, 2x leveraged ETNs) 2017 Returns:


Source: E-Trade

Search For Value, "SFV," is now simply called the Income portfolio and is gradually being transformed over to fit that name. It historically was a collection of both income and growth individual small- and micro-cap equities. Midway through the year, I wanted to increase small-cap holdings and was finding using just one specific account too constraining. So, I started to make new buys, especially more growth oriented purchases, in other accounts. Thus, in the latter half of the year, this account gradually became more of an income focused account while another account (shown later) became more growth focused. Year to date, the return on Income/SFV was a dismal 1.7% vs. 13.1% for the Russell 2000, significant underperformance, particularly in Q4. Since inception (January 1, 2016) however the portfolio has done better (+47.8%), beating both its primary benchmark the Russell 2000 (+35.2%), and the S&P 500 (+31.8%).

What is immediately noticeable when comparing the Income portfolio to the Russell 2000 in 2017 is its sharp underperformance starting in October. That October drop was due to losses in Blue Capital Reinsurance Holdings (NYSE:BCRH). There were other big losers in the portfolio - CBL & Associates Properties (NYSE:CBL), Frontier Communications Preferred (NASDAQ:FTRPR), etc., but my "Allocation and Trading Rules" encourage me to initially step into new positions with a small allocations so they were not very painful. BCRH is the one that really hurt.

This reinsurance company had been held for years and was significantly overweighted in both the Income/SFV and YMBC portfolios when Hurricane Irma hit. All by itself this one position tanked the Income portfolio by 6% (from +12% to +6%) and the YMBC portfolio by almost as much. It created as much overall loss as all the other losers in the portfolio combined. In retrospect, I had realized the portfolios were overweight in this name, and that I was susceptible to a Florida Hurricane, but I thought I had hedged away most of that risk by also buying HCI Group (HCI) puts. I even wrote an article about the strategy back in 2015, "Why I Am Buying Blue Capital Reinsurance And Selling HCI Group".

Unfortunately, Mother Nature found the fault in my strategy. She created enough damage that reinsurance company BCRH took its max single loss limit, 30% of book value, but not so much that losses started kicking back to primary insurers like HCI, sending them bankrupt. This was my error. What I learned from it is there is no such thing as perfect hedging, and thus hedging cannot replace the need to diversify and control position size.

The other thing that tanked the Income/SFV portfolio in Q4 was tax loss selling. This happens every year, but this year was much more drastic than most. First, the overall market saw significant gains across the board, including in small-cap stocks. So, when investors were looking for losses to offset gains, there just were not that many to choose from. Sell-offs got concentrated in stocks that were down significantly going into Q3; deep value plays (a.k.a. falling knives) took even bigger tax loss hits than normal. Many pass-through securities such as those held in these portfolios were singled out, taking the one-two punch of being perceived as losers in tax reform, and then getting sold off by people trying to find offsetting losses. A third factor, that tax reform was encouraging high income investors to pull as many losses as possible into 2017, didn't help either. Had I seen these coming, I could have stepped out of the way, but I didn't. And that is the lesson I'm taking from it. While my style of cash flow focused value investing has been a winner longer term (+47.8% over the last two years vs. +35.2% for the Russell 2000), there are times when it is better to go with the flow. During years when indexes have seen big gains, the latter third of the year may be a good time to just put this and any other contrarian leaning strategy on the shelf for a while, dusting it off in the new year.

You Must Be Crazy (YMBC, green line) is a collection of mostly 2x leveraged, high-dividend, pass-through security ETNs (e.g. BDCL, SDYL, MORL, DVHL, MLPQ, etc.). This portfolio was a multiyear test of a very high dividend, very low effort, cash flow oriented strategy that I started at the beginning of 2014. The primary effort involved was to simply reinvest dividends once per quarter in whichever component I felt was the cheapest at the time (usually the one with the worst return over the trailing twelve months). After four years, I now consider this test complete.

2017 was also a very disappointing year for YMBC, +2.8% vs. +13.4% for its primary benchmark, the Russell 2000. Once again, the culprits were the same: a high allocation to BCRH at exactly the wrong time, tax reform seen as relatively unfavorable to pass-through securities, and end-of-year tax loss selling. The four-year return however was better. Cumulative total return including dividend reinvestment for the YMBC portfolio since inception (January 1, 2014) was 41% vs. 31.3% for the Russell 2000 (the primary benchmark) and 45.8% for the S&P 500.

This better long-term return, in my opinion, had everything to do with income generation and dividend reinvestment. If you look at a price-only graph of the YMBC components on Yahoo or at your brokerage site, you are going to see individual volatility, and for most a predominately downward slope. The income-only portion of the graph however looks quite a bit better:


Source: E-Trade, actual dividends paid scaled to a $100k portfolio

Combining the two, income and price, to get to a total return, you get the blue line in the chart below:

As you can see, YMBC outperformed its primary benchmark, the Russell 2000, but slightly underperformed the S&P 500. This underperformance was due to sharp declines in mid-2015 and late 2017 when high-income, pass-through securities fell out of favor, and the BCRH issue already discussed. What I would like to remind readers however is that YMBC was both 2x leveraged and high dividend focused. It yielded roughly 8x the distribution of the Russell 2000 ETF (NYSEARCA:IWM) during this time.

Thus, those that expected high dividend to equal much higher risk, or high leverage to equal very high volatility, should feel disappointed. These traits are probably true when considering any one individual equity, but looking at the combined portfolio above, you can see much of that 2x volatility and high yield risk is diversified away. Indeed, having lived with this portfolio for four years, my impression is the primary risk was probably not related to leverage; when one type of leveraged investment zigged, another tended to zag. The greater risk was the tendency for income oriented investments as a whole to fall into or out of favor (as well as my mistake in overweighting a specific individual equity, BCRH).

The Treynor ratio for the YMBC portfolio also bears this observation out. Coincidentally, the Russell 2000 and the YMBC portfolio had the exact same Treynor ratio over this period of time, 2.27 (large caps did better at 2.73). YMBC produced a higher return, but it also had somewhat higher volatility (nowhere near 2x higher despite being a 2x leveraged portfolio). YMBC's worst quarterly performance and max drawdown point were worse than the Russell 2000, but better than the S&P 500.

Looking a little deeper into these numbers, one could hypothesize a YMBC type portfolio might be a good thing to use in conjunction with an investment in the S&P 500. Running correlation coefficients bears this out:

As you can see, during this period of time, YMBC (leveraged, very high-dividend, pass-through securities) showed meaningfully less correlation to either the Russell 2000 (small caps) or the S&P 500 (large caps) than the Russell 2000 and S&P 500 did to each other. At least during this period of time, holding high-dividend, pass-through securities and large caps also provided greater return than small caps. Thus, YMBC + S&P 500 had both greater return and lower correlation than Russell 2000 + S&P 500. It is also a combination that may be a more practical fit for one's overall money management strategy.

A portfolio of SPY (large cap, S&P 500) and IWM (small cap, Russell 2000) only generates around 1.5% in yield annually. If one instead had held a portfolio of YMBC (leveraged, pass-through securities) and SPY (large cap, S&P 500), the total return during this period would have been higher, and the yield being generated would have jumped to a little over 6%. From a practical standpoint, this makes it easier to come up with an overall investment and money management strategy one can stick to.

For example, not selling during the next crash may be a bit easier when one continues to collect high dividend cash flows. Conceptually, price and total return still take a scary hit, but psychologically the income experience helps to offset the fear.

As another example, let's say a retiree decides on a 4% Safe Withdrawal Rate. With a 1.5% dividend payout from a Russell 2000/S&P 500 ETF combination, there will need to be some selling of shares each year. If on the other hand there is a 6% yield from a YMBC/SPY combo, no security selling is required. One can spend 4% from the dividends and reinvest the other 2%. Or alternately spend 4% and keep the other 2% in a separate cash account to be reinvested once the market drops 20%. This latter strategy can also have significant psychological benefits that can be very helpful for sticking to the plan. It can encourage one to reason:

1.) "The bull market keeps rising and getting more susceptible to a fall; however, my cash pile is also growing a little bit each year, and thus my total holdings are getting more conservative. Thus, it's OK for me to otherwise stay fully invested."

2.) "Market volatility could actually be good in a way, because it will allow me to reinvest cash at lower prices."

3.) "Look at the dividend yields now on offer now that the market crashed. Cool, I'm reinvesting my cash and thereby getting a raise."

Thus, helping one to buy low, sell high, and stick to the plan. After all, numerous studies have shown the average investor underperforms the market by about 3% per year, mainly due to psychological factors. Any strategy that helps prevent this 3% psychological drag can be quite valuable.

So before summarily dismissing something crazy like a 2x leveraged portfolio of high-yield, pass-through securities, ask yourself what is more important to you:

1.) Low-price volatility on each individual equity, or

2.) a steady high-income stream, with good long-term total portfolio return, and a built-in strategy that encourages me to stick to the plan during tough times?

Growth and Taxable Portfolio

Moving on, I indicated toward the latter half of the year I found it too restrictive to try keeping all Cash Flow Kingdom, "CFK," positions in the two original CFK accounts previously listed. I therefore started buying new positions, especially new growth positions, in an alternate account. Whenever possible I also tried to leave income positions in the original Income/SFV account. This however was not perfect. I wasn't, for instance, going to sell a thinly traded stock like Bri-Chem (OTC:BRYFF) simply because it was a growth investment in the Income account. Here's the return of that Growth - IRA, plus a regular taxable account I'll talk about a little later.


What we can see first is for 2017, the green growth oriented account (+9.6%) did much better than the income oriented accounts shown earlier (+1.7% & +2.8%). This isn't that surprising. As we discussed, the Income and YMBC accounts held a lot of pass-through, high-dividend, value investments. The exact same investments that tended to do the worst in the latter half of 2017. The growth portfolio therefore did better, simply because it did not own as many of these. This confirms what we probably already knew: diversification, holding both income and growth investments in this case, is an important component for mitigating total portfolio risk. I love income oriented investments, but I don't think it is a good idea to only focus on them.

What I found more surprising was the outperformance in the Taxable account (brown line and square in graphic above). This account is not purposely done according to any particular style nor is it something I even consider a CFK account (too much putting money in or selling a stock because I need cash for that). It does however pretty much hold the same names as the other accounts. So, I asked why did it perform so much better than either the income or growth account (+21% Taxable vs. +10% Growth vs. +2% Income)?

In thinking about it, I realized what the Taxable account investments have in common is their tax conscious nature. This account tends to focus on names which are longer-term holdings less susceptible to tax drag. It includes MLPs (e.g. TGP, CPLP, APLP, etc.), growth stocks intended to be held more than a year (e.g. BRYFF, RICK, TK, etc.), and some less volatile qualified dividend investments (e.g., MIND, P, OTCPK:EDPFY, etc.). The growth stocks in particular were some big winners both for me - BRYFF +60%, RICK +74%, TK +82% - and more generally in tax reform legislation. Maybe it's just a coincidence, but a longer-term mindset seems to have helped in this case. That and the fact that indexing and trend investing were in.

2017 was a year where losers became bigger losers, and winners became bigger winners. Index and trend investing were in; active contrarian value investing were out. I'm glad to put 2017 behind me.


Disclosure: I am/we are long ALL POSITIONS AS 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: This article discusses a number of risky investments. I do not know you: your goals, risk tolerance, or particular situation; therefore, I can not recommend any investment to you. Please do your own additional due diligence.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.