Today’s post is about crisis-proofing your portfolio.
- It was drafted back in February before the coronavirus hit Europe.
So you will obviously have to wait for the next crisis in order to take advantage of any lessons it contains.
As I have mentioned before, one of the best investing groups that I attend is the London Quant Group or LQG.
- They hold around eight evening seminars throughout the year, plus an all-day seminar in the spring and a long weekend away in Cambridge (which is not free) in the autumn.
Many of the meetings are held under Chatham House rules – usually because the papers being presented have not yet been published.
- Which means in turn that I can’t write about them.
But sometimes we look at a paper that’s already been published.
The February 2020 meeting was a talk from Otto van Hemert, one of the authors of a paper from Man AHL that was published last year.
- The relevant page on the Man website is called Can a Portfolio be Crisis-proofed, but I prefer the longer title of the paper itself: The Best of Strategies for the Worst of Times.
As we are now at the end of an eleven-year bull market, I only wish the paper had been presented a few months earlier.
- But there is never a bad time to investigate a topic like this.
The paper looks at six defensive strategies from 1985 to 2018, a period which includes eight drawdowns in the S&P 500 of more than 15%, and three US recessions:
- Buying put options on the S&P 500
- Being long credit protection (or short credit risk)
- Bonds (US Treasuries)
- Trend-following (
The chart above shows excess returns (over cash) from the passive strategies over the period.
- The grey areas are drawdowns of more than 15%, and recessions are marked in red at the top and bottom of the chart.
It should be noted that not all of the passive strategies have positive return expectations over time.
- Bonds are positive, and so is gold (though it spends a lot of time underwater).
Both underperform stocks, however.
Puts and short credit risk will both lose you money over time.
- So some element of market timing would be needed to make use of these.
Puts offer good protection in all the drawdowns but are expensive.
- They have a return drag of 8% pa.
This is consistent with our previous findings that buying options has a negative return expectation, but selling (writing) them has a positive return expectation.
- People are happy to over-pay for insurance.
Short credit risk
Being long credit protection also works during all the drawdowns, but particularly in the 2008 crisis, which was a credit crisis.
- Short credit risk is cheaper than puts but still loses money.
Bonds have worked well since 2000, but not before that.
- This is because equity/bond correlations used to be mostly positive, but have been negative for the last 20 years.
As Man put it:
As we move beyond the extreme monetary easing that has characterized the post-Financial Crisis period, it is possible that the bond-equity correlation may revert to the previous norm, rendering a long bond strategy a potentially unreliable crisis hedge.
So if you feel that there’s any prospect of that happening, you might want not to rely on bonds fo protection.
In fact, bond returns are negative in quintile one (the worst periods for equities) for both the 1960–1979 and 1980–1999 periods.
Gold does not provide a dividend, but, as a real asset, it can help offer protection against certain sources of long-term inflation.
Gold is typically priced in US dollars and so its price is partly driven by fluctuations in foreign exchange rates. This then links gold to US monetary policy.
Gold works in a crisis, but it’s long-run returns are so close to zero – and so unpredictable over the short-term – that it doesn’t make sense to hold it as a large proportion of your portfolio.
Man used multi-asset futures to implement trend-following.
We target an annualized volatility of 10% and allocate risk to six groups as follows: 25% currencies, 25% equity indexes, 25% fixed income, and 8.3% to each of agricultural products, energies, and metals. Within each group, markets are allocated equal risk.
Trend (ride winners and cut losers) worked well in recessions and drawdowns.
- Removing long equity positions improved protection during downturns, but lowered returns overall.
Three-month Stock factors
Long/short stocks using various quality metrics also worked well and was not closely correlated to trend.
Man stressed the importance of beta-neutral portfolio construction, rather than more normal dollar neutral.
- This is because dollar-neutral portfolios can have low beta – they protect in drawdowns by having low equity exposure.
The problem with this is that they would then underperform in bull markets.
The next table shows the correlations between strategies.
Man’s conclusion is that crisis hedging is possible:
Although a 50% allocation to the hedge strategy is required to achieve a positive return over the equity market drawdown periods in our simulations, a 10% allocation improves the return in each of the eight historical equity market drawdown periods, resulting in more than a seven percentage point improvement in the annualized drawdown-period return (from -44.3% to -36.8%).
But they also note:
Every crisis is different. For each crisis, some defensive strategies will turn out to be more helpful than others. Therefore diversification across a number of promising defensive
strategies may be the most prudent strategy of all.
It looks like we have four plausible approaches, some of which are easier than others for private investors to implement.
- Most people will have some bonds (or bond-like substitutes) and a bit of gold.
Trend and long/short quality are less straightforward.
- I already have some trend-following portfolios in stocks, but I should look at adding other assets.
Article credit to: https://the7circles.uk/crisis-proofing-your-portfolio/