Correction Protection In Liquid Alts
Late January through early February saw the global equity markets undergo a “correction.” From the close on Jan. 26, 2018 to the close on Feb. 9, 2018, the Vanguard S&P 500 ETF (VOO) lost 8.7%. The Vanguard FTSE Developed Markets ETF (VEA) experienced an even greater loss of 9%. And the Vanguard FTSE Emerging Markets ETF (VWO) lost even more, dropping 10.1%.
A globally diversified portfolio, weighted approximately by market cap (U.S.: 1/2; developed markets: 3/8; emerging markets: 1/8) would have lost 9.0%. Even the Vanguard Total Bond Market ETF (BND) lost 1.3%, reminding investors that stocks and bonds can experience losses at the same time.
Recently, I’ve written about four liquid alternatives I believe investors should consider including in their portfolios. How did they perform during this period? Before reviewing the results, let’s briefly review some reasons I recommend investors consider these alternatives.
The first is that the risk of traditional stock and bond portfolios is dominated by the single factor of market beta. Even market-cap-weighted 60% stock and 40% bond portfolios have about 85% of their risk concentrated in market beta, with the remainder in term risk (if the portfolio uses Treasuries and CDs), and a small amount in credit risk (if the portfolio includes investment-grade corporate bonds).
To further diversify risk, and to improve the efficiency of the portfolio, investors need to add investments that have earned unique premiums (meaning they have low correlation with the portfolio’s other investments) and have demonstrated persistence, pervasiveness and implementability (meaning they survive transaction costs).
Decreasing Market Beta
The purpose of adding assets with these characteristics is to decrease the portfolio’s exposure to market beta to, in turn, reduce the dispersion of potential returns and, thus, tail risk without significantly reducing expected returns. The result would be a more efficient portfolio.
Consider the following example. You have the choice between Portfolio A and Portfolio B. They both have the same expected return, but the expected standard deviation of returns for Portfolio A is higher than for Portfolio B, resulting in fatter tails in the dispersion of potential outcomes.
Those fatter tails offer the opportunity for Portfolio A to experience both higher returns and larger losses than Portfolio B.
That’s the trade-off—to reduce risk and create a more efficient portfolio, you sacrifice the potential for higher returns in good years (when the market beta premium is larger than expected) to lower the risk of larger losses (when the market beta premium is negative).
Replacing Bond Allocation With Alts
If you are like most people, because you are risk averse, you would choose to live with the risks of Portfolio B—sacrificing the opportunity to earn the great returns in the right tail of Portfolio A’s distribution (that don’t appear with Portfolio B) if you also minimize or eliminate the risk of the very bad returns in the left tail of Portfolio A’s distribution (that, again, don’t appear with Portfolio B).
Investors can also consider using the alternatives I will discuss to replace safe bond investments. Doing so would create a portfolio with significantly higher forward-looking expected returns while its estimated volatility would rise only slightly, though term/inflation risk would be significantly reduced.
It is important to understand that expected returns are the mean of a very wide potential distribution of possible returns. Thus, they are not a guarantee of future results. Expected returns are forward-looking forecasts and are subject to numerous assumptions, risks and uncertainties, which change over time, and actual results may differ materially from those anticipated in an expected return forecast. Expected return forecasts are hypothetical in nature and should not be interpreted as a demonstration of actual performance results or be interpreted as a target return.
A Look At Alternative Funds
With that understanding, I will review the performance of four alternative funds in both 2017—a year in which the market beta premium was much higher than the historical average and what investors should have expected—and during the recent correction in 2018. Doing so will allow us to determine if the results were what we should have expected to see in each case. (Note that all of the following alternative funds are relatively new, and thus the sample we can review is limited.)
The following tables show the performance of the AQR Style Premia Alternative Fund (QSPRX) and three funds from Stone Ridge: the Alternative Lending Risk Premium Interval Fund (LENDX), the Reinsurance Risk Premium Interval Fund (SRRIX) and the All Asset Variance Risk Premium Interval Fund (AVRPX). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge and AQR funds in constructing client portfolios. I personally have significant investments in each of these four strategies.)
Equal-Weighting Alt Funds
The tables also show the return of an equal-weighted hypothetical portfolio of the four funds. The use of “naive” (1/N) equal-weighting is common in academic research because it avoids the risk of data mining (looking for the mix that produces the best result). There is, however, a second reason to use that approach.
If you believe markets are efficient, it follows that you should also believe all risky assets should have similar risk-adjusted returns. That leads one to conclude that assigning an equal weight to each of the four alternatives is a good strategy. Individual investors may have their own preferences (for example, they may understand the risks of reinsurance but not the complex strategies of QSPRX, and thus avoid the more complex fund), but equal-weighting is a good starting point/default.
I’ll begin with reviewing the performance of the four alternatives during the February 2018 “correction.”
While the equal-weighted portfolio experienced a loss of 1.6%, it was less than one-fifth of the 9.0% loss experienced by a globally diversified, market-cap-weighted equity portfolio. In addition, it was only slightly worse than the loss experienced by BND, Vanguard’s total bond market ETF. Clearly, the strategy of using alternatives passed this short test, demonstrating the value of diversifying risks across unique risk factors. That said, it is important to note the performance of AVRPX.
A Look At The Laggard
AVRPX sells puts and calls on 50 different assets (referred to as underliers) in the asset classes of stocks, bonds, commodities and currencies, and diversifies those exposures across various strike prices and maturities so the fund typically has positions in about 1,000 different individual investments, to earn an expected variance risk premium (VRP).
However, when volatility spikes, it is expected that the fund will experience losses. One measure of equity volatility, the VIX, closed Jan. 26 at just over 11. It hit a high of 50.3 on Feb. 6, and closed at 29.1 on Feb. 9. Note that this was the largest increase over such a short period in VIX’s history. By the close on Feb. 16, it was back down under 20.
Given the spike in volatility, it was no surprise that AVRPX didn’t perform as well as the other alternatives when equity prices were dropping dramatically—its correlation with equity prices is higher, though relatively low over the long term.
Note also that AVRPX benefited from its diversification across securities and asset classes, as some of the options it sold did generate profits during this period. That is why we not only recommend using this fund (instead of one that only sells equity volatility insurance), but also that investors build a portfolio of alternatives, not add just a single strategy. Each of the four alternative strategies I’ve addressed has low correlation to the others.
It’s also important to note that when volatility spikes, the ex ante VRP increases, and so do the fund’s future expected returns. Thus, losses are often quickly recovered. In this case, by the close on Feb. 16, the fund had recovered 1.2 percentage points of the 4.9% loss (about 25%) it experienced.
Reviewing 2017 Performance
I’ll now turn to a review of how these alternatives performed in the strong equity market of 2017. In 2017, VOO returned 21.8%. VEA returned 26.4%. VWO performed even better, returning 31.5%. A globally diversified portfolio, weighted approximately by market cap (U.S.: 1/2; developed markets: 3/8; emerging markets: 1/8), would have returned 24.7%. BND returned 3.6%.
In a year like 2017, when the market beta premium was high, the portfolio of alternatives should be expected to underperform equities. The stronger the performance of market beta, the larger the gap is likely to be.
Under & Outperformance
Given the very strong performance of global equity markets, we should have expected that the alternatives portfolio would underperform—which it did, by 20.2 percentage points. We also should have expected it would outperform the bond portion of the portfolio, which it did as well.
The alternatives portfolio also outperformed, as expected, in the February 2018 market correction, by 7.4 percentage points. In both cases, the strategy of adding alternatives was performing its role, reducing the potential dispersion of returns.
Unfortunately, we don’t have a clear crystal ball that would allow us to switch our allocation between equities and either bonds or alternatives ahead of market moves. Thus, if we want to reduce the risk of the portfolio without significantly sacrificing expected returns, we must accept the tracking error that will occur—with the alternatives acting as a drag in years when equity returns are strong, but providing ballast during years when equity returns are negative.
The strategy incorporating alternatives was working, doing its job in both periods we examined. There are no free lunches in investing, other than diversification.
Reducing The Risk of Black Swans
In our 2014 book, “Reducing the Risk of Black Swans,” Kevin Grogan and I showed investors how they can potentially reduce the dispersion of returns and tail risk without sacrificing returns by “tilting” their portfolios to the size and value factors while at the same time reducing their overall allocation to equities and increasing it to safe bonds.
An updated version of the book will be published this spring. It will not only refresh the data, but include new material on how we believe adding alternative investments can further improve portfolio efficiency and reduce tail risk.
Larry Swedroe is the director of research for The BAM Alliance.
NOTE: The funds referenced herein are provided for informational purposes only and is not intended to serve as specific investment or financial advice. The funds listed do not constitute a recommendation to purchase a single specific security and it should not be assumed that the securities referenced herein were or will prove to be profitable. This information should not be considered as a demonstration of actual portfolio performance results. Prior to making any investment, an investor should carefully consider the fund's risks and investment objectives and evaluate all offering materials and other documents associated with the investment.
This commentary originally appeared February 26 on ETF.com
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