It sure feels good when the value of your portfolio is rising on an almost daily basis.
But, when virtually all assets are going up, that achievement isn´t exactly magic. A rising tide lifts all boats, as the saying goes and it will pay off in the long run to keep in mind how we will look when the tide goes out again.
It´s a good time to have a thorough thought about the possibilities we have to deal with an eventual bear market. Not because I think the start of one is imminent – the current bull market could end tomorrow or it could go on for months or even years. No one knows and I certainly don´t want to predict anything.
Rather the extreme calmness of the moment is so exceedingly boring, that it is easy to think without being distracted by what is currently going on in the market.
Bear markets pose an especially big problem for investors who, like retirees for example, withdraw an income from their investments. For investors whose savings rate contributes a considerable proportion to their capital, bear market prices present a buying opportunity more then they are something to worry about.
But, if you take money out of your account while you suffer from a prolonged drawdown, your capital faces a double whammy that is hard to stand financially and psychologically. It would be much better to keep the drawdown of our main assets as low as possible and to have a handful of strategies and assets that provide an ongoing income stream or uncorrelated profits in an equity bear market. How is it possible to achieve that in practice and could we implement some strategies at specific times to protect our portfolio?
Let´s first take a step back and consider the possibilities that we are facing.
Currently everything looks just great – a daily deluge of positive new all-time records like consecutive new equity highs on a daily, weekly, monthly and soon yearly basis combined with record low volatility is elevating fundamental valuations and turning investor sentiment from skeptical to highly optimistic. This in itself carries the seed for an eventual serious decline – of course nobody knows when that will materialize (I, for one, am certainly hopeful that the bull market has plenty of life in it yet), but it is also far from certain that the next decline is going to be as bad or worse than the last crash in 2008 as virtually all bear market pundits seem to prophesy.
Apart from a crash of 40% or more, we could experience a regular „soft” bear market between -20% and -40% or a prolonged sideways movement that doesn’t even officially qualify as a bear market (remember 2015/16), but resets fundamentals, volatility and sentiment nonetheless.
A combination of the above could look similar to the 1970s and take much longer to play out. With rising interest rates inflation could also start to play a stronger role again and the 30-year treasury bond bull market may reverse.
In the light of these possibilities only considering (and preparing for) a fast equity-led crash and relying on diversifying assets that have worked well in recent decades (namely treasury bonds) seems a bit near-sighted at the very least. Especially considering that a fast, deep drawdown is exactly what happened the last two times.
Looking at history draws a different picture:
After the catastrophic drawdowns in the 1930s it took until the 70s for the next 40%+ drawdown (characterized more by a prolonged inflationary bear market than a severe crash) and then again until the 2000s, when two such drawdowns happened in fairly rapid succession.
Investors take time to recover from these blows and to regain confidence. Only now are we seeing real positive sentiment for the first time after 2009 – implying that a lot of investors have been sitting on the sidelines ever since.
After the double blow of 2000-03 and 2007-09 it may well take 20 to 30 years once again for the next extreme -40%+ bear market to materialize.
On the other hand declines of 20% or more happened on average once every 3.5 years since 1926, so we are long overdue for at least a mild bear market even if these don´t come along like clockwork.
The most useful conclusion to me is, that we should focus on thriving in the current environment as long as it lasts, while being prepared to do well in a mild bear market as well as in a severe crash.
Bear market strategies
The basic issue is that, by definition, our portfolio assets show a historically positive risk premium – meaning they go up over time. This implies that the basic probabilities work against bear market strategies in any asset class. Which is why it is so hard to find such strategies with long-term positive expectations – most lose more money in bull markets than they make in declines.
Predicting the coming bear market correctly and betting on falling asset prices at the right time (and of course doing the same thing again at the end of the bear market) is extremely unlikely to work. We need to be more realistic.
I will rely on the basic investment philosophy I described in previous posts:
“Market regimes have the tendency to stick around long enough to make it worthwhile adapting your portfolio to them – even if you can´t forecast changes accurately. I use a framework of different measures and concepts for market regimes to dynamically allocate to different assets, factors and systematic approaches in such a way that my portfolio produces superior returns and has tolerable volatility and drawdowns in all market environments.”
Let´s keep the possibilities of an adaptive portfolio allocation at the forefront of our mind when thinking about bear market strategies.
In general these are the basic possibilities that we have at our disposal:
- Adaptive allocation
Diversification is the fundamental tool to deal with our problem. But we need to analyze it thoroughly and step outside the box of classic portfolio construction to make it work really effectively.
The basic premise for building a diversified portfolio is that uncorrelated or – better yet – negatively correlated assets and strategies will add up to produce higher risk-adjusted returns and lower drawdowns in bear markets.
The simplest model of diversification, the classic 60/40 (equity/treasury bonds) portfolio is quite vulnerable and does not solve our problems, because it relies largely on the protective qualities of bonds and most of its risk is concentrated in the more volatile equities. While that diversification has worked quite well historically whenever equities led the bear market, the opposite is not true. Equities were not usually good hedges for bond “tail events”.
The secular decline in interest rates for the last 35 years is a key reason why a traditional 60/40 stocks and bonds portfolio has historically worked well for investors. As interest rates have hit a natural bottom around 0%, that premise may not hold in the future and the next decline might be bond led – resulting in a badly diversified classic portfolio.
When we add real assets, that protect against inflation, to the mix we get a conventional benchmark portfolio – the global asset allocation portfolio – that is better suited to thrive in different market environments. While each portfolio (stocks only – 60/40 stocks and bonds – 40/40/20 stocks, bonds, real assets) has historically returned 9% – 10% per year, each step of diversification has reduced volatility from 18% to 11% to 8%, greatly increasing risk-adjusted returns.
We now want to improve on that conventionally diversified portfolio, because classic diversification between different asset classes has limited use as correlations tend to go up during a bear market and many assets go down together.
What we are looking for are a group of assets and strategies that act as true diversifiers, meaning that they historically deliver low correlations in declining markets and long term positive returns. These assets will play a special role in our portfolio, specifically when our market regime analysis signals us that we are in a bear market.
True diversification assets
- U.S. Treasuries (medium-to-long term duration) – Outperforms during periods of falling interest rates.
- TIPS (Treasury Inflation Protected Securities) – TIPS will outperform Treasuries when inflation is positive, and underperform Treasuries when inflation is negative
- Gold – Outperforms during inflationary periods. Other commodities show mixed long-term results, but many look promising in inflationary environments – especially timber has posted high returns paired with low correlations even in 2008-09.
- Rental Real Estate – a recent paper shows actual ownership of real estate including rent to have returns on par with equities. These returns are uncorrelated, whereas REITs show a much higher correlation to equities in bear markets – their liquidity and low cost still makes them a central element of any global asset portfolio.
True diversification strategies
- Trend-following Managed Futures – are a notable exception, because they have a negative correlation to equities, specifically outperforming in severe market declines, while their positive long term return expectations are higher than equities on a risk-adjusted basis. Managed Futures have historically performed best in the worst equity as well as the worst bond and real asset market environments, providing significant crisis alpha.
- Market neutral Factor Strategies (leveraged long/short) – These strategies have been a staple of very successful hedge funds like AQR for decades, producing uncorrelated returns on market-neutral portfolios of pure style premia (value, momentum, carry, low volatility and others) across asset classes.
An interesting article by ReSolve Asset Management highlights the value of such strategies in combination with a global asset allocation portfolio to boost risk-adjusted portfolio returns over long term market cycles.
Chart by ReSolve: excess annualized historical returns to long-short factor portfolios formed from individual securities (Equities) and asset classes (Multi-Asset) scaled to 10% ex post volatility.
True diversification strategies are extremely valuable diversifiers that will transform our portfolio into a far superior vehicle.
But they come with a drawback: they are very hard to implement directly for an individual investor and, when accessed through funds, usually command very high fees. I´ll try to highlight ways to access these strategies in the conclusion to this post.
A large part of their value stems from the fact that they are market direction agnostic and/or incorporate dynamic allocations according to market regimes as part of the strategy. By adaptively allocating to different parts of our portfolio in line with the current market regime, we will try to improve on this inherent feature starting in part 3.
What differentiates hedging from the forms of diversification we have discussed until now is that it costs money, much like paying for insurance – we usually cannot expect a positive return over the long term from a hedging strategy. As compensation for a negative expected return we gain a more or less certain negative correlation to certain assets in our portfolio. Hedges can be structured to provide guaranteed protection, a correlation of -1 (they will completely compensate all movements of a portfolio´s asset) at predefined levels of decline – for a price. Several papers have analyzed different possibilities for tail-risk protection and the associated costs.
In general, I´m skeptical of the value-add hedges can give when implemented all the time. It is often simpler and more effective to reduce exposure to risky assets or to only allocate to hedges at specific times.
In “Still Not Cheap: Portfolio Protection in Calm Markets“ AQR highlights the prohibitive cost of using index put options for portfolio protection (the most straight-forward way to insure your portfolio) – even when volatility is low and put options are cheap. In fact, the costs are so high, that the opposite strategy – shorting volatility – has been shown to be very profitable over the long term and is a cornerstone of my portfolio – albeit closely correlated to equities and prone to severe drawdowns in bear markets.
To achieve a cost neutral tail-risk allocation to put options, Meb Faber paired treasury bonds (90%) with OTM S&P puts (10%) in this paper and an ETF (TAIL). While being highly profitable in bear markets, in combination with equities a tail-risk allocation historically improved risk-adjusted returns by a negligible amount over the long run – even the classic 60/40 portfolio did a better job.
CAIA (Chartered Alternative Investment Analyst Association) compared different methods for controlling tail risk. Most strategies turn out to have a prohibitively high drag on returns, especially long volatility strategies (buying put options falls into that camp as well as VIX futures and VIX future ETP).
Low volatility equity strategies (long low volatility and short high volatility equities) were shown to be negatively correlated to equities and almost cost neutral. As they are part of the factor strategy portfolio discussed above, they deserve a special position in that category.
Where tail-risk protection really shines is in strategies that incorporate a dynamic allocation according to market direction, namely trend-following managed futures (as discussed above) and tactical equity exposure management, which uses a moving average signal to go long and short equity indices. Both strategies are uncorrelated to equities and highly profitable on their own while delivering reliable protection in market crashes.
These and other papers on practical implementation of hedges boil down to the following conclusion to me: rather than constant hedging or even hedging whenever hedges are obviously cheap, it is more efficient to integrate hedges in an adaptive portfolio that reacts to regimes changes in the markets – the only hedging strategies that don´t lead to a high drag on returns incorporate this approach.
I´ll focus my discussion on that area next.
3 Adaptive allocation
Black swan events do not usually fall from a clear sky, even the most severe tail events, like Black Monday in 1987, were accompanied by signs of a market regime change. It is a possibility that we may see a significant volatility event in low-risk environments, but history tells us it is much less likely. Tail events usually happen when volatility is already up.
A long term trend-following overlay to all portfolio positions is my main tool. It can roughly double risk-adjusted returns from the global asset allocation portfolio by cutting drawdowns almost in half. In a well diversified portfolio trend signals and the implementation of allocation changes will happen gradually as different asset classes and sub-assets (e.g. equities in different regions) will break their trend at different times.
Measures relying on technical indications (trend and volatility) as well as fundamentals (valuation, interest rates and inflation) will incrementally shift our portfolio allocation in the right direction in the beginning of a severe decline. Please refer to this post for exact details.
As these signals are mainly reactive, they won´t predict a turning point, but give back some profits before changes in the portfolio are implemented. The most difficult environment for these models will be sideways whipsaws rather than big declines. Whenever market regimes switch back and forth quickly, losses will accumulate at each switch. The good news is that after a fake bear signal we will quickly recap those losses in a continuing bull market, if we follow our systematic approach and get straight back into bull market mode.
Even real bear markets usually have a much shorter lifetime and higher volatility than bull markets, which makes them very hard to trade actively in our longer term time frame.
One method to deal with declines will be to reduce exposure to the most risky assets and strategies in the portfolio to a minimum allocation and got to cash. Cash will not lose in whipsaws and sudden reversals at bear market bottoms. It also represents significant opportunity to be able to react to new signals on the long side.
On the other hand we can significantly raise our allocation to assets that we expect to perform positively in a bear market. As soon as these show an uptrend we can establish a base position and then increasingly shift our allocation from assets that enter a downtrend to these true diversifiers and hedges.
The mantra is: react, do not anticipate.
Peter Lynch famously said: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
I found two useful exceptions to this rule:
- Fundamentals anticipate change, but can get more and more extreme over long periods of time. We can use them to shift from highly valued to cheaper assets and assets with lower expected returns to assets with higher expected returns. Reversion to the mean is the mechanism we rely on for this to work.
- Rising volatility in a rising market may signal a top as in 1999 and 2007, this can be used to gradually shift from risky assets to protective strategies that thrive on volatility – e.g. trend-following managed futures.
We now have a solid, systematic foundation to be able to react to the development of an equity or bond led bear market. It should provide considerable protection from drawdowns and raise the allocation to cash and to portfolio elements that have positive return potential in bad times.
I want to dig deeper into these protective elements, specifically the possibilities to create a positive income stream from adaptive strategies and conclude with possible practical implementations of all these ideas.
I have not yet found a good way to access pure factor strategies. Top players´ funds (e.g. AQR) are hard to access for (european) retail investors and ETF solutions (e.g. AGFiQ factor long/short ETFs) have the problem that, while the risk-adjusted return of the long/short factor spread is high, the unleveraged absolute return these ETF harvest is so low that their high fees will eat up any return we can reasonably expect (the AQR Style Premia strategy for example uses leverage of about 8x).
For now I access value and momentum factors on the long side via ETF (by taking valuation into consideration in my allocation and through factor ETF like GMOM, IMOM and GVAL, IVAL, for example) and have integrated a combined relative and absolute momentum approach in my options writing portfolio as follows:
I sell options on trending ETF with the highest momentum – put options on securities in an uptrend with high momentum and call options on securities in a downtrend with high downward momentum diversified internationally across all asset classes. I weight the proportion of put to call by the number of assets in an up- or downtrend.
This has the effect that in an up market I mostly write puts and switch to writing calls in a bear market, both over the time horizon of a few months. I harvest a well diversified income stream (from a directionally tilted volatility risk premium) in all market environments.
The volatility strategy in my portfolio will go long volatility (VXX) when a strong signal is flashed by an inverted VIX futures term structure (contango < -3%) and should reliably hedge equities in a falling market. At the same time I´ll stop out of all short volatility positions and stop trading short volatility completely until the signal reverts.
Analyzing different hedging methods in the context of an adaptive portfolio we saw that, while buying index puts as an anticipating hedge is too expensive, tactical equity exposure management (going long equity indices above their long term moving average and going short when below the average) posts historical returns in line with long-only equity exposure. This strategy can also be implemented using LEAP index puts – whenever equities are below their moving average a long-term put position can be entered. I would scale such a position somewhat lower than the long equity position and set an exit goal for it rather than waiting to be stopped out by the moving average as reversals of a bear market bottom can be quite violent.
This tendency to violently reverse from the bottom, which is especially strong for the biggest losers, is also a reason for scaling down exposure to momentum strategies while the bear market is still unfolding. For the strategy of writing call options within a momentum framework lower overall exposure is offset by higher premiums due to the high volatility in a down market.
A deep value strategy, on the other hand, can be used to gradually allocate to securities whose valuation speaks for high expected returns – once these have begun a new uptrend and trade above their moving averages.
I also use a handful of asymmetric option positions as a cost neutral hedge. These are far OTM put and call options with a tilt towards the downside. In case of a strong move in the right direction, these have a risk-reward ratio of 1:10 – only one winner in 10 trades is needed for the strategy to be cost neutral. As these options are very cheap, a small position can deliver considerable exposure to the underlying. The strategy follows a similar principle of buying puts on strongly downtrending individual equities and vice versa.
Conclusion and practical implementation
So, what do I actually plan on doing and what do I think I will achieve by that?
I want to be invested at full leverage in risky assets in up-trending markets with low volatility and hedged or moving into safe assets in down-trending, high volatility regimes.
Step 1 – Current portfolio allocation
Make sure your portfolio allocation is as it should be in current market conditions.
This step is very important for me and I look at the whole portfolio, working down from the top asset class and strategy level to the individual securities I own, at least once a month.
I don´t know about you, but I have an urge to make overriding intuitive adjustments to my systematic allocation decisions. When I´m not looking at the whole picture, but get caught up in individual trading decisions, often a „superior, one-time-only prediction“ creeps in, almost magically leading to bad outcomes – it´s quite astonishing really.
At the moment, for example, the fatal reasoning goes: volatility is at all time lows, an eventual spike is inevitable, so let´s stop short volatility trading right now to avoid being stopped out of the strategy with uncomfortable losses. And while I´m at it, why not buy some index puts (hey, even billionaire investor Jeffrey Gundlach is supporting that point)? The market is so calm it simply has to go down sooner or later, doesn’t it? Of course the market doesn’t listen, cranks on and on at incredibly low volatility and profits are left on the table making the overall strategy less profitable as a result.
Here is how I allocate within the global asset allocation and to short volatility strategies at the end of 2017. In general I use the upper limit of exposure (2x leverage) I set for my portfolio as virtually all important assets are in an uptrend.
Because I rate current expected bond returns very low (approximated by bond yields), I only hold a minimal bond allocation (around 10%). Instead I hold a larger allocation in other true diversifiers: gold (GLD, which is just hovering above the 275-day moving average) and timber (WOOD, which is performing very well, but, consisting of REITs, has a stronger equity correlation than the commodity itself).
I also allocate an uncommonly large percentage to trend-following managed futures, because I think they are the single best diversifier with return expectations in line with equities over the long run. Especially convincing, I find research results pointing to the best returns for managed futures when equity as well as bond markets are in their best and worst performing quintiles (referred to as the „smile”).
Despite the high fees I allocate to funds available to european individual investors (e.g. MAN AHL Trend Alternative or ESA Galaxy) and ETFs (e.g. WDTI) – I suspect that in this case the sophistication of experienced managers is actually worth the fees.
I aim for an allocation between 15% up to 40% of the portfolio. At the moment I´m at about 20%, but I will likely make my first changes here raising the current allocation in step 2.
Step 2 – Anticipate
Two indications will lead me to slowly increase my managed futures allocation (up to 30%):
- Increasing equity overvaluation going hand in hand with falling expected returns
- volatility establishing higher lows when rising from all time low levels
This step will likely not cost a lot of return while we are still in a bull market, because managed futures are set to perform well with rising volatility.
I also gradually reallocate from overvalued pockets of the market (e.g. the US) to more reasonably priced regions (e.g. Europe and Emerging markets) as well as expensive assets in general (e.g. bonds, equities increasingly so) to cheaper assets starting an uptrend (e.g. commodities, managed futures which have both underperformed for several years).
Step 3 – React
I will keep my portfolio mainly long as basic probabilities favor this (risk premia are positive over the long term) – reducing exposure in a bear market is my primary tool.
First I will reduce exposure to the most risky assets and strategies in the portfolio.
Volatility will probably flash the earliest signal through an inversion of the VIX futures term structure. I will then immediately stop my direct short volatility strategy. Most of the time this is just a temporary measure as long as the S&P 500 stays in an uptrend and the term structure reverts back to contango, giving a new entry signal. But if the S&P breaks its moving average and VIX futures contango falls below -3%, I´ll even reverse the strategy and go long volatility (VXX). This measure takes a major source of risk (and return) off the table.
Observing the trends in the overall markets will inform my top-down asset allocation:
- Global asset portfolio (e.g. GAA): if it breaks down below the long term moving average (275-day) reduce overall portfolio exposure.
- World equities (VT), world bonds (BWX), commodities (PDBC): if they break down below long term moving averages reduce exposure to respective asset class.
- Sub-assets (e.g. regional equities) will likely break their moving averages first, leading to a gradual reallocation to stronger sectors and other assets (50-50).
- Raise allocation to true diversifiers that are already in an uptrend: reallocate partly from sub-assets that are showing weakness.
When a bear market is clearly underway the portfolio should already have a very different structure and I will implement some of the additional measures described above in small size. I´ll make sure to write about it in detail once we get there.
Mostly I will stay at a reduced exposure and wait for opportunities at the end of the bear market. I don´t want to be caught in reversals and whipsaws which can be very sudden and violent.
Bear markets usually last much shorter than bull markets – approximately 25% of the time are spent in a bear market. And, of course, different assets often go through bear markets at different times, only rarely will we see an event that drags down everything at the same time as in 2008.