Value Investing / Main Index / previous / next

February, 2014


Smaller-capitalization stocks such as those in the Russell 2000, if held for the long-term, beat the generally larger-cap stocks of the benchmark Standard and Poors 500 Index by roughly 20% in the average year (i.e. approximately 12% vs. 10%, respectively, with dividends included in each category). There is a catch, though, which may be why most people do not invest that much in small-caps: they have much greater downside volatility during corrections and bear markets.

The trick then is to come up with a fairly easy way to benefit from that volatility instead of letting it scare us away from the higher performance potential of lower market-capitalization equities. This may be accomplished by: 1. Using exchange traded funds (ETFs) to stand in for both the overall small-cap portion of the securities market and short-term bond funds; and 2. Buying most of one's equity shares when they are down, then selling some and switching back to one or more short-term bond fund ETFs when they are up. An investor can allocate between the low- vs. high-risk ETFs so that when one goes down another will tend to go up, remain the same, or at least not go down nearly as much, then rebalance between them, thus buying when prices are low and selling when they are relatively high.

Here, for example, is a five-step strategy using BSV* (Vanguard Short-Term Bond Exchange Traded Fund) and UWM (ProShares Ultra Russell 2000 Exchange Traded Fund):

  1. Begin by investing a quarter of the total liquid assets (available for this strategy) in UWM, i.e. leaving three-fourths in BSV. (In the illustration below it is assumed the initial total investment amount is $400,000, of which right off the bat a fourth, or $100,000, is to be invested in the leveraged exchange traded fund, UWM, yet this figure is just to make an easier example. A person can vary the amount appropriately for his or her own nest egg, for instance $2500, $25,000, $250,000, etc.)

  2. Review at quarterly intervals. If UWM's price has remained in a threshold of less than 5% up or down since the previous review, simply hold the asset.

  3. Only when such quarterly review shows that UWM has increased in price 5% or more since the average purchase price (cost basis) and since the last three-month review, sell one-fifth of open UWM shares.

  4. If, however, by the next quarterly review the UWM shares are down (or down again) by 5% or more since the last such review, buy an additional amount of new UWM shares equal to 25% of then available liquid holdings (UWM plus BSV shares), unless or until, by successive quarterly purchases, all BSV shares have been redeemed and one is 100% invested in UWM, in which case merely hold existing shares until the guidance per Rule 3 applies.

  5. Continue with quarterly reviews, and, as indicated, follow Rule 2, 3, or 4 indefinitely.

*BSV had an early 2009 inception at Vanguard. Stats prior to that assume investment of the non-equity portion of one's assets in a money market fund.

In the following table, results of this method are shown for the period 9/2/08 though 12/4/13 (the adjustment of days in some months being due to weekends or holidays preventing earlier date trading):

A UWM and BSV Portfolio History
(9/2/08 - 12/4/13)

UWM ActionNew
$400,00012/2/08$16.191866$30,211$300,000Buy 5099 shares$330,211<17.4%>
$330,2113/2/09$10.736965$74,735$217,447Buy 6808 shares$292,181<27.0%>
$292,1816/2/09$20.6413,773$284,275$144,402Sell 2755 shares$428,677+7.2%
$428,6779/2/09$22.6911,018$249,998$201,265Sell 2204 shares$451,263+12.8%
$451,26312/2/09$25.808814$227,401$251,274Sell 1763 shares$478,675+19.7%
$478,6753/2/10$30.327051$213,786$296,759Sell 1410 shares$510,545+27.6%
$514,5449/2/10$27.865641$157,158$339,510Buy 4457 shares$496,668+24.2%
$496,66812/2/10$39.1110,098$394,933$215,343Sell 2020 shares$610,276+52.6%
$610,2763/2/11$45.488078$367,387$294,345Sell 1616 shares$661,732+65.4%
$668,1959/2/11$31.046462$200,580$367,841Buy 4578 shares$568,421+42.1%
$568,42112/2/11$34.4011,040$379,776$225,740Sell 2208 shares$605,516+51.4%
$605,5163/2/12$40.978832$361,847$301,695Sell 1766 shares$663,542+65.9%
$663,5426/4/12$34.327066$242,505$374,048Buy 4491 shares$616,553+54.1%
$616,5539/4/12$42.6011,557$492,328$219,917Sell 2311 shares$712,245+78.1%
$712,8003/4/13$53.089246$497,435$318,366Sell 1849 shares$815,801+104.0%
$815,8016/4/13$60.987397$451,069$416,511Sell 1479 shares$867,580+116.9%
$867,5809/4/13$66.295918$392,304$506,700Sell 1184 shares$899,004+124.8%
$899,00412/4/13$79.094734$374,412$585,187Sell 947 shares$959,599+139.9%

Over the 5.25 years of our example, short-term bond holdings exceeded the equity portion more than half the time and, as of our review period analyses, never fell below 30% of the total portfolio value. While frictional costs were not taken into account, neither were the bond asset distributions. Those costs and distributions should have approximately cancelled each other out.

As equity markets decline substantially, the portfolio rules automatically put more funds into UWM, thus capilalizing on the then lower prices. Yet when markets rise significantly, the portfolio system automatically reduces equity exposure and increases the funds then available (in case of corrections or bear markets) in the non-equity portion of the total. In the example above, for instance, by the last review of 2013 the non-equity portion had already risen to 61% of net asset value (actually 69%, once the 947 shares of UWM have been sold per the system's guidance as of that last review). If in 2014 small-cap equities continue their strong upward climb, by early December of this year the portfolio would (via the quarterly adjustments called for in Step 3) likely again be "ready" for a steep market decline with then 75% or more in BSV and only about 25% or less then in equities.

Despite the healthy non-equity allocation, the performance of this BSV-UWM blend over the previous 5.25 years would have been almost 140% above the sample initial portfolio value. Thus $400,000 would have become nearly one million dollars, for a compound average annual return of over 18%. Though it is in a way comparing apples and oranges, by contrast, a buy and hold $400,000 investment in the S&P 500 Index over the same period would have become about $752,000, up roughly 88%, for a compound average annual return of not quite 13%.

Please note though that, due to UWM's leverage, costs, and reliance on derivatives, even with the significant short-term bond ETF holdings our proposed portfolio blend and method are hardly low risk. Further, they are likely at times to generate substantial short-term profits and so may not be fitting for taxable accounts. In addition, this technique requires more frequent and active portfolio management over the long-term than many would like. All things considered, in my view a maximum of 5-10% of one's net asset value might be safely and conveniently employed in this way. Yet that, combined with a more conservative allocation of the balance of an investor's liquid assets, for instance, one that is initially 20% in a money market account (or in BSV) and 80% in VBR (Vanguard Small-Cap Value Exchange Traded Fund) and rebalanced yearly, appears to have an excellent chance to do the major market averages one better.

Happy investing.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

Value Investing / Main Index / previous / next