For nearly forty years investors of all stripes have relied on the 60/40 portfolio, the cornerstone of traditional asset allocation, to balance the competing demands of preserving and enhancing capital.
Beginning in the early 2000’s, risk management was pushed to the backburner by most portfolio managers as easy money and successive rounds of increasingly large stimulus spending brought all asset classes up in an elevator. Novices poured into the market and were rewarded for throwing caution to the wind, while more conservative investors could sleep well at night knowing their portfolios were ballasted with bonds.
The widespread exuberance that defined financial markets over the previous two decades came to an end, and investors were finally forced to reckon with the risks they’d been carrying in their books. Rising interest rates, surging inflation, and geopolitical uncertainty sent stocks and bonds lower in tandem. With bonds failing to serve their intended function as portfolio shock absorbers, the efficacy of the 60/40 portfolio – which fell 17% in 2022 according to Blackrock - has justifiably been brought into question.
To give an analogy to last year’s events from a risk management perspective, it’s as though a patient was told by his doctor “you can eat a cheeseburger and fries every day and you’ll be fine, as long as you take this pill.” Ten years later, the patient, now obese, suffers a heart attack. Lying on his death bed in the hospital, he cries out to the doctor: “but I took the pill!” The doctor shrugs: “I guess I was wrong.”
Looking ahead, we expect the current whirlwind of geopolitical and economic disruptions will continue. In such an environment, risk management is paramount. From our perspective, investors can do much better than hoping the 2022 (not to mention March 2020) breakdown of the perceived relationship between stocks and bonds was an aberration.
For investors looking for downside protection, well-constructed option strategies can provide several advantages over bonds and other alternative products that are marketed to have a low correlation with the stock market. Options can provide a predictable and reliable hedge to an equity portfolio unlike any other asset, and when used properly, they can efficiently solve for specific concerns in a portfolio.
For years, long-short equity hedge funds, despite their egregious fee structure, were the preferred vehicle for sophisticated investors looking for equity exposure with less volatility. What turned out to be the case was that many of these funds were effectively leveraged-long funds riding a decade-long technology stock wave on the back of ultra-low rates. As a group, they’ve ended up becoming the worst of both worlds: failing to keep up with the benchmarks in the good years, and struggling on the downside. In fact, a study by Goldman Sachs indicated that during periods of market decline, the long picks of L/S funds tend to perform worse than the short picks.
We do not consider ourselves to be an overlay strategy, and unlike high-yield bond funds or alternative assets which can lack liquidity when it is needed the most, our fund exclusively consists of highly-liquid S&P 500 options and ETFs. Our proprietary four-quadrant strategy, which adjusts to the current volatility regime as reflected by the VIX and the skew, provides growth and stability, allowing investors anticipating volatility events to maintain a balanced diet and comfortably remain invested in the market.