high beta stocks give protected leverage

[stone]

There is a great artical that discuses many topics brought up on this board:
"Re-thinking risk: what the beta puzzle tells us about investing"
http://www.gmo.com/America/

"Compare, for example, the fate of two investors, each starting with $100: one invests $100 in a portfolio of
beta-2 stocks, while the other borrows an additional $100 from his prime broker and buys $200 of the market. The fi rst
is using implicit leverage, while the second levers the portfolio explicitly. While the investors earn similar returns in a
market advance, each gaining twice what the market does, their outcomes should differ when the market falls. When
the market declines 50% or more, the investor who borrowed money explicitly has no capital left from his investment
(and could potentially lose even more). The owner of the high beta portfolio, however, will have some value left in his
portfolio, as the prices of the equities in the beta-2 portfolio will most likely remain above zero in a down 50% market
(and they certainly cannot go down 120% in a down 60% market).
The point here is that the form of leverage offered by high beta is different in an important way from explicit borrowing.
Investors should prefer this kind of leverage, and, in an effi ciently priced market, they will accept a lower return for
it. As we will show, the performance of high beta is not a product of excessive demand, but rather a reasonable and
rational consequence of the fact that it provides a convex payoff to the market."


They also talk about options and say that selling puts works much better than buying calls and back that up with historical data.

[Rick S]

Has anyone ever used covered calls or naked puts to sell or buy assets that are close to a rebalance point?  It seems like free money with little risk.  If, for example, GLD was 33% of your portfolio and would need to sell some if it went any higer then you could sell a covered call at a strike price that you would need to rebalance.  If it reached the strike price then you would be forced to sell but you would pocket the premium for the covered call.  The only real risk is that GLD blows out you rebalance point in a short time and you would not be able to capture that additional gain.  If you are following your rebalance plan the you should sell GLD as soon as it reaches the rebalance point rather than waiting for it to climb higer so you might miss out on the opportunity anyway.  The same could be done with assets that you need to buy with a naked put.  This approach seems like a way to add a little extra money without any risk.  Am I missing something?

[AdamA]

Am I missing something?

One potential problem I can think of would be if you sold covered calls on an asset class, and the rebalance trigger came from a fall in another asset rather than a rise in the one you'd sold the covered call on.  Then, you might have buy back the call prior to rebalancing...maybe just write the calls on half of the position to avoid this, and make sure to do it in a tax sheltered account, if possible.

Another problem is that you have to wait for the call to expire to rebalance.  So if the asset goes through the roof a week after you sell the call, you're going to have to wait to rebalance, and may miss your chance if the asset's value falls quickly enough.  Again, just writing the calls on half the position would probably protect you from this situation.

[AdamA]

Actually, after thinking about it more, you'd want to write covered calls on only a small portion of any PP position.  If you have covered calls pending, and you rebalance early and then you get called out of the position it would screw things up, if that makes sense.

[Rick S]

If I had 500 shares of GLD then I would only write one or two calls to sell off 100-200 shares.  This would put me back around 25%.  Adam...does it make a difference if your asset increases in proportion from an increase in price or a decrease in the price of the other assets?  I need to think on that one.  Offhand it seems that it would not matter.

[Rick S]

I just reread your reply Adam and now I understand what you mean.  Would you need to buy back the covered calls?  Couldn't you just sell some shares of the underlying and wait for them to expire.  The covered call might get assigned but that would be a small chance.

[craigr]

High Beta is a rearward looking measure. You only know what was high Beta well after the fact. You can't use that data to predict which of those stocks will remain high Beta going forward which is the rub.

The original Permanent Portfolio idea was trying to use higher Beta stocks to capture more market volatility like the other components. But this strategy probably didn't work well for the reason I mention above, plus the trading and expense costs are much higher for high Beta funds typically. So even excess profits, if any, are chewed up in higher fees.

TANSTAAFL!

[AdamA]

The covered call might get assigned but that would be a small chance.

Why do you think it would be just a small chance?

[Rick S]

The covered call might get assigned but that would be a small chance.

Why do you think it would be just a small chance?

If you sold a deep out of the money covered call then the asset might need to appreciate 20% in order to reach the strike price.  It would be rare for SPY, GLD, or TLT to rise > 10% in a few months. 

[Storm]

The problem with writing covered calls is that the PP benefits from the unpredictable nature of the markets.  Our stocks never hit 35% exactly on the nose and then the next day we go "boom, 35%, better rebalance."  A smart PP investor isn't checking daily either.  He's going to check next month and see that stocks are 37.124% or something like that and say "oh, maybe I should rebalance soon."  Someone writing covered calls just missed an extra 2.124% upside.

There are two main reasons I think that writing covered calls doesn't fit the PP:

1. The reason above - that additional upside might not be captured.
2. It requires watching your portfolio on a daily basis to see if any of your calls have been triggered, which doesn't fit in with the "lazy" portfolio management style of the PP.

[AdamA]

If you sold a deep out of the money covered call then the asset might need to appreciate 20% in order to reach the strike price.  It would be rare for SPY, GLD, or TLT to rise > 10% in a few months. 

There is less of a chance that you will get called out of your position that way.  Just keep in mind that whoever is paying you your premium thinks otherwise. 

I'm not saying not to do it, just to beware that it might not always work out the way you'd like.

A better idea might be to do it within your VP.  This would complement your PP nicely.  In years that the PP was stagnant  or "range bound" the premiums in your VP would help earn extra income.  During years where the PP did well, you'd still do okay within the VP, although you'd probably get called out of at least one position. 

[stone]

That article linked in the first post has lots of charts that are worth checking out to compare covered call strategies, selling puts and using leveraged ETFs. I'd really like to know what they think of the HBPP strategy.
Another quote from it:
"Investments with concave payoffs (buying low beta stocks, writing put
options, and investing in hedge funds) generally have better long-term performance than those with convex payoffs
(buying high beta stocks, buying call options, and owning levered ETFs). Altering the payoffs through the use of options
also alters the long-term performance; adding convexity tends to hurt returns, while adding concavity tends to help.
There are three main implications. First, beware of beta as a measure of risk—when behaviors differ in up markets
and down markets, simple beta will not be a good measure of the real risk in a strategy. This can cause one to see
market ineffi ciencies where they are not really present, but more importantly, it can lead one to over-allocate to
strategies that appear to be lower risk than they really are. Hedge funds, for example, carry a relatively low beta, but
this understates substantially the real risks they are taking, and allocations to this type of investment should take that
into account.
Second, a broad set of strategies exists for taking downside equity market risk, one of the very few risks that should
earn a return over the long run. What separates these strategies from each other is not the risks they take, but the
way they get paid for taking that risk. Like standard long equity positions, concave strategies like hedge funds, putwriting,
and low beta equity portfolios all earn a return that can be traced to the downside market exposure they have.
The volatility reduction and diversifi cation these “alternatives”? offer when placed alongside standard equity portfolios
derive not from taking different risks, but rather from different payoffs when the market goes up."

[Rick S]

Here are my thoughts on writing covered calls or naked puts in the PP.
If they are written for a strike price that is near where you will need to rebalance then there is little risk.  You could either:

1) Pocket the premium if the price moves with you
2) Purchase the asset as the option is exercised at a lower cost basis (strike – premium) if the price moves against you.
3) By back the option and keep the difference of the premiums.


Here are a few problems with this approach:
1) You might run across a scenario where one or more of the assets drop in price enough so that you would need to rebalance the asset with the option.  If this were to happen then you could:
a. Buy back the option and rebalance as usual.  Due to time decay you would most likely still profit from the option if you are closer to the expiration date than the date it was written.  If a major event happened that caused some of your other assets to fall so much in value just after the option was written then you could lose the premium + the bid/ask spread + the commission on the trade.  This is an extremely unlikely situation with a minimal impact.
b. Wait to see what happens as the option expires.  The option could expire worthless and you could keep the premium and rebalance as usual.  There is some risk that the price of the asset could have gone up from your rebalance point but it could also drop.  If you are far away from the option expiration then you should probably buy the option back to reduce this risk.  Either way it would be market timing to try and guess which way the stock is headed.
2) If you sold a covered call, for example, and the underlying asset skyrockets over your strike price then you might feel disappointed that you had to sell the asset at a lower price than you could have if you did not have the option.  To do anything other than rebalance at your rebalance points is market timing and speculative.  There might be some news or other things that makes you rethink your rebalance points but this is still market timing and speculative.  This situation does not introduce risk.
3) You need to have one or more of your assets close enough to a rebalance point so that you can catch a profitable premium.  If you rebalance at 15% and 35% then your asset might need to be a few points away from the lower or upper bound to have a premium worth going after.  After you rebalance all assets you won’t be able to do this for a while…maybe years until the assets are again close to the bounds.
4) There needs to be some volatility in the underlying assets.  If the volatility of the assets slows down then you won’t be able to capture the premium.


So in short, if all of the following apply you can make (almost) risk free money selling covered calls or naked puts in the PP.
1) The market are sufficiently volatile
2) You have assets near the rebalance point
3) You have sufficient cash to buy the asset(if a naked put) at the strike price or enough of the  underlying asset to sell (if a covered call)
4) You have a small amount of time to devote to the process.

[stone]

RickS Do you think that new permenant portfolio style ETF probably intends to do such a strategy when it says that it will have up to 20% of assets as derivatives?
http://gyroscopicinvesting.com/forum/ht ... ic.php?t=1

[Rick S]

The approach I outlined above is the risk free approach to derivatives.  Given the limited time you would be able to use it then it might add only 20 basis to to your yearly retuns. I'm working on another approach to write options against the PP regardless of where the assets are in the bands.  I'm slowly working through the models for this so I don't have a good feel for risks or returns.  Off the top of my head I think you could add 50 to 100 basis to yearly returns with this approach, albeit with a lot more work.  I'll have more on that when I work out the angles.

I could only speculate abou the 20% approach of the ETF.  On one hand I like HB idea of the VP.  Generate safe returns on money that you need and shoot for the moon with a small portion.  This also agrees with Talab's approach of 90% tbills and 10% shoot for the moon.  My problem with the ETF is that I'd rather do the VP myself than to trust it to another joker. I certainly would not want many things in the VP that would correlate with the PP.  If they are selling options as I outlined above for minimal gains then that's one thing but if they are speculating with assets in the PP then I want no part of that.  I guess we'll find out more as the etf unfolds.

[Storm]

The biggest problem I see with your strategy is that you might "stop out" of certain assets without rebalancing.  You say you would rebalance anyway at the bands, but let's take a real world scenario.  Stocks are at 34 and bonds are at 26. You sell a covered call for stocks at 35. Stocks jump to 37, bonds fall to 24, and your covered call is triggered.  You end up all in cash, then the next day stocks plummet to 23 and bonds rally to 26.  You just lost 2% upside on bonds, or 50 basis points per year.  This is only one such incident.  As always, your mileage may vary, but don't expect to tweak the PP this much and come out ahead in the long run...

[Rick S]

That's a good point storm.  I never considered an all-in approach where an excercised option would take you down to zero.  I assumed that 100 shares might be smaller than 25% of your holding in that asset.  For example, one option might be 100 out of 400 shares of GLD in your portfolio. You would probably not want to do this if your portfolio was less than $200k.  A single call option might cause the problems that you mentioned.  I'll admit that there are limited times when you can use this approach but when the time is right it's free money.