Once again I’ve been horribly late in updating the speculative alternatives portfolio.  Two positions have changed since I posted about it last:

• Nov. 26: Exit the J&J position & associated hedge
• Dec 3: Buy NWN and enter associated hedge

The resulting portfolio is:

• Short 18% BMS
• Long 12.2% SPY as beta hedge for BMS
• Long 18% NWN
• Short 4.7% SPY as beta hedge for NWN
• Long 18% SPY as trend follow
• Long 15% GLD as trend follow

The SPY positions sum – total is 25.5%.

Here are all the transactions to date: Transactions 2012-12-11

Current value of the portfolio as of today is about $32,020 – a 6.6% gain from portfolio inception.

I want to discuss a little how the portfolio has been doing.  We’ve gone 6 months now and held 13 stock positions (two still open) and changed the direction of our gold position twice.  This is NOT enough information to really evaluate how good the strategy is (I’d want to see 50+ trades over several types of markets to begin getting an idea), but it is enough information to talk about how the strategy has performed recently.

It’s interesting to note that over the same 6 months, the S&P500 has increased by almost exactly the same amount – 6.5%.  One classic way of evaluating strategies is to compare their return to the S&P.  By that metric, what I’ve done here is no better – the return in the same.  And in some sense that’s really true.  If you invested $30,000 in my strategy, or invested it in the S&P, you would have the same number of dollars either way.  It would make no difference.  But what I want to convince you here is that a dollar earned in a market neutral spread trading strategy like the speculative alternatives portfolio uses is much more valuable than a dollar earned by investing in the S&P.  If that sounds wrong, well, read on.

This really goes back to what I previously called “Monkey Thinking“.  The point of that article is that you need to consider not only the actual outcome of your bets, but also all the outcomes (good and bad) that could have happened to you but didn’t.  The Monkey Thinking article used the extreme example of betting on Russian roulette to illustrate that dollars won at extreme risk are not a real win.  But even in much less extreme circumstances, the same thinking applies.  The last 6 months have been very good for the S&P, with it exceeding the zero rate risk of return by about 6%.  That’s better than many 6 month periods in the index’s history.  So if we apply monkey thinking, there are a lot of monkeys out there that invested in the S&P and got much worse results than we did.  The 2nd half of 1929, 2H ’87 and both ’08 monkeys in particular suffered huge double digit losses.  Other monkeys (like 2H ’09) did much better than +6%.

Contrast this with the monkeys trading the speculative alternatives system.  Since their beta is always withing the +-20% range, they really don’t care much whether the market is booming or crashing.  The ’08 monkeys made money.  It’s hard to re-construct what the speculative alternatives portfolio would have looked like in ’29 or ’87.  But there’s a decent chance they would have made money.  Or at least not have lost very much.  The vary nature of market neutral strategies is that they don’t really care what the market is doing.

Now, it would be overly optimistic to assume that the speculative alternatives strategy never suffers losses.  It certainly does.  But those losses are essentially uncorrelated to broader market behavior.  Because of the conservative design of the strategy, they’re also much smaller than those you might see were you to just buy the S&P.  For example, over the last 6 months the largest drawdown the speculative alternatives portfolio suffered was about 3%.  In contrast, the S&P had an 8.5% drawdown during the same period, and that’s over a period when the S&P has overall been doing well.  So one way to think about it is that the speculative alternatives portfolio returned over 2x its max drawdown whereas the S&P returned less than 1x.  The rewards may have been the same, but the risks taken to earn them were not.  This sort of thinking is formalize in the Sharpe Ratio, which is worth reading about.

Another way to think about it is that there’s a lot more unhappy monkeys trading the S&P.  That’s why I only trade market neutral strategies and suggest you consider doing the same.