Foolproof Failsafe: Revisited & Updated
How to Sidestep Bear Markets Great and Small
Using Three of the Major Indexes in the World
Percent Gains--Weekly--Hypothetical
6.2 years April 12, 2002--June 13, 2008
See Comments below: The Aggressive Prudent Trustee
THIS ARTICLE DEALS with why and how to expand trustee (and quasi trustee) investment choices and still remain prudent. Prudence deals with getting the best reasonable returns with maximum risk avoidance. Systems analysis may help. (The following content pertains to non-trustee investors as well.)
The eternal question in systems development is the balance between gain and loss. How much of each is best? Always a tradeoff, the relationship is direct. Increasing one increases the other; decreasing one decreases the other.
Can there be a way to take low and low-volatility returns (with their accompanying drawdowns) and convert them to higher returns but still not inflate the drawdowns to more painful and unacceptable or litigious levels? (Notes on drawdown definition and characteristics are here and here.)
The World of theTrustee, especially the corporate and institutional trustee, is supposed to be a quiet affair, embracing care, skill, diligence, and, above all, prudence--in fact, U.S. federal pension law commands these virtues, especially the last. You should not get too far out from under the center of the bell-curve umbrella; your investments must not be boat-rockers. All skippers must sail on quiet seas.
The Aggressive Prudent Trustee. Here is how it might work ... and provide a far more placid and profitable voyage than the standard 'prudent-man' policies and investments currently used by others managing trust assets.
Money Management and Leverage are the keys, the former to preserve prudence by controlling the added risks that the latter will evince. The combination both enhances returns and reduces risk, as we shall see.
Leverage usually comes by borrowing money and is prohibited by ERISA (the federal Employees Retirement Income Security Act of 1974) under its prudence provision, Section 404(a)(1)(B). But due to the unlimited creativity of American ingenuity, including--and especially in--the financial sector, and the ability of the entrepreneurs to lobby successfully to circumvent the intent of enacted legislation, we have today a legal way reap the benefits of borrowing (leverage) but without actually borrowing.
Enter the leveraged ETF. It does the borrowing but sells you the equity in the fund. Hence you are an investor making an investment. The fund is the borrower, not you. Its leverage can still kill you, but not bury you--small solace. The following table displays the glories of leverage characteristic of the system in this study. After you take a look and shudder, questioning how could anybody believe this is prudent, I will show you how to take the sting out of the scorpion's tail and stay out of jail.
In the table below the first column is the amount of leverage. The second column is the compound annual return the portfolio produces. The third column shows the compounded profit over 6.2 years. Next column, the worst weekly drawdown over 320 weeks, and finally, the duration of the drawdown in weeks over the same period.
For example, with leverage of 3, portfolio profit is 23% per year which compounds to a gain of 261%. The worst-case drawdown is -44.4% and its duration is 14 weeks.
Peak leverage gains occur at 7 times the initial principal invested. Profits explode to 36% per year and compounded total profits to +562% over six years. But what trustee, or for that matter, what investor or trader can withstand a drawdown of -80%?
As an individual, I can tolerate drawdowns to the level, perhaps, of -20% or less, but I would prefer not to as a trustee. Is there a way to cut the drawdowns and keep the returns?
TABLE OF RESULTS
Relation of Leverage to Profits & Drawdowns
|
profit |
compnd |
% |
duration |
|
levg |
%/yr |
tot%profit |
drawdn |
weeks |
|
1 |
9 |
71 |
-16.6 |
14 |
|
1.2 |
10.7 |
87 |
-19.8 |
14 |
|
1.3 |
11.4 |
95 |
-21.3 |
14 |
|
1.4 |
12 |
103 |
-22.8 |
14 |
|
1.5 |
13 |
112 |
-24.3 |
14 |
|
1.8 |
15 |
139 |
-28.7 |
14 |
|
2 |
17 |
158 |
-31.5 |
14 |
|
3 |
23 |
261 |
-44.4 |
14 |
|
4 |
29 |
371 |
-55.6 |
14 |
|
5 |
33 |
471 |
-65.1 |
14 |
|
6 |
35 |
540 |
-73.1 |
14 |
|
7 |
36 |
562 |
-79.7 |
14 |
|
8 |
35 |
527 |
-85.2 |
14 |
|
9 |
31 |
438 |
-89.5 |
14 |
|
10 |
26 |
313 |
-92.9 |
14 |
|
11 |
18 |
177 |
-95.5 |
14 |
|
12 |
8 |
57 |
-97.4 |
14 |
|
13 |
-6 |
-30 |
-98.7 |
14 |
(chart)
The worst-case drawdown problem occurs, by definition, at the peak price of an uptrend. The worst drawdown in the series in the chart occurs in late 2002. (You would not be buying this peak, anyway, in observance of the timing rule.) But if you invested new money prior to the peak, your fund would suffer during the following drawdown. However it would be attenuated because your purchase price is lower. For example, if you leveraged 3x, the drawdown (from the Table) is -44.4%, but your portfolio drawdown is 'actually' -35.7% based on your cost price. To control and diminish that, you would break your purchase up into three tranches of one-third each, spaced over six week periods. Your effective 'drawdown' on your position loss now is limited to -11.9%. Without leverage, the worst system loss using scale-in was -5.5% in six years.
But this is a quibble. If prudent trustees can tolerate drawdowns of -89% in the Dow Jones Industrial Average (1929-1932), and -48% in the S&P500 (1973-74) and most recently -43% in the S&P (2000-02), then any moderate level less than those should be tolerable. The worst 'actual' realized system loss during the six-year study period has been -8.76%. Furthermore, on the plus side, typical boards of trustees usually view only quarterly, or less frequently, reports from fund managers. Those schedules will reduce both the frequency and the magnitude of reported drawdowns in this study which uses and reports weekly data on a weekly basis (321 weekly 'reports' vs 24 standard ones).
Above all, it is noteworthy that the long-run average total return on the S&P500 is around 9 to 10% per year. This six-year study shows an average annual return for the S&P at 3.3%. When the current market cycle returns to its long-term norm, the average annual return will be three times higher than now. Taking the current system results of 9.1% per year and multiplying by 3 equals an expected 27.3% annual return. Over 10 years, the system would compound total return to more than 1,023% vs 159% for the benchmark S&P.
Should the prudent trustee, or his or her board, move to adopt a system based on a reasonable expectation that results will approximate those shown here? Is it prudent not to use tools which may tell you to sell stocks and go into Treasury Bills? (This system was in Treasury Bills during a total of three and a half years out of the past six.) Is it prudent not to pick the best single fiduciary asset which contains from 30 to 500 diversified stocks if you have the tools to do so? What do you think? After due discussion, vote the motion up or down?
A new paradigm for the pension or estate fiduciary?
Caveats. The obvious one is that the sample period is short. The remedy is time. Differences of opinion may arise as to how long a test period is adequate if any. The biggest caveat is less obvious. It rests on the future effect of widespread acceptence and use. The components in the study enjoy massive market liquidity. The bid/ask spreads are one cent or pennies. The intervals between trades are fractions of a second or simultaneous. This effective liquidity is further ameliorated by the incessant trading activity in the underlying stocks which are components of the indexes. These interactions are continuously reflected in the dynamic premium/discount levels of the trade prices of the ETFs vs the reported repoorted prices of the underlying indexes. If widespread acceptance and use of this system were to become monunmental enough to impact trading prices in the market, there are remedies, such as scaling, enlarging the number of broad-market index ETFs used and held in market uptrends, and so on.
The issue today comes down to the psychological possibility of unintended consequences (they may never happen) vs underutilized advantage (available for the taking as you read this.)
You will recognize that that this study is an update and revisit of the Systems Tips article of February 22, 2008, Foolproof Failsafe
(q.v. to review those notes which are relevant to update and expansion).
Posted
6/22/2008 5:04 p.m. EDT
Amended
6/24/2008 5:52 p.m. EDT
Some additional useful notes on leverage here
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