Last week was a great time to look in the (portfolio) mirror and ask yourself what you see. As Taylor Pearson of Mutiny put it succinctly on Twitter:
If the stock market dropping 5% causes you to freak out, it’s probably a good time to re-evaluate either/both:
1. The effectiveness of your portfolio’s diversification
2. Your emotional relationship with it.
One of those two is likely out of whack
— Taylor Pearson (@TaylorPearsonMe) February 24, 2020
Another great one came out of a post by Ben Hunt, saying:
There are decades where nothing happens; and there are weeks where decades happen.
The question from a portfolio/mirror/soul searching aspect is whether you were prepared for the ‘decade’ that happened last week. And the question in our little world here of diversification strategy and alternative investments is – how “Alt” was your Alts last week. Many so-called Alts, as we tweeted out in the thick of the storm last week, don’t necessarily do much in the way of diversifying.
While it will be a few days/weeks until we see the numbers showing how different managers and different types of Alternative Investments did in February, that’s sort of beside the point at this mirror/inward looking stage. At this stage, we’re more interested in the direction of so-called Alternatives and diversifiers during the big market sell-off. We’re more interested in whether they displayed what we call fundamental non-correlation, in addition to their statistical non-correlation. In short, what we really need to ask ourselves when taking stock of our Alternatives portfolio is:
- How much of it is an Equity Replacement
- How much is an Absolute Return Strategy
- How much is a Diversifier
- and How much is a Hedge
The trick is, all of these different types of Alts are ALL already in the Alts bucket (that’s a lot of Alt/all alliteration) typically sold as some combination of those terms (our super great fund XYZ is an absolute return vehicle providing diversification). The trick is knowing beforehand how your particular Alts investment is likely to perform during a market rout, and whether you are comfortable with that return/risk profile.
Absolute Return or Diversifier or Hedge
So while you’re looking in the portfolio mirror after/during the Corona Virus sell-off, ask yourself what you really want out of your Alts. Because it is all too easy to get lured into this Hedge Fund or that one expecting negative correlation during a market sell off when it really only provides NON-correlation (sometimes moving the opposite way in a crisis, sometimes not). It’s all too easy to think you’re in Alts that may protect your portfolio in a market sell-off, but they’re really designed to just give you equity exposure with less risk. To help you identify just what you’re invested in, and what it’s likely to do in a market sell off, here’s the basic buckets we view Alts in:
Equity Market Replacement
(Correlation in a Crisis = Highly Positive)
Many Alts follow the game plan identified by BMO Global Asset Management in a 2016 paper, “A good alternative [investment] should give the portfolio either a higher return for the same amount of risk or the same return for a lower amount of risk”. These Alternative Investments aren’t actively trying to provide positive returns during a market sell-off. No, they are trying to beat the stock market on a relative basis in one of two important ways: higher returns with similar risk, or similar returns with lower risk. We’re talking Alts here like Private Equity, Venture Cap, a lot of Long/Short Equity Hedge Funds, and sector region focused Hedge Funds (Asia, Healthcare, etc.). Basically, anything that relies on a growing economic cycle, functioning credit markets, and discounted future cash flows. These types of funds/strategies were, generally speaking, down alongside the market during the Covid-19 sell off; but down less. We’ll also throw option sellers and outright short volatility traders (VIX Arb with Short Vol Bias) in this bucket, as they provide a near identical long stock profile, usually with less risk in the short term, but more hidden risk over the long term (those lost more than the market during Covid-19).
(Correlation in a Crisis = Unknown and Unreliable – could be highly positive, could be low, could be negative)
These Alts aren’t directly tied to the stock market, doing things tangential to it, but may or may not have the same negative skew profile (lots of small gains interspersed with less frequent large losses). Here we’re talking certain delta neutral long/short equity and options strategies, Risk Parity, and certain stat, debt, and Convertible Arb strategies, Distressed Debt, and Alternative Debt. As well as managers doing unique things in Commodity Markets (think energy traders, Ag traders), Short Term Systematic Strategies, and newer AI quant models without much directional exposure. Absolute Returns sound great, and indeed are typically great at being non-correlated on average, but that on average part is the killer. If your hog trader just happens to be down -5% in the same month equities are down -7%, they will remain non-correlated on any meaningful lookback – but they won’t feel so Alt right there in that month that you needed them. Absolute Return is great for your portfolio as long as you understand and accept that it won’t be there for you in a crisis. It may be, but it will be tough to count on. These strategies have been mixed during the Covid-19 sell-off.
(Correlation in a Crisis = potentially high in beginning, negative in extended market rout)
These Alts are similar to Absolute Return investments most of the time, providing (on average) non-correlation to equity markets. But there is a key difference in that they have positive skew profiles and the ability to capture extended down moves in the stock market. We’re talking classic managed futures strategies here like Trend Following and Diversified, multi-market long volatility focused systematic quant funds (was that enough adjectives), and classic diversifiers like Gold and Bonds. Managed Futures as an alternative allows for crisis period performance when it is needed – while also having the ability to perform some in a rallying stock market in sort of a best of both worlds. The rub, however, is that they are an imperfect option on a short-term market crash (like last week), where their ability to have negative correlation (i.e. positive performance) during a market rout depends on how they are positioned coming into that rout. If they are already long Bonds, they’ll do well as Bonds see a flight to quality. If they come in long stocks, they’ll under-perform until those up trends end. For them to really perform, the ideal is a 2008 type of slow-moving months on end market crisis. So far in the Covid-19 sell-off, managed futures have lost some money (small single digits) in a tug of war between existing long positioning in Equities and Bonds – the former hurting, the latter helping. A quick note on bonds in this category; while true that bonds have been a flight to safety diversifier that shows negative correlation in a short term market rout – that hasn’t always been the case when looking back 50 to 100 years (see here). And there’s the little bit of an issue of bonds being near the zero bound, theoretically limiting the hedge characteristics of bonds (unless they go into negative yielding territory).
Active Long Vol: (Correlation in a Crisis = highly negative)
Which brings us to the most direct hedge available in the Alts toolbox these days, dedicated, active long volatility strategies. Otherwise known as tail risk or convexity strategies. Now, there’s lots of stuff out there which is labeled tail risk but is actually only Bonds or Gold or some other type of diversifier – so be careful and be sure to look under the hood. But true, actual Active Long Volatility strategies are different in that they actively look to profit from a market sell-off. They don’t rely on their portfolio eventually becoming negatively correlated to stocks (ehh hemm Managed Futures). They don’t rely on their historical negative correlation to stocks like Gold and Bonds. And they don’t rely on just being statistically non-correlated (the absolute return bucket). They actively set up their trades and portfolios to make money (at an increasing rate – what we call convexity) when the market sells off. The simple example to this is buying Puts, which payoff when prices fall – not because that’s what’s always happened, but because that’s how the investment is actually structured. It can’t not make money when the market falls. More advanced examples or being long and short VIX futures at the same time – the long portion typically in the front months where volatility spikes most, and the short portion being in the back months which don’t spike as much – and erode similarly to help pay for the long exposure. As alluded to there, the trick with this strategy is being able to limit the cost of owning this long volatility exposure. In the owning Puts example, you would have to pay the premium month after month until the markets move down past your Puts. That gets expensive and is essentially the reason you see the long VIX ETFs lose money month after month. The professional managers in this strategy use several methods to limit this bleed, including many different flavors and methodologies in and around the aforementioned long/short VIX strategy, the use of cheaper proxies to own Put options on stock down moves (like Bonds or Gold), and the use of short term down capture strategies which use different flavors of volatility breakout type models to try and capture short term sell-offs. So far during the Covid-19 sell off, these active long vol strategies have done quite well – as they are designed to do.
So as you look in the portfolio mirror to do your post sell-off self-evaluation. Or head down whatever path Google leads you down after you decide to Google [Alternative Investments], make sure you check the signposts and mile markers to make sure you know what Alts path you’re actually headed down. You could be on the Equity Replacement path, the Absolute Return path, the Diversifier path, or the Active Long Vol path. Any of those may be marketed as an alternative path but may in fact be a parallel path to the stock market journey you’re already on. And maybe you’re fine with that…maybe that works for you. But if you’re after something truly different, something truly alternative, something that is designed to make money during a market sell-off – make sure you’re getting what you’re after with your ‘alternative investment’. For us, that means continuing to help our clients look for dynamic investment strategies that react to paradigm shifts and get on board with them. Things that do well in volatility spikes, but also when the spikes don’t happen. Things that do well in extended down moves, but don’t crumble the rest of the time. Antifragile alternative investments that are setup for the Black Swan, but ever aware of the White Moose.
So, take a look in your portfolio mirror….and let us know what you see.