Swedroe: Correction Protection In Liquid Alts

February 26, 2018

Equal-Weighting Alt Funds

The tables also show the return of an equal-weighted hypothetical portfolio of the four funds. The use of “naive” (1/N) equal-weighting is common in academic research because it avoids the risk of data mining (looking for the mix that produces the best result). There is, however, a second reason to use that approach.

If you believe markets are efficient, it follows that you should also believe all risky assets should have similar risk-adjusted returns. That leads one to conclude that assigning an equal weight to each of the four alternatives is a good strategy. Individual investors may have their own preferences (for example, they may understand the risks of reinsurance but not the complex strategies of QSPRX, and thus avoid the more complex fund), but equal-weighting is a good starting point/default.

I’ll begin with reviewing the performance of the four alternatives during the February 2018 “correction.”

 

 

While the equal-weighted portfolio experienced a loss of 1.6%, it was less than one-fifth of the 9.0% loss experienced by a globally diversified, market-cap-weighted equity portfolio. In addition, it was only slightly worse than the loss experienced by BND, Vanguard’s total bond market ETF. Clearly, the strategy of using alternatives passed this short test, demonstrating the value of diversifying risks across unique risk factors. That said, it is important to note the performance of AVRPX.

A Look At The Laggard

AVRPX sells puts and calls on 50 different assets (referred to as underliers) in the asset classes of stocks, bonds, commodities and currencies, and diversifies those exposures across various strike prices and maturities so the fund typically has positions in about 1,000 different individual investments, to earn an expected variance risk premium (VRP).

However, when volatility spikes, it is expected that the fund will experience losses. One measure of equity volatility, the VIX, closed Jan. 26 at just over 11. It hit a high of 50.3 on Feb. 6, and closed at 29.1 on Feb. 9. Note that this was the largest increase over such a short period in VIX’s history. By the close on Feb. 16, it was back down under 20.

Given the spike in volatility, it was no surprise that AVRPX didn’t perform as well as the other alternatives when equity prices were dropping dramatically—its correlation with equity prices is higher, though relatively low over the long term.

Options Diversification

Note also that AVRPX benefited from its diversification across securities and asset classes, as some of the options it sold did generate profits during this period. That is why we not only recommend using this fund (instead of one that only sells equity volatility insurance), but also that investors build a portfolio of alternatives, not add just a single strategy. Each of the four alternative strategies I’ve addressed has low correlation to the others.

It’s also important to note that when volatility spikes, the ex ante VRP increases, and so do the fund’s future expected returns. Thus, losses are often quickly recovered. In this case, by the close on Feb. 16, the fund had recovered 1.2 percentage points of the 4.9% loss (about 25%) it experienced.

Reviewing 2017 Performance

I’ll now turn to a review of how these alternatives performed in the strong equity market of 2017. In 2017, VOO returned 21.8%. VEA returned 26.4%. VWO performed even better, returning 31.5%. A globally diversified portfolio, weighted approximately by market cap (U.S.: 1/2; developed markets: 3/8; emerging markets: 1/8), would have returned 24.7%. BND returned 3.6%.

 

 

In a year like 2017, when the market beta premium was high, the portfolio of alternatives should be expected to underperform equities. The stronger the performance of market beta, the larger the gap is likely to be.

Under & Outperformance

Given the very strong performance of global equity markets, we should have expected that the alternatives portfolio would underperform—which it did, by 20.2 percentage points. We also should have expected it would outperform the bond portion of the portfolio, which it did as well.

The alternatives portfolio also outperformed, as expected, in the February 2018 market correction, by 7.4 percentage points. In both cases, the strategy of adding alternatives was performing its role, reducing the potential dispersion of returns.

Unfortunately, we don’t have a clear crystal ball that would allow us to switch our allocation between equities and either bonds or alternatives ahead of market moves. Thus, if we want to reduce the risk of the portfolio without significantly sacrificing expected returns, we must accept the tracking error that will occur—with the alternatives acting as a drag in years when equity returns are strong, but providing ballast during years when equity returns are negative.

The strategy incorporating alternatives was working, doing its job in both periods we examined. There are no free lunches in investing, other than diversification.

Reducing The Risk of Black Swans

In our 2014 book, “Reducing the Risk of Black Swans,” Kevin Grogan and I showed investors how they can potentially reduce the dispersion of returns and tail risk without sacrificing returns by “tilting” their portfolios to the size and value factors while at the same time reducing their overall allocation to equities and increasing it to safe bonds.

An updated version of the book will be published this spring. It will not only refresh the data, but include new material on how we believe adding alternative investments can further improve portfolio efficiency and reduce tail risk.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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