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-- Posted Thursday, 20 February 2003 | Digg This Article

In several previous essays we have discussed various ways to use short funds in both conservative and aggressive portfolios. It’s now time to get down to business and discuss their great volatility and how an informed investor can make it work for better gains and lower losses. Our last essay was for beginners. This one is not necessarily for experts, but for those with enough experience to have learned that "Rome Wasn’t Built in A Day."

This essay will attempt to summarize what we have learned in the last five years of experimenting with short funds. We can tell you at the outset that short funds are a wonderful addition to a wide range of bear market portfolios. But to fulfill their bright promise, they must be chosen carefully and managed frequently. Only in quite conservative portfolios, discussed later, can some funds be bought and held indefinitely without supervision.

Do not read this essay to learn how to select a particular short fund. We leave that task to you. But if you are now using short funds or plan to do so, you will learn some of the problems associated with this asset class and perhaps gain a few ideas on how to manage them better and escape some of the pitfalls that may lie ahead.

In the performance data given later, we have restricted our coverage to no load funds whose aim is to be short the market. We eliminated the few loaded funds in order to have the ability to move in and out without penalty during the current volatile bear market. We also eliminated a group of so-called market-neutral funds that hold both long and short positions in their portfolio. We prefer to retain the ability to fix the long/short ratio in our portfolio. We also eliminated a short fund that is a reverse of a bond index, although this will be of interest if and when the bond market turns down as some expect.

CLASSES OF SHORT FUNDS

Short funds all have the objective of profiting from market downturns, but there are two quite different categories (1) fully managed by its manager and (2) funds which follow a policy of holding a fixed portfolio, which is the reverse of a major stock index. This category has a sub-class which employs leverage, usually from 125 to 200%.

In this essay we present performance data on 13 no-load funds, three fully managed and the rest of the reverse index type. All of them can be used to hedge long positions or to hold naked short positions.

VOLATILE HISTORY OF SHORT FUNDS

Before we go further, I want to give readers a verbal picture of what I see on my FastTrack screen, which charts the daily prices of any six funds I choose. During the past three years, the charts of a representative group of short funds look like a magnified section thru the Swiss Alps or our Grand Tetons. Here are the dates and prices of a 200% leveraged Nasdaq fund at the major lows and highs of the past three years:

Note that this volatile fund has a long climb ahead to top its price at the last October high.

BUY AND HOLD PERFORMANCE DATA

In the performance table below, the starting date of 6/19/00 was near an early bear market low and the 2/10/03 ending date was rising from a November 2002 low.

The 13 short funds are listed in order of their total return in the first data column from 6/1/9/00 to 2/10/03, the longest period where all 13 funds were in existence:

Note in the one-year performance column that the Small Cap Index, which was the last market index to succumb to the bear market, finally led all the index funds to the downside in the past year. The other funds performed over the full period in line with their market index and percent of leverage.

PERFORMANCE FROM 6/19/2000 TO RECENT PEAK AND LOW

For dramatic evidence of the tremendous volatility of the short funds, we present the returns at the latest bear market low (short fund peak) and the top of the bear market rally just 7 weeks later (short fund bottom):

PROFITING FROM THE VOLATILITY OF SHORT FUNDS

A very conservative investor, not interested in short term trading, should avoid the leveraged short funds and select one more of the less volatile funds. In modest percentages these could be held for the duration of the bear market without encountering sleepless nights.

In this essay, we wish to discuss some ways for serious investors to use the full spectrum of short funds, in modest quantities and fully managed, to take advantage of the differences in their volatility. It is possible to do this with any desired level of risk by varying the overall ratio of short funds to bond funds in the portfolio. We are going to demonstrate the overall concept with a moderately aggressive portfolio which can be varied to suit the needs of any experienced investor. We do not recommend this portfolio idea for novices or for use with other than "play" money until you gain confidence from the "school of hard knocks."

We will use as an example a portfolio with the following composition:

In the table below, we will record two performance records for the $20,000 portfolio: the buy and hold record and that of a hypothetical portfolio rebalanced at each peak and valley in the short fund prices.  Between the 5/24/00 start date and the 2/10/2003 end date, there were 3 major price peaks and 4 major lows. To clearly show the benefits of the rebalancing, we report the total values of the short funds, the bond funds and the portfolios:

DISCUSSION

Note, first of all, that in the final total, the balanced portfolio has already exceeded the 10/07/02 peak level due to the rebalancing done at the 11/27/02 bottom. If in the current stock market decline, the short funds rise to their former peak price, the value of this balanced portfolio will be much greater. In contrast, the final total of the buy and hold portfolio is about 10% below the previous peak.

The above study was done to demonstrate the beneficial effects of rebalancing. For this example, we chose to use the exact high and low dates for rebalancing. Thus, the above data represent the theoretical maximum effect.  In real time, it is impossible to determine the developing high and low points exactly.  So, in the future, if the rebalancing is done a few days before or a few days after the actual price peak, the final results will be somewhat lower.

However, compensating for this decrease in real-world results is the fact that the beneficial effects are compounding over time.  So, let's assume that a realistic gain from rebalancing is reduced by 10 or 20%. It would probably be made up in the very next rebalancing.

Note these important points from the table:

1. The total return for each portfolio was the same at the first price low on 9/1/00, at which date the first rebalancing was performed.

2. From the first high on 4/04/01, the balanced portfolio total gained ground vs. the buy and hold portfolio, with the rate of gain increasing at each period.

3. It’s nice to get a greater return, but other benefits are at least as important. In the Buy and Hold Portfolio, note the continuing large increase in the dollar amount and percentage of the short funds vs. the bond funds. They rose from the initial 30% to 57% and  will continue to rise in the future. In contrast, the short funds in the balanced portfolio rose only to 32%, which will be lowered  to 30% at the next price peak.

4. Now let’s look at the large changes in individual funds for the Buy and Hold vs. the Balanced portfolio. On 2/10/03, here are the totals for each of the seven funds:

In looking at the above numbers, remember that the values reflect the market condition slightly above a short fund low and considerably below their last peak.  The striking difference between the two portfolios is that, while the total value of the 5 short funds remained the same, profits of about $9,000 were transferred from the volatile short funds to the stable bond funds. The balanced portfolio experienced a near doubling in growth; while retaining its original asset mix and market risk. That is what "smart" investing is all about!

THE ABC’S OF PORTFOLIO REBALANCING

During this two years-plus-nine months of bear market action, there were 4 lows and 3 peaks in the short fund prices - a total of 7 rebalancing exercises or 2.4 times per year.  This is exactly once every five months. If we had followed the 5-month schedule, the total return and benefits would have been somewhere between those of the Buy and Hold and Balanced portfolios discussed above.  But the longer this 5-month schedule rebalancing continues, the closer the results will approach the theoretical "peak and valley" results. And also, the greater will be the benefits of the 5-month rebalancing schedule over that of the Buy and Hold portfolio.

For most investors, we think that a four or five-month rebalancing would work out best in the long run with a volatile short fund portfolio To time the peaks and valleys would probably require the use of the Elliott Wave thrice weekly reports plus a good source of daily fund charts.

Here are some examples of the rebalancing changes during the early and late market phases for the most volatile short fund and the most stable bond fund:

At the 9/1/2000 low in short funds, the value of the leveraged Nasdaq fund was increased by $244 to $1,160 by buying 11.5 shares. The U.S. Bond fund was decreased by $365 to $6,769 by selling 35 shares. The changes in the other 5 funds were smaller than these, with the market value of the portfolio $660 below the starting $20,000.

At the10/7/2002 peak in short funds, the leveraged Nasdaq fund had its value decreased by $2,830 and shares reduced by 21.6 shares.  The U.S. Bond fund had its value increased by $3,417 and shares increased by 285 shares.

At each market peak in short funds, the short fund gains above the 6% limit were sold at high prices, added together and transferred to the bond funds.  At each market low in short funds, excess money in bond funds was used to buy more short fund shares at low prices to enhance the short funds gain in the subsequent market rise.

There is no fancy math in any of the above transactions, just some very simple record keeping. In our example, the initial small dollar transactions would have to be made by adding new money or postponing the rebalancing until the portfolio size has increased.  But due to the built-in safety features of a rebalanced portfolio, using carefully selected asset classes, there is no reason to place a limit on the portfolio size provided the ratio between short funds and bonds matches the investor’s risk tolerance.

VARIATIONS ON A THEME

Some of the greatest music ever written was created by expanding and varying a musical theme written by an earlier composer. I am sure that any experienced investor, who appreciates the advantages in regular smooth growth, risk control and sounder sleep from portfolio rebalancing, is capable of designing a variety of great bear market portfolios. The number of possible variations is limited only by the knowledge and imagination of the designer. We probably will not write on this subject again due to our increasing time limitations. So we invite our readers to play some soothing music and start developing their own new portfolio ideas.

We have described our suggested asset mix of 30% short funds and 70% bond funds as moderately aggressive, both because of the 30% allocation and our use of 12% of 200% leveraged short funds. We have many readers who can use and profit from this portfolio, but there are others who might be terrified watching a single fund drop to a third of its value in just 7 weeks.

By increasing the bond allocation to 82% and eliminating the 12% of leveraged short funds, we make a "sea change" in the risk level.  This more conservative way to benefit from short funds would offer an approach for either a buy and hold or a rebalanced portfolio. Here is what this fund would do on a buy and hold basis:

Moderate Risk Bear Market Portfolio
1.      6%  reverse Nasdaq fund
2.      6      reverse S&P500 fund
3.      6      fully managed short fund
4.     41     U.S. short/medium bond fund
5.     41     Foreign Govt. short/medium bond fund
      100%  Total

Columns 2 and 3 record the total and annualized gains in each of the five funds; while columns 5 and 6 give the weighted total and annualized gain each fund contributes to the portfolio.

An overall return of 14.5% per year for a moderate risk portfolio over the bear market to date would probably beat every mutual fund except the gold and short funds - not too shabby!

Now let’s consider the possibility of a large bear market rally, perhaps one lasting 6 months. This will call for the 18% of short funds to decline fairly substantially, perhaps by as much as 40 or 50%. Even in a Buy and Hold portfolio, it would be a good idea to make a "once only" rebalancing operation, moving money from the bond funds to the short funds as near their price low point as can be determined.

Another problem that may lie ahead is a bear market in bonds, which means lower prices and higher yields. Due to the moderate average bond maturity, any losses will be easily made up by the gains in short funds. In this possible event, it might be desirable to do another special rebalancing and move money from the short funds to the bond funds. There is never a perfect portfolio for all occasions, but we consider this one to be worth serious consideration.

QUESTIONS TO ASK A FINANCIAL ADVISOR

Since publication of this essay, I have received over 125 reader requests for the addresses of the 3 advisors. Most of the requests were for all 3 and a few asked for the one nearest to their location. I would like to make a few comments that may be helpful to some readers.

I have looked carefully into the background and current views of the principals of all 3 firms. I could not find any significant difference in their written views of this long bear market.  But having said that, their investment approaches are not the same.  For what value it may have to your thinking, I have concluded that, if I were to subcontract the management of my assets, I would probably choose to spread them between 2 or all 3 advisors. After one or two years of experience, meaningful comparisons could be made and any change made then if desired.

In the age of the Internet, I do not believe that proximity to an advisor’s office should be a decisive factor in the selection.  Factors like age, experience and competence of the advisor should be more important to most investors. We will continue to send the addresses as long as we receive requests.

NOTE TO READERS

My daily e-mail from readers has now exceeded the level experienced prior to my December 2002 eviction form the Gold-Eagle web page. I am extremely happy with my new relationships with www.financialsense.com and www.freebuck.com.  Both of them are publishing my new essays and freebuck.com is maintaining a complete archive of all my essays.  I want to express my thanks and appreciation to Jim and Mary Puplava and to George Paulos for their wonderful support through a difficult period.

In the15 months my 57 essays were being published on Gold-Eagle, I received over 1500 e-mails, more than 25% of them from just about every country in the civilized world. I did not retain any address file that allowed me to reach my far-flung reader group. Since December I have heard from just an extremely small number who accidentally discovered my new websites. I miss contact with the German woman who printed and distributed 5 copies of my essays to her friends. I miss the 16 men and women in all continents whose letters I published in my essay "Letters from the Remnant." I miss the reader in Singapore who offered to show me his city on my next visit. My current mail load is just about all I can handle and, whether the letters are long or short, their quality continues at a very high level. So, please keep them coming.

My production of essays will slow considerably in coming weeks as we develop means to cope with my wife’s declining memory problems and physical condition. I brought her a lovely orchid corsage for Valentine’s Day, but she thought it was for her 88th birthday coming next month. I showered her with orchids before our marriage in 1942 and it remains our favorite.

Robert B. Gordon, Sc. D.
Sun City West, Arizona
February 18, 2003
rgordon145@aol.com

-- Posted Thursday, 20 February 2003 | Digg This Article

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