Dickson On The Best Portfolio Insurance

December 30, 2013

Vanguard’s Joel Dickson argues that when it comes to combating black swan events, nothing does the trick as well as good old government debt.

The economy might be on the mend, and the U.S. Federal Reserve might be taking its foot off the gas when it comes to pumping money into the system, but that doesn’t mean things couldn’t go wrong. “Black swan” events could be lurking for all we know.

The very definition of a black swan event is that it’s an unforeseen one, meaning the only defense against unpredictable tail risk is a strong offense. Joel Dickson, senior investment strategist at Vanguard, who will be discussing this topic at the upcoming Inside ETFs conference in late January, argues that the best weapon of choice when it comes to protecting portfolios from black swans is high-grade sovereign debt, pure and simple.

IU.com: At the upcoming Inside ETFs conference, you’ll be talking about how to prepare for black swan events. Is the Lehman collapse one of the most recent of such events, in your view?

Joel Dickson: Yes. But I have to say that one of my goals for that panel discussion is to try to have some sort of rationality around this theme, because “black swan” has become a bit of an overused term. As a matter of fact, it’s gotten so overused that I’m wondering if white swans are the ones that are rare. We seem to have a new black swan event every year.

From an investment standpoint, we don’t know what the next “black swan” is going to be, but everyone seems to look to complicated strategies for some sort of portfolio insurance, just trying to not have the portfolio crash when everything else around it is crashing

But from what we’ve seen in past events—and certainly the global financial crisis showed this dramatically—is that most risk assets declined together. For all of the uncorrelated assets that were around prior to the global financial crisis, they were basically all very much correlated once we got into the black swan event

If what we’re talking about are really bad black swan events, the one source of stability—at least historically—has been high-quality sovereign debt such as U.S. Treasurys, German bonds, Japanese bonds. That is the flight to safety. In some ways, you don’t have to be more complicated than that

IU.com: That’s all the portfolio insurance you need.

Dickson: We already have the instruments people need to protect themselves from black swans, which is a diversified, balanced portfolio that includes high-grade, sovereign debt

IU.com: To be clear, how do you define a black swan event?

Dickson: I think when people think about insulating portfolios from black swan events, they are thinking about an unforeseen catastrophe. The concern around black swan events is how you, in essence, provide insurance in a portfolio against the small probabilities of very bad events.

IU.com: Beyond Treasurys and, as you suggested, high-grade sovereign debt, what else is there that really, truly offers that kind of insurance?

Dickson: There might be other options. If you are worried about equity market blowups, you can think about put option strategies, like out-of-the-money put option strategies, for example.

Keep in mind that these are forms of insurance that tend to be very costly. You’re going to pay a lot for option strategies that may protect in those outside cases, but it’s not clear that, over time, the insurance is worth the price. And that’s a question that investors have to think about.


Dickson (cont'd.): The analogy I would make is that you have fire insurance for your house. That’s a black swan event, and pretty much everyone has fire insurance. We all know it’s not worth it, but the question is, Do you still have it, even though the probability of a fire occurring and you needing it is very small?

Investors have to decide that for themselves. I understand the want for it, but you can do it more cheaply, more effectively and more consistently in the form of a high-grade, fixed-income portion of your overall portfolio.

IU.com: Are ETFs the best vehicles to accomplish that, or not necessarily?

Dickson: You can do it any way you want. ETFs are just a delivery mechanism for an investment approach.

IU.com: Why are we talking about black swan events now? Aren’t the U.S. and the global economy on the mend?

Dickson: Well, there’s always tail risk, and we can talk about insulating portfolios from bad events. The main message here is that you don’t have to be all that complicated in terms of the implementation of this portfolio insurance, because the best way to insulate portfolios from unforeseen risk events that could hurt broad equity and other risky asset returns is with high-grade sovereign debt; it’s that simple.

IU.com: As we head into the new year, most seem to expect something to start happening to interest rates. How should investors position their fixed-income allocations at this point?

Dickson: From a Vanguard perspective, we very much say that the market has already priced in what the general expectations are, whether it’s fixed income or equities, meaning that any bets you make relative to the market, or to fixed income, is a bet on your personal view versus the market’s current information consensus.

Because the fixed-income market already has priced in rising rates, over the course of the next several years, that doesn’t mean you could make money by shortening duration necessarily just because you expect rates to go up. The market has already priced that in, in the form of a very steep yield curve where you give up the income component.

That’s to say that in terms of total return, a broadly diversified fixed-income portfolio remains appropriate, like a Barclays Aggregate aproach to the U.S. investment-grade marketplace.

In the end, that fixed-income allocation maintains its role in the portfolio as a diversifier for the equity-centric portfolios most investors have. That’s one of our ways of saying “stay the course.”



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