Crisis Alpha: Surprising Ways to Hedge Stock Portfolio Risk

Crisis Alpha: Surprising Ways to Hedge Stock Portfolio Risk

August 19, 2015 Tactical Asset Allocation Research
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Investing in the current environment is difficult. Most, if not all, asset classes have high nominal prices, suggesting low nominal expected returns. Not exactly exciting. And for many investors who are retired and/or have near-term liquidity needs, investing in equity exposures–while necessary to generate higher expected returns–also prevents many investors from sleeping at night!

One solution to curb the risk of a massive market meltdown is to buy portfolio insurance. However, in a rational world, insurance contracts are expensive because they protect us when we need protection the most. Insurance has this pesky problem of charging a large premium for downside protection. For example, consider put options on the S&P 500 market index. If an investor wants to hedge against a 10% drawdown for a year, the cost (as of August 13, 2015) would be approximately 4% of the notional value to be hedged. So if you had a $1,000,000 stock portfolio and wanted to ensure the most you could lose was $100,000, the cost of that insurance for one year would be around $40,000.

Clearly, buying portfolio insurance can be expensive.

But what if we could identify unique assets where the cost of insurance was much lower?

We’ve identified 3 candidates that may fit this profile (in no particular order):

  1. US Treasury Bonds
  2. Hedge Fund Factors
  3. Managed Futures

We highlight some of the historical evidence of the abilities of these assets to provide portfolio insurance (they go way up, when stock markets go way down).

Of course, past performance is no guarantee of future performance, and nobody can know what will happen in the future, but the results inspired us to dig a little deeper and think harder about our own portfolio construction efforts.

1. US Treasury Bonds

The results below highlight the top 30 drawdowns in the S&P 500 Total Return Index from 1927 to 2013. Results are gross of management fees and transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends).

Next to the S&P 500 return is the corresponding total return on the 10-Year (LTR) over the same drawdown period.

Bottomline: When the market blows up, flight-to-quality 10-Years have done well.

Caveat(s): A low yield environment may limit the upside potential of the insurance benefit; flight-to-quality status required.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

2. Hedge Fund Factors

We examine 3 common hedge fund “factor” portfolios alongside the S&P 500 Index:

  1. SP 500 = SP 500 Total Return Index
  2. HML  = The average of 2 value portfolios (small and large) minus the average return of two growth portfolios (again, small and large)
  3. MOM  = The average of 2 high return portfolios (small and large) minus the average return of two low return portfolios (small and large)
  4. QMJ = The average of 2 high-quality portfolios (small and large) minus the average return of two low-quality portfolios (small and large)

Results are gross of management fees and transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends).

Data are from AQR and Ken French.

Next to the S&P 500 return is the corresponding total return on hedge fund factors over the same drawdown period.

Bottomline: When the market blows up, hedge fund factors have done well.

Caveat(s): Transaction costs on the short-book can be extraordinary; carry costs during raging markets can be unbearable.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

3. Managed Futures

Here we examine a chart from a white paper by the folks at AQR. The paper is called, “A Century of Evidence on Trend-Following Investing.” The trend-following concept analyzed can be considered a generic managed futures strategy.

Bottomline: When the market blows up, trend-following managed futures have done well.

Caveat(s): Won’t protect an investor in a “flash crash” event; need historical correlations during bad markets to continue.

crisis alpha managed futures
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Conclusion

Historically, Treasury Bonds, Hedge Fund Factors, and Managed Futures have all managed to act like portfolio insurance, even though they aren’t traditionally considered insurance assets. Will this pattern continue in the future? Who knows…and of course, that is the million dollar question…

Let us know if you’ve seen other hidden portfolio insurance options out there. Please share ideas…

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Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.

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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • Mark

    As a Canadian Investor, I know that buying USD is also a good hedge and buying LT US Govt Debt is even better. As you said, who knows if those assets will continue to outperform…maybe AA can do some work on this:)

  • Mark

    By the way, for QMJ, the majority of returns are from short side, right ?

  • Really wish we could predict future performance with a high degree of accuracy…sadly, haven’t found that model yet!
    Will let you know if we do!

  • Yep, and obviously one would have to consider the cost of carry on a L/S book before determining if the insurance was actually “cheap.” The devil is in the details, but the high level concept is that how one assesses market neutral L/S strats–when viewed from the insurance aspect, as opposed to the asset class aspect–can lead one to different conclusions. Maybe a stupid idea, but thought-provoking for me at least.

  • robbo
  • Tilman

    Managed futures provide a good equity hedge because during times of stress trend following models are long the entire spectrum of bonds, i.e. long short dated and long dated bonds. Additionally, most models will profit from some exposure in short commodities and to a larger degree from long or short positions fx trends (mostly long USD against short EM crosses), which become stronger during flight to quality. One might think of managed futures as being long treasuries plus short fx and commodities. Interestingly, most managed futures models won’t provide the hedge through a short equity positions as most models are slow to switch positions. I think this element is important in order to pick the right hedge position. In fact, an outright position in long treasury bonds probably has a clearer hedging fit to a long S&P position from a correlation perspective.

  • Martin_Schwoerer

    So, in the past 90 years, there was only one instance (11/1968-6/1970) where applying an Antonacci-style momentum filter using bonds didn’t prevent actual damage to your portfolio. Works for me!
    (At least, if it continues to work in the future, as it has in the past…)