When I See A Bubble, I Rush in to Buy It

August 14, 2020

Dominick Paoloni, CIMA®
CIO & Founder
Portfolio Manager, IPSAX
Adjunct Professor, University of Denver
& University of Colorado

“When I see a bubble, I rush in to buy it,” says George Soros, the Portfolio Manager of the infamous Quantum Hedge Fund.  Soros is legendary for his stellar returns achieved by investing in bubbles and getting out before they burst.  Soros uses what he calls reflexivity theory, which states that investors do not base their decisions on reality, but rather on their perceptions of reality.  As a professor at the University of Denver and the University of Colorado, I teach behavioral finance, which is the study of the influence of psychology on the behavior of investors.  In behavioral finance, the concept of the reflexivity theory is referred to as “herd mentality.”

The secret to Soros’s success is not necessarily recognizing a bubble and investing in it.  His secret is in getting out before the bubble bursts.  Many pundits have argued that the market today is in bubble territory, and this uncertainty has led advisors and investors to move trillions of dollars into cash.  Bloomberg has pointed out there is over $3.3 trillion being held in money markets, the highest total since the credit crisis of 2008*.  The extraordinary bounce off the March bottom has left many advisors and investors who moved into cash or debt in a quagmire.  As the market rallies, should cash holdings be moved back into equities, or is it more prudent to wait until the bubble bursts?

The problem with waiting for a bubble to burst is you could be waiting a long time.  I am reminded of the real estate bubble, which was sounding alarm bells as early as 2005 only to burst 3 years later.  Where does this leave the average pension, endowment, advisor, or investor if you don’t have the skill of George Soros?

John Rekenthaler of Morningstar believes that attempting to hedge with bonds is a “fool’s game” * when interest rates are at zero.  He points out that although debt has historically been a fantastic portfolio diversifier when yields were dropping and bonds were rallying, expecting bonds to rally when markets are crashing in a negative yield environment will guarantee losses unless great fools buy them.  This is not an investment strategy, but a recipe for disaster.

Hedging with defined Risk tools is the solution

If the money manager could protect a portfolio using defined risk tools with an acceptable cost to carry, this would solve the advisor’s greatest dilemma:  when should you be aggressive, and when should you be conservative?  What if you could be agnostic to economic, geopolitical, technical, or fundamental changes in the markets?  You could then invest in bubbles without fear of missing the inflection point, which Soros identifies as his exit point.

IPS Strategic Capital Hedging Solutions

Options enable us to invest agnostically, however, using exchange-traded options to define and hedge risk is a difficult proposition.  It is easy for an advisor to buy a protective put and understand that if the market goes down, the protective put will make money.  What makes using long optionality to hedge and manage risk difficult is determining when, where, and how to position the options in a cost-effective way to maximize upside participation while still providing significant protection against the left tail when the market turns.   At IPS Strategic Capital, we believe our hedging solutions have solved this dilemma.

Options used correctly deliver strong asymmetry

The IPS Bear Strategy has proven to be a great overlay SMA within a portfolio framework.  Through the COVID drawdown, a small allocation to the IPS Bear Strategy (see chart) would have reduced the market drawdown (S&P 500) from 33.9% to 11.9% (IPS Bear Strategy), which represents a 35.1% downside capture (11.9/33.9).

While reducing drawdown with optionality (protective puts) in down markets is to be expected, the real edge in the IPS Bear Strategy is the small upside drag the strategy delivers.  Since the inception of the strategy, the S&P 500 annualized at 11.52% while the IPS Bear Strategy returned 9.39%, which represents an 81.5% upside capture ratio (9.39/11.52).

This asymmetrical risk/reward inherently provided when using options correctly is not possible with any other investment vehicle.  Diversification has proven to reduce the upside more than it protects on the downside.  For example, the 60% S&P 500 and 40% Barclay Agg saw a 17.6% drawdown through the March drawdown.

So, how can you prudently invest in a market bubble going forward?   You can have the talent of a George Soros, or you can add a rules-based option strategy like the IPS Bear Strategy.  Regardless, if you see a bubble, rush in and buy it only if you are properly hedged.

Dominick Paoloni, CIMA is a member of the OIC Advisory Council and the TD Ameritrade Trading Panel. Mr.Paoloni guides future professionals as an Adjunct Professor at the University of Denver and the University of Colorado. He is a published author and is frequently quoted in financial journals and can be reached at dominick@investps.com

Disclaimer

Please note that the information contained in this piece is intended for investment professionals. This information should not be misconstrued as an offer to buy or sell, or a solicitation to buy or sell securities. Any performance contained in this article is strictly informational and is not necessarily indicative of the future performance of investments. Past performance is not indicative of future investment performance and investors should always consult a financial professional prior to making any investment decisions.
The performance of the IPS Bear Strategy is representative of the performance of the IPS Bear Strategy composite. This composite is managed via separately managed accounts. The performance data is shown net of fees. The performance of the accounts comprising the IPS Bear Strategy was scaled to a 20% exposure to represent a hypothetical portfolio that was invested 80% to the S&P 500 and 20% to the IPS Bear Strategy. This is purely a hypothetical portfolio that is intended to illustrate how the IPS Bear Strategy can be combined with equity exposure to provide reduced drawdown and volatility. Any performance relating to the S&P 500 is representative of the price returns of the index. Please note that the S&P 500 is an index and therefore not a directly investable asset.
The IPS Bear Strategy trades options contracts on the S&P 500 index. Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options. Put options give the purchaser the right, not the obligation, to sell a specified number of shares of the underlying security at a specified date in the future. The seller of a put option has the obligation, not the right, to have a number of shares delivered to them at a specified price at a specified date in the future in exchange for receiving a premium upfront for the risk.
The results shown here are strictly for informational and educational purposes. All investments have the potential for profit and the potential risk of loss. Changes in investment strategies, contributions or withdrawals may cause the performance results of one’s portfolio to differ materially from the reported composite performance. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s portfolio. One should always consult an investment advisor before making any investment decisions.

DISCLAIMER: The information on this website should not be misconstrued as an offer to buy or sell, or a solicitation to buy or sell securities. The performance data represents past performance data. With any investment, past performance is not necessarily indicative of future performance. The Absolute Return Strategy performance is representative of a size-weighted composite of the accounts managed by the firm classified as the Absolute Return Strategy-Moderate composite. The returns represent net returns of clients invested into the strategy, accounting for the 1% annual management fee. Please note that all performance in 2011 represents one non-fee paying account comprised of the firm’s capital. Due to the nature of composite performance, it cannot be guaranteed that an investor in a specific composite will receive the same gains as the size-weighted average of the composite. As of April of 2016, the separately managed accounts in the ARS–Moderate composite gain their exposure to the ARS through a 40 Act fund that utilizes the Absolute Return Strategy. The performance of the ARS shown on this sheet still represents the size-weighted average of the SMA’s that are part of the ARS-Moderate.

The Absolute Return Strategy invests in derivatives securities. Specifically, the fund sells and buys put and call options and sometimes utilizes leverage; these factors can cause portfolios invested in the strategy to show greater fluctuations than investments in the underlying assets. Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options. Put options give the purchaser the right, not the obligation, to sell a specified number of shares of the underlying security at a specific date in the future. The seller of a put option has the obligation, not the right, to have a number of shares delivered to them at a specified price at a specified date in the future in exchange for receiving a premium upfront for this risk. The seller of a call option has the obligation, not the right, to deliver a specified number of shares to the buyer at a specified price at a specified date in the future in exchange for receiving a premium upfront for this risk. The risk of buying either a put or call option is limited to the premium paid for said option.

The performance of the S&P 500 Index is representative of price returns not including dividends over the specified time period.
The performance of the AGG Index (Bloomberg Barclays US Aggregate Bond Index) is representative of the total return including reinvestment of dividends. These indexes are unmanaged and thus it is impossible to invest directly into these indexes.

One should always consult an investment advisor before making any investment decisions as well as consider the investment’s objectives, risks, charges and expenses carefully before investing or sending money. This and other important information about the Strategy is available upon request.

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