Given the recent market decline, we thought it would be helpful to review some of our blog posts from the past that may be relevant to the current crisis atmosphere. These posts focus on research that explores investment strategies that are believed to help investors manage risk and diversify their portfolios.
Most regulators around the world reacted to the 2007-09 crisis by imposing bans or constraints on short-selling. These were imposed and lifted at different dates in different countries, often applied to different sets of stocks and featured varying degrees of stringency. We exploit this variation in short-sales regimes to identify their effects on liquidity, price discovery and stock prices. Using panel and matching techniques, we find that bans (i) were detrimental for liquidity, especially for stocks with small capitalization and no listed options; (ii) slowed down price discovery, especially in bear markets, and (iii) failed to support prices, except possibly for U.S. financial stocks [Author comment: Did we really need to support the largest leaches known to mankind?].
Risk-taking is central to human activity. Consequently, it lies at the focal point of behavioral sciences such as neuroscience, economics, and finance. Many influential models from these sciences assume that financial risk preferences form a stable trait. Is this assumption justified and, if not, what causes the appetite for risk to fluctuate? We have previously found that traders experience a sustained increase in the stress hormone cortisol when the amount of uncertainty, in the form of market volatility, increases. Here we ask whether these elevated cortisol levels shift risk preferences. Using a double-blind, placebo-controlled, cross-over protocol we raised cortisol levels in volunteers over 8 d to the same extent previously observed in traders. We then tested for the utility and probability weighting functions underlying their risk-taking and found that participants became more risk-averse. We also observed that the weighting of probabilities became more distorted among men relative to women. These results suggest that risk preferences are highly dynamic. Specifically, the stress response calibrates risk-taking to our circumstances, reducing it in times of prolonged uncertainty, such as a financial crisis. Physiology-induced shifts in risk preferences may thus be an unappreciated cause of market instability.
The holy grail of financial markets is finding strategies that have misaligned risk and reward characteristics. In the traditional view, investors try to do the following:
- Identify strategies that have high returns, then…
- find ways to get the exposure with the lowest risk possible.
However, there is another angle on this concept…
- Identify strategies that have great risk-management benefits, then…
- find ways to get the exposure at the lowest cost possible.
For example, you might buy out of the money puts, which in a crisis will finish in the money and generate insurance-like returns. But puts might be expensive… What if you could identify an asset where the cost of this insurance is de minimus or–better yet–you get paid to own the insurance? That is, if you commit capital, you will, in expectation, generate positive returns over time–and get an insurance benefit. This would be the holy grail! This line of thought is a bit unorthodox but may lead to creative portfolio solutions.
Similarities between the Great Depression and the Great Recession are documented with respect to the behavior of financial markets. A Great Depression regime is identified by using a Markov-switching VAR. The probability of this regime has remained close to zero for many decades but spiked for a short period during the most recent financial crisis, the Great Recession. The Great Depression regime implies a collapse of the stock market, with small-growth stocks outperforming small-value stocks. This helps to explain the cross-section of asset returns when risk is priced according to a version of the “Bad Beta, Good Beta” Intertemporal CAPM that allows for regime changes.
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): US Treasury Bonds, Hedge Fund Factors, 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.
Bonds are often viewed as being great diversifiers due to the perception that they perform well during tough times for stocks. Historically this has been a true statement. But will it continue? Our answer: unclear. Most investors use correlation to measure the diversification benefit an investment might provide an existing portfolio. However, this article uses a slightly different approach to measuring diversification – Crisis Alpha. Crisis Alpha, as defined by Dr. Kathryn Kaminsky in her articles (and fantastic book Managed Futures the Search for Crisis Alpha), is the excess return of an asset (the asset’s return less the return of cash) given that the US stock market is in “crisis,” meaning it has declined by more than 5% in a month.
As part of our research education series on futures, we recently reviewed an engrossing paper, “Time Series Momentum and Volatility Scaling,” by Abby Y. Kim, Yiuman Tse, John K. Wald (KTW), which revisits the findings regarding another futures paper, “Time Series Momentum,” by Tobias J.Moskowitz, Yao Hua Ooi, Lasse Heje Pedersen (MOP). We recap the core findings from KTW and MOP.
Clients who have delegated all of their equity investments to actively managed mutual funds are almost twice as likely to sell all of their equity positions during the 2008 financial crisis than their peers who only hold individual stocks…The fragility of stock market participation by these well-diversified textbook investors is remarkable. We argue that it can be attributed to such investors needing a money doctor to give them the sense their investments are under control. Once the financial crisis exposed this sense of control as an illusion, the investors withdrew.
In the case of the 2008 financial credit crisis, we find many investors, investment professionals, and the general media attributing the market collapse almost entirely to the shenanigans in the financial sector and related consequences in the real economy. And while this is likely part of the explanation, what appears to get lost, is the fact that valuations (outside of the financial sector) were elevated far above fundamentals prior to the crisis. This brief article revisits the credit crisis and subsequent market decline: Was the 50%+ market collapse less about fundamentals and more about the realization that the market was dramatically overvalued? If valuation was the real issue behind the dramatic drop in the stock market, this has direct implications for investors today, as we believe current asset valuations are expensive (Meb Faber has some input here). Indeed, several years of quantitative easing (QE) has elevated prices and valuations in virtually all asset classes. We do not know what the catalyst will be this time around (China, Brexit, US politics, geopolitical issues, etc.) or what will happen over the short term, but we find both stocks and bonds are priced for dismal returns over longer periods.
The authors present more evidence from global markets and look at black swan scenarios. They conclude that in these cases as well, the VRP is positive in low volatility environments, and it is a costly bet to go long volatility even if the world does blow up. They replicate the 1987 crash when markets dropped 20% in a day, and implied volatility spiked to 150%. In the low volatility decile, in order to break even on a protective put strategy with 5% out-of-the-money options, a 1987-type black swan would have to occur every 21 years. Is this reasonable? The crash of 1987 was the worst daily crash for the S&P 500 going back to 1950, and when the 1987 crash occurred, the VIX was in the 7th decile (not in a low, calmer decile). The authors suggest that if people have a strong view on an imminent market correction that they implement that view by reducing equity exposure, or by purchasing insurance assets that pay you to hold them. Accordingly, paying through the nose for an option-based hedging program that loses money for years while waiting for a big payoff that may never materialize is not the way to go.
So you’re a trend-follower. Great. But here is a question: What do you invest in when your rules suggest “risk off?” Many investors suggest low-duration cash or t-bills. Seems reasonable. But is it optimal? Perhaps we should invest in longer duration risk-off assets like 10-yr bonds? We investigate these questions and come to the conclusion that keeping it simple is probably the best solution — dump “risk-off” assets into truly low-risk assets like cash or t-bills.
A risk tolerance assessment can show us when our financial objectives are too conservative or too aggressive. Ignoring risk tolerance can cause us to abandon our financial plans during times of market stress. According to FinMetrica, 60% of the people who take their risk tolerance questionnaire (RTQ) find there is no strategy that will allow them to reach all their investment goals given their risk tolerance. In such cases, investors could use their risk tolerance profiles to revise their financial goals.
Consistent with research on social capital published in other disciplines, this study confirms that company-level social capital is equally important when the trust regarding our financial institutions and markets plunge as they did in 2008-2009. The conclusions presented here argue that the trust level between a company and its investors is as equally important as its trust level with other stakeholders during crisis periods. The insurance umbrella that high CSR ratings provide goes well beyond the simple reduction in sources of “legal” unsystematic risk during normal periods. Finally, and most importantly, this research underscores the need to expand the scope of financial impacts when attempting to understand corporate performance during a crisis of trust.
This study is an important reminder that full-sample correlations are misleading. The authors propose a robust approach to measure left- and right-tail correlations, and document the extent of the failure of diversification on a large dataset of asset classes and risk factors. The good news is that tail risk-aware analytics, as well as hedging and dynamic strategies, are now widely available. To enhance risk management beyond naive diversification, investors should reoptimize portfolios with a focus on downside risk, consider dynamic strategies, and depending on the aversion to losses, evaluate the value of downside protection as an alternative to asset class diversification.
This article proposes tail risk hedging (TRH) as an alternative model for managing risk in investment portfolios. The standard risk management approach involves a significant allocation to high-quality bonds. However, this approach has historically reduced expected returns over the long term (see article here and PDF available here). Accordingly, it could be sensible to pursue an alternative approach by managing equity risk directly, rather than avoiding or reducing it – thereby allowing investors to maintain higher overall equity allocations, which tend to deliver higher expected returns. But how can one manage equity risk directly? Answer: market timing…I know, I know…a bad word in the world of investing but hear me out. Market timing has rightfully been associated with poor investment performance in many situations. In my view, however, much of this underperformance can be attributed to inefficient implementations that involve uncomfortable tracking error (i.e., watch markets continue higher from the sidelines).
We examine hedge fund risk management practices and their association with left-tail risk during the 2008 financial crisis. Consistent with risk management practices reducing left-tail risk, funds in our sample that use formal risk models performed significantly better in the extreme down months of 2008. We find no evidence that having either position limits or a dedicated head of risk management is associated with reduced left-tail risk. Funds employing value at risk models had more accurate expectations of how they would perform in a short-term equity bear market.
The results in this paper challenge the view that put options are the most direct and effective approach to protecting a portfolio against large losses. Differently, buying protection more often than not and on average leads to worse drawdowns than does divesting the equity position to match the average return. This is particularly true when options are priced with a volatility risk premium. In the words of the author:[in this case], ”The outcome is precisely the opposite of what is intended.”
In the late stages of long bull markets, a popular question arises: What steps can an investor take to mitigate the impact of the inevitable large equity correction? Hedging equity portfolios is notoriously difficult and expensive. In this article, the authors analyze the performance of different tools that investors could deploy. For example, continuously holding short-dated S&P 500 put options is the most reliable defensive method but also the most costly strategy. Holding safe-haven US Treasury bonds produces a positive carry but may be an unreliable crisis-hedge strategy because the post-2000 negative bond– equity correlation is a historical rarity. Long gold and long credit protection portfolios sit between puts and bonds in terms of both cost and reliability. Dynamic strategies that performed well during past drawdowns include futures time-series momentum (which benefits from extended equity sell-offs) 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). The authors examine both large equity drawdowns and recessions. They also provide some out-of-sample evidence of the defensive performance of these strategies relative to an earlier, related article.
Simple trend-following strategies have been documented as cost-effective, transparent alternatives to the hedge-fund style managed futures strategies. Although largely capturing the returns of the managed futures industry, those simple strategies may periodically suffer significant losses due to oversimplified trend signals and underdiversified portfolio construction. In this article, the authors show that trend-following strategies with moderate sophistication and better diversification can significantly reduce the downside risk of simple trend-following strategies without sacrificing much upside potential. The authors therefore recommend that investors who seek the benefits of cost-effective trend-following strategies consider adding reasonable complexity to the strategies.
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).