By Julian Koski, CIO at New Age Alpha

Imagine you’re sitting, minding your own business, and your buddy, Louie, shoulders up to you and begins his sentence saying, “What are the odds…?” With such an introduction, his next words will almost certainly detail a plan with little chance of success. Whether it involves a sketchy business venture or his shot at a career in the big leagues, the implication is that the possibilities are not in his favor. Why is that? Why, when people speak about odds, does it always seem to carry a negative connotation? Perhaps it’s because we’ve been trained that way—by casinos, by bookies, by even life itself? When it comes to odds, humans seem to naturally assume the worst and conclude there’s nothing they can do about it. Because the truth is, there’s a better way.

“I will lay odds that, ere this year expire, we bear our civil swords and native fire.”

The use of the term, “odds,” dates back to the 1500s with one of its first, and most famous, usages occurring in Shakespeare’s Henry IV, Part 2: Act 5. Generally regarded at the time as an expression signifying, “unequal things, matters, or conditions,” many believe it evolved from the more numerically focused concept for, “things that don’t come out even.” While the connotation of the word is different now, it’s important to remember this etymology. Because, when investing or gambling, the odds will never be equal. So, it’s up to you to shift them in your favor.

How can one do this?  Approach the endeavor differently. When gambling, for example, the outcome is often a bifurcated event—either the ball lands on black or red, and you either win or lose. Investing is a different beast, however. Here, there are chances to impact the odds. For example, diversification forms a key part of risk management for many investors. They believe that spreading one’s investments across similar stocks or industries can avoid a disastrous, unexpected event in any single company. It is important, no doubt. But true risk management doesn’t end there since this approach does nothing to mitigate the risk of human behavior bias. We believe this is where investors have a unique opportunity to alter the odds.

Think of it like the classic European roulette wheel. If a person believes that the ball will land on black—a faulty assumption, for many reasons, as discussed further here—that person can spread their chips across all the 18 black outcomes. They think this crude diversification will help since, in the abstract, it would make their odds 50-50 versus the red slots. However, while the wheel is composed of an equal number of these black and red slots, it also has one outlier in the green slot bearing a zero (“0”). It doesn’t seem like much, but that single slot means the long-term distinction between winning and losing. It’s an edge to ‘The House’ of a mere 2.7%. Only 270 basis points, in financial-speak. Yet that’s enough over the long haul to ensure casinos can continue to light the lights, comp the free drinks and employ hundreds of thousands. Think about that. That crucial 270 bp detail is the foundation of the notion, “’The House always wins.”

But what if we told you there was a way to metaphorically carve out your own 38th slot on the wheel?

“If One is to Engage in Gambling, then One Should BE the Casino.”

Most gamblers and investors would likely kill for the ability to alter the odds in such a way. It would offer the chance to mitigate risk without impacting potential upside—in essence, an utterly new type of diversification. How can investors apply this approach to their portfolio? We believe the best way to mitigate the risk of human behavior is to avoid the losers. In our opinion, most investors think in terms of picking winners—but this means investors are forced to predict the future that, by definition, is unknowable. This is akin to guessing and it plays directly into the hands of oddsmakers such as sports bookies or casinos. They’ve already mastered the art of odds-making; they simply sit back and allow others to take on that risk. By, instead, avoiding the losers, you’re playing the role of the casino or bookie.

Below, we present the Up and Down Capture Rates as of May 31, 2021 of the U.S. Large-Cap Leading 50 Index and the U.S. Small-Cap Leading 50 Index that are benchmarked against the S&P 500 and the S&P SmallCap 600 Index, respectively, which are generally recognized as primary representatives of the U.S. equities markets. A high Up Capture indicates that the Index beat the benchmark during periods when the market, overall, was notching higher. Conversely, when the market went down, a low Down Capture indicates that the Index avoided many of those companies in the benchmark that went down.

While we believe the Up Capture across each Index and time period is noteworthy, in our opinion, the Down Capture truly stands out. Over the last year buffeted by uniquely unusual events such as the pandemic, market stimulus and the rise of the retail traders, our Indexes weathered the down moments with Down Captures entire quartiles lower than the respective Indices’ value of 100.  Unto itself, we believe that’s an impressive accomplishment for our methodologies. But this belies the most important aspect of the offerings: this performance was achieved with very little overlap in the largest names of the respective benchmark. By using our actuarial-based approach to focus solely on known information, our Indexes avoided those stocks most impacted by human behavior bias and utilized the same universe to provide different exposures. In the process, we created a differentiated source of return that can be used to complement any of the major benchmarks.

Since Inception

(1/1/02 – 5/31/21)

1 Year

(6/1/20 – 5/31/21)

Up CaptureDown CaptureUp CaptureDown Capture
U.S. Large-Cap Leading 50 Index

(Benchmark: S&P 500 Index)

111.0684.0096.6470.44
U.S. Small-Cap Leading 50 Index

(Benchmark: S&P SmallCap 600 Index)

104.6892.2181.2749.37

Source: New Age Alpha, Morningstar Direct.

Gambling and investing are entirely different activities. Any proper investor knows that. But one thing both activities share is their reliance on odds. Seemingly, people refer to ‘odds’ when they’re stacked against them—as in the case of casinos or sports bookies—but they don’t use the term as much in relation to their investment portfolios. Perhaps they should. If all it takes is a new investment option such as these, why wouldn’t they want less correlation with the overall market while potentially producing the same or better performance?

Originally published by New Age Alpha