What if you could invest in what you knew would be the highest performing asset class of the year?
For a portfolio of stocks and bonds perhaps you’d build a strategy that can invest in US stocks [for simplicity, let’s assume the S&P 500 Total Return Index] and One-Month US Treasury Bills. You’d rebalance once per month, on that day you would know with certainty the return of US stocks and US Treasury bills over the following month. This perfect “market timing strategy” would then invest all in equities or all in Treasury Bills, depending on which one will have the higher return over the following month.
Of course, nobody knows with certainty what the future returns on any asset class will be. And without that knowledge, there is no way to create a perfect market timing strategy. Or is there?
In The Cost of a Perfect Market Timing Strategy, Stanley W. Black and Samuel Wang conduct an interesting exercise [Mr. Black is a Vice President at Dimensional Fund Advisors and Mr. Wang is a Researcher also at Dimensional Fund Advisors]. They share a strategy by Robert Merton that involves buying one share of stock and a one-month put option with a strike price equal to the current stock price adjusted for the yield on the one-month T-bill. In the absence of costs, the payoffs from this “protected equity strategy” are identical to the perfect market timing strategy. They write, “in the absence of costs, the hypothetical returns and wealth generated by the equivalent perfect market timing and protected equity investment strategies are astonishing. For the 1962–2014 sample period, a $100 initial investment grows to over $146 million which is much larger than the $18,273 from investing in the S&P 500 Index.”
Then, of course, they return to the costs associated with the protected equity strategy. Their calculations are complicated, but the bottom line is clear. The hypothetical growth of $100 turns out to be just $6,086 after costs, much less than the value of $100 invested in the S&P 500 Index ($18,273). Accordingly, they conclude, “we can now answer our original question: What if we could construct a strategy with a correlation close to 1 with the perfect market timing strategy? It turns out that while this is possible, the cost of implementing would have resulted in inferior performance (in terms of ending wealth) to just holding the S&P 500 Index.”
The lesson for investors is clear. As the researchers conclude, “If volatility and maximum drawdowns are something an investor is particularly concerned with, a balanced portfolio may be a more cost-effective way to achieve this goal. For example, 60% S&P 500 and 40% T-Bills would have achieved a similar level of volatility to the downside protected strategy with a higher average return–so your $100 would have grown to $7,215.” And, I might add, with a lot less stress, time and effort.
Contact us if you would like a copy of The Cost of a Perfect Market Timing Strategy.