Retail investors and wealthy investors putting their money into an ETF or mutual fund believe that passive buy-and-hold investing is the way to go, thinking a more different approach will kill their returns. However, we believe that passive investors overlook three important factors: the impact of drawdowns on their 'beloved' compound model, win rate and outlier risk, and volatility in their annual P&L.

There's one thing that our wealth management clients will inevitably start panicking about: a lack of consistency in our returns. Yet, most investors just buy a stock or ETF, don't look back and get whipsawed in times of a correction. Apart from applying fundamental metrics and technical analysis, that approach is far from strategic or mechanical. Let's dig deeper into the subject called passive investing and why it doesn't lead to the risk-adjusted returns you're looking for.

Impact of Drawdowns

As Lance Roberts laid out perfectly in one of his articles back in November of 2019, buy-and-hold investing doesn't fully take into account the cost of living, social security et cetera. But the most important element that should stand out to you is the myth of perfect compounding.

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(Source: Seeking Alpha)

Sure, for dividend growth investors the annual or quarterly checks flowing into your account will grow exponentially over time if no dividend cut occurs. By picking reliable dividend growth stocks, your future returns will increasingly exceed the importance of capital gains as dividend payments are based on fundamentals not on Mr. Market's behavior (except for the starting yield).

The real question we should ask ourselves is: to what extent will a serious drawdown crush our returns? The graph below tells the whole story: banking on too optimistic expected returns while relying on the hypothesis of seeing no significant drawdowns can cut your realized profits in half.

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(Source: Seeking Alpha)

Win Rate, Outlier Risk and Consistency in Returns

Backtesting Study (forward 1-year returns from June 2010 - June 2019)

Let's examine the forward 1-year returns for 108 different trades entered at the beginning of the month. We have already dedicated several articles to in-the-money covered call backtesting, but let's compare that to the EUSA ETF, i.e., the MSCI US equal-weighted excluding dividends.

For example: we buy EUSA on June 1, 2010, and take a look at the return on June 1, 2011. Next, we enter the second trade on July 1, 2010, and look at our forward 1-year return on July 1, 2011 et cetera. We finally execute our last monthly trade on June 1, 2019, and take a look at our June 1, 2020, return. We don't factor in dividends.

Choosing ICE and CRM as individual stocks, we do the exact same thing but also backtest a 5% in-the-money covered call with a 1-year expiration period. Both strategies are not managed and don't factor in the dividend distributions. The in-the-money covered call is thus held until expiration, as the backtesting results should paint a fair picture.

Given the solid performance of the stock market over the past decade, a passive buy-and-hold approach is supposed to have generated juicy returns but that doesn't tell where your real risk lies...

EUSA: Buy-And-Hold Performance

Let's start with the win rate: 82% of all trades saw positive forward 1-year returns, which is quite disappointing given the magnitude of the latest bull market. Moreover, its 10% average annual return was associated with a 9.9% standard deviation in those observations. Based on this metric alone, one would expect the 68% of the data to fall within 0% and 20%. The median return stands at 11.4%.

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(Source: Option Generator Research)

In reality, outlier moves tend to be underestimated, while the odds of landing exactly on the average return were overestimated. Stated differently, we see above- and below-average returns.

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(Source: Option Generator Research)

Based on the box plots, the 25th percentile average annual return settles at 4.3%, while the top 75% would have made 17.5% or more. So despite the massive bull market over the past ten years, a quarter of your forward 1-year trades ended up resulting in a return that's below +4.3%... It's this type of inconsistency that leads to a compound model being perceived as too rosy as steep corrections make the average return a bad metric to rely upon.

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(Source: Option Generator Research)

ICE: Buy-And-Hold Performance and 5% ITM Covered Call Returns

ICE: Buy-And-Hold Performance and 5% ITM Covered Call: Backtesting Results

Let's now take a look at ICE, a stock that has had annualized standard deviation equal to that of EUSA. Over the past decade, the average return for a 5% in-the-money covered call would have been 6.5% with 1.6% standard deviation in all observations. All trades would have been profitable on a forward 1-year basis.

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(Source: Option Generator Research)

The average buy-and-hold return would have been 17.4% with 7% standard deviation. 96.3% of the observations yielded a positive P&L.

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(Source: Option Generator Research)

Looking at the box plot for in-the-money covered calls, we'll notice that the 0th-25th percentile returns are between 4% and 5.6%. This implies that if your buy-and-hold timing was poor, a simple in-the-money covered call write without setting initial option credit boundaries (for example: a 7% potential return based on the option premium) would have handsomely outperformed the passive investing strategy on a forward 1-year basis.

(Click on image to enlarge)

(Source: Option Generator Research)

(Source: Option Generator Research)

 

ICE: Buy-And-Hold Performance and 5% ITM Covered Call: Return Distribution

Comparing the normal distribution to the actual data shows that we see more occurrences at the average return and more positive outliers, whereas smaller returns actually occurred less than anticipated. This positive skew can be explained through the concept of volatility overstatement.

(Click on image to enlarge)

(Source: Option Generator Research)

As for the buy-and-hold performance, the average return is centered at 17.4%, but that in reality most of the data are wrapped around 7.50%-10% (11.3% of all occurrences). Positive skew, i.e., outsized returns of 25+% lifts the average return to much higher levels. Again, bad timing can lead to missing out on these profits. In-the-money covered call writing has led to more consistency, making it easier to continuously execute the strategy.

(Click on image to enlarge)

(Source: Option Generator Research)

CRM: Buy-And-Hold Performance and 5% ITM Covered Call Returns

CRM: Buy-And-Hold Performance and 5% ITM Covered Call: Backtesting Results

For Salesforce, the average buy-and-hold return would have been 20.3% with 20.6% standard deviation. 86% of all observations yielded a positive forward 1-year P&L.

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(Source: Option Generator Research)

For in-the-money covered call writing, the average return equals to 11% with 3.9% variation in all observations. 96% of all occurrences were profitable 1-year trades.

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(Source: Option Generator Research)

Aside from the three outlier moves, the same pattern like that of ICE shows up: a narrow distribution range and a high win rate.

(Click on image to enlarge)

(Source: Option Generator Research)

The more standard deviation in the returns, the worse the impact of poor market timing. Assuming you'd miss out on a few of the best forward 1-year returns, your average return could easily depreciate to +10% while facing the same volatility (and thus RISK).

(Click on image to enlarge)

(Source: Option Generator Research)

CRM: Buy-And-Hold Performance and 5% ITM Covered Call: Return Distribution

Predicting future results or saying that your returns are consistent is inappropriate when looking at the following return distribution. Even during a great bull market, significant losses occur and will take your annualized return down if market timing comes into play.

(Click on image to enlarge)

(Source: Option Generator Research)

In-the-money covered call writing without timing the market or paying attention to the VIX (and thus negative outlier risk) has produced far more consistent returns with more observations situated at the average.

(Click on image to enlarge)

(Source: Option Generator Research)

Conclusion

Drawdowns cannot be ruled out by investing in a broad ETF, but it's a factor that passive investors tend to neglect. In the current market environment with heightened levels of volatility, most of them will end up earning a mediocre return even if they add more capital to their portfolio on a regular basis. Fooled by rosy expectations, ignorance of tail risk and the risk of poor market timing passive investing doesn't provide the risk-adjusted returns that you're looking for.

We prefer strategies that lead to a long-term edge by combining non-correlated assets and tactics. If you want to mimic a buy-and-hold approach but at the same time face a less directional exposure and improve your probability of profit, in-the-money covered call writing on a 1-year basis remains an attractive strategy. Right now, it's the cornerstone of our wealth management portfolios.