From its inception, AllQuant has maintained an unwavering focus on risk management which remains at the heart of its principles to this day. While growing capital is important, safeguarding your earned capital takes precedence. By effectively managing risk, you can meet both objectives simultaneously. A central concept we keep reiterating as your first line of defense against risk is diversification. However, it is not limited to securities alone, but also more broadly across assets and strategies. Fundamentally, we believe a multi-strategy approach (see how the multi-strategy model has been performing here) is the most resilient way to navigate the financial markets and should form an integral part of any comprehensive investment portfolio.
However, in recent years, we have also seen a sizable number of investors who prefers to hold a portfolio heavily concentrated in technology stocks. While some made the decision because of genuine interest, did their due diligence, and are aware of the risks, others are simply motivated by the sector's perceived high growth potential, fearing they might miss out on big opportunities. Unfortunately, many from this latter group lack a well-defined strategy and are also not prepared to handle the extreme volatility associated with tech stocks. In the technology sector, it is not uncommon to find names that move up and down more than 10% or even 20% in a single day.
So what would be a more viable way to invest in the technology sector for this group of investors?
Invest in a Liquid, Low-Cost Technology-Heavy ETF
For investors who are drawn to the potential of the technology sector, but want a more prudent approach than investing in individual stock names, one option is to consider buying into a liquid, low-cost ETF with a strong skew towards technology companies. One such ETF that fits the bill is Invesco QQQ Trust (Ticker: QQQ).
QQQ tracks the Nasdaq-100 which is a tech-heavy index that carries favorite names such as Apple, Nvidia, and Microsoft. Prior to its rebalancing on 24 July 2023, tech companies comprises almost 60% of this index. With almost USD 209 billion worth of assets under management and an average daily volume of USD 18.6 billion, this is a highly liquid ETF. In terms of expenses, its expense ratio hovers around 0.2%. While that doesn’t rank it among the lowest within the ETF space, it is still much lower than what actively managed mutual funds typically charge.
But Even A Diversified Basket of Technology Stocks Holds Significant Risks
However, even with an ETF diversified across a hundred names, QQQ is also not for the faint-hearted. While the tech sector fared relatively better than other sectors since 2003, it went through a devastating crash before this when the dot com bubble burst in 2000. During that episode, we witnessed QQQ losing a jaw-dropping 83% of its value and the demise of many listed internet companies that enjoyed astronomical rises in their prices before the catastrophe hits. This resulted in substantial losses for investors. Between late 2000 to 2003, QQQ grew at a disastrous compound rate of -17.7% per year.
However, in the years that followed, the technology sector experienced remarkable growth and recovery. While there are also other notable crises along the way, none came close to the Dot Com. From the bottom of the dot com crash in 2002 till now, QQQ delivered an impressive CAGR of 15.1%. In comparison, other major US index ETFs such as SPY (tracking the S&P 500) and DIA (tracking the Dow Jones 30) achieved only around 10% CAGR over the same period.
The post-Dot Com performance, as well as captivating narratives surrounding technology innovations, coupled with all the constant media drumming are what attracted many into the space. Yes, there is potential. But can you handle the risk that comes with it? If another crisis of Dot Com’s magnitude hits again, do you have a strategy to mitigate the damage and tide it through? You will need more than just being mentally prepared. Because if it really happens and you sit facing the real situation without a concrete plan, it will be a different ballgame altogether.
So how can we approach this in a prudent way?
Building A Defensive QQQ Strategy
There are ways to invest defensively and extract more out of every ounce of risk even with concentrated positions. Without delving into the specifics, you will need rules that tell you when to ride the market and when to stay out. You won’t catch the exact turning points. Crystal balls don't exist. But as long as you are able to ride the bulk of the uptrend, and avoid most of the downtrend, then you will come out much better in the long run.
During periods when you stay out of the market, your positions do not need to sit in cash. You can park them into a basket of safe haven assets that comprise short to medium-term Treasuries and Gold. There are actively traded ETFs you can use for this – BIL (short-term Treasuries), IEF (medium-term Treasuries), and GLD (Gold). These assets tend to perform well during times of stress. But there are exceptions, like the challenges faced in 2022, where the twin pressure of rising inflation and interest rates hammers almost everything. But having said that, these safe haven assets still outperformed the stock market that year.
With the rules set in place, we created a model and did a backtest. We pitted the Defensive QQQ (let's just call it such for simplicity) against a simple buy-and-hold on QQQ from September 2000 to July 2023.
Note: All the data are computed using monthly returns. Safe haven's monthly returns before the year 2004 are approximated by taking using a monthly average calculated from their respective yearly returns.
Here is a short summary of the results:
✅Defensive QQQ delivered more than twice the return of a buy and hold on QQQ in terms of CAGR (12.5% vs 6.6%).
✅Defensive QQQ achieved its higher return with lower risk when we look at the Volatility (15.2% vs 22.9%).
✅Defensive QQQ's Maximum Loss is less than half what you would experience if you held QQQ through the dot com bubble (-37.1% vs -79.6%).
✅Defensive QQQ's gives a higher return per unit of risk or Sharpe (0.83 vs 0.29).
This brings us to the next question.
Can We Achieve An Even Higher Return?
This is a common question. Investors who are looking at the tech sector tend to have higher return expectations. And the answer is yes. Because the reduced risk carried by Defensive QQQ gives it more capacity to take on higher risk through leverage. This is something we taught in our classes. As a general rule of thumb, to use leverage without getting yourself burnt in the process, the risk of the base strategy should be low to start with. This is very important because we are not doing short-term day trading here where we close out our positions at the end of every day. We are in for the long haul.
There are different ways you can access leverage. One approach is to use a margin account. But that will require you to monitor things like financing rates and margin levels. A more straightforward option for most people will be to use a leveraged ETF such as ProShares UltraPro QQQ (Ticker: TQQQ) which is a 3x leveraged version of QQQ. But please be mindful that such instruments are not suitable for buy and hold. They do exceptionally well when the market rides in your favor, but they also lose value rapidly when the market turns the other way. So, we should only use such instruments in conjunction with strategies that can help you stay out of the market when things are unfavorable. While leveraged ETFs are not exactly cost-effective or the best method to implement leverage, it is the simplest and it does not require a margin account.
Let’s call this the Defensive TQQQ strategy, and we will use the same rules as we did earlier and compare it against a buy-and-hold on TQQQ. Leveraged ETFs came about much later than their unleveraged counterparts. TQQQ is only incepted in 2010. Hence, we are only able to compare the period between 2010 – 2023. But even then, the results are telling.
In line with the earlier results for the unleveraged version, defensive TQQQ also delivered superior performance over a buy-and-hold on TQQQ from 2010 to 2023 across all metrics – higher CAGR, lower risk, lower maximum loss, and a higher Sharpe ratio. Notably, if you bought and hold TQQQ, you are now not even halfway through a recovery from the high made in 2021. In contrast, Defensive TQQQ has already recovered and went on to make new highs.
However, these data did not extend back to the dot com era which is far more severe for technology stocks. If TQQQ existed then, it would have been almost decimated. And even though defensive TQQQ stands a better chance to survive, the losses may run high as well. While it will recover eventually given time, it is a situation I would rather avoid since it is exponentially harder to climb out of a drawdown each time it gets deeper. It is just simple math. You would need to make 150% to climb out of a 60% drawdown, 230% for a 70% drawdown, 400% for an 80% drawdown, and 900% for a 90% drawdown (see the chart below). And apart from the numbers, there is a psychological aspect to consider as well. Enduring such significant drawdowns can be emotionally stressful and unhealthy.
Let's create a Defensive TQQQ Plus strategy
We can reduce the risk of the Defensive TQQQ strategy with a few adjustments:
➡️ Allocate 60% to TQQQ and 40% to a safe haven basket when you enter “good” times.
➡️ Exit TQQQ and put the money into the safe haven basket when you enter “bad” times.
➡️ Rebalance when the allocations deviate too much.
With these modifications, your risk is now moderated by not taking the full exposure you could have with TQQQ. And the safe haven basket can help to further reduce the risk and buffer (but not always for e.g. in 2022) against drawdowns during crisis episodes before the rules to exit TQQQ kicks in. The rebalancing mechanism also acts as a profit-taking and topping-up mechanism to keep your allocation in TQQQ within an acceptable range of your target. Without rebalancing, your TQQQ may grow to a much larger pie of your portfolio resulting in a much higher risk in your portfolio than targeted.
The returns delivered in this case will definitely drop but so will the risk and this will also dramatically reduce the probability of experiencing extreme drawdowns. But even with a lowered return, it will still be considerably higher than investing in an unleveraged QQQ (see the comparison in the chart below). For lack of a better term, let’s just call this the Defensive TQQQ Plus Strategy.
The Defensive TQQQ Plus strategy outdoes a buy-and-hold on QQQ across most aspects – higher CAGR, lower loss, and a higher Sharpe. And if you observed, even QQQ, which is unleveraged, has yet to recover back to its high in 2021. The Defensive TQQQ Plus strategy, on the other hand, has gone way past its prior high.
Final Note & Let's Talk Over Cofee If You Want To Find Out More
With leverage, it is not difficult to get a higher return. The day-to-day movements and risk is expected to rise as well. But the value of a defensive strategy comes in terms of lower losses than what would otherwise have been incurred, and a greater ability to squeeze out returns for every unit of risk taken as indicated by the higher Sharpe. This is what enables you to take on leverage in a safer manner.
Most people will want high returns. But then again, always bear in mind the risk behind it. What if an equivalent of the dot-com era returns? You can still run into a sizable loss in our case. This is precisely why our fundamental approach emphasizes diversification across various assets and strategies to construct a stable and resilient portfolio. Some may deem us too conservative and think it is unnecessary given how bullish everything has been. But good risk management takes into account what can happen before it happens. Yes, there will be a tradeoff, but it is a well-calculated one that grants you invaluable peace of mind and fosters a more sustainable growth trajectory.
If you are interested in knowing more about our models and how you can implement them in your own managed account with an advisor from iFAST Global Markets:
1️⃣ Multi-Strategy
2️⃣ Defensive QQQ / TQQQ Plus
Do reach out to us for a casual chat over coffee.
Note: All performances shown here are model performances and not live performances.
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