Tag Archives: premium-authors

Crisis Alpha: Surprising Ways To Hedge Stock Portfolio Risk

By Wesley R. Gray 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: 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. 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. Bottom line: When the market blows up, flight-to-quality 10-Years have done well. (click to enlarge) 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: S&P 500 = S&P 500 Total Return Index HML = The average of 2 value portfolios (small and large) minus the average return of two growth portfolios (again, small and large) MOM = The average of 2 high return portfolios (small and large) minus the average return of two low return portfolios (small and large) 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. Bottom line: When the market blows up, hedge fund factors have done well. (click to enlarge) 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. Bottom line: When the market blows up, trend-following managed futures have done well. (click to enlarge) 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… Original Post

What Is Portfolio ‘Risk’?

The idea of risk is a rather confusing and nebulous concept in modern finance. The traditional textbook definition of “risk” is standard deviation or volatility. This is convenient for academic purposes because it allows us to quantify risk in a portfolio. But this is a flawed concept for several reasons: Volatility isn’t always a bad thing. In fact, volatility with a positive skew is a good thing. No one complains about a portfolio allocation that rises 20% per year and falls 5% every once in a while, but this is a volatile position relative to many portfolios. Negative skew can be a good thing in a portfolio. For instance, many forms of insurance have a natural negative skew and detract from returns; however, it would be bizarre to argue that this is always a bad idea even if you don’t have to use the insurance. Investors don’t live in a textbook world and don’t necessarily judge their portfolios by the academic concepts that drive the way many portfolio managers assess their portfolio performance. This can create a conflict of interest between the investor’s perception of risk management and the asset manager’s perception of risk management. For most investors the “risk” of owning financial assets is not having enough financial assets when you need them. This arises primarily from two factors: Purchasing power risk. Permanent loss risk. Permanent loss risk occurs when your savings is declining in value and you’re forced to take a loss for some reason (emergency, behavioral, short-termism, etc.). Purchasing power risk is the potential that your savings does not keep pace with the rate of inflation. In order to visualize how one might protect against these risks in a portfolio, it’s helpful to view this concept on a scale showing how our savings can be allocated across different assets: The investor who wanted to be protected against permanent loss risk would be 100% cash; however, they would risk falling behind in purchasing power by the rate of inflation each year. Likewise, the investor who wanted to be protected against purchasing power risk would be 100% stocks. A balanced portfolio will tend to protect against these risks somewhat evenly and in my experience investors tend to be more worried about protecting their savings from permanent loss than Modern Finance often implies. Viewing the world through the lens of this Savings Portfolio Scale will provide investors with a much more realistic and balanced perspective of how market risk applies to their actual savings. Share this article with a colleague

What To Do When Financial News Headlines Jump Out At You

I’ve written about how my aunt calls me when the markets worry her. Needless to say, she’s been calling a lot. Rising interest rates. Sinking oil prices. A strong dollar and weak earnings. Greece, China and Puerto Rico. The news headlines make hay of these swings, and investor emotions can ride along with the dramatic stories. The stock market will spike one day, you feel optimistic and invest, then the market drops back down the next day. Earlier this year, we talked about how the markets would seem more volatile than in recent past. Well, they have delivered on that forecast. After years of relative calmness and steadily rising returns, markets have been jumpier lately. (click to enlarge) Turn your gaze away from the headlines, and instead, take a good look at your investments. It is what you do within your portfolio that matters. Here are four strategies to help your investments navigate the turbulence: Diversify . Market cycles typically move in different patterns. I will save you the academic rationale, but you may want to have some investments zig while others zag. This is the crux of what we call diversification. So the most important way to manage portfolio risk overall is to diversify across stocks, bonds, geographic regions and sectors. Getting this mix right is really important. If you’re new to investing, a low-cost way to achieve a balanced portfolio in one single trade is through a diversified iShares Core Allocation exchange traded fund (ETF). If you already have an established portfolio, review your holdings regularly and talk to your financial planner about diversifying. Go min vol . If you want broad market exposure with potentially less risk, minimum volatility ETFs might be a good fit. These funds seek to track market indexes with a mix of historically less volatile stocks, so you can still invest in global, U.S., developed international and emerging markets with potentially fewer bumps in the road. Bargain shop . Who doesn’t like a good discount? Truth is many U.S. stocks have gotten quite expensive , and it has been harder and harder to find true value. So when the market drops, it can be a great buying opportunity. Talk to your planner about potential deals in the market that can complement your long-term portfolio. Stay put . If your investments are in good shape, make no sudden moves. Over time, markets tend to balance out, and you’re likely to do better staying invested in a diversified portfolio than engaging in frenzied, sometimes expensive, trades. As I do with my aunt, work your way through the four steps above to ensure your investments are sturdy. Successful investors don’t panic over headlines. They stay educated and stay invested. Learn more about what to know and what to do from the mid-year update of The BlackRock List , and get back to enjoying your summer. Original Post Share this article with a colleague