06/01/2014 Risk Avoidance and Risk Mitigation

Style Model	Large Value
Sector Model	XLU	-0.21%
Large Portfolio	Date	Return	Days
ABX	4/11/2013	-32.71%	415
NEM	9/30/2013	-16.97%	243
BX	4/14/2014	4.23%	47
TIVO	4/23/2014	-1.41%	38
SHOO	4/28/2014	-8.89%	33
UNF	5/2/2014	3.33%	29
PWR	5/12/2014	1.19%	19
JRN	5/19/2014	2.48%	12
BT	5/22/2014	2.87%	9
PM	5/27/2014	2.28%	4
(Since 5/31/2011)
S&P	Annualized	12.66%
Sector Model	Annualized	26.41%
Large Portfolio	Annualized	25.35%

 

Rotation: selling NEM; buying SPLS. (Correction, buying SR Standard Register)

Continuing the slow rotation to value:

	Large Value	Mid Value	Mid Blend	Small Value	Small Growth	Small Blend	Large Growth	Large Blend	Mid Growth
Utilities	1	2	3	4	8	16	21	25	68
Finance	5	7	10	12	14	34	39	44	71
Staples	6	9	11	13	15	36	43	47	72
Healthcare	17	20	24	29	40	52	57	60	76
Industrial	18	23	26	30	42	54	59	61	77
Materials	19	27	32	35	46	56	62	66	78
Technology	22	28	33	37	48	58	63	67	79
Cyclicals	31	38	41	45	49	65	69	70	80
Energy	50	51	53	55	64	73	74	75	81

 

The sale of NEM is somewhat against my better judgment, but the caveat is the deflationary posture of the sector and style matrix.  Energy and Materials are both poorly placed.

The recent weakness in Utilities reversed this week:

 

The blue “benchmark” line is simply the average return rate of the 14 year back-test of the Sector Model. 

So where does all this leave us?

It leaves us with the last gasps of QE.  The market isn’t going down, but it is getting more skittish by the week.

The key here is in how we deal with “risk.”

In simplest terms, “risk” is the maximum potential drawdown, while “reward” is the average rate of return.  A “reward / risk ratio,” then, is simply the average rate of return divided by the maximum potential drawdown.

You want to have the greatest possible value on that ratio.

The fallacy that most investors fall into, however, is the practice of risk avoidance rather than risk mitigation.  You cannot avoid risk.  You can only avoid reward.

Consider the ultimate “risk off” illusion: cash.

Does cash really eliminate risk?  No, it doesn’t, because of the problem of inflation.  If you were to put everything into cash and hold cash forever, its value would inexorably sink toward zero.  Your reward to risk ratio would be 0% / 100%.  That is, 0% potential reward against 100% potential risk.

 

How about timing?

In my own experience, I cashed out at the top of energy stocks in the summer of 2008 and avoided the entire Lehman Brothers collapse.

And then I lost a great deal of money in the roaring (albeit Fed induced) “bull” market that followed.

My own risk avoidance and clever timing strategies made me far poorer than I would have been had I simply held SPY throughout the entire debacle and ignored the account entirely.

 

 

How about hedging?

Sorry, that doesn’t work either.  Consider the classic hedge of being 100% long versus 100% short.

SPY gains about 8% a year on average (if you include dividends).  If you subtract out inflation you get about 6.6% net gain.  Siegel measures various asset classes from 1802-2012 with a net return of:

Stocks   6.6%

Bonds   3.6%

Bills        2.7%

Gold      0.7%

Cash      -1.4%

(Siegel, Stocks for the Long Run, Fifth Edition, page 6)

Let’s say you are shorting SPY as a “hedge”.  Typically the borrowing cost is about 8%, so the average investor has to pick stocks that outperform SPY by 16% just to break even!  That 16% is the cost of borrowing (8%), plus the net gain of the stocks you are shorting (6.6%), plus the value of cash that you are losing (1.4%).

A better variation of this approach (the best possible, I think), is to sell call options on SPY, which gives you a profit of 3% versus a borrowing cost of 8%.  Instead of requiring an outperformance of 16%, then, you would ONLY have to outperform the market by 5% (6.6% - 3% +1.4%).

Now think about this – over the course of time, year after year, that strategy costs you 5%, which locks in a loss nearly equivalent to the entire net return of SPY.  And if you CANNOT outperform, then you end up with 6.6% (long) minus 5% (short by call option overlays), for a cumulative return rate of 1.6%.

And if you are paying taxes on the account you will likely only realize 0.96% net annualized returns year after year (“net” is after taxes and inflation).

You would do better just holding Bills!

Risk avoidance, then, does not avoid risk at all – but instead it locks it in.

 

Does this mean that all defensive strategies are doomed to fail?

No.  I’ll describe two that work: Gargoyle Strategic Investments, and Gold Coast Advisors LLC.

 

Gargoyle: Risk Avoidance

I’ve mentioned Gargoyle Strategic Investments in the past.  They have a mutual fund that soundly outperforms the S&P 500 over the course of its lifetime, with less volatility:

http://www.riverparkfunds.com/downloads/FactSheet/RiverPark_Gargoyle-Hedged-Value-Fund_Fact-Sheet.pdf

How?  Because of hedging?

In my view, their success is in spite of hedging.  They are very good at picking value stocks.  My personal opinion is that the hedging aspect is to satisfy people’s demand for a hedged fund.  The fact that they can succeed in doing so is a tribute to the brilliance of their stock selections, and the genius of minimizing the cost of “hedging” through the selling of call options instead of a straight short.

Most hedged funds under-perform the market.  They are also out of range for the typical investor.  Gargoyle’s mutual fund is the only hedged fund I would recommend to anyone.

If you must hedge in order to sleep at night, don’t do it at home.  Park your money into RGHVX and call it a day.

 

Gold Coast Advisors: Risk Mitigation

If you are open to an alternative to hedging, you can check out the Sector Fund being managed by Gold Coast Advisors:

The Sector Fund picks beaten down sectors.  They are less risky than the broad market because they have likely already experienced the risk before the fund enters them.

Utilities vastly under-performed the market in 2013.  They are vastly out-performing the market in 2014.  It’s like getting onto a skateboard AFTER it has already fallen to the bottom of a cliff.  If 90% of the risk has already occurred before you got into the sector, then there’s only 10% of the risk left now.

This is mean-reversion investing.  Benjamin Graham called the approach a “margin of safety,” and he used a series of fundamental indicators to find it.  My sector model uses technical indicators to do the same, and the sector fund being managed by Gold Coast Advisors, LLC is managing client accounts with the model.

Since I just advertised for a competitor (Gargoyle), I might as well advertise for myself too (Gold Coast Advisors):

Anyone interested in taking advantage of the Sector Fund may contact http://gcallc.com/contact.htm:

Gold Coast Advisors, LLC
245 Park Ave
New York, NY 10167
917-566-8883

info@gcallc.com

The key is in determining whether you want to try to use risk avoidance (through Gargoyle’s option overlays) or risk mitigation (through Gold Coast Advisors’ mean reversion strategy).

But please, for your own sake, don’t time!  Neither of these approaches time the market.  Timing is seductive, but ultimately a fool’s errand.

 

Tim