Tracking Portfolio Performance
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@q2capital
Q2 Capital
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Bumping up my Buy the Dip competition post again, as I posted it late last night.
I present a market neutral long-short idea here that severely limits draw downs in the portfolio, and even get positive returns in bear markets like the one we are in right now. Let me know what you think!
Buy the dip to make your portfolio more resilient
Summary
The Buy the Dip competition asks to "post a pitch for an investment idea that will have the best 12-month return”. Given that we are in a bear market, it is difficult to predict the direction of securities movement amidst all the volatility, bull rallies, and leg downs. This, along with uncertain macro-economic conditions (from inflation and interest rate hikes), makes a market neutral portfolio attractive. It aims to profit off current trends in the market without guessing which direction the market will move. The portfolio I propose is:
Why market neutrality?
All graphs and figures in this section are sourced from Blackrock [1].
Historically, in economic conditions like this, stocks and bonds both perform negatively.
So it is worthwhile to see how to add resiliency to a portfolio to limit drawdowns and even profit off these times without guessing the direction of this market.
The idea is to find two assets that have been correlated historically, but in the recent times have deviated from their correlation. Then, one can bet that both assets will return to their historical correlation without guessing directionality of the asset's movement. So it can be portfolio component for times like these:
History
The idea originates in pair trades, an approach introduced by researchers in Morgan Stanley [2] where one goes long and short two highly correlated stocks. However, finding such individual stocks are difficult and this idea is old enough that any alpha that can produced is already exploited to oblivion by algorithms. So we limit ourselves to indexes instead of individual stocks. Then this enables us to exploit long term patterns different indexes follow with respect to each other.
Quantitative Aspect: Investment Idea
Large cap tech and large cap value have largely moved in tandem historically. If the market goes up, over the last decade tech stocks have gone up more, and value stocks have gone up less, but both have gone up. The historical correlation for these two assets have been 0.79 (measured from Feb 2004).
However, since the COVID bull run, the historical correlation has been broken, and now sits well below 0.79.
This correlation has been broken because $QQQ has increased a lot more than $VTV over last 2 years, so we can place a bet on these two indices to return to their historic correlation.
Qualitative Aspect: Macro-economic Background
After the COVID bull-run, we are now in an economy with high inflation and Fed is doing interest rate hikes. Interest rate hikes impact present value of future cash-flows, thus making growth companies less attractive. These are usually tech companies which derive their value from future cash flows. Companies in the Nasdaq 100 ($QQQ) are a good example of this. On the other hand, value stocks tend to perform better as these have good cash flows, pay dividends. A good benchmark is the Vanguard Large Cap Value Index $VTV.
The backdrop of Fed's interest rate hikes gives a good opportunity to enter our position as it is easy to predict it will cause the inflated $QQQ ETF to go down, but $VTV will go down less.
Backtesting
Traditionally, a long-short portfolio is done by going long a stock and going short another stock. But as a retail investor, it is difficult to short stocks, so I will use $PSQ which is the inverse NASDAQ index. While this is not equivalent to shorting Nasdaq directly, it serves as a good approximation.
I compose the portfolio as said above by putting $PSQ at 50% and $VTV at 50%, and start the backtest for this year (as the Fed declared they would hike interest rates this year):
We can see the pair portfolio performs well in this scenario, beating the S&P500 index, and our max drawdown is also much lower. However, this is only one scenario that is tested for few months.
Now let us check how well this allocation does in the longer term, from Jan 2020:
The portfolio doesn't perform well as S&P500 as expected. However, there are few interesting things:
- It limits drawdowns significantly, as can be seen during the COVID crash time frame.
- The market neutral portfolio does not lose much value over time. The market neutrality shows up over longer term, it is just -0.06.
As discussed in the Blackrock article [1], these long-short components can act as a hedge or drive returns in a larger portfolio during volatile times like these.
Additional Comments
One can ask the question, if we know Nasdaq 100 index will fall, we can just short $QQQ (or equivalently buy $PSQ). However, this is a directional bet, i.e., if one is wrong they might lose almost all of their position. Being wrong in a neutral portfolio doesn't cause a huge loss, but can drive returns in volatile times if the correlation returns to historical value.
Better returns in a market neutral portfolio can be derived by flipping the individual bets, if the correlation diverges in the opposite direction. For example, such a situation can happen to this neutral portfolio if $VTV outperforms $QQQ for a long period of time such that it diverges from their long term correlation. In such case a market neutral portfolio might go long $QQQ and short $VTV. More such interesting opportunity arises in other asset classes too.
I explore investing ideas at the intersection of quantitative and qualitative aspects. Follow me for more such content. I plan to write a detailed version of this on my Substack: https://q2capital.substack.com/
References
Investopedia
Pairs Trade: Definition, How Strategy Works, and Example
A pairs trade is a trading strategy that involves matching a long position with a short position in two stocks with a high correlation.
very interesting read. Thanks for the post
Won $1 from Investor from Nepal’s giveaway!
Congrats my man!
Should I start a Substack?
I am avid follower of the investing Substacks that I see shared around here and I really enjoy reading them. I have often wondered should I start one myself? It would primarily be a non-professional hobbyist investor perspective, and I cannot earn any money from subscriptions (due to legal reasons). Given that I receive no professional nor monetary benefit out of it, I would like to know what are some other reasons that led you to start your own newsletter? How did you find the niche on which to base your newsletter?
I do enjoy writing, but I don't think I am disciplined enough to get myself to write to a newsletter audience regularly.
I hate writing. I always have and I know I'm not good at it. I prefer public speaking but writing has forced me to become a better writer. As far as the content, it's a great medium for me to get my research out for my fund and get marketing exposure since I'm not allowed to put paid dollars behind advertising. My expertise is already in a somewhat niche environment (at least for publications to retail investors). Don't ever start it to make money because gathering a following takes time. Do it because you WANT to do it and think you can maintain a regular cadence. You want to have fun while doing it. Don't treat it like a job
Challenges in valuing Synthetic Biology companies
I am writing this post in response to https://commonstock.com/post/3a23055e-1364-4c1e-b712-3fdb2cedd7db by @markpaddey and a following comment by @growthinvesting.
It is great to see interest in synthetic biology companies. I know the founder of a synthetic biology startup who had to shutdown his company. But this is from a time when synthetic biology was not a cool buzzword. They were the first to design micro-organisms that can produce acetaminophen (Tylenol) by fermenting sugar. I will share 2 key concerns he had raised before understanding if a synthetic biology company will be successful.
- Synthetic biology platforms are not like software: Despite all the claims that input specifications of an organism goes in and the genetic code for an organism comes out from their "proprietary platform", there is a broader set of challenges here. Biology is much more complex than software, biological processes in the organism are interacting in ways that we do not understand all of it and thus it has not been modeled in software. This in turn leads to predictions being off, and the only way to verify if a predicted genomic code being correct is to extensively test them in the lab by designing the organism and going back to the drawing board again. This leads to much slower turnaround times before you hit an eventual success. A key indicator of this: the list of genetically engineered microorganisms will remains relatively stagnant or grow very slowly for these companies.
- Unit economics do not line up: Genetically engineered microorganisms are desired because they can replace an industrial process or chemical production. Hence the competitor in this space is then the chemical industry, who have tuned their industrial processes over decades (some even centuries) to be very cost effective. To get customers, a biological process has to be more reliable and cheaper than the existing industrial counterpart. Simply producing a chemical in a lab conical flask won't sufficient. It needs to give the equivalent output in the same space at lower cost.
This is by no means a bear case for new generation companies like Ginkgo Bioworks, etc. I am just sharing some challenges that these companies have to overcome, and as investors some points we should keep in mind. It is very well possible that maybe these companies are working on these limitations.
Disclosure: I do not have any positions in any synthetic biology companies.
Thanks for the response! I do not currently have a position in Ginko, but do look forward to following their progress as they attempt to ride do cost declines over the coming years. I've listened to several interviews with Tom Knight (one of the founders) that make me cautiously optimistic on the prospects of synthetic biology as we move through the 2020's.
Wanted to share this piece from Bridgewater Associates (Ray Dalio's firm) on inflation resulting from demand increase and supply not able to keep up.
If that is the case, what would be the play in such a market?
Sell consumer discretionary? If they think this is a shock that will soon subside then it stands to reason demand for that stuff will drop off
I made a spreadsheet to track the long-term performance of my portfolio. It tracks the performance by percentage gains and also how much an equivalent portfolio would have performed if it had invested only in S&P 500 or Russell 2000 indices by buying on the exact days as on which I transferred cash into my brokerage account.
The goal is too is see if I am beating the S&P500 in a time-weighted manner, otherwise I should be better of investing in ETFs.
Also open to hearing everyone's thoughts about my portfolio. I started investing in Jan 2020. :)
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