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Keeping powder dry with liquid defensive alternatives in 2023
The ability to remain calm and take advantage of future problems is often the hallmark of the greatest investors. To be a contrarian is one thing, but to be a contrarian with capital as markets fall is another.
A well-diversified portfolio should provide sources of capital to take advantage of future problems via re-balancing.
2022 has highlighted the risk of over-reliance upon historical asset class correlation and expected diversification. Most traditional portfolios experienced loss as both growth and fixed income have suffered in this rising rate and inflationary period.
As Bank of America Global Research highlighted recently, the 60/40 portfolio has had its worst performance in 100 years. Figure 1.
While the attractiveness of fixed income has improved since the recent zero-rate environment, investors should consider the possibility of continued rate hikes and correlation with equities in a negative real rate of return environment. In our view, fixed income duration may be a more beneficial tactical allocation as the volatility of the asset class remains high.
Like diversifying amongst growth assets, diversification of defensive strategies provides more robust portfolio outcomes. At a minimum, higher correlation between bonds and equity argues for more diversification of defensive features within a portfolio. Below we highlight recent performance in various defensive alternatives.
Diversifying risk management
The past 12-month period has seen varying performance from a mix of liquid alternative and more explicit defensive strategies, highlighting the importance of diversifying defensive strategies.
Cash – Increasing cash levels is straight forward, albeit requiring tactical decision-making and exposing portfolios to opportunity cost. Holding cash does not incur significant management fees and provides liquidity to take advantage of lower asset pricing if the bear market continues. The optionality of holding cash as dry powder is powerful.
However, for any significant holding period cash is a drag on portfolio returns – particularly in periods of higher inflation. Further, to increase cash holdings (by selling assets) investors may face significant tax consequences on unrealised capital gains.
Futures – dynamic exposure management
Investors can utilise futures to offset the physical exposure to risk assets in a portfolio. The risk offset can be gained without the need to sell out of underlying holdings. Short futures can be viewed as synthetic cash as markets fall this short position increases in value.
Historically, investors may have utilised futures or Equity Index Short ETFs in a simple static fashion. However, there are strategies available in the market that operate a more dynamic net exposure management combining long growth assets with a varying offset position. Through a continuous process of identifying higher risk environments or falling markets, these strategies can modify exposure daily to meet pre-determined risk parameters.
Options – tail risk
Option puts have historically been used to hedge downside risk and tail risk solutions are designed to mitigate extreme market falls. However, while options can deliver strong performance and offset portfolio loss, 2022 has seemingly experienced poor performance for tail risk solutions given both A) relatively high cost of protection, and B) the path of market declines. However, in comparison with bonds it has outperformed.
Generally, put options perform best when the market declines are large and rapid. The market declines over the past 12 months have been relatively calm and to date more of a slow grind lower over this entire bear market period.
Further, since the pandemic induced market falls of 2020, implied volatility which denotes market expected range and cost has been relatively high and with market nervousness around rate normalisation and potential recession reinforcing higher implied volatility levels. Option purchases require an outperformance of market expectations to be profitable.
While this current equity bear market movement has not seen a major capitulation yet, options do provide significant protection for violent market movements. For example, over the March 2020 market correction and GFC period option-based strategies provided investors with much needed anti-correlation and portfolio protection.
Further, it is more appropriate to compare the cost of option protection in comparison with other strategies.
Generally, option protection enables a portfolio to maintain higher growth allocation when investors feel nervous or seek to protect a portfolio tactically. Therefore, actual cost of any option strategy should consider this added return instead of its isolated performance.
Finally, a more professional approach to long volatility and explicit equity downside protection can be delivered in more actively managed strategies than the naïve strategy of the 2020 study. This is particularly relevant when the environment is costly.
Long Volatility Hedge Funds
While simplified equity option-based strategies are more common and available via ETF and managed funds, the more actively managed and multi asset class exposure to volatility can be found in volatility-based hedge fund strategies. While most of these hedge funds will have monthly or quarterly liquidity windows and may utilise more complex instruments including OTC derivatives, the opportunity set is more diverse and managers are able to use spreads and term structures to manage costs.
Clearly, long volatility exposure has been a strong portfolio diversifier – particularly in periods of systemic risk where diversification fails.
Critically, investors need to understand any manager’s strategywq0ssa and their potential exposures including currency, correlation, fixed income, and commodities to better understand expected potential performance.
