In our last article, we looked at some of the best performing portfolios on the WhoTrades Marketplace. This time, we are looking at portfolios that were flat to down this past year and making an assessment of their future prospects going into 2018. Winning in the markets is difficult to do and just about everyone is going to lose money at some point. Even though US equities are up approximately 20% in 2017, those who have had more exposure in unpopular sectors (e.g., telecom, energy, retail), over-concentrated in certain securities, or followed a “value” strategy more broadly likely haven’t done as well. But there are still things that can be learned from portfolios that have underperformed, just as those that have performed better than or in line with the market. So let’s go through a few: Strategy #1 This trader uses a concentrated investing approach, with only five stocks in the portfolio. The largest holding (Magellan Midstream Partners (MMP), a natural resources master limited partnership) takes up 47% of the portfolio. The second-largest, restaurant chain Chipotle (CMG), takes up 28%. Pharmaceutical maker Gilead (GILD) and cybersecurity firm FireEye (FEYE) round out the portfolio at 18% and 7% allocations, respectively. (Source: Strategy #1) Of these four, MMP has been slightly down even when taking into account the dividend; CMG is down 20%, GILD has been precisely flat, and FEYE has made slight gains. When considering trades closed during the year, the portfolio took heavy losses on Nike (NKE) and Rocket Fuel (FUEL), both of which were initially placed in 2015. Positions in Expedia (EXPE) and Costco (COST) both made gains. What’s to be made of this? The prominent theme is that concentrated investing produces lumpy returns. Such an approach can and will severely deviate from the performance of the broader market at times. The positive of this portfolio is that this trader largely invests in quality names. MMP is an appropriately leveraged MLP with a sustainable distributable cash flow. Gilead has been hit due to run-off in its core franchises, but is making some headway with acquisitions to replenish and diversify its pipeline. Chipotle has been under fire for more than two years due to food safety concerns and lack of competitive insularity in a saturated industry. FireEye is unprofitable but in a quickly growing niche of the tech industry. Some additional level of diversification would benefit the portfolio to help better smooth out returns. Even if one wants to stick with stocks, investing into around 25 stocks equally can provide about 90% of the diversification benefits of the S&P 500. Strategy #2 Here we have a portfolio that is only somewhat concentrated at the top, with PotashCorp (POT) at 17% of the holdings and Annaly Capital Management (NLY) at 13%. (Source: Strategy #2) This trader also takes some bets in other asset classes in ETF form. For example, he has a position in EUO (short euro ETF at a 9.5% allocation), USO (long WTI crude oil at an 8.1% allocation), JO (coffee), and UNG (US natural gas). The portfolio also has exposure to high-yield credit (HYG and DSU), which is beneficial for diversification purposes to mitigate volatility in returns. Unless one has a specific competitive advantage in a certain niche of the financial markets, I generally think it’s prudent for most investors to have some part of your funds put into bonds/fixed income and a little bit of gold as this particular portfolio does. Going back 50 years, if one diversified from 100% stocks to 50% stocks, 20% high-yield bonds, 20% long-term corporate bonds, 5% intermediate Treasuries, and 5% gold, the maximum drawdown of the portfolio would have been reduced from 51% to just 31%. This would have come at the cost of sacrificing a very reasonable 1.4% in annualized returns. This portfolio is more suitable to trading rather than long-term investing. Bets on commodities and currencies (with the possible exceptions of carry trades in the case of the latter) are generally done with the intention of generating alpha. Long equities investment, on the other hand, is a long-term winnable strategy from the vantage point that there’s an alpha and a beta component. So long as the US economy and global economy continue to grow, US stocks will see appreciation over the long-run as well. Given currencies and commodities are non-cash-producing assets (unless one considers any interest earned on carry FX trades) trading these markets is more or less a zero-sum game. Strategy #3 Overexposure to non-diversification risk is one of the primary causes of underperformance and this particular portfolio is no different. It’s concentrated heavily in one name – Applied Optoelectronics (AAOI), which from January to August had quadrupled in price, before losing over half its value. Nonetheless, it is still up 72% over the past year. It represents 62.5% of the allocation: (Source: Strategy #3) The portfolio consists of just two other stocks – Medtronic (MDT) (up 13.2% over the past year) in a 24.4% allocation and Tesla (TSLA) (up 58%) making up 9.8%. This trader puts 3.3% of the funds in short-term VIX futures (VXX), though due to the rolling nature of these contracts (the vast majority of which expire worthless) and exposure to contango, VXX has lost over 70% in the past year. Having some small amount allocated to the VIX is perfectly rational to help protect against a downturn in risk assets; however, the expense of the options – then passed off to the ETF in the form of a lower price – can be a drag on the portfolio’s returns. Moreover, AAOI and TSLA are both more speculative bets. Since its IPO, AAOI has been nearly 9x more volatile than the S&P 500 on an annualized basis. TSLA, since its 2010 IPO, has been 5x more volatile. MDT, as a mature, profitable company with a $100+ billion market cap is less volatile at just 1.6x the broader market. This trader also displays an active interest in trading the oil markets through the UCO and SCO ETFs. Oil trading is a pure alpha strategy given its lack of a beta component. Conclusion All three of these portfolios have underperformed the market over the shorter time horizons they’ve been established. But this doesn’t mean that portfolios that have underperformed in the short-term aren’t viable in the long-run or that there is nothing to learn from them. However, the main culprit of said underperformance is due to a lack of diversification in each case. Accordingly, there is a certain level of diversification that can be beneficial to investors, and particularly those who may lack prime information with respect to whatever market or security they happen to be investing in. Taking advantage of beta can be a perfectly workable strategy and can be blended together within the context of an alpha-generating strategy. For example, instead of indexing into the S&P 500, picking 25 solid securities (both stocks and bonds) and adding in a small bit of gold for the sake of diversification to protect against rare supply-side shocks to an economy (e.g., cutoff in an oil supply channel) can provide the benefit of both beta and alpha without excessive reliance on either. There’s a certain level of beta that is beneficial to capture in a portfolio by taking advantage of the idea that cash-producing assets will appreciate over time and provide a return in excess of cash. At least this generally holds true in developed markets, which have the benefits of robust institutions, rule of law, private property rights, developed debt and capital markets, low levels of corruption, and relatively steady productivity growth. The exception to this rule is during financial depressions; only then will cash outperform practically all financial assets. But due to central banks and the tools they have available in their arsenal – e.g., interest rate manipulation, fiat monetary systems to purchase financial assets directly – financial depressions won’t last for elongated durations. If financial assets don’t outperform cash, then our entire economic system would cease to function. When you invest, you’re fundamentally chasing a spread, also typically referred to as carry. How you chase this carry in one or more forms constitutes your strategy and can entail investment(s) into equity, credit, volatility, duration, rate differentials, and/or currencies in some form. Given the numerous available channels to capture this carry, the higher the level of concentration a portfolio has, the greater the risk that a single security can adversely impact the market value of a portfolio relative to if it were invested in a larger number of securities. The bottom line is, unless you really know what you’re doing, it’s generally in one’s best interests not to become too concentrated in a smaller set of securities.