My piece last week, "Another Great Trade You've Probably Never Heard Of," generated a fair number of page views, comments, and emails. Since there seems to be a lot of interest, I'd like to expand on some of the ideas and show more of how you can implement it, with some more explanations and backtests.
As most of you know, my niche is using data to trade against the constraints and biases of investors. I'll start by explaining the process a little more.
What is investor bias?
Bias in investing is simply when people consistently overestimate or underestimate the economic value of an investment. If you fall victim to it, bias causes your risk to increase and your returns to decrease. The most common biases that investors have is piling into the stocks of large, familiar and popular companies, and trading against momentum due to the disposition effect.
Individual investors and actively managed mutual funds are an endless fountain of biased decision-making. Importantly, these two groups of people manage, at a minimum, 10x the AUM of all the hedge funds in the world combined. Investors tend to herd, which leaves opportunities in places they ignore.
The perception of hedge funds is that they make their money trading against each other. Maybe it's the reality for long/short hedge funds and high-frequency traders. Bobby Axelrod seems to think so. However, all you need to run a highly successful macro fund or family office is to figure out how to effectively exploit investor bias and constraints and systematically trade against them. It's a lot easier to do!
Billions is back for a fourth season in a couple of weeks, by the way.
What are investor constraints?
Different market participants have different needs and preferences. A classic example of this is taxes. Markets are usually priced in ways that are fairly insensitive to taxes because a large slice of the market (think pension funds, foreign investors, etc.) doesn't have to pay taxes on investment gains.
A good example of this is municipal bonds. Investors in the top tax bracket can realize far greater returns by buying municipal bonds than they could by investing in corporate bond funds. Why isn't this priced in? Well, roughly half the money out there doesn't have to pay taxes on their investment income, so their demand for municipal bonds is different from yours. This can help you make decisions but it is a little hard to effectively trade with, unless you want to park your money in municipal bonds for a tax-free 3 percent return.
Constraints are a big deal, because most assets out there are highly constrained. Here are some rough estimates of the total global assets under management by groups of investors. This isn't intended to be an exact science but to show the relative sizes of different groups of investors (note that private equity has grown the most since these figures were collected, with now around 3 trillion in assets).
These groups of investors collectively make up "the market," but they all have different needs and preferences.
The most common constraint that large investors have is the constraint to hit a return target. The other major constraint that they typically have is that they aren't allowed to use leverage. This causes the majority of institutional investors, like pension funds and insurance companies, to bid up the prices of long-term bonds (which they need to guarantee to have X amount of money at a future date) and risky and liquid assets like large-cap US stocks. On the other hand, safer assets with lower returns show much higher returns per unit of risk, which can be realized into greater cash profits by using leverage via the futures market.
There is a pretty consistent constraint against leverage against retail investors also, caused by the fact that relatively few investors know how to borrow cheaply enough to make profitable trades. The only way to get competitive rates for margin for retail investors is to use the futures market (where the interest is implied from the product pricing) or borrow $1,000,000+ from Interactive Brokers, which still isn't as good as futures. Customers at places like Vanguard, Fidelity, E-Trade, and TD Ameritrade are locked out from exploiting these anomalies unless they have access to futures, due to the unfavorable rates to buy stock on margin.
One way to trade this anomaly
Pension funds and insurance companies combine for roughly twice the amount of AUM that mutual funds have, so their constraints have a huge impact on the market. In particular, these two groups of investors have a need for guaranteed long-term returns.
This alone is enough to distort the market for US Treasuries.
As most of you know, long-term interest rates have fallen over the last 30 years. Buying them would have been a profitable trade. However, shorter-term Treasuries have had a much better risk-reward ratio than long-term Treasuries, as shown by their Sharpe ratios. To exploit this, you have to do what pension funds and insurance companies can't and use some leverage, avoiding the overpriced assets and buying the underpriced ones.
To show how this works, I constructed three portfolios (link to model here).
The first portfolio is 100 percent S&P 500 (SPY) (blue line). This is the benchmark.
The second portfolio is 80 percent S&P 500 and 20 percent long-term Treasuries (TLT) (red line). This is a common and smart way to achieve some risk parity in your portfolio, as government bonds tend to rally dramatically in times of market meltdowns like 2008.
The third portfolio holds a leveraged position in 5-year Treasuries (IEI) with the equivalent duration risk of TLT (yellow line). Note that you have to leverage 5-year Treasuries 3.75x to get the same risk as a 30-year Treasury bond. Investors are trained to be afraid of leverage, but in this case, there's a direct relationship between Treasury bonds and future cash payments made by the US Treasury, so there's only so far they can deviate from their ending cash value. You would use futures for this trade. I'm assuming that 5-year Treasury ETFs and futures have the same carrying cost, which is the risk-free rate plus 15 basis points. Additionally, if you were to implement this in your portfolio, you'd want to have exposure to a variety of asset classes like stocks, bonds, MBS, gold, etc. so you aren't just betting on lower interest rates. Stocks and bonds work for the illustration though.
Here were the results:
Portfolio 3 beat not only the market but the long-term bond portfolio as well. The returns of the portfolio went up, the risk went down, and the maximum loss/drawdown during the time period went down as well.
The reason why this trade works is because of distortions in the marketplace caused by pension funds and insurance companies, which manage trillions and trillions of dollars. As I noted in my original piece, this anomaly in asset pricing has held since at least 1959.
It's one piece of the puzzle that can help you crush the market over time.
The strategy of trading against the constraints of institutional investors, like pension funds and insurance companies, has been shown to work over and over again in a variety of markets. When combined with strategies that also trade against the biases of mutual funds and individual investors, you can get over twice the return of the S&P 500 for about half of the risk. See my most recent articles for ideas on implementation.
Did you enjoy this article? Consider following me for future research updates!
Disclosure: I am/we are long SPY. 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.