By Jack Forehand, CFA, CFP® (@practicalquant) —
For the last 40 years, managing risk for investors has been pretty easy. There have certainly been bear markets in the period, and some of them have even been severe, but the consistent negative correlation between stocks and bonds during those periods meant that bonds served as an excellent diversifier.
So as we entered 2022, many investors expected that if we got a bear market, that same formula would continue to work. That, unfortunately, hasn’t happened. As of October 7th, the S&P 500 was down around 23% for the year. The Bloomberg Aggregate Bond Index was down 15% over that same period. So not only have bonds not gone up, they have actually gone down almost as much as stocks and have offered little diversification benefit.
The issue here is obviously inflation. During deflationary bear markets, bonds work great. Yields fall, prices go up and they offer excellent diversification. But many investors have not seen significant inflation during their investing careers and didn’t recognize that during inflationary bear markets, bonds do the opposite and fall along with stocks.
The fact that bonds haven’t worked has made risk management very challenging during this bear market. But that doesn’t mean there was no way to manage risk.
One of the things we do at Validea is track a variety of ETF based risk management approaches that utilize different methods to diversify equity portfolios. Given that this year’s bear market has been very different than any other we have seen for a long time, I thought it would be interesting to take a look at how they have worked.
The major caveat to keep in mind as we do that, however, is that this year constitutes a very short period of time in a historical context. So I am looking at this not to draw major conclusions from it, but rather to illustrate how certain approaches have worked in the inflationary environment we face today.
Here is a look at what has worked from a risk management perspective in our quantitative ETF portfolios this year, and what has not.
Permanent Portfolio – Grade: C
The concept behind the Permanent Portfolio is a simple one. It is constructed by looking at the four major economic environments we can experience (growth, contraction, inflation and deflation) and investing 25% of the portfolio in an asset that has historically performed well in each of them. The result is a portfolio that consists of 25% stocks, 25% long-term bonds, 25% cash of short-term bonds and 25% gold. This portfolio has worked exceptionally well historically at limiting drawdowns because it has typically always had something that is working well. The maximum drawdown coming into this year of this portfolio was around 13%. But like many portfolios, this one is also making history in a bad way this year.
This chart from Portfolio Visualizer shows all the historical drawdowns of the Permanent Portfolio back to the 1970s. What probably stands out to you is that the biggest drawdown it has seen is the one we are in right now.
The problem with the Permanent Portfolio this year has been that the asset it holds for inflationary times has not worked. Instead of producing a positive return in an inflationary environment as intended, Gold is down 7.7%. So while the Permanent Portfolio has outperformed a 60-40 portfolio this year, it hasn’t done so by much.
All Weather Portfolio – Grade: F
The All Weather Portfolio is based on the work of Ray Dalio. The version of this run by Dalio for Bridgewater is obviously a much more complicated one, but the basic version that can be replicated using ETFs invests 30% in small and large-cap stocks, 40% in long-term bonds, 15% in intermediate-term bonds and 15% in securities that would be expected to perform well in inflation (7.5% in gold and 7.5% in commodities).
The big positive for this portfolio this year has been the direct commodity exposure that it couples with gold in the inflationary basket. The downside, which has more than offset that upside, is the portfolio’s large exposure to bonds, and particularly long-term bonds. The end result of all of that is a performance this year that slightly trails the 60-40 portfolio.
We also run a version of this portfolio called the Modified All Weather portfolio that uses the same exact asset classes, but runs a trend following overlay that will move any asset class to cash if it is in a down trend. That version is down about half the standard version, so trend following has helped limit losses.
Protective Asset Allocation and Generalized Protective Momentum – Grade: A
Picking up on the idea of using momentum and trend following, these two approaches are based on research papers by Keller and Keunig. In the papers, they selected from a diverse series of assets (the S&P 500, the Russell 2000, the NASDAQ 100, European Equities, Japanese Equities, emerging market equities, long-term treasury bonds, high yield bonds, corporate bonds, commodities, gold, and real estate).
Protective Asset Allocation invests in the 6 of those assets with the most momentum at any given time. Generalized Protective Momentum uses a score that combines an asset’s momentum with its correlation with the other assets and selects the top three assets with the highest score.
Both utilize a system that will move the portfolio more and more into short- or intermediate-term bonds (whichever of the 2 has the most momentum) as more and more assets within the basket of twelve develop negative momentum.
There is a saying in markets that price is truth and these portfolios use that idea to follow whatever the market is telling them. This has the advantage of being able to adapt to different types of bear markets, including ones like the current one that throw a curveball at investors’ popular beliefs about what works in a bear market.
Year to date, both of these portfolios are down around 6.5%. So they have done a much better job of protecting from losses than the 60-40 portfolio, or any of the other approaches we follow.
These are obviously only a few of the ways investors can manage risk. There are many others that we do not follow because we can’t build quantitative versions of them using ETFs that have performed very well this year. Managed Futures is one example of that.
And as I said before, how any strategy performs over a nine-month period tells you very little about its long-term performance. But I think it is interesting when we get a risk-off event, particularly one like this that is very different than the others we have seen, to look at how various risk-managed strategies hold up. In this case, it is a mixed bag. But looking at risk management strategies that go beyond stocks and bonds may be very important for investors going forward, so keeping an eye of these and other approaches may be worthwhile.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
