Saturday, February 2, 2013

A Better Way To Invest In Technology

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)
I had written an article titled The Best Way To Invest In Technologycouple weeks back. My thesis was simple. Instead of investing in individual securities, I recommended that investors buy and hold theProShares UltraPro QQQ ETF (TQQQ) instead.
The article was not well received. Two main complaints were lack of backtesting for a sufficiently long period, and big max drawdowns. Many readers believed that because of the typical erosion leveraged ETFs encounter, this strategy will result in a total wipeout over a long period of time. Fair points, both. In this article, I will attempt to show an alternative strategy that tries to counter both these complaints.
This is the strategy, which avoids the seasonally bad months for investing, May through October, and invests in the 3x leveraged ETF on the Nasdaq 100.
  1. Buy TQQQ at the close of the last day of trading in October, at the closing price
  2. Buy a 6 month put option for the first strike at or just below the closing price to go with it
  3. Sell TQQQ at the close of the last trading day in April, at the closing price
  4. Between May 1st and October 31st invest in money market funds, estimated at 1% annual yield
I backtested this for the period of 27 years from October, 1985, to April 2012. Some key assumptions that I made are
  1. Since no TQQQ was available back then, I use 3x daily return of the core index under the PowerShares QQQ Trust ETF (QQQ), the NASDAQ 100 Index (^NDX), to simulate the TQQQ
  2. Since I didn't have historical put option prices, I estimated he cost of the 6-month put at ~10% of the strike price, as it is today for the TQQQ
  3. The put is bought on margin for 6 months, which requires an interest payment of ~2.5%
  4. I gave another allocation of ~2.5% for fluctuations in put price and margin interest rates over time
  5. Each annual return for this strategy is calculated from November to October, and not January through December
I will first show the results without the put, and then with the put. Note that the backtesting period includes many, many market crashes. The S&P 500 was at 190 on 10/31/1985, and ended on 1412 on 10/31/2012, which means the average annual return has been ~7.7% and total return has been ~7.4x.
Without the put, the average annual return for this strategy over 27 years is 17.9%. It is not quite 3x the return of S&P500, but it still beats S&P500 by a nice margin. However, the volatility is huge. The maximum annual return is 234%, for the period ending 10/31/1991. The maximum annual loss is 95%, for the period ending in 10/31/2001.
So, it is clear that the strategy works in the long run and through thick and thin, even when the market collapses. But the max drawdown remains a concern. This is where the put comes in. With the put, you give up 15% of the gains in the good years, but incur a maximum loss of 15% in the bad years. This, when applied, results in an average annual return of 22.3% for this strategy over 41 years. This beats the S&P500 by almost 3x over a really long period of time, has a max annual drawdown of 15%, and a max annual return of 180% in 1991.
I would encourage readers to simulate this on their own and prove for themselves that leveraged ETFs backed up by puts work very well for long periods of time, and yields really good long term performance. While not quite Warren Buffet like because of the massive 2000-2001 crash, this would be a very respectable return that would beat 99% of active fund managers over 27 years.
Period EndingReturn w/o putReturn w/ Put
Hope this will answer all the questions raised by readers when I posted my previous article. I await the responses.
One parting note. As the Apple (AAPL) earnings showed last week, investing in individual technology stocks is incredibly risky. Passive investing using index ETFs historically beats 80% of active fund managers over the past 5 years. I believe individual investors would do well to take this into account when choosing the right options for retirement savings.
Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice.

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