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Trading Strategy

143 posts in this topic

On 2016-03-25 at 3:56 PM, explo said:

I've calculated the individual return, max drawdown and volatility from the individual stocks asset class and the combined (stock funds and hedge funds together) funds asset classes to see if one of the classes is inferior in its risk adjusted return contribution to the portfolio.

Note that the funds asset classes have 11.5 times higher allocation than the individual stocks, so equal return, max drawdown and volatility performance would mean that the funds contribute 11.5 times more of that to the portfolio than the individual stocks do. If my picks and trading are successful maybe the individual stocks can perform better than the funds.

Note that the individual risk contributions cannot just be summed up or multiplied. The combo is supposed to have better risk properties (from diversification effect) than the sum of parts. For the return the combo equals the parts multiplied.

The strategy description post above has been updated to show these individual contributions.

I've stopped posting the return, max drawdown and volatility separated for stocks and funds. Instead I've separated out 2 other components of the portfolio return, the interest expense and the tax expense. These non-asset specific components were previously included in the stocks and funds returns by their asset size proportion. I think breaking them out gives a better picture of the stocks and funds actual contribution to the portfolio return as the relative allocation of asset classes is not affected by the amount of leverage chosen and thus the return difference between the stocks and funds should not reflect the amount of leverage used.

So instead of tracking these now 4 portfolio components in daily updates in the "About Me" tab in my profile (it becomes to messy with too many numbers) I'll just include them in the quarterly updated performance charts. In these performance charts I will also show the unlevered return of the portfolio. The levered return equals 4 times (this is the leverage factor) the sum of the unlevered return contributions from the stocks, funds and tax expense components plus the negative return contribution from the interest expense.

The charts to date for the 16H1 view have been attached. For now the asset returns are not even covering the negative return from the interest and tax expense. The funds being 11.5 times larger in asset size than the stocks is expected to return 34% on average annually and the stocks only 3% annually with equal asset return requirements. This would cover the interest and tax expenses and leave a net 30% annual portfolio return.

So far the portfolio is performing below expectation on return, but as expected on risk. The unlevered portfolio has much less risk than the stock index (not to mention the high beta ETF) and the leverage effect seem to put the levered portfolio on the same order of volatility and drawdown risk as the stock market index. This is as intended although the portfolio is long-term expected to have 50% more volatility than the stock market index but only half the drawdown risk of the stock market index.

It is too early to evaluate the strategy now though, but could still be interesting to follow.

16H1_return.PNG

Edited by explo
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5 hours ago, explo said:

is expected to return 34% on average annually

what fund are you investing in to get that expected return?

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29 minutes ago, disdaniel said:

what fund are you investing in to get that expected return?

Mainly local ones. As described in my profile the asset value of the funds are 345% of the portfolio capital, while the stocks' asset value is only 30% of the portfolio capital (11.5 times lower). Thus if both stocks and funds would achieve my 10% average unlevered return on assets requirement (needed to achieve my 30% levered return on capital goal) they would contribute 3% and 34.5% return on portfolio capital respectively and the interest and tax components would contribute -6% and -1.5% respectively for a total of 30% levered return on portfolio capital. The benefit of the funds (dominantly hedge funds) is more in the low risk (enabling the high leverage) than in high return.

The funds I use have a historical average return closer to 11% than 10%, so from a historical perspective the 10% return requirement is reasonable for the funds. For stock markets however the long-term index gains tends to be around 7%. To get to a 10% long-term average one would have to be very successful in beating the market, but 7% does not include reinvested dividends. If that's included (which is the fair measure of long-term average return on stocks) the long-term average return on stocks gets close to 10%. Then with active trading effort there is further potential to add trading gains if successful in trading, thus not really requiring to beat the market in stock picks, just to be close to par with a broad index.

Edited by explo
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2 minutes ago, explo said:

The benefit of the funds (dominantly hedge funds) is more in the low risk (enabling the high leverage) than in high return

You are losing me here...how can 34% expected return be considered low risk?

Or are you saying that both stocks and funds have 10% expected return, and then you leverage that (initially low risk fund return) up?

 

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7 minutes ago, disdaniel said:

You are losing me here...how can 34% expected return be considered low risk?

34% is achieved through high leverage. High leverage requires low risk. The funds I use have low risk and thus allow high leverage and thus enables high levered return. What's special about them is not super return, but good return at super low risk. Like you say here:

7 minutes ago, disdaniel said:

Or are you saying that both stocks and funds have 10% expected return, and then you leverage that (initially low risk fund return) up?

Edited by explo
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I think I get it now.  For every $100 you put in the account, you buy $30 of stock and $345 of funds because you are allowed to borrow money to buy the low risk funds.

Never mind doing dd on the individual stocks, you better be damn sure you know what your "low risk" hedge funds are doing...imo

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Explo, Under this low interest environment, the 10 to 11% low risk seems very good. 

I am sure that you are aware of some Ponzi scheme peer to peer lending that happened in China that caused almost 1 million people to lose their money.  This scheme also gave people who lend money around 10% return.  The funds make up fake project to borrow money. 

Please be careful.

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18 minutes ago, disdaniel said:

I think I get it now.  For every $100 you put in the account, you buy $30 of stock and $345 of funds because you are allowed to borrow money to buy the low risk funds.

Never mind doing dd on the individual stocks, you better be damn sure you know what your "low risk" hedge funds are doing...imo

Yes. The credit mechanism from my broker is complicated, but I've set things up to view it more simply:

If I put $100 in my account I borrow another $300 from my broker, then I reserve $25 for cash buffer, use $30 to buy stocks and the remaining $345 to buy funds.

Due to much lower inherent volatility of and correlation between the funds in the funds basket than the stocks in the stocks basket the return volatility (deviations from average) of the funds basket in absolute dollar is only slightly larger than it is for the stocks while the expected average return of funds basket is size proportionally larger (11.5 times) than the expected average return of the stocks basket.

This can be seen in my chart as the amplitude of swings for the funds return on portfolio capital is only slightly larger than for the stocks. While the average return is not yet proving to be 11.5 times higher for the funds than the stocks. But the average return for them need to get positive first before that comparison becomes meaningful. Ideally one needs to view it over a full economic cycle of maybe 10 years to include both a crash and a recovery period for the stocks.

 

Edited by explo
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Expo, if you are being offered "low-risk" 10% returns you are being taken for a ride. I don't know how else to put it, as I know you have a very solid financial head on your shoulders. With negative interest rates in several major countries and US 10-year rates at 1.72%, I would be very skeptical of any low-risk investments that return 10%. Here in San Diego investors continue to pile into real estate driving CAP rates below 4% for hot properties. Many of us thought that yeildcos provided low-risk returns over 10%, only to be very quickly proven wrong. 

Expecting a 10% return is inline with S&P long term averages if dividends are reinvested though. Personally I would be very cautious maintaining a 3.5:1 leverage ratio though as one unexpected crash can wipe you out, but I know you fully understand what you are doing. Any long time member of the solar investor scene has seen the number of option players come and go as making the wrong leveraged bet can make you broke just as fast as making the right one can make you rich.  

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35 minutes ago, BIPV Investor said:

Expo, if you are being offered "low-risk" 10% returns you are being taken for a ride. I don't know how else to put it, as I know you have a very solid financial head on your shoulders. With negative interest rates in several major countries and US 10-year rates at 1.72%, I would be very skeptical of any low-risk investments that return 10%. Here in San Diego investors continue to pile into real estate driving CAP rates below 4% for hot properties. Many of us thought that yeildcos provided low-risk returns over 10%, only to be very quickly proven wrong. 

Expecting a 10% return is inline with S&P long term averages if dividends are reinvested though. Personally I would be very cautious maintaining a 3.5:1 leverage ratio though as one unexpected crash can wipe you out, but I know you fully understand what you are doing. Any long time member of the solar investor scene has seen the number of option players come and go as making the wrong leveraged bet can make you broke just as fast as making the right one can make you rich.  

The much lower risk is in terms of max drawdown which is relevant to the risk of leverage. The normal risk concept of volatility (which is relevant to IRR impacting investment timing risk) is also lower than stocks, but not that much for some individual funds. Both types of risk are significantly lower in the basket than individually due to low correlation between the funds while different stocks usually have high correlation (to market and thus eachother) through their positive beta, especially in down periods, making it hard to reduce max drawdown in a stocks basket a lot through diversification.

The youngest fund is 12 years old and the oldest one 18 years. They all achieved the above 10% average return since inception and experienced very low drawdown during 2001 and 2008 market crashes. Their max drawdowns are between 10-15% (stock index max drawdown is above 50%) and the basket would have had less than half of that. Thus the leverage holds in historic simulation. Future not repeating history might break the strategy though. I think the risk that the future return will be much lower than historic is much bigger than that future risk will be much larger than historic, but it only takes one new record negative event to blow up the portfolio and more. Only one very low risk fund expose more than 100% of the portfolio capital. 

I guess I'm the SUNE or LDK of investing. I just hope that I'm smarter than those guys in how I apply my leverage. The idea is that my risk level should be much lower with my new strategy than the old one. But I can understand that combining this with much higher return expectation than achieved with old strategy as well might sound too optimistic.

Edited by explo
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