Disclaimer: This is a personal trade I made a couple weeks ago based on my own risk profile. I use it as an example to my point. I am not advocating anyone enter these positions and I am currently (still) in these positions as of January 26th, 2012.
There is a counter-intuitive disconnect between academics in Economics and Finance and investors. More often than not intelligent professors and academics do not make fancy investments or try to beat the market. They usually just hold passive and diversified portfolios. I have heard my professors say that they do not believe they can compete with hedge funds and money managers in any meaningful way in between research. I have also heard investors in the industry who have high level positions (but no graduate academic work) talk about how professors and PhDs often underestimate the reality of markets and how there is more opportunity to make money than efficient market models suggest. It is a topic I struggle with because I like to trade but tend to view myself as an ‘academic’ rather than a ‘trader’.
I have a simple trading strategy that I just executed today (and a few weeks back if you’re reading this). It is perhaps the most mundane and boring strategy. But I think it is elegant and reasonable. The current macro-economic environment is so volatile the majority of active money managers this past year under-performed passive (non actively managed) funds. The European crisis hasn’t had a meaningful solution. The US manufacturing is increasing. Turmoil in oil countries such as the ‘Arab spring’ movement as well as hostility from Iran has threatened oil exports. The US is entering an election year. There are fears of a Chinese ‘hard landing’ and doubts as to the strengths of emerging markets in the following year. The consensus seems to be that volatility is on stand-by. That the markets will increase over the year. And that they might collapse first or instead. With this information it is difficult for managers to create strong market-beating strategies. This is why the entire active sector failed last year, and I believe will under-perform again this year. I did not do well personally.
Generally after a recession a global recovery is strong and makes up for lost ground. While due to the structural severity of this past recession we probably won’t make up all lost ground, we are due to make up some more, based loosely on empirical trends we have observed in the past (and would like to believe will hold). While 2010 gains were strong, this past summer markets suffered tremendously. The range of S&P500 predictions is just below 1200 by Morgan Stanley to 1500 by DB. If the leading world asset managers are this unsure I urge home investors to be weary.
So what is a good strategy for someone who wants to be active but is willing to acknowledge this isn’t a good environment to beat the markets? I suggest the S&P500 and (the exciting part) selling some calls. It’s terribly boring, but knowing the right times to enter an equity index is important. Even though the S&P500 is the most popular, it isn’t intrinsically special. It is only in the US and holds large & mid-cap stocks. I believe by not holding international equities the ability to avoid EU, Chinese, and emerging market risk is prudent. In addition the US is poised for growth, with recent employment numbers and sentiment improving, and is slowly decoupling its correlation with Europe. However, in the US it is difficult to forecast what sectors will outperform. Financial markets are in disarray and many believe defensive sectors are overbought. For my personal risk profile I believe the SPY (S&P500) ETF is a strong buy.
I purchased the fund today at $129.20 and sold calls on it at a strike price of $134, set to expire in June. For an investor who wants some risk from an active bet, but understands this market is uncharted water, this offers the ability to gain strong return in six months with protection from the downside. It is an elegant and simple way to make a market bet but have safety and a cushion. I am not trying to beat the market, since I am simply buying the market. What I am doing is moving around my risk to best suit my desire for a personal bet on a recovery while not being so haughty as to believe I can beat the market. This bet offers a capped return of around 7%
The economics behind my move is simple. I am selling all my potential benefits for above $134. Every dollar this ETF goes above $134 I have promised someone else in a contract. However, for this right, I have demanded $4.20 a share. This means unless this ETF moves above $138.20 I am better for having done it. In addition, I won’t lose any money until this ETF drops by more than the premium I received for selling those rights, $4.20. For the purposes of my personal risk profile this investment suits my needs. It allows me to be bullish on a modest recovery, skeptical of a large rally, and earn some returns even if the market stagnates. It allows me to avoid international risk as well as potentially gain 7% over a six month period, while if the market crashes again, I will be hedged (but it is possible it will end up worse than had I held cash).
I am also currently holding a Small Cap S&P 600 Energy ETF called PSCE. This is also a U.S. fund. I am holding it to bet on a US recovery over the next 12-18 months. Energy is a high beta sector. This means that if there is a U.S. recovery this fund will see strong growth. I am still waiting for the market to settle before I re-enter the international market.
This website is not to broadcast my trades though, my point of this post is that there are compromises between active investing and the academic consensus. I am not buying and selling daily, and I am buying passive ETFs. However, through over-weighing some areas, selling calls, and letting my own macro-economic forecasts guide my portfolio, I am still able to make bets.