Because equities are much riskier than high-quality bonds, the vast majority of the risk of a conventional 60 percent equity/40 percent bond portfolio is equity risk. Here’s the simple math demonstrating the point.
Well-diversified equity portfolios have volatility of about 20 percent, and high-quality intermediate bond portfolios have volatility of about 5 percent. Thus, in terms of risk points, about 86 percent of the conventional portfolio’s risk is in equities: (60 x 20) + (40 x 5) = 1400 and 1,200/1400 = 86 percent. And equities are subject to the risk of large crashes, such as the ones that occurred from January 1973 through September 1974 when the S&P 500 Index lost 43 percent, from February 2000 through February 2003 when it lost 37 percent, and from November 2007 through February 2009 when it lost 51 percent.
Given the risk of such large crashes, it’s not a surprise that investors are concerned about finding ways to “crisis-proof” their portfolios. The interest in hedging that risk tends to increase as the length of a bull market extends and valuations reach higher than historical averages—the very situation we find ourselves in today, with the bull market now in its 11th year and the Shiller CAPE 10 not far from 30.
Campbell Harvey, Edward Hoyle, Sandy Rattray, Matthew Sargaison, Dan Taylor and Otto Van Hemert, authors of the May 2019 paper “The Best of Strategies for the Worst of Times: Can Portfolios be Crisis Proofed?”, analyzed the performance of a number of defensive strategies, both active and passive, between 1985 and 2018, with a particular emphasis on the eight worst drawdowns (the instances where the S&P 500 Index fell by more than 15 percent) and three U.S. recessions (8 percent of the full period).
Following is a summary of their findings (note that all return figures are gross of expenses):
- The most reliable defensive tool, continuously holding short-dated S&P 500 put options, is also the costliest strategy (-7.4 percent return over all periods). While it performs well during crashes (earning a 42.4 percent return on average), it is very costly during the “normal” times (losing 14.2 percent on average), which constitute 86 percent of the sample, and expansionary (nonrecession) times, which constitute 93 percent of the observations. As such, passive option protection seems too expensive to be a viable crisis hedge. They noted that options are also expensive to trade, and thus returns would have been even worse after implementation costs. See here for a discussion.
- A strategy that is long credit protection (short credit risk) benefits during each of the eight equity drawdown periods, but in a more uneven manner, doing particularly well during the 2007-2009 financial crisis, which was a credit crisis. While the credit-protection strategy is less costly during normal times and nonrecessions than the put-buying strategy, it has negative returns overall (-3.6 percent) because, while it earns 39.6 percent in crisis, it loses 9.8 percent in normal times. They did note that trading costs, using synthetic indexes such as CDX, are very low, only about 0.1 percent per annum.
- Holding “safe-haven” U.S. Treasury bonds produces a positive carry but may be an unreliable crisis-hedge strategy, as the post-2000 negative bond-equity correlation is a historical rarity.(1) They noted: “It is only during the drawdowns after 2000 that bonds performed well. During earlier drawdowns, the performance of bonds was mixed, and over the Black Monday period, the bond return was -8.3%.” They added: “The bond performance is consistently positive during the three recessions.” They also suggested: “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.”
- A long gold strategy generally performs better during crisis periods than at normal times (9.0 percent versus -0.6 percent), consistent with its reputation as a safe-haven security. However, its appeal as a crisis hedge is diminished by the fact that its long-run return, measured over the 1985-2018 period, is close to zero (0.7 percent), and with 2.6 percent inflation, -1.9 percent in real terms. In addition, extended historical evidence presented in Claude Erb and Campbell Harvey’s 2013 study “The Golden Dilemma” suggests that gold is an unreliable equity and business cycle hedge. They noted, “Gold is also subject to significant idiosyncratic risk, for example, miners’ strikes and political instability in mining regions, which may make gold an unreliable hedge in many circumstances.” They also noted that transactions costs are very low at about 0.1 percent per year. The authors concluded: “Gold is an unreliable crisis hedge and an unreliable unexpected inflation hedge. While gold has kept its buying power over millennia (real return is zero), the large amount of idiosyncratic noise means that holding periods need to be measured not in years — but in centuries.”
- Dynamic strategies that performed well during past drawdowns include futures time-series momentum (which benefits from extended equity selloffs) and a quality strategy that takes long/short positions in the highest/lowest quality company stocks (which benefits from a “flight-to-quality” effect during crises). For example, a three-month time-series momentum strategy returned 22.5 percent in crashes, 6.2 percent in normal times, and 8.7 percent overall. Estimated trading costs are about 0.7 percent per year. A one-month momentum strategy would also have performed well. However, a 12-month momentum strategy would not have worked as well in the three most recent drawdowns, though it had higher returns overall. Thus, there is a tradeoff between greater protection and greater long-run returns, with shorter-term momentum strategies offering more downside protection while providing lower longer-term returns.
- A beta neutral long-short quality strategy stands out in terms of performance during crashes, providing a return of 32.1 percent.(2) However, it returns just 1.7 percent in normal times, resulting in a 5.6 percent return overall. The estimated implementation costs for a quality strategy are 1.5 percent per year. In addition, the two strategies of time-series momentum and quality have historically uncorrelated returns, meaning that they can act as complementary crisis-hedge components within a portfolio. They did add that “The value factor has been much less effective as an equity market drawdown hedge than the quality and profitability factors.”
Erb and Harvey also noted:
The annualized S&P 500 return during recessions is -12.1% and during expansions it is 13.2%.
Does this mean that hedging recessions is less important than protecting against drawdowns? Probably not. Both are important. While the drawdowns during recessions are less, recessions are often accompanied by painful negative shocks to investors’ incomes.
When they examined the benefits of adding the two strategies of time-series momentum and quality (in equal amounts), they found that a 50 percent allocation was required to avoid drawdowns, but even a 10 allocation reduced the average drawdown by about 8 percentage points, from 44 percent to 36 percent. A 30 percent allocation would have reduced average drawdowns to 19 percent. Importantly, they found that the allocations to the two “hedging” strategies improved overall returns as well. For example, while a 0 percent allocation provided a return of 10.8 percent, a 10 percent allocation not only reduced tail risk significantly, but it improved returns to 12.2 percent. Increasing the allocations up to 50 percent led to further improvements so that a 50 percent allocation would have returned 17.0 percent. The above figures all include estimated trading costs.
The authors concluded that, while it was possible to hedge crash risk, it was very costly in terms of a loss in total return (which should be expected, as insurance comes at a cost). And holding Treasuries is an unreliable hedge. They added that dynamic, though systematic, strategies have historically provided downside benefits and also improved long-term returns. They ended with this caution: “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 most prudent.”
The takeaway for investors is that the evidence demonstrates that at least, historically, an allocation to time-series momentum and quality (defensive) stocks would not only have improved returns but significantly reduced tail risk, the kind of risk that can lead to the failure of financial plans.
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