Note: This article is part of Seeking Alpha's series on author investment strategies.
My investing philosophy is fairly simple. Use data to find places where investors consistently over or underestimate probabilities and returns, or where investor/market constraints cause them to make decisions that don't maximize their profit. Next, take the other side. This gives you a collection of "edges". To decide how much to allocate to each edge, optimize the portfolio to maximize the risk-adjusted return of the portfolio, taking care to pay attention to how correlations may change in the event of a financial or political crisis. If you do all these properly, my research indicates that you can get between 3-4 times the risk-adjusted return of the S&P 500. This said, you'd need about 2x leverage on average to get the same volatility as a 60/40 portfolio, so you'd have to be comfortable with having some leverage to fully take advantage of these constraints and biases.
Now, I'd like to share a few edges and how you can exploit them. Feel free to follow the links I've shared, as I've linked to high-quality white papers and academic studies where applicable.
1. Equity investors (especially mutual funds) tend to favor the stocks that are large, popular (as defined by having high valuations), and familiar to them. As such, such stocks have lower returns than the stocks of companies that are small, trade for low valuations, and are in "unsexy" industries. To exploit this, consider tilting your portfolio towards small-cap stocks and value stocks (with a quality overlay in both cases). The past few years have been rough for value stocks, but they still have shown superior risk-adjusted returns in line with historical trends.
2. The stocks of quality companies that have positive earnings, lower amounts of leverage, and low volatility tend to outperform the stocks of companies with the opposite characteristics (high volatility, losing money, overleveraged). This flies in the face of market efficiency and increased risk equaling increased reward. Companies that pay dividends and have low valuations tend to do well also. This phenomenon is referred to as the "quality minus junk" factor.
3. International diversification works quite well for US investors when you properly hedge the foreign exchange effects, as it's a source of uncompensated risk. If you live in a commodity producing country like Canada or Australia, you likely want to leave the FX unhedged, however.
4. Trend following works for equities. You can use the volatility environment to tell you how much risk to take and what the reward is likely to be for doing so, much in the same way that card counters use the count to tell them how much to bet. This fact is very helpful for trading the NASDAQ and S&P 500.
5. Diversification across individual equities is important for not only reducing risk but also for boosting overall return. The median stock returns less than the mean, meaning a few big winners are responsible for much of the overall gain in the market over time.
6. If you don't understand the disposition effect, you're not going to make much money in individual stocks. This, along with point 1 and point 2 are the main reasons why mutual funds typically underperform the S&P 500. Allowing winning stocks to run forces you to contend with concentration risk, however, which you need to manage one way or another.
7. Market microstructure matters for all asset classes, but for equities, it's an especially big deal. My research shows that the ideal amount to trade is between $25,000 and $100,000 per transaction, using an algorithm that can reload roughly 6-10 times per minute. I had paid close to $20,000 in commissions and untold amounts of bid/ask spreads before I figured out that the execution of trades should be treated as a business and not as a hobby.
1. Institutional investors continually pile into long-duration bonds due to their investment constraints, leaving an opportunity for traders to buy shorter-term Treasury notes using leverage. You need to be able to access the repo or futures market to take advantage of this, but this allows to directly profit from Federal Reserve rate cuts, which usually occur around the same time that equities are in a bear market.
2. There are significant opportunities for alpha in high-yield bonds and mortgage-backed securities due to the fact that most institutions aren't allowed to touch them. Of particular interest are the old "AAA" rated non-agency mortgage-backed securities that now are mostly rated CCC and yield 8+ percent with little risk due to the significant discounts to par that they now trade at, 10+ years homeowners have had to build equity, and mortgage servicer guarantees. You can access a piece of these through funds like PIMIX, which has a $25,000 minimum at Interactive Brokers and Vanguard.
3. Trend following works in high-yield credit and MBS as well.
4. In general, investors are constrained from using leverage, which gives you opportunities to invest in lower volatility assets using cheap leverage rather than concentrating your risk entirely in equities (especially high beta equities). This allows you to achieve risk parity in your portfolio and is optimally done on Treasuries. This is called "betting against beta." You need to use futures or repo to do this as broker margin loans are too expensive.
5. Bond investors should aim to keep their duration risk constant, meaning that they slowly reduce their gross exposure to bonds the lower interest rates go and increase their exposure as interest rates rise. Because higher yields shorten the duration of bonds, this allows you to buy low and sell high.
1. If you have a real estate broker's license or have the time and ability to do renovations yourself, rental real estate and/or flipping can be a profitable business to get into. However, real estate scales poorly unless you want to go into multifamily or development, making it a more effective wealth creation vehicle for the middle class than if you're already a multimillionaire. You need to be able to beat the returns of REITs plus a fair illiquidity premium to justify the time and effort spent, however. Lower priced and in-demand properties have the highest margins.
2. Home prices are more seasonal than is commonly believed. You can consistently get much better deals between November and February. This occurs for sociological reasons, as families all try to move their kids during the summer and houses are more attractive during the spring and summer months. This is yet another example of constraint/bias costing investors money. You can apply this to investments or to acquiring property for personal use.
3. Global REITs are a better deal than US REITs presently due to the current strength of the US dollar. Global REITs are in line with historical valuations, whereas US REITs are higher than normal. Invest accordingly and diversify your real estate holdings internationally.
4. Many investors suffer from bias in their household capital structure. In particular, they carry mortgages costing 4-5 percent while investing in short term bonds (often in classic 60 stock/40 bond portfolios). Such bond funds typically pay less than 3 percent. If you do this, you're giving away about $2,000 in negative carry for every $100,000 in mortgage balance outstanding. This is suboptimal because investors could get a guaranteed 4-5 percent by paying down the mortgage, and instead, they often choose to invest the money at lower rates. The better move is to shift whatever money you would invest in bonds to pay off the mortgage. Then, you can turn around and get a home equity line of credit if you need to, which you could draw any time your equities are down more than 20-25 percent to make sure you have enough cash/stocks to ensure 12+ months of living expenses at all times. You might also consider pulling money back out if your local housing market tanks.
1. When crude oil is in backwardation, there is a strong expected profit to buying futures contracts 3 months out and selling them around when they become front month (pretty cool paper from a French university on this). Brent crude oil is usually better than WTI for this because you get a free call option on Russia or Iran causing chaos for the global oil market. There are also potential opportunities to profit at the expense of passive commodity investors like ETFs when the crude oil market is in contango (you might need to rent an oil tanker though). Owning crude oil also protects you from exogenous shocks, like terrorist attacks or war, which can hurt equities and cause supply shock inflation.
2. Gold is an excellent hedge against unexpected inflation over a 5-year period and can be accessed inexpensively via the futures market. This isn't an edge, per se, but it reduces drawdowns and helps manage risk. There is a reason why central banks own gold and don't own random commodities, as it's the global benchmark for a store of value and hedges the stocks and bonds in your portfolio quite well against the depreciation of the US dollar.
1. The foreign exchange market is an endless source of opportunity for traders. Carry trades structurally profit from changes in currency valuation. The trick to maintaining profits is understanding that emerging market and commodity currencies are risk assets and treating them accordingly. Even small carry trades such as being short the euro against the dollar and long European stocks have an edge (such as buying a hedged European stock ETF– as you'd get 2.4 percent in positive carry for free). Currencies can be accessed through monthly futures contracts through most online brokers.
2. Undervalued currencies in terms of purchasing power parity tend to appreciate over time against overvalued currencies.
3. The foreign exchange market shows a good deal of momentum. US equity volatility, for example, can predict FX returns. This is a lot like the card counting method for equities. This gives good hedging possibilities in currencies like the yen when the S&P 500 is below its 200-day moving average.
Instead of only investing in one or two asset classes, consider investing in at least 5 among US stocks, international stocks, bonds, MBS, gold, oil, real estate/REITs, and foreign exchange. Unfortunately for investors, ETFs only work optimally for stocks and REITs (and municipal bonds). The way I see it, investing half of your money in a Vanguard account with nothing but Vanguard and iShares ETFs, and then considering a carefully constructed macro trading plan for the rest of your capital is a good way to increase your wealth. You need $500,000 to $1,000,000 to trade with to properly play the macro game, so keep that in mind. Even if you want to stay ETF only, you can apply principles like risk parity and factor investing in your portfolio and get a better risk-adjusted return for yourself by paying attention to which assets are negatively correlated with each other.
Additionally, having up to a 10 percent allocation to a private equity manager or value investor that you trust can help you achieve your goals. Individual stocks can add value but are very information intensive, so you need to stay on top of them, particularly if they're small caps. For many investors, this means that the best move is to allocate to ETFs and pick stocks as a hobby.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.