Crisis Alpha: Surprising Ways to Hedge Stock Portfolio Risk

////Crisis Alpha: Surprising Ways to Hedge Stock Portfolio Risk

Crisis Alpha: Surprising Ways to Hedge Stock Portfolio Risk

By |2017-08-18T17:07:48+00:00August 19th, 2015|Tactical Asset Allocation Research|

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…


  • 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. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
  • Join thousands of other readers and subscribe to our blog.
  • This site provides NO information on our value ETFs or our momentum ETFs. Please refer to this site.

About the Author:

Wesley Gray, PhD
Wes Gray has published multiple academic papers and four books, including Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016).After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm that delivers affordable active exposures for tax-sensitive investors. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes currently resides in the suburbs of Philadelphia with his wife and three children.
Yes No
This website uses cookies and third party services. Settings Ok

Cookies

We use “cookies” on this site. A cookie is a piece of data stored on a site visitor’s hard drive to help us improve your access to our site and identify repeat visitors to our site. For instance, when we use a cookie to identify you, you would not have to log in a password more than once, thereby saving time while on our site. Cookies can also enable us to track and target the interests of our users to enhance the experience on our site. Usage of a cookie is in no way linked to any personally identifiable information on our site. Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies.

Embedded Content

Articles on this Site may include embedded content (e.g. videos, images, articles, etc.). Embedded content from other websites behaves in the exact same way as if the visitor has visited the other website.These websites may collect data about you, use cookies, embed additional third-party tracking, and monitor your interaction with that embedded content, including tracking your interaction with the embedded content if you have an account and are logged in to that website.