Beating the Market in 2022 - How I Did It and How I'm Thinking About 2023

Originally posted on LinkedIn here.

2022 was a fortunate year in my role as an investor. However, it's important to remember that this was tough year for so many—not just in the market, but the broader economy. With that acknowledgment, please find my reflection on investing this year below.

I began investing in my discretionary account on April 27, 2022 [1]. Over the period starting April 27th and ending December 19th, we observe the following returns:

Looking at returns for one year is a poor way of measuring long-term performance. Because I began investing in this account in April, we have even less data to analyze.

Even so, we see that performance is quite strong over this nearly 8-month-long period.

Here are a few more stats for the nerds among us (myself included), this time comparing my portfolio to a common S&P 500 ETF (SPY):

One may suspect my strategy may simply have been to short the market in what many thought would be a tough year. As you can see in the chart below, my portfolio rises with the market. Importantly, you can see the constant in the fitted line intersects the y-axis above the x-axis, meaning I successfully generated positive "alpha."

Let's dive into my strategy.

Portfolio Strategy

Primary Strategy: Bet Against the Bad

This involves betting against companies and financial products I believe to be completely overvalued or misunderstood.

Misunderstood Products

Most of my strategy this year focused on taking unorthodox positions on ETPs (exchange-traded products, including both ETNs and ETFs). While I am a strong believer in the promise of passive, diversified ETFs for retail investors, there are so many ETFs today that are either poor products or simply misunderstood.

Take, for example, the Amplify Inflation Fighter ETF (IWIN). On its face, this ETF sounds like a great idea: give investors a way to benefit when inflation might hurt some of their other investments. In practice, this has not worked (at least not yet). Here's IWIN's performance since it began trading earlier this year:

If the "inflation fighter" ETF can't beat the market in a year with relatively high inflation, when will it ever beat the market?

(Another fun example: this AI-powered ETF has underperformed the market since its inception)

While I did not take a position against IWIN, it demonstrates an important point: there are many ETFs that fail to achieve their goals or are misunderstood by investors. On occasion, this creates opportunities to profit.

Unfortunately, I am not disclosing my positions that have yielded substantial returns in this area at this time, though I can say that I use a mix of long, short, and options positions based on a quantitative strategy to generate returns using a set of niche ETPs.

Inflated Valuations

The second and smaller part of the primary strategy is betting against companies with valuations that cannot be reasonably defended.

For example, even before the Fed's rapid increase in interest rates, I was bearish on those tech companies that failed to prove they will earn substantial profits in the future. The marketing technology company HubSpot has a strong product offering and is well-respected in its industry. However, it has struggled to show profitability and management has not yet made a convincing case that will change [4].

Highlighted Win: Digital World Acquisition Corp.

Smarter people have written about this, so I'll be brief. A controversial political figure launched a new social network in an already crowded industry. It didn't seem to pick up too much steam. A SPAC, called "Digital World Acquisition Corp.", planned to merge with the company to take it public. It missed key deadlines to do so. The parties involved are butting heads with the SEC, likely driving up costs for the SPAC. And then Musk took over Twitter, which weakened the value proposition of this new social network. After all, Musk said the new network exists because Twitter "censored free speech." But now Musk has made "free speech" (or, at least, his version of it) the center of Twitter.

I decided it was unlikely the merger would not go through and, even if it did, the assets wouldn't be worth much.

Over the summer, I began putting together a short position and grew it over time. I've earned a 22% return to date and expect my return to increase over time.

Secondary Component 1: Forage for Value

Public markets are generally efficient. There are a high number of smart, well-trained, and highly compensated professionals who spend many of their waking hours analyzing public companies. This makes it near-impossible for an individual investor to select a high number of stocks that will outperform the market. Instead, most individuals should be investing through diversified mutual funds or ETFs.

One exception is investing in a very small number of companies where the individual investor has a deep knowledge base. For example, someone who spent several decades working in telecom before retiring may be able to make some smart bets on individual telecom firms.

I consider investments in a very small number of publicly traded companies where my experience or perspective may offer me a slight edge. But I do not consider individual investments in the vast majority of public companies. To do so would produce mediocre returns.

Highlighted Win: Meta

I earned just over 9% on a long position on Meta this year. If you know me, it's surprising I bought Meta stock. I think this company has made plenty of poor decisions over the years. Just this year it made headlines for spending tens of billions on the Metaverse, a service that is not projected to make meaningful contributions to the business in the near future. Even worse, management seems indifferent to the market's reaction to said headlines.

Meta's core business also faces challenges. Efforts by Apple, Google, and others to protect user privacy have reduced the effectiveness of ads on Meta's key properties [5]. As 2022 wore on, it seemed to many that a recession was becoming more likely. Advertisers often pull back on spending during recessions, which puts Meta's revenue at risk, as the vast majority of its revenue is advertising sales.

But Meta still has the best advertising platform in social. Period. TikTok has been unable to create a more compelling advertising offering and is facing scrutiny from U.S. government officials. Twitter is facing its own challenges.

When interest rates continued to rise and there seemed to be only bad news coming from Meta, the market overreacted. For a brief period in early November, Meta was trading at less than 10 times forward earnings [6]. Despite all of Meta's challenges, this seemed to me that the stock had plunged too deeply. I bought the stock near its low hoping for a relatively quick profit, but was prepared to hold it for much longer if the market needed several quarters of financials to be convinced that Meta is worthy of a higher valuation.

Manage Cash

My "bet against the bad" strategy often leaves me with quite a bit of excess cash, as I'm often shorting companies or investment products. Inflation devalues this cash, and higher interest rates make it attractive to invest that cash. Additionally, I am charged (often substantial) interest on many of the shares I borrow when I short businesses or financial products. Therefore, I must prudently manage my cash. So far, this has meant government bonds, government bond ETFs, and public REITs.

I have no significant wins in this area in 2022, and intend to devote more of my time here in the new year.

How I Plan to Improve in 2023

Despite my solid performance in 2022, I also made plenty of mistakes and missed a substantial number of opportunities.

Substantially Reduce Interest on My Highest Profit Strategy

I paid substantial interest on my short positions in 2022. One of my key winners in 2022 was shorting a particular kind of ETP. Lucky for me, there exists a leveraged version of these ETPs with a similar interest rate for short positions. This could allow me to short half as much stock to achieve similar performance, thus cutting my interest payments roughly in half.

While leveraged ETFs have the possibility of doing a poor job of tracking their underlying index over an extended timeframe, I believe I can use careful risk management practices to hedge against potential adverse impacts. Even after accounting for the risk management tactics, I believe this will net out to be a substantially more profitable strategy.

Improve My Cash Management Practices

I made some key errors in managing my cash in 2022. For example, I failed to carefully plan for liquidity needs across my portfolio. Further, since I had invested relatively little funds, purchasing corporate debt outside of an ETF would not be prudent, as I would not be able to diversify sufficiently. I plan to remedy both of these challenges over the coming months by developing a detailed cash management plan and depositing more funds.

Develop Detailed Contingency Plans

2022 was a good year for my portfolio. Luck likely played some role in that. But one cannot plan to be lucky.

With any strategy, there are four possible types of outcomes:

1. The positive outcomes we hope to achieve
2. The negative outcomes we know are possible
3. The positive outcomes we do not expect to achieve
4. The negative outcomes we do not know are possible

As investors, we plan for outcome types 1 and 2. Outcome type 3 is welcome, but it is often based on luck and we do not plan for it (e.g. an unexpected generous acquisition offer for one of our holdings). Outcome 4 has the opportunity to make or break careers and fortunes.

I will spend the early part of 2023 identifying scenarios that are possible but unlikely (e.g. an exchange temporarily halts trading on a security that I have shorted). From there, I will plan the best possible actions I can take to reduce any adverse effects on performance.

Some of the biggest mistakes are made because investors let emotions cloud their judgement. After all, facing the unknown can be scary. Thus, a good way to increase long-term performance is to reduce the number of unknowns.

Thank you for reading and I sincerely look forward to your comments.

-Christian

Notes

[1]: Here, I refer to an account outside of my 401(k) and IRAs I use to save for retirement. The discretionary account differs from my retirement accounts in that I am able to take some positions I am unable to in my retirement accounts (e.g. short positions on public equities).

[2] Source: Interactive Brokers. Risk-free rate for sharpe ratio calculation based on daily treasury bill yields derived from https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_bill_rates&field_tdr_date_value=2022. There's likely a better data source for this and I welcome your suggestions.

[3] Sources: Amplify ETF's website, Microsoft Excel's STOCKHISTORY function

[4] Sadly, I did not open the account on which this post is based until 2022. Kerrisdale Capital (and presumably others) smartly opened a short position on HubSpot in December 2021, and the stock fell substantially, removing much of the opportunity for opening a short position in 2022.

[5] Some may argue Apple and Google were not making these tech changes to improve user privacy. Instead, they were seeking to strengthen their own advertising businesses by reducing the effectiveness of Meta's advertisements. I think there is likely some truth to this argument.

[6] Source: FactSet: price/earnings (forward 1-year) for Meta

Disclosure

This is not investment advice. It should not be used to guide your investments. Speak with a financial advisor (preferably one that is a fiduciary) before making an investment in any financial product. There are risks associated with investing. The author's past performance of his own portfolio does not necessarily predict future results.

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