My "Core Plus" Strategy - Feedback on the "Plus" part?

[milmoose]

I post regularly on MSN Money and was referred here by a member. I've developed what I refer to as a "Core Plus" strategy for my retirement and would love some thoughts on maximizing return in the "Plus" portion of the strategy.

Background on "Core":
I am very fortunate to have a high income (average $350,000) and net worth of approximately $760,000 at age 29. My initial retirement goals (set in 2003) were to have purchasing power of approximately $275,000 (2003 dollars) per year in 2040, my target retirement date. The "number" necessary to get this purchasing power is roughly $22M in 2040 dollars.

So, my goal was to create a diversified portfolio with 3/4 of the risk of the S&P 500 (StdDev = 12.5%) to achieve this goal. I am far enough ahead of schedule that I should have adequate assets in 2011 to reach this goal without ever saving another penny (not that I plan on stopping my tax-advantaged retirement account savings). So, in 4.5 years I will have excess savings that I can deploy for maximum return, thus the "Plus" part of my strategy.

The "Plus" Strategy:
My goal here is simple, to maximize return. I'm willing to accept roughly double the market risk (StdDev up to 35%) with these assets. Starting in 2011, I should have approximately $75,000 a year to pursue this strategy. Here are my ideas for maximizing long-term return. I'd love to hear any thoughts:

1. "Double-leverage" ETFs or index funds, most likely a Rydex fund such as RYRUX or RYTNX or a Proshares ETF. These funds have double the market risk, but tend to only provide 150-180% of the market upside. Not optimal, but available with modest investment and liquid.
2. Index futures. I could just buy an index future on the S&P, but they are not tax efficient and even a "double leveraged" index future would require a cash backstop of approximately $160K. A double leveraged future on the Russell 2000 Value index would give exposure to small cap and value factors for the long term.
3. A hedge fund that engages in futures strategies. Hefty fees. Ugh.
4. Investing in private businesses. Lots of time input. Would this really provide a long-term return better than a small cap fund?
5. "Optimized" ETFs, such as PZI. Small cap, value and dividend biases.
6. 95% leveraged commercial real estate. Lots of property-specific risk...

Other thoughts? Should I start before 2011 and direct a portion of my future earnings to the "Core" strategy?

- M

 

[brewer12345]

I guess my first thought is that $275k 2003 dollars is waaaay more than I would require to live on comfortably for the rest of my days, and 2040 is a lot longer than I would be willing to wait to retire, but to each his own, I suppose.

You happy with the "core" portfolio? What is in it, out of curiosity?

On the plus:

1. These might be OK in moderation, but they are likely to be a very bumpy ride and leverage cuts both ways. Probably not my first choice for a shoot-the-moon bet, but better than some of your other listed options.
2. The big drawback to futures is that you may have to post a LOT of collateral in a hurry of things go wrong. I'm not sure I'd be ahppy with that risk.
3. Do yourself a favor and skip it. The good managers don't want to deal with small, retail investors like yourself. You will also have a hard time discerning the good from the bad.
4. If you stumble across one of these and it is a good opportunity, that's great. But there are a lot of potential issues that you would have to be comfy with (individuals running it, lack of control, no liquidity, risk of fraud, etc.).
5. Eh, not likely to provide the kinds of returns you are looking for.
6. Maybe OK if you find the right property, but how do you propose to do so?

Other ideas:

If I were looking to take big risks for big rewards, I would consider the following.

- Options and LEAPS: buy long term, out of the money call options/LEAPS on names you like or on specific index ETFs. Very little risk of blowing yourself up, and high risk, high reward.
- Invest in leveraged companies: You;d have to do the work, but if you assembled a portfolio of well chosen individual names that have a lot of debt and a low stock price, when things go well for leveraged companies, they go REALLY well for the investors.
- Closed end fund arbitrage: There are lots of closed end funds trading at a discount to NAV and sometimes there are reasons why the discount might close. Check out what is going on with PPT, PIM, PYM, PCF, and other Putnam funds. If you went long a CEF trading at a discount and shorted a similar ETF, you would be hedged against the underlying assets, possibly levered, and potentially set up for nice gains if teh discount to NAV closes.
- Start-up banks: Banks are fundamentally levered animals and can post big gains when things go well. I suspect that if you assembled a collection of start-up bank stocks like the ones here: http://www.bankipo.com/ you would see excellent returns over time, assuming you were willing to wait and endure illiquidity.

 

[milmoose]

Brewer,
Thanks for the reply. Since you're curious, I'll post my "Core" portfolio.

Equities: 65%
a. Self-Managed Individ. Stocks (DEEP value): 20%
b. LC Domestic Index: 10%
c. International Index: 15%
d. Small Cap Value Index and Quant Managed: 20%

Absolute Return (SWHEX): 8%

Real Estate: 15%
a. Home Equity: 12%
b. REIT Index: 3%

Fixed Income: 7%
a. Treasuries, varying duration: 5%
b. Other Bond: 1%
c. Cash: 1%

Commodities: 5%
a. Physical Precious Metals: 1.5%
b. Managed Futures Fund: 3.5%

As far as my retirement date in 2040, I love what I do and do not (currently) have any interest in retiring in my 50s.

The options point is a good one, but transaction costs tend to be a bit higher than with futures. I know the risk of the futures and would be limiting myself to 2.0X leverage, so I'm not too worried about margin calls (unless the index drops > 50%).

Leveraged companies- there is no historic data that shows excess returns from companies with high levels of Debt/Equity or Debt/EBITDA, but risk is higher. Uncompensated risk seeking is not my goal.

The start-up bank point is facinating and something I'll have to think about. It is a fundamentally levereged vehicle and a good bank tends to show a 18%+ ROE. Hmmm...

As for Commercial RE, I have a trusted friend that is a CE broker. I can do the due dilligence, but I'm still not sure if a highly levered property can get the returns I'm looking for.

Thanks for the reply. Great stuff.

- M

 

[brewer12345]

Care to tip your hand on your deep value picks? I tend along the same lines. I am currently heavily invested in catastrophe reinsurers (AXS, IPCR, AHL) and dry bulk shippers (EGLE, DSX, DRYS and BULKW).Tiptoeing into auto parts now (mostly SUP so far).

 

[milmoose]

My current "deep value" holdings:

AHL (hey, one in common - it's DAMN cheap)
DVN
YCC
SCG
TLK
MRW.LN
BSY

Sold GKIS two weeks ago and looking to redeploy that cash. Considering ISNS and CALL.

 

[unclemick]

hmmm

At the ripe old age of 63, I am rewarding myself for being a really really cheap bastard the first 13 yrs of ER. Slowly phasing out my dividend oriented DRIP stocks toward more growth.

Core: 85% VG balanced Index mostly Target Retirement, a tad Lifestrategy.

"plus" : 15% individual stocks - have taken to watching what Buffett buys.

An aside for Brewer - MSN has a blurb on DRYS.

heh heh heh heh heh heh heh - and yes I listen to what gets posted here for my 'male hormone money'.

Fund or stock - so what's the next Dell, Harley, etc., - I'm all ears.

 

[brewer12345]

MM, take a look at BULKW. I think the company's net asset value of the fleet alone is at least $6 a share, and the port and other assets are probably worth $.50 to $1 a piece. Industry fundamentals are extremely favorable, so I actually think that the company is worth more than net asset value. If it continues being this drastically undervalued, I suspect they will either go private or someone will come along and buy them.

 

[CCdaCE]

Ran across this on DRYS myself...

Motley Fool on DRYS

I don't think I'll ever invest in individual stocks, but that's just me. Thought someone'd be interested in this article.

-CC

 

[brewer12345]

Ran across this on DRYS myself...

Motley Fool on DRYS

I don't think I'll ever invest in individual stocks, but that's just me. Thought someone'd be interested in this article.

-CC

I think the article was basically a plagiarism of a smear piece written a year ago, and phenominally poorly researched.

 

[kcowan]

...3. A hedge fund that engages in futures strategies. Hefty fees. Ugh.
4. Investing in private businesses. Lots of time input. Would this really provide a long-term return better than a small cap fund?
6. 95% leveraged commercial real estate. Lots of property-specific risk...
...

3. I would avoid hedge funds. It has become impossible to select future winners and the field is crowded with wannabees now.
4. This can be a big winner. But you will be plagued with lack of liquidity. And if you spend time working with them, you will tend to buy into their story and lose your objectivity. Maybe talk to some Vencaps and offer your services free to their companies for shares/options. At least the conversations will provide some much needed education on their approach. Often Vencaps will churn because they are under the gun to produce annual returns. This can hurt their businesses.
6. Many people have done this successfully. Liquidity is a major problem. Watch occupancy assumptions (overstated) and cost of maintenance and management (understated).

Sounds like a good plan. Good luck with execution.

 

[CCdaCE]

I think the article was basically a plagiarism of a smear piece written a year ago, and phenominally poorly researched.

Yeah, I have a tough time trusting Motley Fool for anything, just thought I'd toss out the URL "for balance".

-CC

 

[milmoose]

Thanks kcowan.

I'm leaning towards using my Year 1 funds to buy a Rydex or Proshares 200% leverage fund. High fees (for a low value added product) but good liquidity.

Year two will likely be a leveraged future on the Russell 2000 Value index.

Year three I'll start considering hedge funds (would have to be REALLY compelling to justify the fees) or levered Commercial RE.

 

[saluki9]

I just don't get it. What is the point?

If you're happy doing your work and you don't want to retire for 34 years why not just invest in a SIMPLE growth oriented portfolio?

I think you're trying to make this too complex.

 

[FIRE'd@51]

1. "Double-leverage" ETFs or index funds, most likely a Rydex fund such as RYRUX or RYTNX or a Proshares ETF. These funds have double the market risk, but tend to only provide 150-180% of the market upside. Not optimal, but available with modest investment and liquid.

Not to nit-pick, but I just wanted to point out that even in theory, holding a portfolio with a beta of 2 does not mean you will get twice the market return. It means you will get an excess return (return minus the risk-free rate) that is twice the market's excess return. Only if the risk-free rate is zero should you expect to get twice the market return. This, of course, is because you have to pay interest on the money you borrow. So even if you could borrow at the risk-free rate (assume it is 5%) and the market were to return 20%, your theoretical return would be 35%, not 40%. This would be 175% of the market return. So, actually 150-180% of the market return may be close to optimal.

 

[milmoose]

If you're happy doing your work and you don't want to retire for 34 years why not just invest in a SIMPLE growth oriented portfolio?

The point is increasing net worth and managing for risk.

even in theory, holding a portfolio with a beta of 2 does not mean you will get twice the market return.

True. Unfortunately, you capture nearly 200% of the downside, though. Hmm.

- M

 

[saluki9]

The point is increasing net worth and managing for risk.

That's my point. If what you are worried about is shortfall risk I don't think you're making a good trade. Most of the assets you listed have either high betas or high leverage. On top of that they have correlations and expected returns that are almost impossible to estimate.

Shortfall risk can be overcome by both having more time and higher savings. There are both things that you have already.

 

[milmoose]

If what you are worried about is shortfall risk I don't think you're making a good trade.

I'm not overly concerned about shortfall risk. I would be happy in retirement with $22.4M in 2040. My current net worth of $780,000 would get me there with a 10% annualized return (on the "Core"). To be intellictually honest, I will make further contributions to the "Core" strategy as most of those assets are in my tax advantaged accounts, so the $780,000 base is not likely to stagnate.

My primary objective is seeking excess return with the "Plus" part of my Core Plus strategy.

DRYS isn't my kind of company. Cheap due to cyclical strength, not due to a lack of market enthasium. I prefer a company like AHL that trades cheaply on every core metric, but can generate a full-cycle ROE of 18-20%. Ditto for YCC, though it probably won't be independent for long.

- M

 

[brewer12345]

I hate to burst your bubble, but both AHL and DRYS are cyclicals. DRYS is obviously cyclical due to the nature of the bulk shipping industry. AHL is driven by the underwriting/insurance cycle. I think both are attractive, but don't fool yourself into thinking either are "set and forget" positions.

 

[milmoose]

I agree that AHL is cyclically exposed, but it isn't cheap because it's at the top of a cycle.

AHL should generate attractive full-cycle ROEs and trades at 1.3X book. I like the margin of safety.

DRYS is also cheap at 1.2X book, but tends to produce full-cycle ROEs of 6-8%.

 

[brewer12345]

I agree that AHL is cyclically exposed, but it isn't cheap because it's at the top of a cycle.

AHL should generate attractive full-cycle ROEs and trades at 1.3X book. I like the margin of safety.

DRYS is also cheap at 1.2X book, but tends to produce full-cycle ROEs of 6-8%.

The problem with something like AHL is that even an insider only has a vague clue as to what is really in their book of liabilities. For example, I can pretty much guarantee that someone spent Sunday figuring out how much Hawaii quake exposure they have in their cat book. Knowing the market as an informed observer (not a partiipant), I think they are well positioned to generate solid ROEs, but that won't last forever.

How do you know what full cycle ROEs DRYS will generate? The company has only been around <2 years. If you mark their fleet to current market value, I get a net asset value in excess of $17 a share. It also looks to me like dry bulk ships will generate a 20% or so ROA at current prices and day rates. Since DRYS is about 60% levered, ROE is a lot higher if day rates stay anywhere near where they are now.

I intend to sell both of these positions before the cycle turns downward.

 

[youbet]

before the cycle turns downward.

Since you mentioned it......... when is the cycle turning downward. I could really, really use this information and can't find it anywhere!

 

[brewer12345]

Since you mentioned it......... when is the cycle turning downward. I could really, really use this information and can't find it anywhere!

Different for the specific industries that these two are in. I think that the dry bulk shipping market is in a multi-year bonanza. If DRYS spikes, I will happily let my shares go because I have other, less risky positions in the industry. But i think the next 3 to 5 years will be embarassingly profitable ones.

For AHL, I suspect that the 2007 renewal season will be quite profitable, with property cat rates continuing to rise slightly. 2008 is probably the year that the build in capital and new entrants finally offsets all the stuff pushing demand way above supply in the industry. So I expect to liquidate in late 2007 or early 2008. But if I hear good things about renewals, I could stick around until 2009.

 

[eridanus]

The options point is a good one, but transaction costs tend to be a bit higher than with futures. I know the risk of the futures and would be limiting myself to 2.0X leverage, so I'm not too worried about margin calls (unless the index drops > 50%).

You'd have to roll your futures, which would increase transaction costs (including slippage). The farthest out Russell 2000 contract is Sep07.

Do I understand 2x leverage to mean you'd hold 2 contracts and keep one full contract amount as the performance bond? I.e., you'd hold 2 ER mini-contracts and keep ~$77000 in the futures account?

With $77000, you could hold 100 Jan09 strangles for the QQQQ at 10% OTM. That gives you 2 years for a >10% movement. The transaction costs would be $200 total, depending on the broker, and it would be 100% long-term capital gains, as well. That alone could save you $200.

 

[milmoose]

Fire'd@51,

I was thinking about this over the weekend:

even in theory, holding a portfolio with a beta of 2 does not mean you will get twice the market return. It means you will get an excess return (return minus the risk-free rate) that is twice the market's excess return.

That's true for an pure futures position, but the Rydex and Proshares funds own Treasuries as a backstop (similar to the PIMCO Real Return funds) so the "Beta 2" portfolio with futures can achieve double the market return (with double the risk).

 

[FIRE'd@51]

Fire'd@51,

I was thinking about this over the weekend:

even in theory, holding a portfolio with a beta of 2 does not mean you will get twice the market return. It means you will get an excess return (return minus the risk-free rate) that is twice the market's excess return.

That's true for an pure futures position, but the Rydex and Proshares funds own Treasuries as a backstop (similar to the PIMCO Real Return funds) so the "Beta 2" portfolio with futures can achieve double the market return (with double the risk).

The futures price contains a "borrowing cost" embedded in it. To have a beta of 2, you would only backstop half the futures with Treasuries, so you would still be borrowing the other half. So you will not get twice the market's return, even in theory, unless the borrowing cost were zero.