One Hedge to Rule Them All

This post is available as a PDF download here.

Summary

• About two years ago, we compared and contrasted different approaches to risk managing equity exposure; including fixed income, risk parity, managed futures, tactical equity, and options-based strategies.
• Given the recent market events as the world navigates through the COVID-19 crisis, we revisit this analysis to see how these strategies would have fared over the past two years.
• We find that all eight strategies studied have continued to successfully reduce risk, with two of the previously underperforming options-based strategies now jumping to the forefront of the pack.
• Over time, performance of the risk management strategies still varies significantly both relative to the S&P 500 and compared to the other strategies. Generally, risk-managed strategies tend to behave like insurance, underperforming on the upside and outperforming on the downside.
• Diversifying your diversifiers by blending a number of complementary risk-managed strategies together – even at random – can be a powerful method of improving long-term outcomes.

“The primary requirement of historical time is that inly one of the possible alternatives coming at you from the future can be actualized in the present where it will flow into the pat and remain forever after unalterable. You may sometimes have “another chance” and be able to make a different choice in some later present, but this can in no way change the choice you did in fact make in the first instance.”

– Dr. William G. Pollard, Prof. of Physics, Manhattan Project

23 trading days.

In a little over a month, the S&P 500 dropped nearly 35% from all-time highs in a sell-off that was one of the fastest in history. Many investors experienced the largest drawdowns their portfolios had seen since the Financial Crisis.

While the market currently sits in a drawdown closer to 25% (as of the time of this writing), the future remains could take any path. Following the relative calm in the market over the preceding year, we are now living through a historic time with the uncertainty and severity of the growing COVID-19 pandemic and its far-reaching ramifications.

However, as a firm that focuses on managing risk, we are used to not knowing the answers.

In the summer of 2018, we published a piece entitled The State of Risk Management where we examined the historical trade-offs in terms of returns during market downturns versus returns during calm market environments of a variety of risk management methods.

Since that time, especially with the benefit of hindsight, one might argue that risk management was unnecessary until this past month. While the S&P 500 experienced a 19% drawdown in Q4 of 2018, it quickly recovered and went on to post a gain of 32% in 2019, rewarding those who stayed the course (or, better yet, bought the dip).

Source: Tiingo. Returns are gross of all management fees, transaction fees, and taxes, but net of underlying fund fees. Total return series assumes the reinvestment of all distributions. Data through 3/27/2020.

With the future poised to follow a variety of uncertain paths, we think it is a prudent time to check in on some of the more popular ways to manage risk and see how they are handling the current events.

The Updated Historical Track Record

For risk management, we examine eight strategies that roughly fit into four categories:

• Diversification Strategies: strategic 60/40 stock/bond mixand risk parity
• Options Strategies: equity collar, protective put, and put-write,
• Equity Strategies: long-only defensive equity that blends a minimum volatility strategy, a quality strategy, and a dividend growth strategy in equal weights
• Trend-Following Strategies: managed futures and tactical equity

Index data was used prior to fund inception when necessary, and the common inception data is December 1997.

The following charts show the return and risk characteristics of the strategies over the entire historical period. Previously, we had used maximum drawdown as a measure of risk but have now switched to using the ulcer index to quantify both the duration and severity of drawdowns.

Data Source: CBOE, Tiingo, S&P. Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. Data is from December 1997 to 3/27/2020.

Data Source: CBOE, Tiingo, S&P. Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. Data is from December 1997 to 3/27/2020.

Relative to when we previously presented these statistics (as of July 2018), the most notable changes are that the 95-100 Collar index and Risk Parity have improved and that Managed Futures moved into the top-performing spot up from the middle of the pack. Trend Equity dropped slightly in the rankings, which is partially attributable to our switching over to using the Newfound Trend Equity Index, which includes exposure to small- and mid-cap companies and invests in cash rather than corporate bonds for the defensive position.

Six of the eight strategies still exhibit strong risk-adjusted performance relative to the S&P over the entire time period.

But as we also showed in 2018, the dispersion in strategy performance is significant.

Data Source: CBOE, Tiingo, S&P. Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. Data is from December 1997 to 3/27/2020.

This chart also highlights the current trailing one-year performance for each strategy as of 3/27/2020.

Both the 95-110 Collar and the 5% Put Protection indices are in the top 10% of their historical one-year returns, with the put protection index forging new maximum territory. Trend equity and defensive equity have exhibited returns closer to their median levels, while managed futures, strategic diversification with bonds, and risk parity have had returns above their medians.

When we examine the current market environment, this makes sense. Many options were relatively cheap (i.e. implied volatility was low) heading into and early in February, and the option rollover date was close to when the drawdown began (positive timing luck). Equity trends were also very strong coming out of 2019.

With the sharp reversal in equity prices, option strategies provided a strong static hedge that any investors had been paying premiums for through the previous years of bull market returns.

Trend equity strategies were slower to act as trends took time to reverse before cash was introduced into the portfolio, and managed futures were eventually able to capitalize on short positions and diversification once these trends were established.

Zooming in more granularly, we can see the trade-offs between the hedging performance of each strategy in down markets and the premiums paid through negative returns in up-markets. This chart shows the returns relative to the S&P 500 (SPY). When the lines are increasing (decreasing), the hedge is outperforming (underperforming). A flatter line during periods of calm markets indicates lower premiums if we think of these strategies as insurance policies.

Data Source: CBOE, Tiingo, S&P. Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. Data is through 3/27/2020.

All eight strategies have provided hedging in both Q4 2018 and the current downturn. The -95-100 Collar- provided some of the lowest premiums. -Trend Equity- also provided low premiums but had a slower time getting back in the market after the hedging period in 2018.

-Managed Futures- have provided some of the best hedging through both down periods but had the highest premium during the strong market of 2019.

With the continued dispersion in performance, especially with the “new” market crisis, this highlights the importance of diversification.

Diversifying Your Diversifiers

Not every risk management strategy will perfectly hedge every downturn while also having a low cost during up markets.

We see the power of diversifying your diversifiers when we test simple equal-weight blends of the risk management strategies. In our 2018 update, we had used an equal weight blend of all eight strategies and a blend of the six strategies that had historical Sharpe ratios above the S&P 500. This latter selection was admittedly biased with hindsight. The two excluded strategies – the 95-110 Collar and the 5% Put Protection indices – were some of the best performing over the period from August 2018 to March 2020!

Our own biases notwithstanding, we still include both blends for comparison.

Both blends have higher Sharpe ratios than 6 of the 8 individual strategies and higher excess return to ulcer index ratios than all of the eight individual strategies.

This is a very powerful result, indicating that naïve diversification is nearly as good as being able to pick the best individual strategies with perfect foresight.

Data Source: CBOE, Tiingo, S&P. Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. Data is through 3/27/2020.

But holding eight – or even six – strategies can be daunting, especially for more aggressive investors who may only want to allocate a small portion of their portfolio to a risk management sleeve.

How much diversification is enough?

The following charts show the distribution of risk-adjusted returns from randomly choosing any number of the 8 strategies and holding them in equal weight.

As is to be expected, the cost of choosing the “wrong” blend of strategies decreases as the number of strategies held increases. The potential benefits initially increase and then back off as the luck of choosing the “right” strategy blend is reduced through holding a greater number of strategies.

Both charts show the distributions converging for the single choice for an 8-strategy portfolio.

Data Source: CBOE, Tiingo, S&P. Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. Data is through 3/27/2020.

Data Source: CBOE, Tiingo, S&P. Calculations by Newfound Research. Past performance does not guarantee future results. All returns are hypothetical index returns. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses, sales charges, or trading expenses. Index returns include the reinvestment of dividends. No index is meant to measure any strategy that is or ever has been managed by Newfound Research. Data is through 3/27/2020.

Even holding 3 or 4 of the eight risk management strategies, chosen at random, leads to robust results, in general, with narrowed bands in the distribution (e.g. 25^th to 75^th percentiles).

Blending strategies from each of the different categories – static diversification, options, equity, and trend-following – can further reduce concentration risk verses selection at random and ensure that a variety of risk factors within the hedging strategies (e.g. interest rates from bonds, volatility from options, beta from equity, and whipsaw from trend-following) are mitigated.

Conclusion

We’ve said it many times before: There is no holy grail when it comes to risk management. While finding the perfect hedge that beats all others in every environment is enticing, it is impossible via the simple fact that risk cannot be destroyed, only transformed.

In an uncertain world where we cannot predict exactly what the next crisis will look like – or even what the current crisis will look like after today – diversifying your diversifiers by combining a number of complementary risk-managed strategies may be a prudent course of action.

We believe that this type of balanced approach has the potential to deliver compelling results over a full market cycle while managing the idiosyncratic risk of any one manager or strategy.

Diversification can also help to increase the odds of an investor sticking with their risk management plan as the short-term performance lows won’t be quite as low as they would be with a single strategy (conversely, the highs won’t be as high either).

Developing a plan and sticking with it is the most important first step in risk management. It is obviously desirable to keep premiums in strong markets as low as possible while having efficient hedges in down markets, but simple diversification can go a long way to provide a robust results.

Risk management is, by definition, required to be in place before risks are realized. Even when the market is currently down, risks in the future are still present. Therefore, we must periodically ask ourselves, “What risks are we willing to bear?”

One potential path has been locked into history, but the next time potential risks become reality – and they inevitably will – we must be comfortable with our answer.

Nathan Faber

Nathan is a Portfolio Manager at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Nathan is responsible for investment research, strategy development, and supporting the portfolio management team. Prior to joining Newfound, he was a chemical engineer at URS, a global engineering firm in the oil, natural gas, and biofuels industry where he was responsible for process simulation development, project economic analysis, and the creation of in-house software. Nathan holds a Master of Science in Computational Finance from Carnegie Mellon University and graduated summa cum laude from Case Western Reserve University with a Bachelor of Science in Chemical Engineering and a minor in Mathematics.