CORE Portfolio Management: GS, MS, BAC, WFC, SPY, SDS

CORE Portfolio Allocation


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Analyst:  Thomas H. Kee Jr.

October 13, 2016

This is designed to provide the framework for CORE Portfolio allocations.

Our definition of a CORE Portfolio is not unlike traditional CORE Portfolio definitions which imply allocations and diversification amongst large cap stocks that pay decent dividends and that can be held for long-term periods of time.

However, our objective and our approach is vastly different than traditional definitions and portfolio allocations that might come from investment firms like Goldman Sachs Group Inc (NYSE:GS), Morgan Stanley (NYSE:MS), Bank of America Corp (NYSE:BAC), Wells Fargo & Co (NYSE:WFC) or UBS Group AG (USA) (NYSE:UBS).

Historically, with very few exceptions, CORE Portfolios designed and managed by the above firms using their traditional approach have significantly underperformed the S&P 500 over time.  The market has outperformed these portfolios, in almost every case, so if the market is a winning vehicle for longer-term allocations to CORE Portfolios we believe our focus should be on the market instead of on individual stocks.

Therefore, our primary vehicle for our CORE Portfolio strategy is the S&P 500 and SPY, the ETF that tracks the S&P 500 specifically.  All of the non-IRA client CORE Portfolios that I manage are fully invested into SPY, but these accounts are also marginable and we use margin to protect these CORE Portfolios as well.

Clearly, we recognize that the market itself has outperformed most traditional CORE Portfolios over time, but we also recognize that there are significant risks in the market, the S&P 500 was 24 times earnings when this white paper was written, and the FOMC was threatening to raise interest rates and global stimulus was poised to come to an end across the pond as well.  With a rich looking market and significant downside potential the notion of a CORE Portfolio allocation was also not immediately appealing, but we also incorporate hedges to our CORE Portfolios that neutralize risk.

In these non-IRA CORE Portfolios, this changes slightly for IRA accounts by the way, we begin with a full allocation to SPY for every account, regardless of price or immediate market sentiment or direction, but depending on our immediate outlook for near-term market moves we made or may not simultaneously incorporate a hedge on to that position.

The hedge that we use in our CORE Portfolio strategy is SDS, the double short ETF for the S&P 500.

Effectively, we use this ETF to completely neutralize the risk in our CORE Portfolio when we perceive risks to exist, and in doing so, when this neutralization is in place, we prevent downside risks in our CORE Portfolio positions.  We use the word neutralized because that is exactly what happens to these CORE Portfolios when we engage SDS against SPY in a proportional manner.

For example, if a client's allocation to his CORE Portfolio was $100,000 we could completely neutralize that with a $50,000 allocation to SDS because SDS is 2x the inverse of SPY.  When we have our hedges on this is exactly what we're doing, and when we removed the hedges, or sell SDS, the CORE Portfolio is free to trade along with the market and will experience volatility a long with the market should that come, but when it is neutralized there is no volatility given the direct proportion of the hedge.

This simplifies the approach to CORE Portfolio management considerably.

Instead of attempting to find the appropriate stocks and a model diversification that traditional investment firms might have us believe is necessary, an approach which has also underperformed as we discussed, we instead embrace the entire market, all 500 stocks in the S&P 500, and we do that within one investment vehicle to keep it simple.  We are diversified into large cap companies, they pay a decent dividend, and we are invested into the market, which has beaten traditional portfolios over time, but our objective is also to beat the market so there is more work that needs to be done.

When the market is in a position where it is poised to decline our hedge needs to be placed to protect that CORE Portfolio from experiencing volatility.  It is not perfect, we do not expect to be perfect, but when we remove some of the risk it can add up fast overtime.

In addition, when we engage in hedging techniques like this we are able to add to our CORE Portfolio position without investing more money into it.  For example, assume that the $100,000 referenced above bought 1000 shares of SPY, but we also used margin to hedge that position and bought SDS to neutralize the portfolio right off the bat.  Next, assume the market fell by 10% immediately; the $100,000 was now only worth $90,000, but the allocation to SDS was actually up by $10,000, which neutralized the risk in the portfolio.

If we made a decision to remove the hedge, or sell the SDS position, we would have $10,000 that we could use to buy more SPY at a lower price.  We can add a little more than 10% specifically, so instead of 1000 shares we would actually own 1100 shares, and we could let the market work for us if it was appropriate and then repeat this hedging process again when it in turn was appropriate as well with the objective of adding more shares along the way with lower volatility.

This is the exact method that we use in the CORE Portfolio strategy that I manage at equity logic, and this approach is something that I believe works well to outperform the market in a very simple and easy to use format that removes the traditional burdens of longer-term portfolio diversification.

In addition, we are getting dividends the entire time, and interestingly if we were margined with SDS for the entire year we would still have a positive net return because of those dividends given the low margin rates that exist for our client portfolios at this time.

In summary, our approach is not unlike traditional portfolio management in the sense that we stay fully invested all the time, but we use margin to neutralize our portfolio from time to time in an effort to reduce risk and improve performance over time in a simplified manner.

Our CORE Portfolio strategy is something that we believe will not only outperform the stock market itself, but also outperform those traditional managed account portfolios that have underperformed the stock market historically and therefore allocations to our CORE Portfolio strategy make a tremendous amount of sense, especially when market risks are as high as they are today.

Information about CORE Portfolio Managed Accounts: EQUITY LOGIC