Fidelity has an interesting study out. The whole thing is worth a full read here.
While the only predictable thing about market behavior is its unpredictability, history has shown repeatedly that continued plan contribution and diversified, age-based asset allocation has delivered better results over time. During turbulent times, a steady course is most often the best one. A reactionary approach, including a focus on short-term market activity and related attempts to time the market, typically leads to poorer outcomes in the long term.
Besides, how you diversify matters greatly. BlackRock:
The fact is that in times of stress, correlations of stocks and bonds rises greatly. And a traditionally diversified portfolio contains a high degree of equity risk.
Rising commodity prices are “triggering second-round effects via higher wages,” Alain Bokobza, the head of asset allocation strategy at Paris-based SocGen, wrote in an April 11 report titled “The EM Party Is Over.” He recommends switching to developed-nation equities from emerging markets.
“In most emerging markets, you do have these margin pressures building,” Michael Shaoul, the chairman of Marketfield Asset Management in New York, who has been shifting investments to the U.S. from emerging markets, said in an interview. “We’re fairly convinced that this monetary cycle will end in some distress.”
It is easier to work with core strategies that fall into one of these extremes:
low volatility / low max-drawdown that can be levered to achieve higher returns without blowing up, or
high volatility / high max-drawdown and high returns that can be managed through asset-allocation and rebalancing.
The worst ones are those that have neither low volatility nor high returns.
Trend-following techniques deliver on (1). However, not everything trends.
Case in point are the Trendpilot ETFs PTLC over the S&P 500 (SPY) and PTNQ over the Nasdaq 100 (QQQ).
The methodology makes intuitive sense.
However, performance is a different matter.
The trend ETFs have worse Sharpe ratios than their benchmarks.
The silver lining is that the ETF versions are better than naïve trend strategies using only SMAs and would work out to be more cost and tax efficient than rolling your own.
However, the naïve versions all have Sharpe ratios less than 1.0 and high drawdowns. This tells us that the indices themselves may not amenable to trend-following and that they belong to (2) above?
Strategy design should follow the “first make it work then make it better” philosophy. If the simplest approach doesn’t work, then adding bells-and-whistles to it is unlikely to make it any better. If something is not trending, then what exactly are you following?
Here are a couple of popular definitions and explanations to get the conversation started:
Investopedia: A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite position in a related security.
Varsity: Hedging makes sense as it virtually insulates the position in the market and is therefore indifferent to what really happens in the market. It is like taking vaccine shot against a virus. Hence when the trader hedges he can be rest assured the adverse movement in the market will not affect his position.
The way it is commonly described, hedging is the act of taking offsetting positions against a portfolio to even out the bumps in the market.
The CAPM β
According to EMH, a portfolio’s return could be fully explained by the market (source):
r = rf+ ß(rm – rf) + α
Where:
r = Expected rate of return
rf = Risk-free rate
ß= Beta
(rm – rf)= Market risk premium
If you set the risk-free rate (rf) to zero, you get r = ß*rm + α
Now, subtract away the market from the asset returns and you’ll be left with α.
Basically, a perfectly hedged portfolio will be a completely market neutral portfolio who’s returns will be pure alpha.
The offsetting positions can be taken via futures or options. To keep it simple, we will use futures to illustrate an example.
An Example
It is 2005 and the master analyst that you are, you expect HDFCBANK and KOTAKBANK to be decades long compounders. So, you setup an equal weighted portfolio that has only those two stocks.
If you stayed with this portfolio, then you truly have ??
Even though the annualized returns during the ~15 year period is twice that of NIFTY 50’s, very few investors would have stuck through the 70% drawdown that the portfolio had in 2008 and the 40% drawdown it had in 2020. Not to mention the numerous 20% dips along the way.
The question that hedging tries to answer is as timeless as time itself: Can I have my cake and eat it too?Is there a way to get only the excess returns without the market’s ups and downs?
What is the “market?”
Given that your portfolio consists entirely of banks, what exactly is your “market?” The answer to this question is not trivial.
You could go with the NIFTY 50 index but it has companies from different sectors like oil, metals, IT, etc. How much of an offset do you expect it to provide?
Or, you could go with the NIFTY BANK index. Intuitively, you would expect it to be a better hedge because it is composed almost entirely of banks – just like your portfolio.
Rolling βs
Rolling βs of the portfolio to each index gives us an idea of the appropriate benchmark to use.
What this is telling us, with perfect hindsight, is that the NIFTY BANK index comes close.
Theoretically, Hedging works in Theory
The math checks out. Irrespective of whether you hedge against the NIFTY or the NIFTY BANK index, you end up with much lower drawdowns.
For example, if you hedge against the NIFTY BANK, assuming no frictions and slippage, drawdowns never exceeded 20% and returns came in at a respectable 12% annualized.
Reality Sucks
Hedged portfolios have high Sharpe ratios and look attractive in backtests. However, reality is quite different.
βs are not Stable
The chart of rolling betas of the portfolio over different indices highlight the biggest problem with hedging: the hedge ratio needs to be constantly adjusted because the relationships are unstable.
Adjust it too often, then you lose to transaction costs. Adjust it too slowly, then you are no longer perfectly hedged.
βs > 1
Sometimes, betas can exceed 1. This means that your portfolio is net short during those periods. If the original intent of setting up the portfolio + hedges was to just even out the market fluctuations in a long-only portfolio, then being net-short is something that you may not have bargained for.
Margin requirements Vary
The backtest presented above allocates 90% to the cash (long-only) part of the portfolio and 10% towards margin requirements. However, during periods of market stress, brokers are known to hike margins to protect themselves. This might end up putting you in a position where you will need to pare back some of your long-only exposure to raise funds to meet the increased margin requirements. Basically, selling the dip.
Markets have a Positive Drift
Over long time horizons, markets typically have a positive drift. With a hedged portfolio where you are short the market, you are betting that this drift is overshadowed by volatility and portfolio alpha. It may very well be true, but you are betting against the winds.
Who should Hedge?
Leveraged Investors
Hedging doesn’t make sense for long-only cash portfolios. If you are a CNC (Cash N’Carry) investor, then you are better off de-grossing (reducing overall exposure or positions) and focusing on diversification rather than trying to hedge your portfolio.
Investors who employ leverage, however, should hedge. For example, if you were to take levered positions in HDFCBANK and KOTAKBANK through futures, then it makes sense to try and hedge out the market risk. Futures have 5x leverage built in, so it has the potential to boost your CAGR, as long as you can meet the mark-to-market during the 20% drawdowns.
Tactical Positioning
Some investors may prefer to hedge only when they expect market volatility. In our introduction to Tactical Allocation, we touched upon how we can use moving averages to shift between stocks and bonds. Instead of trading in-and-out, investors might prefer to add a hedge instead.
Needless to say, we are not big fans of investors trying to time the market like this.
Conclusion
Hedging makes sense if you are a leveraged investor. Given the costs, complexity and performance drag involved, it doesn’t make much sense for cash investors to hedge.
Looking for a sensible way to invest? Here’s how to get started.
Every advisor you speak to likely extolls the virtues of diversification. “Buy stocks, bonds, gold, real-estate in x/y/z proportion.” Since no one can predict future returns of individual assets, by buying all of them, investors can protect themselves from steep drawdowns.
But what exactly is “diversification?” Is it right for you? Over what assets should you diversify? And how long should you wait before you expect to see the benefits of such diversification?
There are several theories on sex and all of them are lies. – Santosh Kalwar
Before we dive into the how/what/when, let’s set the backdrop through which we’ll discuss the topic.
American Exceptionalism
Most portfolio research is conducted with US Dollar assets trading in America. It is then ported over unquestioningly to other markets. However, there is no other country like America – the only country in the world that can print US Dollars that every other country in the world needs to hold as a reserve asset. This gives US assets a steady, unrelenting bid.
For example, government bonds are supposed to be low-volatility assets with limited downside. However, Indian investors have a completely different experience compared to Americans with it comes to investing in them. Here’s the rolling 3-year standard deviation of weekly returns of Indian 10-year gilts (in USD) and a US fixed-income fund for comparison.
Not only are Indian bonds more volatile, they have +30% drawdowns that take years to recover.
In a flight-to-safety, Indian bonds get sold and American bonds get bought.
The 60/40 Buy and Hold
Since the mid-90’s, an American investing in American assets did spectacularly well. Not just in equities…
… but in bonds as well.
An US-based advisor can be excused for beating the drum of buy-and-hold. After all, US equities and bonds have always recovered. And they can afford to keep-it-simple with a static 60/40 allocation between stocks and bonds.
However, look at the performance of Emerging Market (EM) equities and bonds. An absolute disaster both in terms of returns and volatility.
So, when advisors wax eloquent of the 60/40 portfolio, what they really mean is US Equity/US Bond 60/40 portfolio. Investors in the rest of the world, especially in EMs like India, will do well to formulate a strategy that works given their reality rather than blindly following US-centric allocations and strategies.
King Dollar
While the US Dollar has appreciated against most currencies since 2010, it is nothing compared to how much it has appreciated against the Indian Rupee.
A falling currency is a headwind against a portfolio trying to preserve purchasing power and presents a performance hurdle of sorts.
While USDINR is not the worst currency pair out there, it pays to think of portfolios in Dollar terms.
The Streetlight Effect
A policeman sees a drunk man searching for something under a streetlight and asks what the drunk has lost. He says he lost his keys and they both look under the streetlight together. After a few minutes the policeman asks if he is sure he lost them here, and the drunk replies, no, that he lost them in the park. The policeman asks why he is searching here, and the drunk replies, “this is where the light is.”
The Center for Research in Security Prices (CRSP) was founded in 1960. They went live in 1964. Initially, the center’s database consisted of monthly share prices of common stock trading on the NYSE, dating back to 1926. Over time, the database grew in size, introducing other exchanges and securities, as well as daily updates.
In India, the Total Return NSE mid-cap index prices are available only from 2005. In search of robustness, researchers use US datasets by default. However, every market is different because the political backdrop in which they operate are different. It is called the political economy for a reason. So, before taking US financial research at face-value, it behooves us to understand the qualitative drivers behind the numbers: are regulation, politics and market structure similar enough for the data-set being analyzed that the conclusions can be applied to the target market?
Besides, with limited datasets, it is easy to play games by cherry-picking data and begin/end dates to fit a narrative. Here is a sample:
OVER THE LAST 10 YEARS, NIFTY 50’s DOLLAR RETURNS TRAIL THE S&P500’s BY A WHOPPING 6.5%
OVER THE LAST 15 YEARS, NIFTY 50’s DOLLAR RETURNS TRUMP THE S&P500’s BY A WHOPPING 3.5%
While trying to figure out the right asset mix and investment strategy, Indian investors have to recognize that they may be looking through a tinted window, at a small dataset.
The Allure of Commodities
The theory behind investing in commodities is that they offer an inflation hedge unmatched by most other asset classes. While the relationship between commodities and equities varies considerably – at times there is a negative correlation – on average, they show a low but positive correlation.
Here comes the BUT: the dataset used to analyze these relationships largely covers prices before commodities were financialized, democratized and packaged into ETFs that can be traded by mom-and-pop investors by the click of a button.
While some advisors may hold onto the trope that commodities “work” if actively managed, historical performance of such funds have been a disaster.
The best way to become a millionaire is to start with a billion dollars and invest in commodities.
Take-away
While diversification is often recommended as a “free lunch” that every investor can partake, a lot depends on the assets that go into the basket. Each one of them have “worked” in the past for different reasons. Increasing financialization means that assets that were uncorrelated in the past because of trading friction suddenly become correlated during market panics. Currency depreciation is a real problem for Indian investors, silently eroding purchasing power.
Portfolio construction should be done against this backdrop – not blindly throwing together a bunch of assets and hoping that it works. We will discuss some of these approaches in subsequent posts.
