Trading Strategy: Investing in S&P 500 and Hedging with Bonds
Trading Strategy: Investing in S&P 500 and Hedging with Bonds
What could be scarier and more unpleasant for an investor than a crisis?
Many investors with capital starting from $10,000 ask themselves: how can one survive a crisis and the fall of global stock markets, how and where can a large capital be placed without worrying about its safety?
Some Statistics
During the last crisis, the S&P 500 index fell in price by more than 55%. Such a capital drawdown is unlikely to be pleasant for anyone. Many stocks, even of companies with high capitalization, fell by more than 80%.
Shares of the gold mining company ABX (Barrick Gold Corp.) fell from $52 to $19.
Shares of AAPL (Apple Inc.) fell from $189 to $80.
Shares of BAC (Bank of America) fell from $52 to $3.
According to data from the last 100 years, the average cyclical nature of crises that affected the central bank market ranges from 8 to 12 years. The last crisis was 9 years ago, in 2008, meaning there is a high probability that new shocks are coming soon.
With such prospects and news background, it is extremely difficult to invest in the long term. Of course, one can form a portfolio from the most stable sectors, which lose the least during crises. These include Consumer Staples, Health Care, and Utilities, as people will always use these services, regardless of the political and economic situation.
Fortunately for investors, portfolio management has gone much further than simple stock trading. Professional market participants use very complex portfolio structures, which require separate computing servers and expensive trading platforms to calculate. But even for private investors, there are simple and effective investment strategies. One of them is the well-known combination: stocks + bonds, which has been popular among financiers since their student days.
Stocks and Bonds
Historically, stocks have been a more profitable instrument than bonds. However, during times of turmoil, capital always seeks a safe haven. Bonds, with their small returns and high reliability, are what always increase significantly in price during crises.
Let's historically compare stocks and bonds.
SPXL-TMF 1 SPDR S&P 500 | Fondexx
The chart clearly shows that bonds rise during financial troubles. But when buying bonds and stocks, we lose yield in exchange for cutting risks. To increase yield and maintain moderate risk, we use 3x ETFs for stocks and 3x ETFs for bonds. SPXL and TMF.e
If the underlying asset grows by 1%, the 3x ETF grows by 3%. And vice versa, in case of a decline.
Let's assume an investor has $100,000. 50% is invested in SPXL and 50% in TMF. $50,000 in one asset and $50,000 in the other.
For example, on April 16, 2009, with prices of SPXL at $9.66 and TMF at $14.63, the portfolio would look as follows: 5,175 shares of SPXL and 3,417 shares of TMF.
Now, let's analyze and see what the return curve would look like with passive investing — the favorite tactic of Warren Buffett, "buy and hold."
SPXL-TMF 2 SPDR S&P 500 | Fondexx
On April 28, 2017, SPXL is priced at $129.76 and TMF at $19.55. So, the average annual return over 8 years was 60%. In some places, the drawdown reached 40%, but considering the yield, this is a very moderate figure.
To increase profit and reduce drawdowns, it is worth adding reinvestment. This means reallocating money from the asset that has grown into the one that has fallen.
When the portfolio consists of $50,000 in SPXL and $50,000 in SPXL, after some time the difference between them will become $57,440 and $47,000, which is 10% of the total amount ($104,440 * 10% = $10,440). One can sell the profitable instrument for $5,222 and buy the fallen instrument for $5,222.
Thus, part of the profit is fixed and reinvested into the falling asset, the growth potential and possible future profitability of which increases. With such balancing, it is possible to achieve a smaller drawdown during crises and higher profits during growth.
Using the tools of asset modeling in the past, one can immediately state that in 2008, the drawdowns would have been around 60-70%, and the average annual profit, taking into account reinvestments, would have been from 70-80% per year.