20% annual returns over 40 years...interested?

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Wonk
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20% annual returns over 40 years...interested?

Post by Wonk » Sat Jan 22, 2011 10:54 am

I've been stalking an investment for the better part of a year, and it led me to think long and hard about what I expect from a VP investment.  This could be a bit controversial, but I'm proposing it as a mental exercise, not an investment strategy per se.  That said, the numbers are all real and the investment is actually there--not a purely hypothetical.  So let me ask you...

If you found an investment that for the past 40 years had:

-A CAGR of 20.10%
-Standard deviation of 16.6%

....would you be interested?  Of course, you should probably know the main risk of this investment is in counterparty solvency which would be difficult to quantify.  Also, systemic risk could be an issue--also difficult to quantify.  Let's say that the risks appear to be minimal, but within the realm of possibility.

So...if you were to be faced with such an investment, would you ever consider investing a small portion (say, 5%) of your portfolio in it as a means of generating alpha?  The question another way is would you risk the possibility of losing 5% of your portfolio to potentially achieve 20% annual returns? 
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Lone Wolf
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Re: 20% annual returns over 40 years...interested?

Post by Lone Wolf » Sat Jan 22, 2011 11:22 am

Are the losses confined to the 5% you stake on the investment?  If so, it's hard to think of a more ideal Variable Portfolio investment.  Over 40 years, you'd expect a gain of something like 1500x your original stake.

The opportunity to turn $1000 into $1.5 million seems ideally suited to the VP.  Browne always seemed to favor really "going for it" with the VP and I'd tend to agree.  I personally don't have much interest in "going for it", so I don't keep up a VP myself.

You point me toward this 1500-bagger, though, and my feelings about the VP might change, LOL...  ;D  (Kidding... mostly!)
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Re: 20% annual returns over 40 years...interested?

Post by MediumTex » Sat Jan 22, 2011 7:28 pm

The contrarian in me would say that such an investment is probably nearly exhausted after such a run.

Aren't Warren Buffett's numbers about like that?

Anyone think Berkshire Hathaway's future will look like its past?

I don't know if this is an equity play or not, but any time I look at an equity I like to see large manager ownership (25% plus), little to no debt (just because ANY leverage scares me), a double digit return on assets, and good macro fundamentals within the industry and good micro fundamentals within the firm itself.

A dividend is also nice.
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Pkg Man
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Re: 20% annual returns over 40 years...interested?

Post by Pkg Man » Sat Jan 22, 2011 8:53 pm

MediumTex wrote: The contrarian in me would say that such an investment is probably nearly exhausted after such a run.

Aren't Warren Buffett's numbers about like that?

Anyone think Berkshire Hathaway's future will look like its past?

I don't know if this is an equity play or not, but any time I look at an equity I like to see large manager ownership (25% plus), little to no debt (just because ANY leverage scares me), a double digit return on assets, and good macro fundamentals within the industry and good micro fundamentals within the firm itself.

A dividend is also nice.

Wow!  I think you just described the company stock I recently unloaded...
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Re: 20% annual returns over 40 years...interested?

Post by Wonk » Sun Jan 23, 2011 10:43 am

Lonewolf, yes--worst case is that losses would be confined to the amount invested in this strategy.  If you invest 5% and there is a catastrophic loss, the entire 5% could be lost.  It could be partial loss, but total loss is always possible.  In my estimation, the largest risk lies in counterparty solvency.

MT, there is irony in your answer.  More info to come.

Clive, you are 100% spot on.  Assessing the risk of a complete loss of 5% (or whatever you choose) in order to achieve the expected alpha.  I'll wait another day or two to hear anyone else's take before revealing the mystery strategy. 
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Re: 20% annual returns over 40 years...interested?

Post by Wonk » Mon Jan 24, 2011 9:50 pm

The investment strategy I'm speaking about could be seen as breaking rule #7 of HB's 16 rules: leverage.  The difference is you don't have to use a margin account to employ the leverage so some of the danger is removed--no margin calls.  If you haven't guessed by now, the 20% strategy is simply the permanent portfolio using 2x ETFs.  The leveraged etfs use derivatives to produce 2x daily moves of the underlying assets.  The funds are:

SSO: Proshares Ultra S&P
UBT: Proshares Ultra 20+year Treasury
UGL: Proshares Ultra Gold
SHY: Ishares 1-3yr treasury

You really couldn't construct this portfolio before Jan 21st, 2010 because UBT wasn't conceived yet.  I decided to track the 2x PP for the last year because I was curious to see if it would behave the same way as the standard PP.  For the most part, it did.  I used smartmoney.com to track the 2x & 1x PP over the past year and here are the results starting at Jan 21, 2010:

1xPP: 9.68%
2xPP: 19.80%

There was a small amount of tracking error with each fund.  The S&P had the smallest TE and the long-bond fund had the largest.  I'm assuming this is primarily because of liquidity--2x S&P has lots of liquidity, whereas UBT does not.  From what I can see, the primary risks of employing this type of strategy would be in counterparty/systemic risk.  I see tracking error as a pretty minimal risk, but it exists nonetheless. 

For the record I don't have any of my own money in these funds.  Following the 2xPP is an interesting exercise for me because it made me ask questions about my VP strategy.  What added return above the standard PP am I seeking for the added risk?  What portion of my entire portfolio am I willing to put at risk of complete loss?  What is the probability of complete loss?  Will other strategies compare from a risk/reward standpoint? 

I'm pursuing my VP alpha elsewhere, but I'll also be keeping my eye on the 2x ETF strategy for the next few years to see how it performs.
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Re: 20% annual returns over 40 years...interested?

Post by MediumTex » Mon Jan 24, 2011 10:10 pm

Wonk wrote: There was a small amount of tracking error with each fund.  The S&P had the smallest TE and the long-bond fund had the largest.  I'm assuming this is primarily because of liquidity--2x S&P has lots of liquidity, whereas UBT does not.  From what I can see, the primary risks of employing this type of strategy would be in counterparty/systemic risk.  I see tracking error as a pretty minimal risk, but it exists nonetheless. 
The 2x ETFs have a serious "decay" problem over time.

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Re: 20% annual returns over 40 years...interested?

Post by Lone Wolf » Mon Jan 24, 2011 10:43 pm

Heh, neat.  I thought this might be where you were going with this.  This idea has intrigued me for a while now ever since I heard someone mention it (I can no longer remember where this was.)  I did not know about UBT!  I think at the time people were talking about using zeros for the bond portion but I really can't remember very well now.

Since this is the appropriate forum for "greed fantasies", I wonder what happens if you just dump the cash and go 33% each on SSO \ UBT \ UGL.  Is SmartMoney good at letting you "rewind" and see how a portfolio would have done if you backtrack it?
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Re: 20% annual returns over 40 years...interested?

Post by MediumTex » Mon Jan 24, 2011 11:02 pm

Last edited by MediumTex on Mon Jan 24, 2011 11:04 pm, edited 1 time in total.
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Re: 20% annual returns over 40 years...interested?

Post by Lone Wolf » Tue Jan 25, 2011 8:37 am

What an interesting subject.  For anyone who (like me) knows almost nothing about leveraged ETFs, this article was also informative: http://seekingalpha.com/article/35789-t ... raged-etfs

I think this could be a fun thing to track over the coming years.  In fact, I may set up a few "play" fake money portfolios based on this.  (I'll of course be sticking with the good ol' 4x25 for my real money!)
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Re: 20% annual returns over 40 years...interested?

Post by Wonk » Tue Jan 25, 2011 12:42 pm

MT,

I was interested in how decay would affect the funds.  I figured 1 year should be enough time to observe the decay, but as of yet I haven't seen it.  Any idea on how long it would take to see the affects of decay?  The 2x funds do have some tracking error, but not much from what I've seen so far.

LW,

I would imagine the 3 x 33 set-up would increase CAGR and volatility.  Craig referenced the historic returns of this setup on pg 3 of the bogleheads thread.  Smartmoney will allow you to set it up this way so you can see how it behaved over the last year.  I actually liked the idea of adding the SHY--primarily because if the funds behave properly, you should have more frequent rebalancing bands to capture the volatility.  No rebalancing was triggered in 2010 for the 2x portfolio.

Like you, I'm more interested in watching this as much as I'd prefer to watch a mutant rat in a cage.  You never know how it'll behave.  Before I'd ever entertain such an idea, I'd like to see at least 3-5 years worth of performance.
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Re: 20% annual returns over 40 years...interested?

Post by Storm » Sat Jan 29, 2011 12:55 pm

I brought up not using the 2x leveraged funds, but using an Interactive Brokers margin account, which lets you leverage 5:1, in a past thread.  The general consensus was that #1 it violates one of the rules (no leverage) and that #2, the likelihood of a margin call was extremely high, given the volatility in each of the 4 underlying asset classes.

I wouldn't use the 2x ETF leveraged funds, simply because they are incompatible with the PP.  Due to decay, the 2xETF funds are designed only for quick in and out trades.  The entire philosophy of the PP is based on buy and hold, long term, and minimizing rebalancing by using the 15/35 bands.

I suppose you might be able to emulate PP-like returns x2 if you did use them in the manner intended - you would need an institutional investor-like account (IB offers a good one) where you only pay a fraction of a cent per share to trade.  You would need a significant amount of money to offset the trading costs you would incur.  You could automate daily or perhaps even weekly trades where you would buy 4x 25%, then move back to cash and perhaps back in every few days.  I'm not sure what the returns would be like, but you might approximate 1.5-2x PP results.  My guess is it would be closer to 1.5 because of all the trading costs involved.  Not to mention tax burden... ugh...
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