04/28/2013 Margin and Risk

Sector Model	XLI	1.98%
Large Portfolio	Date	Return	Days
BBRY	7/16/2012	107.17%	285
SEAC	9/25/2012	31.33%	214
CAJ	9/25/2012	5.44%	214
BOKF	2/4/2013	10.20%	82
SWM	2/12/2013	9.76%	74
TTM	4/1/2013	10.61%	26
MWW	4/11/2013	-2.01%	16
ABX	4/11/2013	-24.16%	16
TPX	4/22/2013	6.04%	5
NYCB	4/24/2013	-1.40%	3
S&P	Annualized	8.88%
Sector Model	Annualized	24.66%
Large Portfolio	Annualized	31.54%

 

No rotation for Monday.

Note also that the sector model is listing XLI, rather than XLB as posted before the close on Friday.  In the last few minutes of trading the technical configuration of XLI just barely passed XLB by 2 tenths of a percent.

Don’t sweat the sector model whipsaws.  The average holding period is a month, but that’s built off of times like this week averaged against months with no change at all – such as last year’s extremely long hold of XLF.

In any case, the opportunity loss of missing a day or so is offset by the benefit of saving on trading costs in a whipsaw week.

Now, on to the next missive (I’m still planning a post on time frames, but today I’ll write more detail on risk)…

Last week we looked at risk in a cash account, and this week we’ll look at risk in a margin account.

Most folks are charged around 8% borrowing costs for use of margin.  High net worth folks and hedge funds can do better, but I’ll stick with 8% for us small fry.

Now, to put this into perspective, since 1950 the S&P has averaged 7.46% per year.

The amount you are charged for margin is greater than the amount the S&P usually gains.

You’re already starting from behind.

The limit on your use of margin, then, should be based on your average return WITHOUT margin – as calculated through an ENTIRE business cycle.  If you average 10%, and the cost of margin is 8%, then you shouldn’t be more than 100 + 10 – 8 = 102% invested.

In THEORY, then, the Mousetrap COULD be 100 + 31.5 – 8 = 123.5% invested.

But it isn’t.  That 31.5% annualized performance has not yet seen a bear market, and it is not safe to assume that outperformance in a bull translates to outperformance in a bear.  Back-tests of the Sector Model indicate that the Mousetrap will also outperform, but a back-test isn’t as good as the real thing.

So, if you can’t go more than 100% net long, what about hedging?

Ah – hedging is another subject entirely.

You hedge when you are long one thing and short something else.  A typical hedge fund will be 100% long and 100% short.  Right now I’m reading a series of white papers put together by www.gargoylegroup.com about selling S&P calls, rather than using a simple short.  The idea is to reduce that 8% borrowing cost, and they have an extremely impressive track record with the strategy.

It’s probably the safest, most inspired way to hedge, by a value oriented investment model.  They INVEST; they don’t GAMBLE like Paulson.

If you’re rich, check them out!

If you’re not, keep reading…

First, let’s stick with that 8% borrowing cost to keep the math easy for us poor folks.

We saw above that your margin exposure should never exceed your average annual return, less 8%.

But HEDGING is a different animal altogether, because you have something ELSE working against you: the long term bullish bias of the S&P itself.  If you were 100% long the Mousetrap AND 100% short the S&P, your expected return would be 31.5% (Mousetrap) – 8% (borrowing cost) – 7.5% (S&P bias) = 16% per year.  Add in our lovely 43.8% tax rate and you NET 9%.

Think about this for a minute.  You’re pumped up on full use of margin, having to monitor the account on a daily basis to make sure you don’t EXCEED that margin, and you NET 9%?

Why not pop everything into SPY and have a life instead?

You’d do still better if you were 123.5% long the Mousetrap and 76.5% short the S&P, which would give you an expected return of 25%.

Here’s the breakdown:

Long Mousetrap 31.5% * 123.5% = 38.90%.

Short S&P -7.5% * 76.5% = -5.74%

Borrowing cost -8%

38.9% - 5.74% - 8% = 25.17%

That’s fantastic!  Let’s go, right?

Er, no.

We forgot those taxes.  After taxes you’d NET 14%.

Almost double the S&P, and not too far behind an after tax Mousetrap NET of 18%, with much less volatility.

But ponder this:  Why is it that only rich people invest in HEDGE funds?

The purpose of a hedge fund isn’t to GET rich, but to AVOID becoming poor.  Those of us trying to GET rich should make full use of an IRA account – which does NOT allow hedging.  The NET for the Mousetrap in an IRA is 31.5%, rather than 18% for a taxable account.

I DO plan to create a second model for taxable accounts, but I haven’t yet found the sell point.  Once I reach it, I’ll let you know.  Right now it appears to be somewhere between 2 and 3 years per stock.

In any case, the point I’m trying to make is that margin is NOT a tool for maximizing returns, but instead for using a hedge to minimize risk.  If you aren’t already rich, you’re better off staying in a cash account and calling it a day.

So, do you have enough to live off of for the rest of your life if you quit working?  Great!  Hedge!

But if you don’t, your best bet for improving your reward / risk ratio is by good old fashioned value investing and fundamental stock picking.  Ben Graham called this the “margin of safety.”

And THAT kind of margin doesn’t charge you 8%, but instead PAYS you in dividends!

Tim