(part 1, part 2, part 3, part 4, part 5)
We’re almost done. In part five, we figured out what the major stock positions in our portfolio are going to look like. Now it’s time to clean up some lose ends and look at some results.
Bonds & Commodities
If you go all the way back to part 1, you’ll recall that I laid out some limits on what positions the speculative account would take:
No more than +-20% exposure to the broad stock market (beta), any one firm’s alpha, any or all commodities, or US long term rates.
Thus far I’ve said out what I want to do with two of those four types of position – I discussed how to trade beta in part 3 and how to trade the alpha component of dividend stocks in part 5. But thus far I haven’t touched commodities or rates. Now it’s time to fix that.
Commodities are pretty easy. Gold has historically traded very well with the 40 week average, 13 week delay trend following system we’re already using for the S&P. There’s no good reason not to use it there too. Other commodities would work as well, but gold seems to have nice trends on those long time frames so I’m inclined to keep it simple (at least as simple as anything at ORF) and go with that.
Rates are harder. The obvious instrument to work with is the exchange traded fund TLT. It represents US 20 to 30 year bonds – the long end of the yield curve. I can see four options:
- trend follow
- some sort of mean reversion method
- go long
- do nothing
A quick look will show that the 40 week/13 week trend following system works horribly on bonds. We could potentially consider revering it, it works so bad. That would be the mean reversion system. But I only like fading trends (aka mean reversion) like that when I have good reasoning why price movement is unlikely. We have that with our dividend stocks. But with bonds, not so much. There could easily be a long term bear trend in bonds if inflation picks up. I don’t think that’s terribly likely (I perceive we’re balanced more on the deflation side of the knife) but it could happen. And if it did happen, bonds could easily move a long ways. Long term yields could go to 7% or whatever – it’s happened before. Were that to happen, TLT would lose about 35-40% of its value depending on their exact holdings. Depending on how we weighted it in the portfolio, that could be within our “no worse than 3% drawdown” risk parameters, but the TLT position would have to be pretty small. Not sure it’s worth it.
That’s the long way of saying I’m not going to take a position in rates in this portfolio. I might find a better idea in the future, and if so I’ll let you know.
Margin & Portfolio Allocation
Back in part 1, I mentioned that this strategy is going to have to live in a margin trading account. A margin account is one that lets you borrow from and form a credit relationship with your broker. Margin accounts both allow you to increase your leverage somewhat and take short positions. They also allow you to trade derivatives, but we’re not going to be making use of that feature.
The basic rule for margin accounts is something called Regulation T (Reg T for short). Reg T says that the maximum position you can take in a margin account is 2x the value of the account in securities. Both long and short securities count against this total. So if I want to go long $7500 of XYZ and short $2100 of ABC, that would be $9600 of securities. I would have to have an account with at least a $4800 liquidation balance to take those positions. Brokers may have additional margin restrictions (ex. no buying penny stocks on margin), but they likely won’t come in to play for what we’re doing here.
It turns out you don’t ever want your account to get too close to the Reg T “line”. If, near market closing time, you’re close to being in violation of Reg T your broker will have to liquidate some of your positions for you. This is known as a “margin call” because in the old days they would actually call you and tell you that you had to either put up more money or close positions. Now the whole process is usually automated (read your broker’s info carefully). Murphy’s law says a margin call always happens at the worst time – you’ll get horrible prices on the liquidation. We never want that to happen to us, so we want to under-utilize our margin. The strategy is designed to have no worse than a 5% drawdown, but let’s double that and make sure we wouldn’t have a margin call until a 10% loss. This means we can’t hold more than 1.8x (0.9 after loss x 2) of the account value in securities.
Historically, this method seems to be able to find about 5 stock spread positions to take at any given time. So I’m going to lay the portfolio out with 5 “slots” you can put a stock and beta hedge in, plus the trend following beta and gold positions. It looks like this:
- (up to 5x) Stock position (18% of portfolio each)
- (up to 5x) SPY beta hedges for stock positions) (max 10.8% of portfolio each since stocks are selected for a max beta of 0.6)
- SPY trend following position (18% of portfolio)
- GLD trend following position (15% of portfolio)
That adds up to a max margin usage of 177% of account liquidation value – right at our target. I intentionally made gold smaller than the other positions since it’s a littler more volatile.
Most brokers allow you to designate which position will be liquidated first in a margin call. The obvious choice is GLD, because everything else is part of the beta neutral spreads. Account volatility would go way up if you liquidated just one side of the spread – you’d no longer be beta hedged. So pick the GLD – it’s pretty liquid so you’ll get a decent price if it gets auto-liquidated, and you won’t break your hedging scheme.
Rebalancing?
In general this portfolio shouldn’t have to be re-balanced very often. Once a week you check to see if it’s time to enter or exit a stock position, but most weeks you’ll be making no change. When you do buy or sell a stock, you can take the opportunity to adjust all the SPY positions and get your hedge exact again. There is one case, however, where you have to pay close attention.
If all 5 stock positions are shorts (and thus all 5 beta hedges are longs) and the beta trend following position is a long, you can get in a bit of margin trouble if the market consistently goes up from there. The reason is that the size of every position in the account will increase in a bull market. The shorts will have bigger negative face value as the share price goes up. Same for the hedges and the trend following SPY. Now, that’s not to say you’ll necessarily be losing money in this situation. You’ll lose on the stocks and win on the hedges. But margin will get tighter and tighter because face value of everything will increase faster than you profit. In this case, you need to monitor your margin carefully and if it gets too tight reduce your position size. One option would be to temporarily stop trend following gold for a few weeks to free up a little extra room.
Current Holdings
As of the week of 8/17/2012, the portfolio was as follows:
(percentages are percentage of account liquidation value)
Short 18% ABT
Long 5.8% SPY as beta hedge for ABT
Short 18% CLX
Long 6.8% SPY as beta hedge for CLX
Short 18% JNJ
Long 9.7% SPY as beta hedge for JNJ
Short 18% NWN
Long 4.7% SPY as beta hedge for NWN
Short 18% PEP
Long 8.6% SPY as beta hedge for PEP
Long 18% SPY as trend follow
Short 15% GLD as trend follow
Of course all the seperate SPY positions add up – net long 53.6% SPY.
As you can see, all the beta neutral spreads are short stock/long SPY because all the dividend stocks have been near their upper Bollinger band. This is exactly the configuration I described above sometimes causing margin issues. We’re only using 158% of our total 200% margin (because some of the stocks used for spread have betas well below 0.6), so trouble is pretty far off. But it’s close enough you should check in at least once a week and make sure things haven’t moved too far.
A Few Recent Results & A Warning
Since the start of this series, I’ve been running the speculative alternatives portfolio both on real money in my personal trading account and in a Google Finance account. Here’s a list of the transactions in csv format: Transactions. The transaction sizes aren’t exactly the same as what I suggested above, but they’re within a few percent. The portfolio has been running for exactly 13 weeks (one quarter) today, so it’s a good time to do a little analysis. The equity chart looks like this:
The net return over that quarter is about 4.2% for an annualized rate of 16.8% without compounding. Our target was 15-20%, so this is right on target. I’ve slightly underperformed the S&P over this period – about 1.5% worse. That’s not particularly concerning to me. Since this is a nearly beta-neutral portfolio, it’s going to underperform in bull markets like we’ve had this quarter. And it’s going to radically overperform in bear markets – it’s totally feasible to still be making 15% a year while the S&P is tanking.
By far the best trade has been the Piedmont natural gas long. The worst trades have been Abbot Labs short and Pepsi short. The SPY trend-follow has continued without change. The GLD trend follow switched from long to short a few weeks ago. The biggest peak to trough drawdown was 3% which is within our risk parameters.
Basically so far, so good. Now, I want to be clear – PLEASE DO NOT START TRADING THIS TODAY. I’m not just saying that as a disclaimer to cover my ass. I enjoy a nice ass breeze. The fact is, we still are a long way from having enough proof to know that this is a good strategy. I’m trading it on real money in my own account because I have some additional information that has convinced me it works well enough to bet on. You don’t have that information, and you’d be stupid to trust some anonymous guy on the internet. Part of this blog is convincing my readers not to be gullible about financial education. That means not being gullible about what I say either. Thus far all I’ve done is explained is how the system works, and demonstrated that it wasn’t totally disastrous for a short period of time in fairly calm market conditions. In future articles we’re going to use this system as an example when we talk about testing and validating systems and risk management. You need that information before it’s rational to trade the system. If the system interests you (and unless you have something fabulous lined up to do with your money, it should) then what you can do is start trading it on “paper” in a spreadsheet or Google account or IB demo account or whatever. Make sure you can make the same trading decisions at roughly the same time points I do and that your accounting matches mine. Over the next 6 months or so we’ll walk this system through the trading system development process, and at the end we’ll have a better idea whether it’s safe to trade or not.
I’ll publish an update some time on any Monday where the portfolio contents change, and quarterly performance updates. Stay tuned…
Correct me if I’m wrong, but I think you may have made a grammatical error in the paragraph immediately following your portfolio contents. In your table of contents for your portfolio, you say “short (stock ticker) / long SPY” and in the following paragraph you say “notice all the neutral spreads are long stock / short SPY”, which is the opposite of what you stated in your list of positions. That was the only part that confused me, otherwise I think this is a great series of articles. It’s nice to see someone write about something other than the standard regurgitated “buy low cost index funds” material.
You are correct, and I’ve fixed it. Thanks! I’m glad you enjoyed the series.