AIM UK

[ls7550]

Selections, Scaling and Expectations

Bit of a novel this posting, but may prove useful to some

Which stocks/sectors to Ladder?

Ideally we want to individually Ladder each of a range of stocks and/or sectors that don't all zig and zag at the same time. This way we can share cash reserves across multiple Ladders and enhance volatility capture gains.

If you add to a core defensive stock based holdings some things that don't start to go down until much later (commodities and Brazil) in the cycle and can find some things that turn up much sooner (cyclicals) you have a chance for that one zigging another zagging effect over the whole cycle.

Cyclicals include such sectors as automobiles, heavy machinery, steel, manufacturing, travel etc. and typically move with the economic cycle.

Defensives, such as utilities, food etc. are much less affected by economic downturns.

Yet another possible option is to include the likes of long/short (hedge) based funds.

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Scaling to overall 100% equity exposure levels.

Assume that we set a Ladder Top of 2 times the 52 week mid price value and a bottom that's 0.25 times that 52 week mid price value.

Assuming a mid price of 100, then this amounts to a top of 200 and a bottom of 25.

If we rebase to zero then we have 0 bottom, 75 mid and 175 top - which equates to 75 out of 175 cash and 100 out of 175 stock proportions, or around 43% cash, 57% stock.

The stop-loss based strategy that I use for cash (to reduce cash drag), typically averages 60% stock exposure time and 40% cash exposure time.

In total given 57% Ladder stock exposure and 0.6 * 43 = 25.8% stock exposure from the stop-loss based style. A combined 82.8% overall average stock exposure expectancy (17.2% cash).

We can however scale up the stop-loss based style such that overall we average 100% stock exposure across the total account. We can do this by using a Double Long (twice leveraged) index fund instead of a conventional unleveraged index fund for a relatively small amount of holdings.

Typically scaling the cash reserve by 1 / 0.6 = 1.667 will result in such an average 100% overall total equity exposure level.
So how much double-long does this require to be held? Well we need to solve 2x + y = 1.667 which given that x+y=1 is a simple simultaneous equation

2x + y = 1.667
- x + y = 1
= x = 0.667 and hence y = 0.333

So with 66.6% double-long, 33.3% conventional we have in effect 166.6% overall equity exposure on the 43% of cash reserves managed under the stop-loss arrangement, and as the stop-loss style averages 60% stock exposure we have an overall 100% stock exposure.

Relative to the total account this means holding 66.6 * 0.43 = 28.6% of the total funds in double-long type funds.

The net effect from this is that we typically will average around 100% overall stock exposure across the total account, and supplement the returns from such exposure levels with the volatility capture gains achieved by Ladder trading in and out of stock over time.

An alternative to holding a double-long is to scale up the cash reserves by 28.6% of the total fund value, so instead of a Ladder being comprised of perhaps 100% * 57% stock and 100% * 43% cash, we instead invest 57% in stock in the normal manner, but then set cash to 43% + 28.6% (71.6%) of the total fund value.

In a somewhat similar manner to how LD-AIM uses virtual-stock, under Ladder we can use virtual-cash.

Reflecting that virtual cash through to the stop-loss style will result in overall average 100% stock exposure levels coupled with additional stock price volatility capture benefits.

Providing our individual Ladders each run against different stock styles as outlined previously, then typically the differently timed zigzag's will enable those Ladders who have relatively high levels of (real) cash reserves to supplement those that are cash-hungry.

o O o

What sort of volatility capture benefits might we expect?

Consider that an Index such as the UK's FT100 might range through 20% to 40% of its value each year.

Our rule of trading at price intervals of 5% in the same direction, 10% in the reverse direction means that for each such paired (buy/sell or sell/buy) we make a 10% profit on the trade amount invested across that range.

As an example prices might decline 5% three times in a row and then reverse and rise up 10% followed by another two 5% gains. Collectively that is a 15% decline followed by a 20% rise, putting the price back to 5% above the original start price level and having ranged through 20%, which is towards the minimum that the FT100 typically ranges through across any one year.

From the Ladder in the iBox we see that typically Ladder will trade just over 1% of the total fund value at each such buy or sell trade level, which amount to around 0.3% of the total fund value in profit after three such round-robin trades (lower end of average 20 to 40% index motion). At the upper end of yearly Index price range we might expect around twice that amount, 0.6%. In practice the trade size is over 1% of total fund value, closer to 1.25% which uplifts that yet further still. Overall typically I generally use a guideline figure of 0.5% of the total fund value in volatility capture gains each year based on the UK FT100 Index.

The US markets tend to be more volatile than that of the UK's, around twice as volatile and as such US index Ladders typically average closer to 1% volatility capture gains.

When applied at the sector level however, typically volatility increases such that volatility capture gains are yet higher still. And if we scale up trade sizes by increasing cash (real + virtual cash) then we can relatively easily double these volatility capture gains.

It isn't particularly difficult to uplift volatility capture levels to 2% of the total fund value or more.

In concept therefore, it is viable that the Ladder and stop-loss money management based combination can yield higher returns than that of buy and hold, yet do so with greater money management controls that reduce volatility. Similar or better investment returns but with lower volatility in turn mean that compound effects add yet further benefits over time (as in how a consistent 10% p.a. is better than alternating years of 0% one year, 20% the next).

Through money management controls alone, it is possible to achieve better returns than buy-and-hold and yet do so with less volatility. All too often novice investors donate to much time and effort to stock analysis, and give too little time to money management controls. Yet it is money management that is likely to provide the greater overall longer term reward.