Diversification’s Failure and the Need for Non-linearity
This is a summary of an article by Muntu Mdwara and Dr Michael P. Streatfield, CFA. We would highly recommend reading the full article on the STANLIB.com website by clicking here.
The core tenet of a traditional balanced fund (60/40) is a combination of equity and fixed income (bonds) to manage risk across business cycles. The investor hopes that in times when equity does badly, bonds will step up and provide defensive support.
This was certainly not the case in this year’s equity collapse, as the COVID-19 pandemic gained momentum. In the first quarter of 2020, returns for South African retirement investors in both the domestic-only (SA Large Manager Watch) and global (balanced with international) portfolios collapsed and had still not recovered four months later. Drawdowns of double digits were experienced, even for the global “more-diversified” portfolios.
At the peak time of equity distress in March 2020, equity’s correlations to bonds surged above the past five-year average of 0.29 to 0.85. In other words, as equity prices fell in the quickest bear market ever, bond prices did so almost as rapidly. Our analysis shows the average level of correlations across asset classes has more than doubled from around 20% before the COVID-19 pandemic to roughly 60% over the last six months.
Exploring the 60/40 Portfolio Downside
Investors in practice are more concerned about tangible changes in their wealth, not mathematical relationships they cannot see, like correlations. We also know from behavioural finance that investors are more sensitive to losses. So, we explore what losses a typical 60/40 balanced with international portfolio would suffer, using historical asset experience.
We created a portfolio using total returns from four broad asset class indices. We used the JSE total return history over 18 years. This is a costless, hypothetical portfolio in which we rebalance to static weights on a monthly basis. The portfolio uses the current 30% offshore allowance and is split 60/40 between equities and fixed income. The goal of this exercise is to get an empirical idea of what an investor’s regulatory portfolio today might experience, drawing on asset performance from SA’s history.
We outline the magnitude of such losses expected from history, showing the top five drawdowns of this hypothetical portfolio, and what has happened to the building blocks from the start of the drawdown period in Table 1. The negative performance of South African bonds in the latest drawdown (the third one) clearly stands out. In the Offshore Bond space, the bonds only provided positive performance in three of the five drawdowns.
This sets the scene for the need for investors, despite geographical and asset class diversification, to contemplate downside risk management in these larger tails to manage these large drawdowns.
The cost of hedging
One approach to manage tail risk is to hedge the risk by paying for protection. However, equity hedging is costly. Estimates of even highly-liquid US equity three-month option premium costs can average 1.5%, but the cost range has large positive skew and can go as high as 3.5% to 4.5%. We believe that a passive approach or mechanical mindset of rolling can be expensive, and is not the optimal solution. An active approach is needed to minimize hedging costs.
Hedged strategies do, however, help to cushion large falls, so there is a case for tactical hedging, although continuous hedging is not practical.
Investors need to step back and choose when to add protection. STANLIB Absolute Returns uses a lens approach, in which we look at markets through different lenses. One of these lenses is volatility. We found that different volatility regimes (high, medium and low), as assessed from the VIX, can provide vital information on the forward risk (as measured by future drawdowns) depending on the regime. This regime can signal when it might be more economical to hedge.
The most liquid market for trading volatility is the S&P 500. There is an inverse relationship between the VIX Index and the S&P 500. When we see large positive changes in the VIX Index, we can expect the S&P 500 has negative monthly returns. The potential drawdowns for investors can greatly depend on the state of market volatility at the outset. This holds important information for the timing of hedging.
Active managers will choose when to put on hedging protection, agree on a budget for the inevitable drag of protection on the return, make informed calls on which contracts to buy (given the volatility term structure), and what derivative strategies to put on (e.g. put spreads). This will also be done in the context of the other portfolio assets and market conditions.
Apart from derivatives, other approaches to manage downside risk are non-traditional assets such as risk premia, private equity, hedge funds, FX or volatility strategies. These all have pros and cons but can be proactive ways of addressing the bond equity correlation in extremes.
Implications for retail investors and fiduciaries
- The traditional balanced fund approach of simply holding bonds is not a guarantee of safety. In extreme market conditions, conditional correlations between equities and fixed income can rise, as we saw in March 2020. Bond funds are not the only answer to manage risk.
- Hedging tail risk is one way of managing tail risk, but a passive systematic ‘always putting your foot on the brake pedal’ approach is very expensive, both in return upside foregone, as well as the actual risk in implementation.
- There is a growing need for active investment management approaches to choose non-traditional ways to tactically deal with non-linearity – choosing the appropriate conditions and execution for hedging.
- More than one lens is needed to view the market. Volatility conditions can provide insight into when hedging can be more cost-effective.
- In very benign markets, equity hedging eats up returns and downside risks are low. In highly volatile markets, when fear is already high, it is not the time to hedge. Protection costs are excessive. It is really in the “Goldilocks” times that dynamically hedging can take the sting out of the drawdown tail.
Multi-asset approaches need to evolve, both in how managers address diversification in extremes and how they purposefully hedge tail risk. Multi-strategy is such an evolution.