Stop Investing Like It's 1950

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What’s the primary goal of the average growth investor who spends considerable time on Seeking Alpha and other online investment platforms? Let me take a swing: To produce absolute returns in excess of broad market performance.

Sure, a better response would likely be much more nuanced than this. But generally speaking, most growth investors want to know if they should buy Amazon (AMZN), sell Apple (AAPL), or hold General Electric (GE). Other than for the pure fun of participating in the markets, I can only assume that they do so in order to beat the returns of the S&P 500.

But there’s something about the stock-picking approach to growth investing, still widely used to this day even by professional investors, that puzzles me.

Credit: U.S. News Money

Not your grandpa’s market

The financial markets have evolved quite a bit over the last several decades. In the 1950s, for example, one might only be able to beat the returns of the broad equities market by owning stocks that, collectively, appreciate over time at a relatively higher rate. Looking for better absolute returns? Do a good job at picking individual stocks. Looking for more safety instead? Buy bonds. Looking for a middle-of-the-road solution? Assemble a famous 60/40 portfolio made up of individual equity and fixed income instruments.

This was basically the landscape back then, when a thriving mutual fund (let alone ETF) industry did not quite exist, international investing was a novelty, and even updated stock prices were hard to obtain in real time.

But here’s the thing: Investors today have a plethora of different investment tools to choose from, beyond just stocks and bonds, that can help them beat the market’s absolute returns, mitigate risks or reduce correlation in a portfolio (or, in very rare cases, all of the above at the same time). Here are a few options that our grandparents did not have easy access to:

  • Common derivatives, like futures and options
  • ETFs, including esoteric types like leveraged, private equity and long-short
  • Hedge funds that invest in alternative asset classes

I bet most non-professional investors would cringe at the thought of “leverage”, “alternative assets” or “derivatives”. And to be fair, I believe individual investors should stay as far away as possible from techniques that they understand little about or that they do not know how to use properly. But better-informed and experienced market participants might benefit from getting involved with more sophisticated approaches to managing money.

Addressing the “L” word

Let me start with leverage. I can not think of an easier, more direct way to beat the broad market over long periods of time than to use modest amounts of leverage. See the following two graphs below:

Source: DM Martins Research, using data from Yahoo Finance

The chart above on the left is an estimate of how a $1,000 portfolio invested in the S&P 500 would have performed since 1950 compared to a “sister portfolio” that leveraged its exposure to the broad market by a factor of 1.5x. Notice that the graph itself is in logarithmic scale, which ends up masking the desirable impact of leverage on a portfolio over a long period of time (at least visually).

Maybe numbers might help to paint a better picture here: A leveraged S&P 500 portfolio would have grown from $1,000 in 1950 to a whopping $1.2 million today (yes, you’ve read it right), compared to only about $170,000 if invested in a plain equities strategy. In annual terms, and ignoring dividends for simplicity, the 1.5x S&P 500 approach would have produced returns of 10.9% vs. only 7.7% for the plain-vanilla index strategy over the past 70 years — while, not surprisingly, also generating quite a bit more volatility and losses during downturns.

Notice that handily beating the broad market over a multi-decade period of time, assuming stocks tend to go up in the very long term, would not have consumed much work or time at all, if only investors had easy and cheap access to leverage in the 1950s. By contrast, picking and choosing individual stocks with the hopes of consistently producing an extra one or two percentage points of returns above the broad market could have taken the full-time efforts of a whole team of portfolio managers.

The good news is that leverage is much more easily accessible to investors today, even without the use of a margin account (i.e. loans).

A different ball game

Let’s now turn our attention to the graph on the right above. It depicts the performance of a $1,000 portfolio invested in the S&P 500 vs. a sister portfolio allocated 75% to ProShares Ultra S&P 500 (SSO), a 2x leveraged index ETF that debuted in 2006, and 25% to cash. The second portfolio effectively mimics the performance of a 1.5x leveraged strategy on the broad equities market.

Despite the deep recession of 2008, the leveraged strategy would have produced superior annual returns of 10.2% over the 13-year period against the benchmark’s 6.9% – while, certainly, also producing more volatility and lower lows.

If easy access to leveraged ETFs was not enough, sophisticated investors today can create similar leveraged strategies through the use of derivatives. For example, the same 1.5x exposure to the S&P 500 can be achieved by going long Micro E-mini S&P 500 Index futures contracts that trade almost 24 hours a day, six days a week – search for ticker MESZ19.CME on Yahoo Finance for more details.

Source: Yahoo Finance

Each Micro E-mini future contract represents five times the value of the underlying index, which as of Sept. 12 amounted to about $15,000 ($3,016 times five). A portfolio of only $10,000, therefore, can produce 1.5x the daily returns of the S&P 500 with only about $500 set aside for initial intraday margin – i.e. a “guarantee” required to establish a long or short position in this particular instrument.

Those who feel more comfortable owning options instead of trading futures could obtain a similar leverage effect by buying deep in-the-money S&P 500 calls. As depicted below, call options on the SPDR S&P 500 ETF (SPY) that expire one year from today and have a strike price of $200/share can be bought at an ask price of $102.67 per share, or $10,267 per contract.

Source: E*Trade

Since one option contract represents 100 shares of the underlying asset that’s currently valued at just about $301/share, each call contract covers a bit more than $30,000 worth of SPY. And because these particular calls are so deep in the money, each $1 move in the value of SPY should impact the options by roughly the same amount (in technical terms, the calls have a very high delta of nearly +1.0).

Therefore, in this example, a hypothetical portfolio initially worth $20,000 could invest $10,267 in a deep in-the-money SPY call option contract (keeping the rest in cash or high-quality bonds) and be exposed to the S&P 500 by a factor of about 1.5x (because $20,000 times 1.5 is roughly equal to 100 shares of SPY at $301/share). The good news is that the maximum possible loss in this portfolio would be about 50%, which is the total loss of the option’s market value in case the S&P 500 falls off a cliff over the next 12 months. In other words, under no circumstances would this “leveraged portfolio” lose in one year more than the S&P 500 did during the 2007-2009 mega bear market.

A real life example

I have been tracking a model portfolio that uses options in a manner similar to the one described above, but that adds yet another element to its strategy: Multi-asset class diversification. The goal of diversifying beyond equities (and even bonds) is to allow a portfolio to perform relatively well in a number of different macroeconomic environments, whether they are favorable to stocks or not.

The $50,000 model portfolio, which I call SRG II (Storm Resistant Growth, version 2), allocates only about 6% to 7% of its assets to call options on the S&P 500, gold (GLD) and diversified commodities (DBC), while holding the other 93% to 94% in cash and investment-grade government and corporate bonds. See the portfolio’s performance below compared to that of the S&P 500, as of last week.

Source: DM Martins Research, using data from Yahoo Finance

To be fair, my SRG II (blue line above) has not quite outperformed the S&P 500 on an absolute basis since inception or even year-to-date. But notice that, in great part as a result of multi-asset class diversification, the portfolio has performed very smoothly over the past 15 months (i.e. since inception), experiencing much more manageable lows during times of market distress — 4Q18, May 2019 and August 2019.

As a result, the SRG II’s risk-adjusted return, measured by the Sharpe Ratio, has been far superior than the benchmark’s. Add a bit extra leverage to the portfolio by increasing the options positions, and the SRG II can probably outperform the S&P 500 without putting as much capital at risk.

The bottom line

Hopefully I have not overwhelmed readers with all the detailed information above. In the end, I would like them to take one key message away from this article:

Whereas buying or selling stocks or bonds was pretty much all that investors could do to try and achieve superior results at one point in time, the many different investment tools available today (ETFs, derivatives, access to alternative asset classes) elevate the game to a whole new level. Asking whether a stock is a buy or a sell may have been appropriate in the past, but may not be the best way to approach growth investing today.

Therefore, I urge readers to stop thinking about investing like it’s 1950 and consider novel ways to achieve superior returns, lower risks and/or better diversification in today’s much more dynamic financial markets.

Disclosure: I am/we are long AAPL, AMZN, TYD, IAU, LTPZ. 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.