Chief Investment Officer & Portfolio Manager
Recent market action is giving new meaning to the concept of risk management. As investors look for ways to mitigate risk, reassessing what to own and what to dump in fast-moving markets, some ETFs are emerging as true winners.
We’ve said this before: Many of these alternative-type funds don’t get a lot of attention when times are good because they are designed for downside protection. They are like insurance policies built into ETF wrappers, and it’s hard to get too excited about insurance when everything is going well—until, of course, insurance is all you need.
Look at the Cambria Tail Risk ETF (TAIL), for example. It’s one of the best-performing ETFs this year—outside of leveraged/inverse and volatility-linked strategies. The portfolio, which owns primarily cash and U.S. government bonds, also invests in out-of-the-money put options on the S&P 500 Index. Its year-to-date returns relative to the SPDR S&P 500 ETF Trust (SPY) are impressive:
Chart courtesy of StockCharts.com
TAIL is only one of many asset allocation ETFs performing well. Meb Faber, head of Cambria and the well-known quant behind actively managed TAIL, tells us what’s working so well in this space, as well as where opportunities lie ahead. Here’s a snippet of our conversation:
ETF.com: Why is TAIL working so well, even relative to other hedged-type asset-allocation strategies?
Faber: When we launched this fund three years ago, we wanted to offer something that was better and cheaper than what was available, and TAIL does both things. A lot of hedged products are either complicated or super expensive. The category average is 1.9%. TAIL costs 0.59%.
We also wanted it to be simple. When you look at the worst months in U.S. stocks, what traditionally hedges those? The things you wouldn’t expect to hedge—foreign stocks, emerging markets, real estate, energy-related commodities—and what you’d expect usually works, which is bonds, gold, cash.
What really works is tail risk, which the way we apply it, is to buy a ladder of puts on the stock market. The puts are a ladder from three months on all the way out to 15. Every month we roll the one that's closest and buy the one that's farthest. Traditionally it's about -5% to -10% out of the money when we rebalance. It should do well in times of market stress. And then, we paired it by putting the collateral on 10-year U.S. government bonds. The two things together should do a good job.
We tried to model it back in history, to the 1980s, and found that it acts very much like an insurance vehicle. When times are good and the S&P 500 is up, it's probably going to be at cost, just like fire insurance or house insurance or car insurance. And when times are bad, it can do a good job of hedging.
ETF.com: With the S&P 500 down almost 30% from 52-week highs, TAIL can own out-of-the-money puts down to -30%, so what happens here? What’s the investor experience if we dip further?
Faber: We just kind of let the puts float. Traditionally, this is a long-term fund, despite the way everyone is behaving, this week, this month. Every month, it resets to where that market is. It'll sell the one that's closest, buy the one where the S&P is trading that day. And the next month it'll do the same.
So, we're not really adjusting the actual ladder. Sometimes, like right now, most of the puts will probably be in-the-money because the market's puked. But we'll sell one and we'll buy one where the market’s at.
One other feature, or caveat, depending on your perspective, is that the puts are about 1% of AUM per month. When volatility's really low—like it had been the last couple years—we end up owning more puts than we would when volatility is really expensive, like it is now. So we're actually buying less now, which adds a little bit of mean-reversion sort of capability.
What you end up with on the downside, when the market's down, is a lot like an inverse S&P fund. But hopefully, when the S&P is romping or times are flat or good, it does better than an inverse S&P because of the way it's designed. That's the hope.
ETF.com: Now, markets have been completely crazy. Nobody knows what happens next. Some are looking for a bottom, some say doomsday is still on the horizon. How can an investor be prepared for the bull case or the bear case right now? What do you do?
Faber: I could very convincingly give you a scenario that is a terrible bear, where the virus isn't contained, it goes exponential, treatments are not effective, governments can't contain it, fiscal monetary policy is defective. Then it reemerges—a nightmare. Then, you could say U.S. stock valuations which are down from 32 to around 25 now—the average is around 18—could go back to the global financial crisis low, which is 50% down from here.
On the flip side, you can say the world ends up looking more like Korea than Italy, and treatments are effective, vaccines are developed and widely distributed, all the policies work and this is gone in two months, in which case we're romping and stomping back to all-time highs.
You have to be able to, as an investor, hold both of those possibilities in your head, not just that they're equally likely, but possible. In reality it's probably somewhere in between.
You need to have a plan set ahead of time. If you have your portfolio in place, you have your strategies already, then for the most part, you're going to do nothing because it's designed for things like these, designed for particular outcomes. It’s like that John Bogle quote, that in a crisis, while some believe you shouldn’t just stand there, do something, in reality it’s, “Don’t do something, just stand there!”
For me, that's been the Trinity portfolio: half global diversified asset allocation across global stocks, global bonds, global real assets, and half the portfolio is in trend following, which adjusts with the market. Then layered on at the very end—which is for most people a personal decision—is tail risk.
We've disclosed many times over the years that I have a big chunk of my portfolio in the tail risk. My company's balance sheet has a big chunk, almost a quarter of the cash in my company is in tail risk. That's what works for me.
For other people, if you've got a 60/40 portfolio and that's what you designed, you rebalance it once a year, that's perfect. Go for it. The problem is, people start to get emotional and the market goes down another 10%, 30%, 50%. The simple answer is, hopefully you had a portfolio ahead of time that lets you sleep at night. Do not react crazy.
ETF.com: Where do you see opportunity?
Faber: If you're looking for opportunity, there's a lot of opportunities now for what we call over-rebalancing or calibrating or trimming. You could tilt a little more towards value. Maybe you're looking at closed-end funds that are trading at 30%, 40%, 50% discount. Or maybe you're looking opportunistically at assets that rebound 80-90%, whether it’s sectors, industries, countries. All those are things I think to add at the periphery.
We've been saying for a long time coming into this year, the stock market's expensive. Foreign markets are much cheaper. Emerging markets are cheaper still. Now you can lop off another 30% of all those. U.S. stocks are still on the expensive side. They're very close to average. They're no longer what I would call really expensive.
The good news is, foreign developed is downright cheap. Foreign emerging is screaming cheap. To the extent you're wanting to allocate away from the U.S., and those investors who have a massive home country bias here, this certainly could be a generational buying opportunity in emerging markets, the emerging market value. We have EYLD [the Cambria Emerging Shareholder Yield ETF]for instance, one of the cheapest funds in the entire ETF universe on value metrics. That to me is the biggest opportunity.
ETF.com: Is there any question or comment you keep hearing from clients or on social media about investing in these markets right now that you wish would just go away?
Faber: I think this is an interesting experience for people. It's hard to really know what you're OK with as far as risk until you go through it.
A very real, physical, visceral pain of losing money is an academic exercise until it happens. One of my favorite quotes in all investing is: “It's the only business that, when things go on sale, everyone runs out of the store.’” Young people should be ecstatic that markets are going down because they're able to allocate at a much lower price for years now, hopefully.
But that's easier said than done. It all ties back to having a plan in the first place.
We did an old piece called, “The Investing Pyramid,” that I think talks to this topic of laying the foundation of what's really important. For most people, nothing has been that interesting or dramatic.
So, this is a great opportunity for a lot of people to experience volatile markets, but realize that this is normal; -5%, -10% down days happened all the time in the past. Once you realize that, feel OK and park your emotions at the door.
Contact Cinthia Murphy at [email protected]