Stop the Dominoes Falling - Portfolio Risk Mitigation
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With the S&P 500 just 15% from its all-time high, and many investors confused by recent market movements, I thought now would be a good time to revisit portfolio construction and more specifically portfolio risk reduction. Although I have covered the topic before, where I covered types of investment risk, this time I will cover strategies in order to mitigate portfolio drawdowns in the face of such risk. This is relevant today regardless of your outlook for markets and the economy. This article is based on the work of Man Group (Strategic Risk Management) and others. For more info follow our Twitter page where I post all research I read!
In this article I will consider:
- Several risk mitigation strategies
- Implementation/feasibility of such strategies
- How this ties back to The Spark’s portfolio
Portfolio Construction 101
The basics of portfolio construction state that investors should diversify. This should be across asset class, geography, size, and factor (where possible). These four types of diversification can be achieved easily by a passive investor through ETFs. When conducting an active approach, and especially if an investor is building systematic (computer-based) strategies, he/she should diversify across timeframes and trading models also.
Alongside diversification, measures of risk such as variance, correlation and tail risks should be measured to ensure portfolios are built with robustness. This involves programming skills which may be beyond the scope of a passive investor but should certainly be incorporated for anyone seeking to outperform markets. Correlation and variance matrices should be viewed over multiple timeframes also as these measures tend to fluctuate over time. The current positive stock-bond correlation is a recent example of this. Only observing correlations over the last 10 years would have left you very exposed to this correlation flip. Also, it is said that when markets fall ‘correlations tend towards 1’ – I.e. everything falls together. This suggests investors should find strategies/products that benefit in market drawdowns, several of which I consider below.
Convexity
More sophisticated strategies for portfolio risk management should involve a convex payoff in market sell-offs. This means the profit from such a strategy should rise as the market falls (see below).
Trend-following tends to perform well in bear markets, Source: Strategic Risk Management
The above image conveys the payoff of a 12-month trend strategy versus the stock-bond performance. This shows that as bonds and stocks sell-off, a trend strategy performance tends to improve. Trend strategies simply buy the stuff that’s rising and short the stuff that’s falling. Over the last year such strategies have been short bonds, generating handsome returns during this bear market.
Although the above image conveys a convex payoff for a 12m strategy, it has been shown that shorter trend strategies (1 or 3 months) have even higher returns in sell-offs with better hit rates. For retail investors, adding an allocation to Commodity Trading Advisors (CTAs) replicates this strategy rather than attempting to implement it yourself, which would require systematic algorithms and has high transaction costs.
Another strategy with a similar pay-off is rolling long put options (definition here). These derivatives give an investor exposure to a convex payoff in market drawdowns in exchange for a small premium. Rather than YOLOing all your capital into zero days to expiry options, like many Reddit retail ‘traders’ did in 2021, these derivatives actually serve a purpose in institutional portfolio construction. Long-dated, far out-of-the-money puts can be rolled using a small amount of capital to protect a portfolio from excessive market drawdowns. Because options make money from direction as well as volatility, the profit from long put options is high as markets fall, as volatility tends to rise. Therefore, only a small allocation is needed.
The key issue with such a strategy is that it exhibits ‘negative carry’. Since markets have long-term positive drift, when the markets rise, an investor employing this risk mitigation strategy will experience many contracts expiring worthless, hurting performance. There is debate and disagreement over the effectiveness of this strategy, but this is a strategy that can be employed by retail investors with active approaches. I have recently added a long-put position to The Spark’s portfolio as volatility is currently cheap and I view the market’s recent rise as unjust following the recent Fed meeting. I believe this is the most effective way to mitigate risk for The Spark’s portfolio at present since many CTAs and hedge funds trade at significant premiums to NAV.
Traditional Strategies
A more simple proxy for a long-put option would be to allocate a portion of capital to short positions in the market. This adds negative beta to an investor’s portfolio, which can protect from market drawdowns. This can be done strategically (long-term allocation) or tactically (short-term allocation), but tactically adding short positions in the market (e.g. S&P 500) is better for the reason outlined below. Of course, there is an exception to be made if you are running a long-short portfolio, but this isn’t for the inexperienced!
The issue with this position over long puts is that rather than giving up a small amount of premium if the market rises, an investor will experience cumulative losses, which can damage performance excessively. This strategy should only be employed tactically rather than strategically, so is probably only applicable to experienced investors.
Buying stocks based on profitability characteristics also exhibits a relatively convex payoff in market drawdowns. This involves going long quality stocks, as during market drawdowns and recessions a ‘flight to quality’ ensues, where investors rush to the safest assets. This could be incorporated in an active way through increasing and decreasing allocations to such assets based on an investor’s short/medium-term economic outlook or strategically through an allocation to quality investments. However, the latter strategy runs the risk of underperformance when the market is rising.
Quality minus Junk (more below) has a convex payoff, Source: Quality Minus Junk (Asness)
Three other strategies that are beyond the scope of this article but definitely warrant further research for those of you interested in institutional asset allocation are:
The holy grail of risk mitigation is a strategy that exhibits downside diversification and upside unification. Let me know if you find it.
I have intentionally kept this article brief as I understand many of these strategies are beyond the scope of a retail investor and many of The Spark’s readers. However, I hope you can use this article as a reference point for further research yourself!
“A trader must have no memory and forget nothing”
Portfolio Return Year-to-date: 3.7% vs S&P500: 6.7%
Total Return since inception (20/09/2021): 6.7% vs S&P500: -6.3%
Let me know your thoughts by emailing me at thesparknewsletter@gmail.com
See you next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.