Risk Management Can Be Very Impactful Over An Investment Cycle - Our Current Strategy
Keith Jaworski CFA• Principal at Quantimental Investments. Former Research Director, Hedge Fund Manager, Portfolio Manager
I posted an article in January suggesting hedging into the impending Fed tightening cycle. Here's how equities (S&P 500 and NASDAQ) and bonds (Barclays Aggregate and 20+ Year US Treasury Bonds) have performed since. We utilize an econometric model to identify shifts in the economy in order to front-run the Fed (recall that just 12 or so months ago the Fed characterized inflation as “transitory” and “they weren’t even thinking about thinking about raising rates”!) as well as other market participants. We utilize mathematics to mitigate much of what we would consider noise in the decision-making process in pursuit of consistency. Over the past few months, we have heard from quite a number of folks that “nobody saw this coming”. We would agree that many firms did not, but we did and recommended others consider hedging as well. In addition, we warned investors they would not be safe in most bonds in a rising interest rate regime and suggested that the old models were “broken” at those interest rate levels. Bonds have been a very poor hedge against stock losses this year. In fact, long-term, AAA-rated, US Treasury bonds of 20+ years have actually underperformed the S&P 500 Index having lost over 27% of their value since that article.
So, what are we doing now?
Earlier this month, on the day of the Fed meeting, we decided to further leverage our year-to-date relative performance gains by rolling some of the cash from the January reallocation into a structured note. The note, maturing in 13 months, will return the inverse of a loss on the S&P of up to 20% or, if the S&P rises instead, up to 9.75% from the index level that day. Finally, if the S&P declines more than 20% at maturity, investors will only be insulated from the first 20% of the decline (still quite significant). Attached is a table and graph of the note’s expected payoff at maturity.
So, for example, $1 invested in the S&P on the day of our January article would now be worth approximately $.80 (-19.99%) whereas cash raised from hedging would be worth a little over $1 (including interest). Looking forward, if a portion of that cash was reinvested in the structured note above and the S&P were to decline another 15%, the original unhedged S&P investment would be worth around $.68 but the cash rolled into the structured note would be worth approximately $1.15. In that instance, the performance spread would be almost 50%. This is referred to as alpha generation, i.e., an example of how we think our investors get excess value for the management fee they pay us. Leveraging a structure like this allows us to build positive optionality into our strategy without having to guess where the ultimate “bottom” of the bear market will be!
The bottom line, while we aim to be largely invested throughout the economic cycle, we maintain that there are important points to lower risk as we indicated in January of this year, which can be very meaningful to long-term investment returns.
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Link to the original January Article: https://lnkd.in/gkhY38Za
