Backtesting Universa strategy
Portfolio returns are non-ergodic translated into plain English this means that the majority of investors will never get the often promised 10 percent annual returns on their investment and the reason for this is what Spitsnagel calls the volatility tax the higher the volatility the lower the returns and losses are absolutely destructive hence why Warren Buffett's cardinal rule is never lose money this is because of path dependency and due to the fact it takes a 100 percent gain to recover from a 50 loss.
Diversify into bonds and try and improve our compound annual growth rate CAGR for short compared to an all-equity benchmark like the S&P 500 this unfortunately is not the case because a diversified portfolio consisting of 75 SPX and 25 bonds only added 0.1 percent to CAGR 0.1 percent is better than nothing but it still isn't enough to solve our problems.
Jesse Felder in an article published in august 2016 in which he explores Spitznagel's option-based portfolio hedging strategy. Spitznagel's back-testing example calls for the purchase of two-month 0.5 delta puts approximately 30 percent out of the money.
Use is in a long equity portfolio which Felder sets at 100 000 in this hypothetical example as such we'll be buying 0.5 percent or 500 in options every month and selling at the end of the month. For this back testing exercise Felder uses the SPY which was trading at 219 dollars and 40 cents at the time.
We're interested in puts with a strike price 30 to below that so we'd look to purchase the October 21st 2016 puts with an exercise price of 155. At nine dollars per contract we would be able to buy 55 of the October 155 put options for 495 dollars.
Felder then simulates the effects of a 20% decline in the price and a volatility spike to levels consistent with previous crashes, like in October 2002. The VIX which is often used as a proxy for market volatility peaked at around 45 in the lows after the 2002 crash at 48 during the market turbulence after the US lost its AAA rating in august of 2011 and at just over 53 during the 2015 crash. So as you can see this level what practitioners like Spitsnagel referred to as the implied volatility surface has remained fairly constant in quote-unquote vanilla crash situations. In years like 2008 and 2020 we can expect readings in the mid to high 80s. Assuming a 20 decline and an implied volatility of 55 that is 45 plus 10 points for 10 out of the money put each of Felder's contracts. In this hypothetical simulation would now be worth 328.10 apiece 55 times 328.10 comes to just over 18000 in total allowing us to virtually negate a 20000 loss in our equity portfolio for next to no cost.
This strategy not only ensures against losses but it actually maximizes CAGR over time here's why regular investors in pension funds are counting on 9 to 10 average annual returns. The so-called ensemble average but the existence of extreme up and down swings in the market means this elusive benchmark remains forever out of reach here's an example provided by Mark Spitznagel himself.
10-year average total returns for the S&P 500 through to the end of 2017 totaled approximately 10.4 percent annually so naturally one would expect a thousand dollars invested in 2008 to have turned to approximately 2690 dollars by december 31st 2017.
A thousand dollars times 1.104 is 1104. 1104 dollars times 1.104 is 1219, 1219 times 1.104 is 1346 dollars and so on so forth the problem is that a 37% drop in 2008 and a lackluster performance in 2011 and 2015 greatly reduced realized investor returns rather than finishing 2008 with 1104 investors actually welcomed 2009 with a measly 630 in their brokerage accounts only breaking even almost a full four years later in 2012.
The stock market roared higher thereafter albeit with some turbulence in 2015 and 2016 but the initial losses had a devastating effect on the annual compounding rate which turned out to be a staggering 16% lower than the expected rate of return this is true even if we only take the five-year period between January 1st 2016 and december 31st 2020.
Even amidst an unprecedented recovery propped up by government stimulus and the federal reserve investors still fell almost three percent short of the idealized returns of the S&P 500 also while retail investors watched in horror as us capital markets opened at limit down day after day after day and gravity worked its magic on their portfolios.
Mark Spitznagel's fund having returned thirty six hundred percent in March twenty twenty whether markets rebounded or continued trading at significantly depressed levels for an indefinite period of time was of little consequence to the hedge fund
Unfortunately the strategy I outline earlier has its weaknesses after surging to 85 in march of 2020 the VIX continued trading at elevated levels throughout the year and into 2021 to such an extent that Felder's back test would no longer work in the current environment. I ran the experiment with March 19 2021 out of the money puts on the SPY which traded at 375.70 at this time we would therefore be purchasing put options with a strike price of 263 which now traded at the staggering price of 75 dollars per contract. This exorbitant price tag allows us to purchase only seven contracts, as opposed to 55 back in 2016. Assuming a 20 price decline and the same volatility level of 55 now yields us and 88 488.88 per contract for a total portfolio loss mitigation of just hundred thirty five hundred dollars.
