Beating The Market: Investors Are Turning Over The Wrong Rock

About: SPDR S&P 500 Trust ETF (SPY), TYD, UPRO
by: D.M. Martins Research

I believe that the great majority of active, growth-biased investors have the ultimate goal of "beating the market."

Contrary to popular belief, doing so is easy. In my opinion, investors should be concerned with the much more relevant issue of downside protection.

I present two tactical approaches to growing a portfolio in the long term with limited risk of substantial losses.

Ask active, growth-biased investors what their main investment objective is. I am willing to bet that most of them will answer: "to beat the market". Investing in a stock or group of securities whose returns outpace those of the broad market (SPY) tends to be seen as a badge of honor by those who have achieved the feat, and the Holy Grail to be pursued by everyone else.

The answer sounds logical. Why would anyone spend time actively managing their portfolios for hours every week, unless the investor was shooting to produce market-beating results over the long run that would justify the time commitment? Were this not the goal, investing passively in stock indexes would make a lot more sense.

Credit: InvestorPlace

But, in my view, and very much contrary to popular belief, spending time and effort trying to figure out how to beat the market on an absolute-return basis should be nothing more than a secondary goal in investing. Why? In part because doing so is rather simple and effortless, more so than most investors realize. The much harder part, the one that deserves obsessive attention and research, is protecting a portfolio from substantial losses when the market undergoes a period of severe weakness.

Wait, rewind... beating the market is simple?

Fair enough, my last statement above deserves some serious unpacking. First, what do I mean by "beating the market is rather simple"? After all, the CFA Institute calls market-beating "mission impossible".

I believe that there are two ways to beat the market's returns over the long run with little risk of the goal not being achieved. The first and most familiar method to most retail investor is through high-beta stocks - i.e. securities that tend to "swing" more wildly than the broad market itself.

Using data from Google Finance, I identified the 10 highest beta names among the S&P 500 constituents. I then went as far back as I could, in this case, January 2001 (right around the time of the dot-com crash) to create an equally-weighted portfolio of all 10 names. I compared the performance of this hypothetical portfolio against that of the S&P 500. The graph and chart below illustrate the results of the backtest.

Source: DM Martins Research, using data from Yahoo Finance

Notice how high-beta stocks easily beat the market over the 18-year period: 10.9% annualized returns vs. the S&P 500's 6.0%. But also notice that the feat was only possible because stocks generally moved up since 2001. When they didn't, high-beta stocks severely under-performed the broad equities index.

Take 2008, for example: while the S&P 500 endured an already painful dip of 32.6%, high-beta stocks added fuel to the fire and lost more than half of their market value. Even last year, when stocks finished 2018 down a modest 3.6%, the high beta portfolio produced a more substantial loss of 12.9%. Still, over a very long (ideally multi-decade) period of time and assuming that stocks will generally appreciate going forward, investing in a diversified basket of aggressive stocks will usually allow investors to handily beat the market, despite a significant increase in expected volatility.

The second, even simpler way to top the performance of the S&P 500 over the long haul is to merely apply some leverage to the index.

At one point, at least about 10 years ago, leverage was a tool available primarily to sophisticated investors who had a margin account at their broker of choice. Today, leveraged ETFs (I have written quite a bit about them) allow anyone to gain exposure to the benefits and pitfalls of leveraged investing. As a disclaimer, I should warn readers that these instruments need to be well understood and thoroughly researched before one chooses to trade them, given the substantial risks.

To test the idea, I created a hypothetical $1,000 investment of 75% SPY and 25% ProShares UltraPro 3x S&P 500 fund (UPRO) starting in June 2009, when the ETF was created, re-balanced every week. By allocating the assets this way, I effectively simulated an indexed portfolio that is leveraged by a factor of 1.5x (75% through the unlevered ETF plus 25% times three through the levered fund equal 150%). I then compared the portfolio's performance against that of the S&P 500 over the period.

Below are the results:

Source: DM Martins Research, using data from Yahoo Finance

The numbers above look very interesting. The leveraged strategy produced six extra percentage points in annual returns, the equivalent of roughly 1.42x the performance of the S&P 500 -- the gap to 1.5x is probably the result of volatility drag (an often confusing topic that was very well addressed by University of Denver Professor Thomas Howard, PhD). Volatility also increased, as expected, by a factor of exactly 1.5x.

Maybe even more encouraging to see was the portfolio's worst weekly return of -10.8%, only 1.4x the S&P 500's most pronounced dip of the past 10 years. In addition, the hypothetical portfolio would have ended 2018 down, not unlike the S&P 500, but only by a -7.8% that seems pretty manageable.

The key takeaway from the two backtest exercises above is that topping the performance of the stock market in the long run is a fairly easy endeavor that, at worst, requires higher tolerance for volatility and sharper drawdowns. Therefore, I believe that producing market-beating absolute returns is barely a topic that investors should pay much attention to or spend much time thinking about.

So, what should investors focus on instead?

Perhaps the two investment experts that I admire (and trust) the most, aside from Bridgewater's Ray Dalio, are Warren Buffett and Paul Tudor Jones. Regarding losses, both gurus have expressed the following opinions, respectively:

Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.

Defense is 10 times more important than offense. You have to be very focused on protecting the downside at all times.

To me, there are two primary ways in which failing to protect an investment from sizable losses can severely hinder a portfolio's performance over the long term.

The first way is through irreversible or nearly unrecoverable losses. Here, I am referring to the classic example of an asset that, after losing a sizable 50% of its value, needs a 100% rebound only to break even. Avoiding oversized losses is a good way to ensure that a portfolio continues to grow at a steady pace, without being exposed to the risk of being under water for a period of a decade or more - consider the S&P 500 between August 2000 and January 2013, flat for over 12 years after the index suffered two sizable peak-to-trough drops of about 50% each. Think of the real-world implications here: thousands (should I say millions?) of people probably had to delay their retirement in the first few years of the new millennium due to the huge losses sustained in the markets.

The other way speaks more to investment psychology. Anecdotally, I can think of plenty of examples when a painful dip in the markets caused investors to panic and rush for the exits, instead of hanging on tight and waiting for the eventual rebound to return their portfolios to pre-loss levels.

Last quarter, in fact, a study showed that a group of professional market timers recommended, on average, equity exposure of -72% in December (i.e. nearly three-fourths of one's trading portfolio allocated to short-selling) right before the S&P 500 began its quick rebound from the 4Q18 lows. After the bounce back, their allocation recommendation shifted drastically to +73% by mid-February, just before the recovery lost steam. Clients following the herd in this case would have lost their pants on the way down, while not participating in the recovery on the way up.

A portfolio that is less susceptible to sizable losses does not pose the same market-timing risk, since its performance tends to be steadier and more predictable.

How to protect a growth portfolio

In general terms, I believe there are two effective ways that an average investor can position his or her portfolio for modest or moderate growth while protecting it from sizable losses. The first is through the use of options.

The traditional approach is to own protective puts that limit the investment's downsize risk. For example, it costs today about $46 per share of the S&P 500 (currently at $2,743) to protect an indexed portfolio from a drop of about 20% over the next 12 months. The option price represents 1.7% of the index's value, and about 22% in implied volatility.

Perhaps what many do not realize is that owning puts help to stabilize the portfolio's daily value fluctuations, thus reducing volatility and, in some cases, offering investors a more predictable exit price when or if they decide to close out of their position. The graph below illustrates the inverse relationship between the change in value in the S&P 500 vs. a protective put on the index.

Source: DM Martins Research, using data from Yahoo Finance and E*TRADE

The less traditional approach involves owning calls alongside cash or investment-grade bonds, instead of puts alongside the S&P 500, to synthetically produce exposure to stocks. I listed this approach as one of my three favorite investment strategies for 2019 - one that so far this year has produced mid-teen annualized returns and low single-digit volatility, with only small positive correlation against the broad equities market. The idea goes as follows:

To get 1x exposure to the S&P 500 with a $1 million investment, one might choose to buy $1 million worth of SPY - simple enough. To get the same exposure through call options, one can simply pay an $87,300 premium to buy about 37 contracts that, above the strike price of $274/share, will produce the same gains that a $1 million investment in SPY would generate, but without any downside risk beyond the premium paid on the options.

A "limited downside, unlimited upside" portfolio, therefore, might look like this: (1) treasuries at 91% allocation, yielding 2.7%, and (2) at-the-money call options on SPY representing just short of 9% of the total amount invested. Under no circumstances would this nest egg lose more than 6% of its total value per year (8.7% paid on the options minus 2.7% yield on treasuries), assuming the government bonds are held to maturity. And while a largely sideways-moving market might leave the portfolio slightly in the red, the investment would still fully participate in a rise in the value of the S&P 500, as if 100% of the portfolio had been allocated to equities.

Notice here that one need not be limited to being 100% exposed to equities through this strategy. Allocating a larger portion of the portfolio to SPY calls would effectively increase (i.e. leverage) its exposure to stocks. For example, buying 55 at-the-money contracts in the example above, instead of 37, would tie up a sizable 13% of the total portfolio's value in options, but expose it to 1.5x the returns of the S&P 500 if it is positive for the year.

Lastly, the second way to protect a growth portfolio from sizable losses is through a balanced asset class approach - in other words, to use a diversified investment strategy and pull together securities that are largely uncorrelated. To be clear, the downside protection feature here would only be as effective as the interdependence between the different assets in the portfolio allows it to be. But at least the "hedge" in this case would come at no cost, unlike the options strategy described above.

Let's look at a real-life example. The chart below depicts the correlation between certain asset classes, represented by a group of ETFs, against the S&P 500 since the start of 2017 (when I launched my Storm-Resistant Growth service and started to pay closer attention to these metrics). Notice that treasuries and TIPS have been inversely correlated with equities over the period; gold has been largely uncorrelated; and commodities have been modestly (but positively) correlated.

Source: DM Martins Research, using data from Yahoo Finance

An asset-class diversified approach that allows for growth while being fairly protected on the downside could be as simple as a three-security portfolio made up of equities, treasuries and gold ETFs (the last two usually uncorrelated with the first, and in turn only modestly correlated with each other).

I backtested a very simple portfolio allocated as follows: (1) one third S&P 500, (2) one third gold, and (3) one third 10-year treasuries, but leveraged to a factor of three to make up for the low levels of volatility compared to the first two buckets. Today, a 3x leveraged investment in intermediate-term government bonds is possible through a fund like the Direxion Daily 7-10 Yr Trs Bull 3X ETF (TYD), which I reviewed in more detail back in December. I was able to obtain data for this exercise that goes back to 1928.

Here are the results:

Source: DM Martins Research, using data from NYU Professor Damodaran and The Balance

The numbers above are inspiring. The balanced portfolio not only produced market-beating absolute returns (in part thanks to the leverage factor), but it did so while producing much less volatility: standard deviation of 11.6% vs. the S&P 500's 19.4%, for a risk-adjusted return that was nearly twice as high as that of the broad equities market.

In addition, the multi-asset strategy endured a worst year of -23%, a breeze compared to the -44% faced by stocks in 1933. Finally, since 1928, the multi-asset portfolio finished the year in the red only 12 times and by an average of -6% vs. the S&P 500's 25 years and average annual loss of -13%.

In conclusion

Beating the S&P 500's absolute returns, considered by some the Holy Grail of investing, is easy. The real test for growth investors is to figure out how to protect their portfolios from sizable losses without hindering their ability to perform at least on par with the market, if not better.

To solve the problem that matters the most, I suggest investors stop asking themselves the wrong question (i.e. "how do I beat the stock market?") and start thinking about how to perform relatively well even when most everyone else is losing money. Doing so, in my view, is the ultimate challenge of the contrarian growth investor, one that I believe is very much worth tackling head on.

Disclosure: I am/we are long TYD, UPRO. 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.