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October 2021: No Need to Fear Overvalued Markets
Posted in Market Commentary on 2021-10-16

Summary

  • Hedgewise has performed very well in 2021, with YTD gains of 15-20% within the higher target risk levels.
  • Many clients worry that the "Fed bubble" and associated market froth will threaten these gains, which can feel especially acute after a month like September when many asset prices fell together.
  • The reality is closer to the opposite: cross-asset drawdowns usually reverse, regardless of what happens subsequently to individual asset classes.
  • Unlike traditional passive approaches, Risk Parity is far less sensitive to "bubbles", wherever they occur. Leaving cash on the sidelines tends to be a far bigger risk, regardless of current market conditions.

Introduction: A Terrifyingly Great Year

2021 has been a fantastic year of performance against a backdrop of extreme fear. Equity valuations are 15-25% higher than their historical averages, interest rates have nowhere to go but up, and price levels for all kinds of goods - groceries, cars, houses, you name it – have been skyrocketing. Intuitively, this feels like a terrible time to be an investor, and that may be true for individual asset classes. Fortunately, Hedgewise clients do not need to share these concerns.

The brutal contradiction of market bubbles is that it can be a terrible move to try and avoid them. Equities provide a nice case-in-point in 2021: earnings this year have come in about 20% higher than the initial analyst estimates in January, which accounts for almost all the YTD gains. Even if the "overvaluation" were to suddenly correct tomorrow, earnings have already made up for it. It would be painful to suddenly lose 20%, but if you had invested since January, you would merely return to breakeven.

The problem for traditional passive investors is that years like 2000 or 2008 exist as real possibilities: losses of that size can wipe out a decades' worth of gains or take a decade to recover. It seems natural to apply the same caveat to Risk Parity, though that would not be proper. The most powerful aspect of the Hedgewise approach is how dramatically it reduces the possibility of such extremes.

The ideas are simple: reduce exposure to assets as their inherent risk increases and balance the overall portfolio equally against any economic outcome (growth, recession, inflation, or deflation). Over the short-term, it can feel scary to trust how this works. Isn't it still vulnerable to an "everything bubble"? What if it happens suddenly? Yet a vast amount of data and theory demonstrates incredible persistence and shows why Hedgewise Risk Parity remains an excellent option, especially during times like these.

Reviewing 2021 YTD Performance

Here is a quick look at how Hedgewise has done compared to the other major asset classes year-to-date. The following shows the performance of the Risk Parity "Max+1" strategy, which is the active Hedgewise portfolio with the closest target volatility to the S&P 500.

Hedgewise RP Max+1 Performance vs. Other Asset Classes, 2021 Year-to-Date

As of 10/15/2021. Risk Parity returns based on a composite return of all clients in those products and include all fees and commissions. Asset returns based on publicly available benchmarks and include an estimate for all dividends assumed re-invested. See full disclosures at end of article.

Hedgewise has managed to keep up with stocks despite an environment of high volatility and significant underperformance in bonds and commodities. Diving a little deeper, it has been a terrible year for gold and 30yr Treasuries, both of which represent significant pieces of the Hedgewise portfolio.

Performance of Gold and 30yr Treasury Bonds, YTD

Source: Federal Reserve, Hedgewise Analysis. Data through October 1, 2021. 30yr Treasury returns based on publicly available benchmarks and include an estimate for all coupons assumed re-invested. See full disclosures at end of article.

Both assets showed signs of elevated risk throughout the year, so neither drawdown had a significant impact on the Hedgewise portfolio. The growth assets that rallied alongside this (i.e., industrial commodities and equities) easily compensated for any losses.

These details paint the more nuanced story of the Risk Parity portfolio. At the start of 2021, it was true that bonds and gold were about to lose ~10%, but that also meant that growth would be strong enough to sustain rich equity valuations and drive significant earnings expansion. This balance is inherent in any given economic outcome; an "everything bubble" is only dangerous if they all somehow pop at once.

This can happen over a short timeframe, but it is fundamentally unlikely to persist. Usually, it is a sign that investors fear conflicting possibilities, but only one can happen. Last month presented an excellent case study for this pattern.

Why Did This Happen in September?

Investors are especially jittery about rising interest rates. In September, the Fed was a little more hawkish than expected, which activated a broad "risk-off" move. Bond investors fear higher yields, and stock and commodity investors fear lower global growth. This naturally resulted in a cross-asset drawdown.

Hedgewise RP Max+1 Performance vs. Other Asset Classes, September 2021

Return from 09/01/2021 thru 09/30/2021. Risk Parity returns based on a composite return of all clients in those products and include all fees and commissions. Asset returns based on publicly available benchmarks and include an estimate for all dividends assumed re-invested. See full disclosures at end of article.

This performance suggests confusion because the Fed is raising rates to fight inflation, but inflationary assets like copper and gold are falling because of worries about global growth. This tug-of-war must eventually reconcile; either the economy can tolerate higher real interest rates, or growth slows down so much that the Fed must reverse course. At least one asset class should be rallying, but no one knows which one yet.

While this may need a few months to resolve, it always has. The following chart shows the six-month subsequent performance for each asset class following any month where stocks lost at least 3% and neither bonds nor gold rallied alongside.

Performance of Major Asset Classes, Six Months Following A Cross-Asset Drawdown

Source: Federal Reserve, Hedgewise Analysis. Asset returns based on publicly available benchmarks and include an estimate for all dividends assumed re-invested. See full disclosures at end of article.

While it is difficult to predict which asset class will recover, the Hedgewise approach makes that unnecessary. Since at least one will rally, it is unlikely that Risk Parity will sustain much additional loss. This is in stark contrast to passive equity investors, as exhibited by the following chart.

Performance of S&P 500 vs. Risk Parity, Six Months Following A Cross-Asset Drawdown

Risk Parity Performance based on a hypothetical model that relies on the same algorithm used in live client portfolios set to the "Max" risk level. Data based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. See full disclosures at the end of the article.

Notice how the Risk Parity model mitigates every major drawdown in the S&P 500. This happens because bonds and gold tend to rally if the S&P 500 falls further, and because the strategy minimizes overall exposure in risky conditions. When utilized intelligently, these techniques function in any market environment. That said, "stagflation" (i.e., sluggish growth alongside high inflation) does introduce a few wrinkles, including the ”outlier" Risk Parity drawdown of 1981. This is worth exploring more deeply, especially since stagflation is one of our major present concerns.

What To Expect From Risk Parity During Stagflation

Stocks and bonds generally suffer losses during stagflation, but real assets like gold, energy, and industrial metals can outperform because those raw commodity prices are a significant piece of inflation. Alongside broader risk management, this explains how Risk Parity weathered the decade-long stagflation of the 1970s and provides a template for what to expect if it happens again. Risk Parity consistently outperformed the S&P 500, but also experienced frequent, sizeable drawdowns (the size of each loss is highlighted on the graph).

Performance of S&P 500 vs. Risk Parity, 1974-1982

See prior disclosure.

Notice how the drawdowns were short-lived and happened alongside annual gains of nearly 10%. This makes perfect sense! Investors were incredibly nervous, and the news was frequently bad: profit margins were under pressure, raw material prices were soaring, and no one knew how high interest rates needed to rise to get inflation under control. Amidst the resulting volatility, various asset classes became undervalued, and Hedgewise was well-positioned to participate in the ensuing rallies. To succeed in this environment, investors needed to constantly look past near-term losses with the understanding that these events had fundamental reasons to resolve.

The takeaway is that short-term drawdowns - even drawdowns of 20% or more - are par for the course, especially in an environment of stagflation. Even if you had invested at precisely the wrong moment in 1974, 1975, or 1977, you still accrued significant gains over any three-year period.

The high volatility presents a temptation to time the tops and bottoms, but this requires an immense degree of precision, and overlooks a significant opportunity cost. Whenever you have cash on the sidelines, you miss potential gains in every month outside of the drawdown. For example, the 15% loss from September to December 1978 was preceded by an even larger gain in the two months prior.

To provide broader historical context, the following table calculates this prior "breakeven period" for every major drawdown of the Risk Parity model since 1970. In other words, this shows how many months you needed to invest before each drawdown to completely offset it.

DateTotal LossMonths Invested Prior to Peak to Fully Offset Loss
September 1974-17%13
October 1975-18%9
February 1977-14%3
December 1978-15%2
April 1980-24%8
October 1981-23%14
July 1984-27%8
September 1988-21%12
May 1990-21%7
December 1994-17%9
September 1996-14%3
November 2008-16%5
November 2018-14%4
Source: Hedgewise Analysis. Risk Parity Performance based on a hypothetical model that relies on the same algorithm used in live client portfolios set to the "Max" risk level. Data based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. See full disclosures at the end of the article.

Even if you had perfect foresight, and could time every drawdown's exact top and bottom, you are usually better off investing earlier and ignoring the subsequent volatility (on average, the breakeven period is 7 months). Consider the experience in 2021: the same set of risks exists today as did back in January, and many investors have been sitting in cash since then in anticipation of bubbles popping. They have now foregone YTD gains of nearly 15% and will need to time a drawdown of at least that size to merely catch up, if such an event happens at all.

Obviously, returns would be better if you could participate in the upside and sidestep every dip, and it is painful to suffer big losses even when you have a large buffer of gains. But if worrying about this keeps you in cash for months or years at a time, you will usually lose much more in opportunity cost than you could ever recover with the most astute timing.

As a final contrast, this same logic does not apply to the S&P 500 in isolation. The crash of 1974 wiped out over 6 years of gains, and the crash of 2008 wiped out over 10 years of gains. The mechanics of Risk Parity dramatically reduce the chance of these extreme outcomes because it is constantly positioned for so many different economic scenarios. While drawdowns are still inevitable, there is a much higher probability that they will be both short-lived and moderate compared to prior gains.

It is sensible for traditional passive investors to fret about bubbles in the S&P 500, but Hedgewise clients have the luxury of different experience.

Wrapping Up

A powerful feature of the Risk Parity framework is how it can empower a shift of mentality. Drawdowns can feel less dramatic, and bubbles can be less important. It becomes easier to embrace this as you more deeply understand the methodology, but it is still difficult to reconcile how a broadly terrible investment environment can be perfectly fine for Hedgewise.

The most important idea is that something will perform well in every economic environment, and that means your portfolio gains protection if you hold everything in equal balance. When investors are highly uncertain, that can lead to pockets where all assets fall together, but this must resolve as the outcome becomes clearer.

Stagflation might seem like an outlier, but this is precisely the environment where gold, energy, and industrial metals do well. Short-term drawdowns may be bigger and more frequent, as they were in the 1970s, because investors are sorting through many conflicting possibilities in a generally stressful environment. However, they do not present the same kind of existential threat that equity investors face because the strategy is built on a different foundation.

The natural intuition may be to avoid these drawdowns, either by timing the market or leaving cash on the sidelines, but it is extremely difficult to overcome the opportunity cost along the way. On average, it takes a mere 7 months to gain more than the size of any subsequent loss. Historically, Hedgewise Risk Parity has never lost money over any three-year period. If you can build drawdowns into your expectation and invest without hesitation, you will almost certainly be better off over the long run.

Equities are probably overvalued. Interest rates will probably go up. The post-pandemic economy may be a twisted mess of snarled supply chains and sky-high prices. For many investors, it seems like there is nowhere to turn. For Hedgewise, it is just another regular year.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

May 2021 Commentary: Sorting Through Market Froth
Posted in Market Commentary on 2021-05-23

Summary

  • In 2021, Hedgewise has gained 2.5% - 9% (depending on your risk level), keeping up with the performance of the S&P 500 despite its torrent pace and without overexposing clients to a potential equity pullback.
  • This performance is especially remarkable compared to bonds, which have lost 10% this year and nearly 30% since last March.
  • Though stocks have performed well in 2021, there remains a significant amount of market "froth". Pockets of excessive speculation have already begun to unwind, with many Covid-era favorites down 20 - 40% from their peak in February.
  • Inflation is a real threat to market valuations because even a slight normalization could justify a 15 - 20% correction to the S&P 500. There is a high probability that rates will return above 2%, but this is not reflected in current equity prices. The Fed may be erring by allowing the economy to run too hot, which is causing labor shortages and supply disruptions.
  • Hedgewise provides a unique haven for its clients by relieving any need to decipher these risks. As we near the tail-end of the Covid crisis and its aftermath, this approach will likely outperform most alternatives.

Introduction: Is There a Bubble or Not?

The chaos of the past year makes it hard to hold on to a consistent narrative. The event itself was terrible, but the economic outcome might be good? Or the economic outcome is bad, but the investing outcome is good? The reality is complex, and there are competing narratives unfolding in parallel.

As previously examined, the combination of enormous fiscal and central bank stimulus has been a primary driver of asset prices over the past year. A single observation sums this up nicely: the S&P 500 is expected to realize earnings in 2021 about 4% higher than what was expected in January 2020, before any of us saw Covid coming. The price of the S&P 500 is now ~30% higher than it was back then. Can both prices be rational at once?

The confounding factors include the impact of near-zero interest rates, government stimulus checks, unemployment benefits, the vaccine and re-opening cadence, and an explosion of speculation. In some segments of the market, this led to definitive bubbles, and many of those have begun to correct. The S&P 500 is more difficult to decipher because of deeper crosscurrents.

The US recovery has been faster than expected this year, with 2021 Q1 earnings beating estimates by over 8%, and this alone has driven most of the YTD gain. Alongside, long-term interest rates have reverted to where they were in January 2020, but there has been little correction of price-earnings multiples to adjust. This latter inconsistency is difficult to reconcile and helps to explain the volatility in equities happening recently. The economy has been snapping back faster than expected, but prevailing prices were anchored to unrealistic interest rate assumptions to begin with.

This "frothiness" will probably continue to unwind, and inflationary pressure is the most likely catalyst. Investors are noticing that a "hot" economy comes with drawbacks, and that higher rates may be both necessary and healthy. In a great final irony, the last act of Covid may be how the return of a balanced, productive economy is directly at odds with inflated asset prices.

If this makes your head spin, take comfort that the Hedgewise approach sidesteps these concerns and is in an excellent position to outperform during this potential unwinding. The strategy is built to withstand any economic environment, and it already anticipates the impact of high inflation, rising rates, or whatever comes in between.

Analyzing Recent Hedgewise Performance

Here is a quick look at how the Risk Parity Max strategy has performed against other major asset classes so far in 2021.

Performance of Risk Parity Max vs. Major Asset Classes, 2021 YTD

As of 05/21/2021. Risk Parity returns based on a composite return of all clients in those products and include all fees and commissions. Asset returns based on publicly available benchmarks and include an estimate for all dividends assumed re-invested. See full disclosures at end of article.

Hedgewise has kept up with the S&P 500 despite its excellent performance and the worst start of the year for bonds in decades. While I've published prior research on how Hedgewise manages the risk of higher interest rates, it is still remarkable to see it go precisely according to plan. Risk Parity is often misconstrued as a bond-heavy strategy, but this period firmly refutes that notion.

Widening the perspective to a longer timeframe reinforces how little correlation Hedgewise performance has with bonds, and how Risk Parity has firmly outperformed that asset class over the past half decade.

Performance of 30yr Treasury Bonds vs. Risk Parity Max, January 2016 to Present

Source: Federal Reserve, Hedgewise Analysis. Data through May 1, 2021. Risk Parity returns based on a composite return of all clients in those products and include all fees and commissions. 30yr Treasury returns based on publicly available benchmarks and include an estimate for all coupons assumed re-invested. See full disclosures at end of article.

Bonds have done quite well since 2016, yielding almost 5% per year, and had a huge spike during the pandemic. That was only sufficient to catch up with Hedgewise, and performance has since regressed with the economic recovery. Risk Parity has exhibited lower volatility, lower drawdowns, and higher returns throughout. This is possible despite bonds having typically been a substantial portion of the Hedgewise portfolio, often at weights of 50% or above. Intelligent use of risk management and diversification transforms a portfolio into something greater than the sum of its parts. Viewed as an alternative "safe" investment to long-term bonds, Hedgewise has demonstrated itself as a consistently superior option.

This story is easy to tell over long stretches of time in which the performance of every asset class has ebbs and flows. It is harder to isolate the benefits for a time period when a single asset class is surging, as the S&P 500 has done recently.

Performance of S&P 500 vs. Risk Parity Max, January 2016 to Present

See prior disclosure.

The missing caveat is that Risk Parity Max is built to target half the overall risk of equities, with the expectation that level can still match or beat stocks over most long-term time horizons. To fairly compare performance, especially over shorter timeframes, both strategies should be set to an equivalent level of risk. The following simulates the Risk Parity strategy set to a similar level of volatility as the S&P 500 during this period (named "RP Max+2").

Performance of S&P 500 vs. Risk Parity Max+2, January 2016 to Present

Simulation multiplies the performance of RP Max client performance by 1.67, which brings that portfolio to a level of volatility close to the S&P 500 over this timeframe. This simulation does not adjust for additional trading or leverage cost, so this graph should be taken for by and large purposes rather than as a reflection of live results. This simulation is necessary to fairly evaluate Hedgewise performance, but such a high level of risk is not generally recommended to clients for a variety of reasons. The larger the magnitude of swings in any portfolio, the greater the urgency to manage it actively and the greater the size of any potential loss.

A Risk Parity portfolio exhibiting nearly identical levels of volatility and drawdown to the S&P 500 has still outperformed it since 2016. Over this stretch, stocks gained over 16% annually and avoided any lasting pullback, market whipsaws dragged on risk-managed performance, and elevated volatility muted Hedgewise participation in the pandemic recovery. None of this has been enough to handicap the strategy relative to equities when compared on an equal basis.

While these results look tempting, remember that the Hedgewise portfolio is designed to outperform stocks over longer-term horizons and to minimize the risk of loss. Whenever stocks next encounter a sustained pullback, Hedgewise should even further differentiate itself because of the strategy's diverse construction. This can be more easily understood by breaking down the source of returns in 2021.

Hedgewise Return Contribution by Asset Class, January to May 1, 2021

Chart depicts the percentage weight each asset class contributed to the total YTD return for the Risk Parity strategy as of May 1, 2021 and includes an estimate for all dividends and coupons. The absolute total adds up to 100%, with negative percentages representing negative contributions and vice versa. These figures are based on monthly model portfolio allocations and benchmark performance and will be nearly equivalent across all risk levels.

Gains in 2021 have been driven by a nearly equal mix of energy, industrial metals, and stocks. Meanwhile, losses in the bond market have been mitigated using the risk management techniques discussed previously. Should stocks switch places with bonds next, the portfolio's resilience will persist.

The takeaway is that Risk Parity has functioned as expected this year and throughout the pandemic. The outlier has been the rapid appreciation in equities and other speculative pockets, which has exacerbated a trend of excessive risk-taking. Much of this is already unwinding with the economic re-opening, and highlighting the inherent dangers of joining in.

Understanding and Navigating Market Froth

The investing story of the pandemic is easiest to understand at the extremes. A flood of money hit the market last year through the Fed and government stimulus, and eventually combined with new financial technology and bored stay-at-home traders to create a tsunami of speculation. Price appreciation eventually snowballed on itself and became disconnected from any real narrative of the economy. Meme stocks and cryptocurrencies are probably the best examples of this, but there have been many other themes, including stay-at-home beneficiaries, high growth stocks, the re-opening trade, SPACs, IPOs, and others.

We have reached a point where these can be clearly labeled bubbles.

Performance of Popular Covid Trades, February 8, 2021 to Present

Source: Quandl, Hedgewise Analysis. Includes an estimate for all dividends paid. Quotes listed are SPAK, ARKK, TSLA, and PTON.

This is meaningful to observe because it dispels the notion that perhaps the appreciation has been reasonable. Bubbles have absolutely been a part of the story, and there have already been serious losses for those who invested recently. Many of these companies remain up 100% or more compared to last January despite this correction, suggesting additional downside is likely.

This extreme view helps to introduce what is happening in the S&P 500 more broadly. Many of these individual companies are part of the index, so there is some direct crossover. The bigger impact comes from a general lift of stock valuations across the board on a relative basis. This "frothy" spillover effect is not large enough to form an outright bubble, but it is having a measurable impact.

The obvious way to examine this is with price-earnings multiples. The best analytical case for elevated valuations is that low interest rates justify higher prices. You can get a sense of how this trade-off works by modeling a few back of the envelope assumptions. The following table shows what different interest rates imply as a "fair" P/E multiple, the associated "fair" price of the S&P 500, and how that compares with the actual market price today.

Interest RateModel P/EModel PriceVs. Current
1.65%21.5$3,947-5%
2%20.0$3,670-12%
2.5%18.2$3,337-20%
Model assumes a 5% equity risk premium and a 2% earnings growth rate. Comparison vs. S&P 500 index price of $4,155 as of May 21, 2021.

Currently, 10yr Treasury bonds are hovering close to 1.65%, while 30yr bonds yield closer to 2.5%. Depending on which one you think is the fair interest rate to apply to stock valuations, the S&P 500 is somewhere between 5% and 20% overvalued.

Part of the reason this persists is because the Fed is keeping short-term rates at 0%. Until these come off the ground, prices lack a catalyst to forces revaluation. Inflation is the most likely driver of this, and the market is grappling with whether the Fed will have to act to control it.

In an overheating economy, rising prices come from a shortage of raw materials, labor, and transportation. This slows down production everywhere, and sudden price jumps in staple goods impact the livelihood of families whose income has yet to catch up. This is a "bad" kind of inflation that causes real suffering.

The Fed appears content to tolerate this for the sake of a robust Covid recovery, but the market is seeing that it might be too much, too fast. For example, lumber prices have jumped over 300% in the past year. This creates scarcity across the construction market with no positive spillovers; it may even reduce hiring because firms cannot get the supplies they need to do their work.

The economy will be better off when it returns to a moderate pace in which 2% - 2.5% interest rates are necessary and a sign of health. If it overheats first and rates jump quickly, an equity correction is likely. If it gets there more slowly, prices could bounce around for a year or two until earnings fully catch-up with valuations. Either way this froth will present a headwind until it resolves.

The question is what this all means to you as an investor.

Does It Matter to Your Portfolio?

The answer depends on what kind of investor you are, and what adjustments you made over the course of the pandemic. For Hedgewise clients, none of this requires action or concern. Risk Parity can weather a 20% stock correction just like it weathered the recent bond crash. Avoid the temptation to shift your risk level or portfolio mix in response to this speculative mania. Performance tends to even out over time without the need for excessive risk-taking.

For pure equity investors, a long-term passive allocation remains reasonable despite the current froth. Over 15 years, this probably will not matter much. Periods of muted returns or corrections should be part of the expectation. However, if you do not have the risk tolerance or time horizon for such losses, or you had participated more actively in the speculation of the past year, now may be an excellent time to unwind those bets.

On balance, the competing narratives of the pandemic will settle somewhere between the economic recovery being faster than expected and speculators getting too far ahead of themselves regardless. The pace of inflation will be the key to how it resolves, and the Fed may contribute to unnecessary collateral damage if it waits too long to raise rates to more normal levels. Risk Parity is well positioned for such an environment because of its mix of inflation-sensitive assets and its ability to navigate corrections, as recently witnessed in the bond market. The froth in equities cannot last forever, but that story is only meaningful if you have constructed your portfolio around it.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

2020 Year-In-Review: Navigating an Everything Bubble
Posted in Market Commentary on 2021-01-24

Summary

  • Hedgewise Risk Parity prioritized stability and returned 3% across most risk levels last year. Maximum drawdowns were less than half those in the S&P 500, and Hedgewise has a systematically brighter outlook than most passive strategies heading into 2021.
  • The Fed has made real interest rates negative and effectively transferred profits from the future to the present. Any money made today is lost from tomorrow, which manufactures a de facto "bubble", encourages excessive speculation, and leaves investors with few realistic options.
  • Hedgewise purposefully foregoes these kinds of short-term gains to ensure that long-term expectations remain positive and stable. Performance data firmly validates that this approach has driven higher risk-adjusted returns over time, even after a year where it "skipped" historically significant price inflation.
  • Moving forward, Risk Parity is uniquely positioned to capture gains regardless of whether bubbles pop, rates rise, inflation spikes, or yet another unforeseen economic shock appears.

Introduction: Zero Interest Rates Are Not Free

As I covered in the last newsletter, the Fed's actions in 2020 represent a bigger economic story than the pandemic itself. It has dropped interest rates further and faster than any other time in history, and promised to keep them down indefinitely. As a result, real interest rates are now deeply negative, meaning investors are paying money to own government bonds, and this has had dramatic ripple effects across the entire investment universe.

In the last piece, my focus was on the broad mechanics of this on the economy, and how it would effectively increase prices, decrease return expectations, and amplify risk across all asset classes. The trouble is that on its face, this message seems similar to whenever the Fed has lowered interest rates, but that's not quite right. We've entered a degree of extremity that is very new, and that is unlikely to follow historical precedents in what happens next.

For a variety of reasons, the Fed threw "everything it had" at the pandemic last year. The scope of its intervention dwarfed anything that came before, and it has also brought the Fed about as far as it can go. If true, interest rates have finally reached a bottom after 30 years of churning ever lower. This creates two novel dynamics: the Fed has little ability to raise bond prices any higher, and current price levels are extraordinarily inflated. This is the end game of an economy over-reliant on the Fed for support, and it comes with a steep cost.

The logical result is asset bubbles with a number of odd properties. Unlike 'normal' bubbles, the Fed literally props these up, and they can persist despite outside investors being fully aware of the circumstances (e.g., the Fed can print money and buy bonds at a certain interest level even if no one else will). Ironically, this anchoring effect enables an inevitable "everything bubble" that is amplified by cascading ripple effects. Interest rates near zero justify explosively high multiples in riskier assets, and the difficulty in establishing an objective "fair price" encourages speculation and irresponsible risk taking. Phenomenal amounts of liquidity injected into the financial system as part of the Fed's mechanical process serve as the perfect enabler to allow this to spiral further.

Investors face an impossible choice. Most assets are already pulling future profits into today's price (because of zero interest rates), so there is no compelling passive option. Meanwhile, the riskiest investments rapidly appreciate due to speculative fervor. Despite increasingly negative long-term implications, there can appear to be no alternative to joining the speculation and hoping you can get out before it breaks.

The glue holding this unstable situation together is the belief that the Fed is in control, and it will not come undone so long as it remains that way. If there is even a tiny inkling that it may lose that grip - any kind of inflation scare would probably be sufficient - the bubbles will lose support. Even if the Fed vows to keep rates at these levels forever, you'd still be vulnerable to any other kind of economic shock, after which the Fed would have little ammunition remaining to buffer the impact.

Fortunately, Hedgewise provides another choice that can still function like a passive investment is supposed to. It has a positive long-term return expectation because it has alternative paths to gains, including commodity exposure and volatility management, and it explicitly minimizes exposure to assets as they become speculative. The trade-off is that you forego some gains along the way, but performance data demonstrates that this is consistently the right move, including in 2020.

Understanding the Fed Bubble Debate

Fed bubbles are tricky because lower interest rates logically inflate prices. If interest rates never rise back up, you could argue that it isn't necessarily a bubble. Mechanically, this is simplest to understand via the Treasury bond market, which now faces a dilemma conceptually like the following graph.

Present Environment of Treasury Bonds

Source: Hedgewise Analysis. Treasury bonds prices are mechanically determined by interest rate levels. Negative real yields mean that investors must pay interest to hold the bond, in real dollar terms. This is why the "Scenario 1" slope is slightly downward sloping.

The situation in our present day is historically unique because real yields are negative, and the Fed exhausted its arsenal last year in response to the pandemic. All available future profit has already been pulled into today. The question for thought is whether this picture represents a "bubble".

Consider that you can only lose money from a passive investment in this asset, and that there is no compensation for significant downside risk. While it may not be based in speculation or irrationality because the Fed is controlling it, it's a terrible deal by any other name.

Investors allow this to persist because the Fed can directly control bond prices via money printing, and because a similar dynamic simultaneously applies to most other kinds of investments. In other words, there is no perceived alternative to taking the bad deal.

The "Everything Bubble"

The link between bond prices and interest rates is definitional, but most other asset classes will be similarly affected. This is because you have to decide how to discount future cash flows for an investment in anything; if you discount them by 1% instead of 5%, you get a much higher present fair value. This is always true, but in the same vein as Treasury bonds, we have gotten into uncharted territory with the Fed's actions during the pandemic.

It's not possible to know precisely how much an impact it should have on an asset class like equities, but we can get to some basic estimates with a simple discounted cash flow model. The following chart models how three different types of investments might respond as interest rates fall from where they started 2020 to the lows reached over the summer. This assumes that there are no other changes to earnings, longer-term economic prospects, etc. - this is the impact of interest rate changes in isolation.

Interest Rate Model Impact on Prices in Bonds, Large-Cap Stocks, and Growth Stocks

Source: Hedgewise analysis. Assumes a 5% equity risk premium, a risk-free rate equal to the 10yr Treasury bond rate, an earnings growth rate assumption of 2% for large-cap stocks, and an earnings growth rate assumption of 5% for growth stocks.

The reason that growth stocks might appreciate so much faster is a mathematical quirk of fast earnings growth assumptions and low interest rates. In broad strokes, the idea is that a risky asset with a small chance of making a huge amount becomes much more valuable when returns are scarce elsewhere. It requires a degree of naivety to believe this is valid, especially at extreme price levels, but the broad point is that the case can still be made.

Though these numbers are merely "back of the envelope", the similarity to 2020 is notable. 30yr Treasury bonds returned 29.53% from January through August; the S&P 500 returned 43.89% from April through August; Tesla was up 393.23% from April through August.

To emphasize, these gains do not come from any actual changes in total profit. If interest rates stay where they are, you face expected future returns that are lower by an equivalent amount spread over time; if interest rates go back up, you expect to incur identical short-term losses as the situation reverts. It's many different versions of the same bad deal: most assets get unreasonably expensive and face increasing downside risk in cascading degrees.

The wild part of all of this is that as the deal gets worse and worse in terms of the future, you make more and more money today. How is a rational investor supposed to approach this?

The FOMO (Fear of Missing Out) Effect

The basic problem is that no rational investor wants to miss out on profit. Consider this example: today is day zero, and somehow you know for sure that equities are going to yield no greater than 3% a year with a 50% downside risk over the next decade. Is that a compelling investment?

Next, imagine a slight wrinkle. Equities keep the same total return/risk profile, but this time you know equities will gain 30% over the next twelve months. After that, they will yield no greater than 0% a year with an 80% downside risk over the remaining nine years. What's the right approach?

It will be extremely difficult for an investor to forego the 30% gain, despite the fact that this is otherwise a poor investment. Thus, many will pile in on the way up, fearing to sell before the peak and miss this last bit of upside.

This pattern is further amplified in riskier, more illiquid segments of the market where outsized returns are perceived as more likely. Ironically, as an asset price becomes increasingly disconnected from economic reality, it becomes easier to believe that it may be justified as others appear to buy at yet higher prices.

With few compelling opportunities elsewhere, and a broad sentiment that maybe low interest rates make all of this reasonable, this kind of speculative fervor can easily turn the "Fed bubble" into a much more garden variety one. There is little doubt that this is now happening in many fringes of the market, including in penny stocks, cryptocurrencies, and SPACs at a minimum.

The psychology in play is similar to most bubbles in history, but our current conditions provide a uniquely fertile ground for this to happen. There is more cash than ever floating around the system due to a combination of massive fiscal stimulus, direct asset purchases by the Fed, and delayed spending due to the pandemic (trips, entertainment, etc.) The normal "safe" options to park that cash are gone because the Fed has put the same "bad deal" in place across the board. If everything is in a bubble anyway, what option do you have but to buy in?

This is a false choice. Proper risk management is built with just these kinds of situations in mind. It allows you to lean away from risk, rather than into it, without sacrificing long-term gains. It sidesteps the bad deals and the speculation, and focuses on a more stable return stream. These techniques continued to work as expected last year, and create a systematically more positive outlook than most investors face moving forward.

Another Option: Evaluating Hedgewise Risk Parity in 2020

Let's briefly return to the basics of the bond market. For the 2020 calendar year, long-term bonds gained 22.5%, but this also introduced negative real interest rates and the bleak future prospects discussed earlier. Hedgewise missed out on most of that gain on purpose, and as a result, returns were 10-15% lower last year than they might have been (depending on risk level). There is also significant evidence that this was the right move.

Risk management is grounded in the idea that greater stability wins over the long run. It isn't worth chasing potential upside if it introduces future downside. By avoiding environments of excessive risk, you expect to eliminate both big gains and big losses, and you expect that to be a winning trade-off over time.

Last year presents a fascinating case study of this principle because bonds had such large annual returns, but achieved this is in the riskiest possible way (i.e., the Fed eliminated the possibility of future positive real returns). It should be little surprise that exposure to bonds was limited throughout. The question is whether this missed upside is mitigated by other periods of minimized downside.

Fortunately, this question is easy enough to answer, and we do not have to wait to see how the immediate future pans out. If the theory is working according to plan, the benefits of stability should accrue constantly over time, and demonstrate resilience even during a year like 2020. Data shows that this is exactly the case.

Here's a look at the performance of the normal Hedgewise risk model compared to a "simpler" one which does not account for the absolute level of interest rates (see more detail on the specific Hedgewise approach). For context, the simple model generally has 60%+ bond exposure at all times, while the normal model had less than 10% exposure for most of 2020.

Hedgewise vs. Simple Model Performance Since 2010

Performance based on a hypothetical model that relies on the same algorithm used in live client portfolios set to the "Max" risk level. The "Simple" model uses simple 30day realized volatility as its risk input, rather than a much broader array of risk metrics utilized in the normal Hedgewise model. Data based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. See full disclosures at the end of the article.
Annual ReturnVolatilitySharpeMax Loss
Hedgewise Model14.11%10.42%1.35-10.66%
Simple Model14.19%13.44%1.06-18.57%

Since 2010, the normal risk management algorithm has achieved nearly the same exact return with 30% less volatility and half of the maximum drawdown. Looking deeper into how that unfolded, notice how the simple model outperformed dramatically from 2019 onward, but that only served to make up for its underperformance for three years prior. These periods are two sides of the same coin; you can't have one without the other. In some periods of heightened risk, it limits losses, while in others it misses gains. Over time, the benefits should outweigh the costs, and it's clear that they have.

This is especially impressive considering that bonds likely reached their peak possible price last year. The strategy has foregone as much short-term performance as it likely ever will, and the results still hold up at this moment in time. Meanwhile, the "simple" model is now facing its darkest ever outlook. You can already begin to see this unwind as interest rates have started creeping back up since their lows last August.

Hedgewise vs. Simple Model Performance, August 2020 through January 1, 2021

See prior disclosures

Every outcome being studied here is not surprising from a financial theory perspective: this is all how it is supposed to work. The challenge is reconciling short-term intuition about what is happening. You do not want an extra 10-15% gain last year in the form that it came; if you had taken it, you would have already lost more than it was worth in the years prior, and now you'd be stuck with a terrible future outlook. Proper risk management is constantly positioned for systematically better performance, but it will be the easiest to second-guess at the height of a speculative frenzy. Ironically, that is also the precise moment when it is more valuable than ever.

Looking Forward: How to Make Money in 2021

Looking ahead, I'd advise extreme caution with any investments that appreciated 100% or more last year, especially where that was not accompanied by an actual increase in revenue or profit. It's too hard to explain any reasonable path back to economic reality, and you face a double risk of excessive speculation alongside a reversion of interest rates, either of which could result in double-digit losses.

Passive fixed income remains a poor choice because any kind of bond, whether corporate or government, is tethered to the negative real interest rates being driven by the Fed. However, there is the potential for volatility-driven gains, especially as interest-rate uncertainty rises. This is the approach which Hedgewise implements and has been discussed at length previously.

The outlook for the S&P 500 is a little trickier. Most large-cap equities have not been subject to as much of a speculative surge as smaller growth companies, but prices are likely inflated by 20-30% due to interest rates, and that will be a headwind if there is any inflationary pressure. If interest rates stay put for a long while, you might still eke out a 4-6% annual gain, but that assumes there are no other negative economic shocks in the interim (stagflation, war, climate change, higher taxes, systemic inequality, among others). The Fed has little ammunition left to support the economy against anything else. It's not a great risk/reward proposition, so I'd tread cautiously and would sooner wrap this exposure into a risk-managed approach than leave it outright.

Commodities are a rare bright spot that have little connection to interest rates while providing an excellent hedge against any inflationary surprises. These prices are determined mostly by supply and demand, so gains and losses generally reflect real changes in economic activity rather than speculation. If we do have a robust bounce back from the pandemic, industrial commodities and energy should do quite well even if interest rates bounce back up.

For most traditional investors, this leaves a barren landscape, and many feel forced to take on excessive risk or speculate. Against this, Hedgewise is uniquely positioned to provide an alternative, as it is built to systematically manage interest rate risk, includes balanced commodity exposure, and is not overly reliant on equities to drive returns.

Speculative environments are always challenging to navigate, and this is especially true during one anchored by the Fed. That doesn't change the basic facts: excessively high prices are bad for future returns, and this applies even if the high prices are everywhere. Hedgewise has an approach to manage this risk that has been effective for decades, and it will likely be even more valuable given the conditions facing the market after 2020.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

September 2020 Commentary: Deconstructing the New Investment World
Posted in Market Commentary on 2020-09-21

Summary

  • Many are perplexed by the current state of markets: how can you have a global pandemic and recession alongside gains in nearly every asset class?
  • This is being driven by the Fed's bold new experiment of targeting negative long-term real interest rates, which logically inflates the price of every investable asset.
  • Unfortunately, this will result in bizarre, risky side effects, including increased volatility, lower expected returns, a more limited ability to diversify, and little buffer against future economic shocks.
  • Traditional passive investors are left with unsavory options: either push into riskier assets despite a poor risk/reward ratio, or miss out altogether.
  • Fortunately, the Hedgewise Risk Parity product presents an attractive alternative since it diversifies more intelligently than traditional products and can accrue gains outside of pure asset appreciation.
  • We'll walk through how the investment environment has shifted, what it means for the future outlook, and how to consider potential changes to your portfolio mix or risk level.

Introduction: The Real Story of 2020

In 2019, if you had told most investors that within a year, the US would have nearly 10% unemployment, a global pandemic, and a worldwide recession, few would have predicted the outcome we have today. Despite the recent bout of volatility in September, stocks remain up over 4% YTD alongside gains of over 20% in bonds and gold. How can this be?

While the weekly media narrative shifts between the impact of retail traders, or a repeat of the dot-com bubble, or the flood of government stimulus, the relatively simple explanation lies with the Fed. The only fundamental economic factor that can cause stocks, bonds, and gold to appreciate at once is the decline of real interest rates, and the Fed has now launched the world into a truly extraordinary state in this regard.

While short-term interest rates were frequently near zero after the Great Recession, long-term rates (i.e., 20yr and 30yr Treasury bonds) never fell below 2%, which makes good sense. Since the Fed's inflation target is 2%, it is reasonable to figure that nominal interest rates will be at least that amount; otherwise, government bonds become a guaranteed losing investment in real dollars (a.k.a., negative "real" interest rates). It also makes sense that most investors want some return on top of inflation, especially for a 20+ year investment, in exchange for taking on the risk of higher than expected interest rates.

Yet the Fed has been on a mission this year to bring long-term rates deeply into negative territory: the real yield on 10yr Treasuries is now -1.1%. On first glance, you might think sure, but it's a recession, so the Fed lowers rates like they always do. But make no mistake, this time is different. We are now far below any historical levels, and this is altering every aspect of the investment world in radical new ways. Some of the expected effects include:

  • Significantly increasing price-to-earnings multiples, especially within growth stocks
  • Lowering expected returns and increasing volatility across all asset classes
  • Eliminating traditional sources of diversification
  • Imposing asymmetric downside risk on all passive investments
  • Amplifying the negative impact of adverse economic events in the future

There are good reasons why this state has been carefully avoided by the Fed in the past, and though it may be necessary for the time being, the ramifications go much further than the pandemic itself will. Let's dive into the nature of this new landscape and what it means for the future of investing.

Gaining Perspective through the Ugly State of Bonds

Treasury bonds provide an excellent and straightforward primer on how we have entered new historical territory, and why this formulaically creates unfortunate side effects.

On the historical front, the following chart provides a view of how the interest rate on 20yr Treasury bonds changed in every U.S. recession since 1953, with our current one in 2020 included as the final data point. The left y-axis measures how far 20yr rates went down from peak to trough over the course of the recession (i.e., if they peaked at 5% before the recession and troughed at 3% during the recession, it would show -2%). The right y-axis converts this to a measure of the relative distance that rates moved toward the "zero bound", where -100% would mean that rates had gone all the way to zero (beyond which rates are extremely unlikely to travel further).

Historical 20yr Treasury Bond Interest Rate Movements During U.S. Recessions

Source: Federal Reserve, Hedgewise Analysis.

The aftermath of the Great Financial Crisis of 2007 was already somewhat unique: long-term rates moved down twice as much as they had historically, and traveled to a much lower absolute level. However, that now pales in comparison to this year, which has been far bigger and far bolder than anything that came before as the Fed moves precariously close to the zero-bound.

To give a sense of the impact, here is the current expected payoff diagram from an investment in 20yr Treasuries compared to mid-2019. This shows you the expected real (adjusting for inflation) total return depending on where 20yr rates move, and assumes inflation meets current expectations of 1.9% throughout the holding period.

20yr Treasury Bond Expected Real Returns, Current vs. Mid-2019

Source: Hedgewise analysis. Assumes an investment in 20yr constant maturity treasury bonds, rolled over monthly and held for twenty years, and includes an estimate for all coupon payments. Inflation expectations set at current rate of 1.9% and presumed constant.

Negative real long-term rates essentially turn bonds into "return-free risk" rather than "risk-free return". This is different from anything we saw during the 2010's; low interest rates are not the same as negative rates. The only reason bonds are being bought at these levels is because the Fed is basically using all of its money-printing powers to keep buying them. This creates asymmetric downside risk: best case, you lose a little bit of money, and worst case, you lose a ton.

The mathematical mechanics in play here are important to understand. As interest rates head toward zero, you are effectively moving all potential future profit into today's price. For example, if you had a 1yr bond that yields 10%, you'd pay $100 for it today and get back $110 next year. However, if it yields 0%, it would already cost $110. The Fed is artificially inflating bond prices to near their maximum limits to service its broader goal of stimulating the economy. While this may be a necessary lever for the Fed, it creates a catch-22 for fixed income investors. It's sort of like a bubble, but it has nothing to do with speculative investors or irrational expectations. It's a pre-meditated action by the Fed that inflates asset prices to create a negative yield.

Unfortunately, it is not possible to limit this dynamic to fixed income, as the yield on Treasury bonds sets what is known as the "risk-free rate" on all other asset classes. Let's take a look at the strange ways that negative real yields have been metastasizing.

"Not A Bubble" Bubbles

Equities have been the big mystery for most investors this year because it doesn't really make sense through the lens of a global pandemic. Why would tech company valuations go through the roof based on a temporary event? How can a market with a recession and millions of newly unemployed be worth more than 2019?

If you try to analyze this through the lens of profit and loss, you will likely be confused. If you look instead to the role of negative real interest rates, far more clicks into place.

From an analytical perspective, the value of any given asset in the present moment is the value of its future cash flows discounted to today. For a stock, this means you would take all the future expected earnings of a company and discount them by some reasonable rate of return to adequately compensate for risk. In perpetuity, such a formula simplifies to the following:

The result of this formula will be your rough "fair value" price, which also reveals your expected price/earnings multiple (e.g., if your earnings were $1 and you divide that by 5%, you get a $20 price and a 20 P/E multiple). In other words, the three variables listed here are the main determinants of the price/earnings (a.k.a., "P/E") ratio.

You can use this to "model" a P/E for the S&P 500 using assumptions for each of the values of the denominator, and compare that to the actual P/E in any given year. For example, the following chart uses 10yr Treasury bonds as the risk-free rate, sets the equity risk premium to its historical average of 5%, and uses an estimate of 2% for the earnings growth rate.

S&P 500 Trailing Actual P/E vs. "Model" P/E, 1954 to Present

Source: multipl.com, Robert Shiller, Hedgewise Analysis. Snapshot of the S&P 500 price on Jan 1 each year compared to the trailing 12 months "as reported" earnings.

To first clarify the wild peaks in the blue line, the only long-term P/E data available is trailing 12 months, which results in an inevitable lag given the market is forward looking. For example, the spike in 2009 represents the market recovery right after earnings bottomed out in 2008. Forward earnings also tend to be higher than trailing earnings, so the blue line is somewhat inflated (i.e., if you could use forward earnings instead, the denominator would be higher, and the blue line would be lower).

Rather than delve too deeply into these mechanics, focus instead on the extreme bounce in the model P/E this year. Holding all else constant, the introduction of negative real interest rates theoretically justifies a 30-50% inflation of the price of the S&P 500. While this dynamic existed to some degree in prior recessions and as interest rates slowly fell over the past thirty years, never has it been this fast or steep.

It is confusing to make sense of this. Price multiples are nearing levels that have never been sustainable historically, but they are also quite reasonable compared to the model. You could argue that equities are too expensive but also too cheap in the same breath. The trouble is that interest rates near zero will naturally produce these kinds of bizarre contradictions.

The reason for this is mathematical. As the risk-free rate in the earlier equity pricing formula approaches zero, all you are left with is the equity risk premium subtracted by the earnings growth rate. This number begins to get quite small, especially for high growth stocks. As the denominator approaches zero, the result expands exponentially. For example, here is how your model P/E changes as you adjust assumptions for the risk-free rate and earnings growth while assuming a static 5% equity risk premium.

How "Model" P/E Ratios Change with Risk-Free Rate and Earnings Growth Assumptions

Calculated using the earlier provided formula using an estimate of 5% for the equity risk premium, which is based on historical averages.

These values justify north of a 40% appreciation this year in "average" stocks, but nearly a 300% jump in "growth" stocks (i.e., from 47.2 up to 178.6). This provides some insight into corners of the market that have seen explosive P/E growth recently, like Tesla currently sporting a multiple north of 900 and Amazon moving from 80 up to 120. The problem is that while these prices may be justifiable mathematically, they are not connected to an actual increase in future expected profits.

This potentially creates a situation similar to a speculative bubble. Despite no change to business fundamentals, assets prices inflate to extreme levels. These prices will functionally reduce earnings yields and future expected returns, and will probably fall substantially if interest rates ever go back up. At the same time, there may be huge near-term gains up until the point of "maximum inflation".

This is the dilemma now facing the world. What is the right way to handle it?

Mapping the Bigger Picture

The following illustration provides an effective roadmap for thinking through these issues at a high level. This shows how the hypothetical total returns of a 10yr passive investment change as interest rates move to the zero bound. The blue line is the "normal" state of markets with rates above 2%. The orange line is the "expected" behavior after rates hit zero, and the yellow line is what may happen at the extremes.

How Passive Expected Total Returns Change Over Time with Zero Interest Rates

Source: Hedgewise Analysis. Assumes a hypothetical asset that earns 8% per annum in normal conditions.

Mechanically, notice how all three lines wind up in the same place. This must be true if nothing has changed economically speaking, as there are still the same total profits available over time in all states of the world. All that is happening is a shift of when you realize those profits.

The more sensitive an asset class is to interest rates, the more likely it is to move closer to the yellow line, at which point it becomes "return-free risk". Treasury bonds are here already, along with all fixed income assets in degrees. High growth segments of the stock market may approach this level depending on the degree of price/earnings inflation. These assets are no longer effective investments because near-term gains have exhausted future earnings potential, yet they may ironically seem attractive because of the visibility of short-term appreciation.

While the S&P 500 as a whole is probably closer to the orange line, it still faces much more asymmetric downside risk than it did before. A return to normal interest rates will probably result in a price correction even amidst positive economic conditions. Should any negative economic shock occur, the S&P 500 will have less built-in cushion due both to elevated initial prices and the inability of the Fed to lower rates further.

Against this backdrop, one of the big questions floating around is whether investors should now overweight or even leverage into equities as there are so few other options to pick up a reasonable return. This framework highlights why that is probably a bad idea: you would be risking up right after missing a period of asset price inflation, which will then amplify your losses should any of the above risks unfold with no clear recourse for recovery.

Despite this, many passive, traditionally risk-averse investors are feeling cornered into this option, further exacerbating the potential loop of rising equity prices and market instability. If any negative shock occurs, there will be a much higher likelihood of large losses due to panic selling. Even small changes in risk aversion could spark spiraling moves, which is likely what we've seen so far this September.

The more sensible move is to sit tight at whatever equity weight you began before all of this. You'll wind up in the same place by the end, even if you happen to accrue more of it now and less of it later. You'll also remain consistent with your prior risk tolerance, and avoid the need to speculate on whether and when interest rates will rise.

This advice may feel dissatisfying against a backdrop of lower future returns, and it doesn't address what to do with the cash that used to be in safer instruments like government bonds. There's no easy way out of this knot for purely passive investments. In a Fed-induced bubble, the two best options are either excessive risk-taking with limited upside, or doing nothing at all. Fortunately, there are some more attractive paths in the world of alternative investments, where Hedgewise Risk Parity fits in quite nicely.

Hedgewise Risk Parity, and Other Alternatives

Hedgewise Risk Parity has two unique attributes that help separate it from the dilemma of the passive investment universe. First, it has a built-in method of managing volatility which can accrue gains independent of asset appreciation. Second, it automatically includes exposure to alternative assets, like gold and commodities, that are less sensitive to nominal interest rates. This opens up other paths of potential return, and maintains the diversification benefits inherent to the Risk Parity approach.

Volatility management is a fancy name for something intuitive: if prices are just going to bounce around for a while, buy a little when it goes down and sell a little when it goes up. I discussed this concept in depth in a previous article as it applies to bonds, but one chart is useful to revisit. The following simulates how the Hedgewise "risk-managed" approach compares to a passive investment in 30yr Treasury bonds over 5 years, assuming interest rates begin near their current level of 1.5% and end at the levels shown on the x-axis of the graph.

30 Year Bond Performance Simulation: Passive vs. Risk-Managed Investment

Source: Hedgewise Analysis. The risk-managed model is using a scaled level of exposure as interest rates shift and presumes a "Max" Hedgewise risk level. Interest rates assumed to move upward steadily over the period with a randomized level of variance.

Depending on how volatile bonds are along the way, Hedgewise can usually pick-up a 10-20% gain, regardless of what happens to interest rates. The mechanics of this can be counterintuitive. You are never holding very many bonds, perhaps somewhere between 5-25% in total. You increase and decrease that amount as rates change to yield small gains, but day-to-day, you will only observe the impact of however bonds move. This can make it appear as if you are "long bonds" despite really being "long bond volatility". It also will leave cash on the sidelines because doing this at too high of a percentage would expose you to the downside of rising rates. This cautious, slow and steady approach is the only way to get outside of the passive trap discussed earlier. (As an aside, note that unlike Hedgewise, a purely passive Risk Parity product that never changes its bond weights would be vulnerable to substantial downside)

The second benefit of Hedgewise Risk Parity is the inclusion of alternative assets like gold and commodities as part of your mix. This exposure becomes more valuable as interest rates hit zero because their prices do not inflate to the same degree as stocks and bonds since they are real assets. For example, the price of oil is determined primarily by supply and demand, which helps explain why its current price remains low (alongside that of most energy companies). It can be easy to misinterpret this as a problem when you've seen such huge gains in the broader market, but it's actually evidence of commodities' independence. This means they are not vulnerable to the same asymmetric downside risk from interest rates, and maintain the possibility for significant appreciation in an inflationary environment. Commodities will remain an effective portfolio diversifier as a result, unlike bonds.

The impact of these benefits can be seen by mapping new risk vs. return expectations for each asset class. In the following diagram, the blue markers show the historical realized return and realized volatility for each asset since the 1970s, and the orange markers have shifted this to account for zero-interest rates.

Expected Future Risk vs. Return, Various Asset Classes

Source: Federal Reserve, Bloomberg, Hedgewise analysis. Traditional 60/40 portfolio is composed of 60% S&P 500, 40% 10yr Treasuries. Risk Parity performance based on the Hedgewise hypothetical model that relies on the same algorithm used in live client portfolios. Data based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. See full disclosures at the end of the article. All asset returns moved down by approximately 6%, which estimates the fall in 10yr yields compared to historical averages and assumes all asset risk premia fall by a similar amount. Note that this shift has happened over many decades, but the full impact is only felt as interest rates hit an absolute minimum.

A couple of neat things are happening. All traditional passive assets face lower expected returns, the reasons for which we've already explored, and expected volatility goes up because of increased sensitivity to interest rates alongside increased speculative risk. Though Risk Parity will still lose the same expected risk premia from the underlying passive assets, its shift into volatility management along with its inclusion of commodities keep it steadier and less penalized by the environment.

This highlights why the Hedgewise Risk Parity product is an excellent alternative for parking cash that used to be in bonds. While you are still moving up the risk-scale to a degree (compared to holding cash), you don't have to go nearly as extreme as equities, and you don't incur the same degree of asymmetric downside from rising rates.

A more nuanced question is whether you should increase your current target volatility (a.k.a., use more leverage) in Risk Parity against this backdrop. This largely depends on whether you have room to absorb the additional risk this will entail in terms of your time horizon and personal goals. It also requires the understanding that such a move must be viewed with a long-term lens.

Nothing has gotten inherently "safer" amidst all of this. Hedgewise Risk Parity has clever mechanisms to help neutralize the risk of rising rates, and while that makes it relatively more appealing compared to traditional passive assets, it still faces the same potential for loss that it always has. As such, the trade-offs are pretty similar to what they were before. If you can tolerate the additional risk, and you require a higher target return than is currently expected, then such a move may be sensible. (I'd recommend a single move up on the risk scale to neutralize the impact of the new environment, e.g., from Low to Medium, Medium to High, and so on). However, an unpredictable negative shock is always a possibility, after which you need the capacity and time horizon to remain steady.

A more difficult conundrum faces those who require a higher return but have little risk to spare. Unfortunately, this is precisely what is meant by the danger of "excessive risk taking" with rates near zero. While there isn't an easy answer, Risk Parity is a much better vehicle than the passive alternatives if you require it. For example, if you used to yield 2% in 3mth Treasury Bills, Risk Parity Low/Medium is a much better replacement than 10yr bonds. Likewise, I'd sooner move up risk levels within RP than overweight into pure stocks.

In addition to Hedgewise Risk Parity, other alternative, more "active" investment vehicles gain relative appeal amidst this. Any strategy that can gain north of 5% independently of interest rates is suddenly much more valuable, especially with the availability of such cheap financing. This should be somewhat intuitive given the goals of the Fed: ideally, it would like everyone to gain a return by investing capital in real projects using real people. If you have access to the opportunity, the best risk/reward ratio will likely come from this kind of "sweat equity".

Wrapping Up: Preparing for a Strange Ride Ahead

Hopefully this provides a useful template for many of the contradictions of 2020, including the growing separation between the "real" economy and stock market, the "K-shaped" performance of growth versus non-growth stocks, the appearance of "bubble-like" speculative behavior in both individuals and asset prices, and confusing desires to invest in either the safest or the riskiest instruments. These are the results of the Fed's experiment with negative real yields, and will continue to have an influence that goes far beyond the pandemic itself.

Market behavior will remain strange. You could easily see short run-ups of 10-20% in the S&P 500 just as quickly reversed, with the same behavior amplified in high-growth stocks, and little of it may seem connected to fundamentals. Bonds will be a sleepy non-factor so long as the Fed is explicitly controlling yields, but underneath the calm veneer is a new source of "return-free risk" that eliminates the utility of traditional stock/bond diversification and lowers the expected future return of all passive asset classes.

The Fed may have no real choice in seeking its mandate of 2% inflation and maximum employment, but it is treading in very dangerous water. Negative real yields create systemic price inflation and instability, and simply returning to the world as of mid-2019 will risk cross-asset meltdowns. It has also removed any future buffer against economic shocks, which eliminates a key crutch that investors have relied on for almost 40 years.

Against this backdrop, most traditionally "safe" investments are no longer viable, which makes alternatives such as Hedgewise Risk Parity even more valuable as an option. While many investors are stuck deciding between cash and excessive risk-taking, Risk Parity provides a more balanced, independent, and inflation-hedged substitute for shorter-term money that may have previously been parked in Treasury bills or bonds.

In long-term portfolios, passive equities should retain a similar role as they had previously, but they are too dangerous to overweight any further. They are still the best source of passive risk premia available, but this new environment will exacerbate the risks of timing or shifting portfolio weights in the midst of it.

If these new conditions have pushed you below your ideal target return, there's no easy answer for how to improve your outlook, but some options are more appealing than others. Investments with less exposure to interest rates, and more opportunity for independent, "active" gains, should be the first choice if available. Increasing your risk level within Risk Parity is another option, if you have the tolerance, given its built-in volatility management and exposure to alternative assets. However, any changes should be handled with care, and with a recognition that they need to align with a long-term plan and weather near-term drawdowns.

Looking forward, the healthiest path for the world would likely be one in which the pandemic passes, and both productive growth and inflation pop right back up to 2%. The Fed would return rates to normal levels, and remove all these sources of dysfunction. Ironically, doing so would cause asset price deflation, but this would be a good thing and not too difficult to weather with the advice of this article in mind. In the meantime, let's hope for peaceful and positive economic developments - but I wouldn't construct your portfolio to count on it.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Risk Parity Shines During Pandemic
Posted in Market Commentary on 2020-05-26

Summary

  • Hedgewise Risk Parity+ incurred less than half the drawdown of the S&P 500 in March, and current YTD performance ranges from -4% to +1%, depending on risk level
  • The Covid pandemic provides a compelling, real-life case study of how the framework effectively withstands 'black swan' events and relieves clients from excessive worry and decision-making when it matters most
  • Longer-term performance is equally impressive, as Risk Parity+ has matched the performance of the S&P 500 for the past 5 years with approximately half the risk (equivalent to a 2x risk-adjusted return)
  • Hedgewise has also outperformed all major competitors by over 5% during the pandemic, and from 12-35% longer-term
  • Risk Parity+ remains uniquely well-suited to handle the substantial uncertainty of our new virus-ridden, zero-interest, financially unstable world. The framework is fundamentally built to manage volatility, and to generate positive returns regardless of what comes next.

Silver Linings of a Terrible 2020

The Covid-19 pandemic marks the first time ever that an entirely external event has seriously threatened the integrity of the financial system, primarily due to the rare nature of the disease itself and the poor global health response. In my initial commentary in early March, I surmised that even if Covid wound up as bad as the Spanish Flu of 1918, it would still be temporary in nature, and justify no more than a 10-15% decline in equity prices. Fast forward to today, and stocks are down around 12% from their peak in February. Yet this belies the extraordinary chaos between then and now, which highlights threats to the theory of "rational markets" while demonstrating how Risk Parity calmly weathers the unprecedented. As we navigate a systemically precarious future, it is some small comfort to have an investment option built precisely for an uncertain world.

To briefly recap, Covid's mix of asymptomatic spread, extreme contagiousness, and highly variable death rate raises it to a similar severity as the Spanish Flu, at least economically speaking. Even so, the WHO had estimated the global cost of such an event at $3 trillion. As of last week, the latest estimates of the cost of Covid are $6 to $9 trillion. Why is this going so much more badly than expected?

Well, the WHO model assumes that governments and individuals will act rationally to contain the disease and minimize the need for draconian lockdowns. It isn't that complicated: you test, trace, and quarantine early and aggressively. The U.S. and many other wealthy countries have continued to fail at this task and it remains highly worrisome that we are now re-opening without much of an improved testing strategy. This failure raises the possibility that a fundamentally external natural disaster might turn into a permanent financial problem, which sets off a number of other financial dominos.

While central banks and federal governments managed to avert an independently fueled financial meltdown in March, it is highly concerning that this was even a possibility. Markets continue to display an inability to effectively price in the impact of the pandemic, which is deeply intertwined with the inability of the larger population to approach the health threat effectively. This is symptomatic of broad societal dysfunction: what should have been a large-scale, contained, temporary natural disaster has now morphed into a global recession.

Fortunately for Hedgewise Risk Parity clients, there has been no need to unravel the financial meaning of all of this. Clients are at or near breakeven YTD, regardless of risk level. In the depths of the March meltdown, drawdowns were also less than half those in equities. Beyond the numbers alone, this helped relieve clients from being thrust into decision-making under duress, while re-emphasizing why there is no need to time your investment with the Risk Parity approach.

Looking forward, there will be various levers for Risk Parity to accrue future gains, whether from volatile interest rates, recovering energy markets, or inflation hedges. Unfortunately, I'm not nearly as optimistic on the return of broader global stability - but that's why Hedgewise offers an investment strategy that doesn't rely on it.

Evaluating Performance During the Pandemic

Here is a quick snapshot of Hedgewise Risk Parity+ performance thus far in 2020.

Hedgewise Risk Parity+ vs. S&P 500, 2020 YTD

Risk Parity+ returns based on a composite return of all clients in those products and include all fees and commissions. S&P 500 returns based on publicly available benchmarks and include an estimate for all dividends assumed re-invested. See full disclosures at end of article.

While the end result remains impressive - every risk level continues to outperform the S&P 500 this year, despite the enormous equity recovery in April and May - the journey through March is far more important. Passive equity investors often point out crashes and subsequent recoveries as evidence that the buy-and-hold approach works just as it should. This point ignores two crucial aspects of any real crisis:

  • There is always a possibility that this time is different, and stocks will fail to recover and suffer additional losses instead. In mid-March, the idea of a second Great Depression was a real and present danger.
  • Passive investors are forced into the position of an active decision-maker as the above possibility becomes more likely.

Risk Parity is designed to mostly avoid this dilemma, but it often takes a crisis like the current one to understand why this is so valuable. This point isn't that traditional equity investing is a bad approach in an absolute sense, but rather that it involves a significant level of risk and decision-making that may be difficult to fully value until you are in the middle of a crisis. The ability to sidestep these situations provides a form of relief on many different levels, both financial and psychological. Even better, this relief is possible without sacrificing long-term returns, which Hedgewise can now demonstrate with years of live performance data.

The Longer-Term Picture

Hedgewise began running the current iteration of its risk management model in 2016. Let's take a look at how the Risk Parity+ Max product (which seeks a similar target return to equities) has performed since then.

Risk Parity+ Max vs. S&P 500 Since 2016

See disclosures on prior graph and at end of article.

On first glance, both Risk Parity+ and the S&P 500 look reasonably similar, especially in terms of total return. The question becomes how to properly value the lower volatility and drawdown levels that Risk Parity+ offers. What is it worth to be able to avoid the need to predict the outcome of the pandemic? Or the Trump election? Or Brexit?

If it's not clear how to value these events, another way to frame this comparison is against more traditional diversified baskets of stocks and bonds, which have closer levels of volatility and drawdown to Risk Parity than the S&P 500.

Below I've compared the performance of three passive iShares ETFs - Conservative (AOK), Moderate (AOM), and Aggressive (AOA) - that are benchmarked to such traditional mixes.

Risk Parity Max vs. Traditional Passive Mix Benchmarks Since 2016

Source: Quandl, Hedgewise Analysis. All dividends assumed re-invested. See disclosures on prior graph and at end of article.

This paints a clearer picture of the benefit. The Hedgewise framework maintained a level of volatility and drawdown closest to a traditional "moderate" mix, yet more than doubled your total realized return.

While the financial theory driving this performance is conceptually simple, there are still many different methods of implementation. Fortunately, recent events have also provided evidence that the Hedgewise approach is uniquely effective.

A Better and Simpler Understanding of Risk

In previous articles, Hedgewise has shared many of the foundational risk management principles on which it relies, such as balancing assets based on macroeconomic environments, explicitly accounting for "bubbles" and tail risk, and uniquely accounting for specific asset classes (e.g., how to think about bonds in a zero-interest rate environment). These ideas are fairly intuitive, and add up to an elegantly simple portfolio, but there is much disparity among managers on how to think about these concepts. Though Hedgewise gains confidence in its methodology through a great deal of research and historical pressure testing, its ability to consistently outperform the competition across many environments goes a long way towards validation.

The period from 2018 through today has presented a highly challenging risk environment, with multiple asset class whipsaws due to trade wars, Federal Reserve misfires, and of course, the current pandemic. The following shows how the Hedgewise Risk Parity+ strategy performed vs. the competition.

Risk Parity+ vs. Major Competition, 2018 to Present

Source: Yahoo Finance, AQR, Invesco, Morningstar. Includes all dividends assumed re-invested. See disclosures on prior graph and at end of article.

There was no avoiding a rocky path over this period - nearly any systematic strategy will deal with drawdowns in these environments - but Hedgewise still outperformed every alternative by at least 7% as of today. There are many details of managing risk that drove this difference, but most other providers suffered greater losses during the pandemic specifically because their portfolios are far more complex. The more complex the product, the more vulnerable it will be to a liquidity crisis like we had in March, and the more difficult it is to properly hedge. By limiting its portfolio to only highly liquid, well-hedged asset classes, Hedgewise avoids this pitfall without sacrificing any of the strategy's benefits.

To better prove this point, let's now extend the view back to 2016.

Risk Parity+ vs. Major Competition, 2016 to Present

Source: Yahoo Finance, AQR, Invesco, Morningstar. Includes all dividends assumed re-invested. See disclosures on prior graph and at end of article. Note that Wealthfront Risk Parity was launched in 2018 and does not have further performance for comparison. Risk Parity High and Max both shown as the volatility targets of the competition likely fall between these two levels.

Hedgewise has outperformed over the longer term by a total of 12% - 35%, depending on the competitive fund and risk level. This was achieved with similar levels of drawdown and a relatively high degree of correlation. Given the tail risk of the extra complexity in the other funds, you'd expect it would at least add to returns outside of crisis periods, but there is no evidence that this has happened.

Risk Parity, in theory, seems easy enough to implement. In practice, there are many more potential pitfalls than a traditional market-weighted index. While the Hedgewise approach may appear simple at first glance, it is based on a foundational understanding of risk that continues to differentiate itself as time goes on.

Looking Ahead: Approaching a Newly Unstable World

So far as Risk Parity+ is concerned, the pandemic has been "just another event," and it is for this very reason that it should continue to perform well. The strategy doesn't rely on any insight into the future, and thus it doesn't require deep analysis to forecast what it might do next. It's provided a rare bright spot in the last few months, and is a uniquely suitable investment option for whatever is on the horizon.

Unfortunately, the same cannot be said for most other traditional investing strategies. I don't have a strong view on how the economy or the health crisis will evolve in the near-term, but I do believe the pandemic has demonstrated worrying fissures in the global fabric of society and forced central banks to inject unavoidable instability into the financial marketplace.

In a largely rational world, Covid should never have had the impact that it has. Despite the fact that the world has now triaged its way back from the edge, it is impossible to deny that this experience indicates a failure of global leadership and individual behavior. This incidence suggests that political fissures around inequality, de-globalization, and partisanship now have a much greater likelihood of boiling over in a destructive manner.

Central banks have been forced to respond to this crisis by injecting incredible amounts of support into the financial system, namely bringing interest rates to zero and backstopping a huge amount of debt that would have otherwise fallen into default. The problem is this eliminates the viability of traditionally safe investments, and lowers the return on the entire investable universe. As a result, even risk-averse investors must pile into increasingly risky investments (e.g., equities, high-yield debt, etc.). Yet the risk inherent in these instruments does not go down simply because interest rates are so low; in fact, quite the opposite. When interest rates are zero in part because the world is handling a crisis really poorly, there's even more reason to suspect future crises will incur excessive damage.

This adds up to unreasonably elevated asset prices (since there are so few low risk alternatives) with lower expected returns and a greater chance of sudden drops. As an example, imagine a very risky company - let's say a cruise company, in our current environment - can sell a bond with a much lower interest rate than it could have before all of this. If that company goes on to default, investors will lose more money than they would have previously (since the bond started at a higher price), and will have received less interest along the way. This company's chance of default is always a constant value - but the Fed is changing the equation so that many more investors will now bear this risk without being compensated for it.

You wind up in a world with a greater likely incidence of damaging external events, and asset prices that are unreasonably high alongside it. How is an investor supposed to handle this?

There are no easy answers, but you essentially need a strategy built with instability and irrationality in mind, or you need to build a much higher degree of volatility and potential loss into your investment horizon than you had previously. Risk Parity is a unique systematic option for handling instability, but outside of that, you are left with various forms of active management along with its pitfalls. On the passive side, equities will still probably be the best long-term choice, but you'll have more frequent periods of loss and long-run returns may not be very high. Traditional diversifiers like Treasury bonds will no longer serve an effective role with interest rates so low, which will drastically limit the options outside of stocks.

It's going to be a challenging new world, and it is definitely not ideal, but the only choice is to navigate the reality in front of us as effectively as we can. I'm hopeful that perhaps global leadership can find its footing, and the populace behind it can rally behind long-term sustainability, mutual support, effective government, and scientific thinking. This may allow us to eventually get back to a more normal state. In the meantime, I'm glad to have Risk Parity as an option.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

A Few Thoughts on the Coronavirus
Posted in Market Commentary on 2020-02-28

It has been quite the week! As of last Thursday, stocks were up 5% year-to-date. Since then, they've undergone the fastest stock correction in history, falling about 13% or so through February 27. Given these extreme events, I wanted to provide a few thoughts on how to think about this situation and how I expect this to play out over the next few months. In short, I attribute a large portion of these losses to panic and uncertainty, as even the worst-case scenarios with the virus should only have about a 10% impact on asset valuations. Regardless, the two Hedgewise frameworks have balanced each other appropriately thus far, and I expect that to continue.

To first address the elephant in the room, let me explain why the Coronavirus isn't quite as scary as the markets might have you believe. This is by definition a temporary event; while it persists, it creates damage, but once it is gone, it is gone. This is different than financial contagion like that of 2008. When the real estate market collapsed, there was a permanent, rather than temporary, loss of wealth. Many mortgages simply couldn't be paid, and the houses were bought at improperly inflated prices. Contrast that to the Coronavirus: once it ends, there's no reason to expect it to continue to impact asset prices. We'll all return to our jobs, pay our bills, and asset prices (whether houses or otherwise) should be worth about what they were beforehand.

Given that, any economic damage must be framed as one-time rather than ongoing. With that in mind, there are three main possibilities for the virus of increasing potential economic damage:

  • It is contained and does not become a pandemic. Importantly, containment simply means that new cases dissipate, and it does not go on to infect 10% or more of the general population. China appears to have successfully done this, so far, based on the daily statistics out of Wuhan.
  • It becomes a "typical" flu pandemic, where 10-20% of the global population may become infected, but it is not particularly severe in its symptoms and mortality rate. (similar to H1N1 in 2009, which is now just part of the regular crew of seasonal flus)
  • It transforms into a far more deadly and massive disease akin to the Spanish Flu of 1918, with mortality rates over 10% and extremely high infection rates.

For the sake of argument, I want to focus on this final scenario. First of all, there is nothing to suggest so far that the Coronavirus is nearly as deadly as the Spanish flu. But let's assume that somehow it becomes that way. Back in the days of the SARS outbreak, the World Bank estimated that:

"Something as bad as the 1918-19 Spanish flu would cut the world's economic output by 4.8 percent and cost more than $3 trillion. "Generally speaking," the report added, "developing countries would be hardest hit, because higher population densities and poverty accentuate the economic impacts."

While $3 trillion is a large number, the S&P 500 also yields a profit of about $1.4 trillion annually. The question becomes what losing about 2 years (i.e., $3 trillion divided by $1.4 trillion) of profit should do to corporate valuations. If you do this via a cash flow analysis, and basically chop off the most immediate two years of earnings for a company, but otherwise leave the future cash flows untouched, you get an expected discount of about 8%. And that's for an outbreak the level of the Spanish Flu!

Yet here we are with stock losses of 13% before we've even entered a full-blown pandemic. I could certainly be convinced that there are bigger indirect impacts at work, or that if this causes a recession directly, there will be other damaging financial ripples. But it would be really, really difficult to envision it lopping off more than 13% of total global asset values, especially if it's a more run-of-the-mill flu.

A more likely story is that investors despise uncertainty, and the recent outbreaks in Europe, Asia, and the US have led to headline-induced panic selling. Companies can't really gauge what the impact will be, and even though it wouldn't be that big of a deal if they lost the entire year of earnings (which they probably won't), investors prefer to sell the unknown.

To buttress this argument, it's worthwhile to do a little data digging. First, to cast a really wide net, I just wanted to look at all possible months where the S&P lost at least 3% in an otherwise solid year of gains. There have been 41 such months, and something happened in each that really got investors on edge. To gauge whether such events manifested in terrible economic outcomes, I looked at the average returns over the subsequent one, three, six, and one year periods.

Average Forward Returns After a Month of >3% Loss in the S&P 500

1mth3mth6mth1yr
1.17%4.67%9.08%13.55%

On average, you fully recover the loss between three and six months, and there's nothing to suggest that these kinds of "sudden" events are good predictors of worse to come. That said, it is interesting to narrow down the data set to only the periods when you did go on to lose money over the next 3 or 6 months to see if some pattern emerges.

All Months of >3% Loss in the S&P 500 that were Followed by Additional Losses

Month Fed Tightening? Recession?
8/1/1956 X
9/1/1959 X X
4/1/1962
5/1/1966 X
6/1/1969 X X
7/1/1971 X
1/1/1973 X X
1/1/1977 X
8/1/1981 X
9/1/2000 X X
7/1/2007 X X
5/1/2011
10/1/2018 X
Source: St. Louis Fed, Hedgewise Analysis

Some mixture of inflation, an overheating economy, and a tightening Fed was the culprit in a whopping 85% of the cases! This makes sense since recessions require financial stress almost by definition; there is no modern case of a geopolitical event causing a full recession purely on its own.

Nonetheless, there were two instances of sustained losses that did not revolve around the Fed or the economy that are worth exploring. The first was called the "Kennedy Slide" in 1962, which an investigation by the SEC attributed to "an isolated, nonrecurring incident with precipitating causes that were unable to be confidently ascertained". What a way to categorize a market panic! The second was more recently in 2011, and was due to the European sovereign debt crisis, and more closely resembles the anxiety resulting from the Coronavirus. The fear is that the geopolitical event will set off a chain reaction, eventually setting off a number of financial triggers that will begin to spiral downward independently of the initial catalyst.

While such fears are frustratingly common to market pullbacks, they have never been realized due to geopolitical factors for two important reasons. The first is that such events are very directly influenced by market participants. For example, the higher panic rises about a virus, the more the public may engage in safety procedures and self-quarantines. It is not a self-perpetuating downward cycle in the same manner as financial contagion. The second is that the moment the problem can be called "under control", the negative pressures on the economy are almost instantly lifted because they were very direct.

It's little surprise that this usually winds up in market whiplash rather than anything more nefarious. A look at market performance in 2011 confirms this picture.

S&P 500 Performance, 2011 to 2013

Source: Bloomberg, Hedgewise Analysis. Note that the market drawdown reached over 20% at its peak and represented a bear market at its bottom.

The terrible irony of these situations is that the "panic" is in some ways necessary to drive the appropriate response from policy makers and the public. Investors face a catch-22: they must drive prices down to account for the worst-case scenario, yet as prices are driven down, it becomes more and more likely that the situation will be controlled. This most often results in a frustrating "V" shape which seems silly in retrospect yet terrifying in the midst of it. There's inevitably a point where the level of loss becomes scary enough to drive more selling on its own despite the rational probabilities.

Thus, the question before us is whether this time will really be different. If we do wind up in a real recession caused by the virus, it would be the first of its kind since World War II, at the latest. For my money, I wouldn't bet on it. Fortunately, I don't even need to when I have both Hedgewise frameworks in use.

Evaluating Hedgewise Performance

While any level of loss will be somewhat difficult to endure, this stretch does provide a useful case study of the benefits of the Hedgewise Risk Parity framework. It picked up on elevated risk levels at the beginning of February, and adjusted exposure accordingly. It has successfully limited client drawdowns compared to the S&P 500 as well as outperformed comparable risk parity mutual funds year-to-date.

Hedgewise Risk Parity "High" Performance YTD

The Hedgewise product is labeled "RP High". The High risk level was chosen as the closest level of volatility to the comparable mutual funds. YTD performance ranges from -0.3% for RP Low to -3% for RP Max.

The primary benefit of Risk Parity is the ability to minimize deep losses, and this is exactly the kind of scenario in which that happens. It can be difficult to feel "good" about it, since you still usually lose some money as assets are correcting, but avoiding a few larger drawdowns is one of the primary drivers of the framework's long-term performance, and this represents another successful data point.

This also highlights why Hedgewise clients are typically recommended to hold at least 50% of their assets in a Risk Parity portfolio. I doubt we are in a "this time really is different" scenario, but if and when we do come to such a day, it makes sense to have this backstop. It can be easy to lose this insight when you already know how history unfolded.

The Momentum framework has experienced a much larger drawdown, with the "Max" risk level moving from a 6% YTD gain last Friday to an 11% YTD loss as of today. The reason is relatively simple: it is an equity-focused product, and unless risk signals demonstrate a substantial chance of an economic recession, it will be highly exposed. In this particular case, the fundamental macroeconomic trends before the virus broke out were quite positive (and remember it was only last Friday that the stock market was +5% YTD). Unless those fundamental trends change, it will continue to be positioned this way for precisely the logic discussed earlier; short-term geopolitical events have neither a theoretical basis nor a historical trend of being meaningful reasons to get out of equities.

To see how this has panned out historically, the following isolates all months when Momentum had the same level of its current equity exposure while equities lost 5% or more, and then examines the subsequent one month, three month, six month, and one year returns of the Momentum product.

Momentum "Max" Subsequent Returns after Similar Months of Loss

Date1mth3mth6mth1yr
1971-10-013.7%20.4%24.8%40.5%
1975-07-01-6.2%-0.7%23.7%32.0%
1978-10-01-4.7%5.2%8.9%25.8%
2002-04-010.6%3.4%18.5%20.3%
2010-05-01-4.4%4.6%28.3%59.5%
Source: Hedgewise analysis. Performance is based on a hypothetical model consistent with that in live portfolios. See full disclosures at end of article.

Note that there were frequently more losses in the first subsequent month. It is not the goal of the Momentum framework to minimize such events to the extent that they are likely to be short-lived. Market panic often lasts a month or two, but so long as true recession risk stays below a certain level, Momentum holds steady. By the six month or one year mark, the initial losses are easily and consistently reversed.

This logic allows the two frameworks to function elegantly together. Risk Parity is sensitive to expected market volatility, so it has a relatively high chance of proactively minimizing drawdowns from any source. Momentum is only sensitive to more deeply systematic risk, so it has a much higher tolerance to bear losses from temporary scares. One framework will probably be more "right" at a given point in time, though both perform well over the long run for different reasons. By diversifying across the two, you remain effectively hedged.

With this in mind, it is easier to contextualize the Coronavirus. It is a scary geopolitical risk, so Risk Parity exhibits caution while Momentum does not. If you were convinced that this time is really different, and equities were doomed, certainly Risk Parity makes more sense to express your view. Conversely if you think this will resolve without a lasting recession (just as all other geopolitical risks have), Momentum is in an excellent position to benefit. If you have no real clue but you are a long-term investor, you have your bases covered across the two. In the meantime, I suggest spending more time washing your hands than worrying about the market!

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

2019 Year-In-Review: The Long and Short of Sustained Outperformance
Posted in Market Commentary on 2019-12-17

Summary

  • Hedgewise posted strong performance in 2019, with year-to-date returns of 21% and 20%, respectively, in the Risk Parity and Momentum frameworks (at the Max risk level).
  • While these gains are consistent with expectations, they were purposefully limited to some degree by various risk management techniques.
  • Longer-term, these methods are powerful expected drivers of performance, yet that can be confusing when they appear at odds with the short-term.
  • By linking every point-in-time decision to the bigger systemic picture, what appear to be small immediate costs are reframed as strategic foundations.
  • We'll examine precisely how Hedgewise has been applying this trade-off to every asset class in 2019, and why that creates such a positive environment for future returns.

Introduction: A Great Year, For Now and For Later

From a risk management perspective, this year has been pretty stellar, but for reasons different than you might expect. Absolute performance was intentionally lower than it might have been due to a number of factors:

  • Bond weighting has been consistently under historical averages, and especially so prior to the ~15% rally in August.
  • Energy has been a recent drag on performance, and commodities have broadly underperformed for the better part of this decade.
  • Equity exposure was relatively low during the whipsaw recovery of the first quarter.

On first glance, these factors all appear negative, but the opposite is true: the same risk management mechanisms driving these decisions are also directly improving future expectations. It's helpful to explain this with a hypothetical example. Imagine you could have a lower realized return this year in exchange for a higher realized return over the next five. This is the direct trade-off being applied in each of the cases mentioned above, but it can be difficult to grasp intuitively.

The key to the approach is not to avoid negative events, but rather to ensure their relative cost is insignificant relative to their benefit. 2019 has been a great outcome because despite all of the circumstances mentioned above, clients still managed to achieve over 20% annual returns! The small opportunity costs incurred this year were all made to significantly improve future return expectations, but like everything with systematic investing, it takes a little patience and understanding to allow it all to play out.

With that in mind, let's examine the story in each individual asset class, with a particular focus on how Hedgewise decisions this year have been intelligently optimizing for what might come next.

Bonds: Understanding the Zero Bound

I want to start with the bond market for a couple of reasons. Clients frequently wonder whether Hedgewise carries excessive interest rate risk, since its strategies usually hold more Treasuries than traditional portfolios. Now seems like an excellent opportunity to explain why this isn't the case and how Hedgewise accounts for a very low interest rate environment. Second, bonds are a perfect illustration of the kind of trade-offs at work in systematic investing because interest rate movements quite literally shift gains between now and the future.

How Future Bond Profit Shifts with Interest Rates

As interest rates approach zero, you've moved all your potential gains to the present, since you are receiving 0% interest by definition. Presuming interest rates can go no lower, you can now only lose money if you remain invested. It wouldn't make sense to continue passively holding this asset (which, by the way, raises a number of problems for traditional passive models if/when this level is reached!)

The problem is that no one knows precisely where the bottom is. It's more of a probability distribution that looks something like this:

Probability of Interest Rate "Bottoming"

Source: Hedgewise Analysis

The red line highlights our current level of interest rates, and it's important to account for the possibility that we have already reached a bottom here. If you could know this with certainty, you'd already want to divest all bond exposure. If you were wrong, and interest rates were going to dive all the way to 0%, you'd be missing out on significant gains.

This presents a thorny scenario for passive and active managers alike. If you don't try to time anything, you will wind up with bond exposure when you can only lose money on that position. If you do try to time it, then you risk getting out too early or late.

Fortunately, when you view this curve through a lens of risk, it is straightforward: you hold less as risk goes up and vice versa, much like any asset. In this case, you get an added level of certainty because of the zero-bound (i.e., in most markets, you still might have gains in a period of heightened risk, but there's little chance of this if interest rates are at zero). Functionally speaking, this means you sell some bonds as rates go down, and buy some back if rates go back up, and you increase that proportionally until rates approach more normal levels (Note that "normal" levels are a matter of some debate, but the Fed is using all of its tools to try to get it back above 3% or so).

The wonderful part of such a method is that you can accrue gains simply from interest rates bouncing around. Here's a look at a performance simulation which compares a passive bond investment to this risk-managed strategy over five years, with the horizontal axis representing the final level of interest rates. Note that I've chosen 2% as the lowest point initially to align with the Fed's stated goal of 2% inflation. This first model assumes that interest rates move linearly between current rates and the ending state, with a random level of chop determined by the volatility level. (We'll get to why this matters in a moment)

I've included risk-managed performance in both "normal" and "high" levels of bond volatility to emphasize the unique manner in which this framework accrues benefits.

5 Year Bond Performance Simulation: Passive vs. Risk-Managed Investment

Source: Hedgewise Analysis. The risk-managed model is using a scaled level of exposure as interest rates shift, with a distribution similar to that shown in the earlier probability curve. These levels are purely rule-based and do not include any additional proprietary risk adjustment or special "knowledge" on the part of Hedgewise.

The risk-managed approach accrues positive returns even if interest rates jump to 4%, which highlights why Hedgewise isn't particularly worried about interest rates going back up.

The story becomes even more interesting if you consider a scenario in which rates fall below 2% in the middle of the five year period. In other words, imagine rates drop to 1% after two years, but then go back up by the end of five years.

5 Year Bond Performance Simulation, Rates Fall to 1% at Halfway Mark

Source: Hedgewise Analysis. Same assumptions as prior graph, but rates dip to 1% at 2.5 years, then return to the final level at the end of five years.

The overall results are similar, though slightly lower across the board because interest rates spend a longer time at a lower level (so less net interest is paid out). This belies a strikingly different view if you look how performance varies along the way. Here's a look at simulated performance over time when rates end at 3.5%.

Full Return Curve When Rates Fall to 1%, Then Return to 3.5% After Five Years

Source: Hedgewise Analysis. Data represents a single simulation point of the scenario. The full model simulates one hundred data points for each net outcome from the previous graph, but this is still a broadly representative picture.

Even though you are better off using the risk-managed model by the end of this period, you have to forgo about a 30% gain right in the middle. By doing so, you eliminate the eventuality of a 50% loss. This is a precise example of accepting a lower return over the short-term in exchange for a higher one over the long-term, which is the heart of a risk management trade-off.

Returning to this year, here is how the fully operational Hedgewise risk model has performed.

Return Attributable to Bonds, Passive Investment vs. Hedgewise, 2019 YTD

Source: Hedgewise. Hedgewise Return shows an estimate of the impact that the live algorithm had on bond returns at in the Risk Parity Max product. Note that this varies slightly by client portfolio and cannot be extracted with absolute precision, but the bond weighting is identical to live portfolios.

Much like the simulation, in August you might have gained an extra 15% in your portfolio when 30yr interest rates dipped below 2%. This would have felt pretty nice, and it would have also made Hedgewise returns exceed those of the S&P 500 year-to-date. Yet if you step back to the last time that 30yr rates got close to these levels, in mid-2016, you start to see the bigger story at work.

Return Attributable to Bonds, Passive Investment vs. Hedgewise, 2019 YTD

See prior disclosures

Even if you include the substantial rally of this year, Hedgewise has still yielded overall higher returns from fixed income than a simple passive approach since 2016. Given the possibility that rates continue to go up, the risk-managed approach holds a significant advantage. Even if rates re-touch their lows or fall again in a recession, the story will remain the same: better to give up gains in the short-term to protect your outlook over the long-term.

Commodities: What Are They Good For?

While oil has had a small resurgence in the past few weeks, it has done pretty badly relative to the overall recovery since 2018.

Performance of WTI Oil vs Other Asset Classes Since October 2018

Source: Interactive Brokers, Federal Reserve Economic Data, Hedgewise Analysis. Includes all dividends and coupons assumed re-invested.

This pattern has been even more pronounced for this entire decade.

Performance of WTI Oil vs Other Asset Classes Since January 2010

See prior disclosures.

You might find it surprising to hear that there's nothing particularly surprising about this performance, nor is does it provide any evidence that energy should be excluded from the portfolio. How can this be?

The answer is that this is precisely how diversification is supposed to work. The decade since 2010 has been highlighted by consistently lower than expected inflation. Interest rates were near zero for a majority of the time, and the Fed has been frequently mystified by the ability of various global forces to keep price levels steady. Since a primary purpose of including energy in the portfolio is to protect against higher than expected inflation, its performance is about what you expect in a decade like this one.

The reason you accept this kind of outcome is because some assets are supposed to do well while others do poorly. On net, you are stabilizing your overall return and reducing expected volatility. A diversified portfolio that includes a mix of all assets (even poorly performing ones) should still keep up with a less diversified portfolio of only the better performing assets, assuming both portfolios are set to the same level of risk.

To test this, we can compare two Risk Parity portfolios set to equivalent levels of volatility. The first includes only stocks, bonds, and gold, while the second contains those same assets plus energy. Both portfolios utilize the exact same underlying Hedgewise algorithms.

Performance of Risk Parity Models With and Without Energy Exposure Since 2010

Performance based on a hypothetical model that relies on the same algorithm used in live client portfolios. Data based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. See full disclosures at the end of the article.

Just as expected, you can hold what appears to be a vastly underperforming asset with no negative impact to your portfolio! This is because you are reducing the overall risk inherent to your portfolio by always including assets that balance in various environments.

The full benefits of this approach are difficult to appreciate when you look only at a decade of low inflation. The real question is what kind of protection you are afforded when the opposite occurs. Unfortunately, the last prime example of higher than expected inflation occurred in the 1970s, when reliable oil data was not available. However, we can substitute in gold as our inflation-protective asset to get a sense of how you shift your expected outcomes across various macro environments. The comparable portfolios become a Risk Parity model of only stocks and bonds compared to a second that also includes gold.

To set the stage with a decade similar to the 2010s, we can use the 1980s, when the Fed successfully stemmed inflationary pressure. Much like oil recently, gold had a terrible decade as interest rates went down, but that still had a minimal impact on a diversified portfolio.

Performance of Risk Parity Models With and Without Gold Exposure, 1980-1990

See prior disclosures.

Note that the portfolio with gold did do slightly worse, but not nearly to the degree you might expect when you held an asset that lost 30% in a decade. On the other hand, the protection you gained can be seen clearly when you expand the view to include performance during the 1970s, a decade of higher than expected inflation.

Performance of Risk Parity Models With and Without Gold Exposure, 1972-1990

See prior disclosures. Note that gold pricing data was only available beginning in 1972.

In the 2010s, intuition would suggest that energy has been a drag, but that's essentially untrue. You've done about as well as a portfolio excluding energy because you still increased your ongoing risk-adjusted return through diversification. Should the 2020s wind up being a decade of higher than expected inflation, the benefits of this approach will become even more dramatic, just as they did with gold during the 1970s.

Equities: The Risk Conundrum

Part of the Hedgewise methodology is to dynamically adjust asset exposures based on real-time measures of risk. The underlying idea is that you can further stabilize returns by removing some of the extreme outliers, whether positive or negative. Even if you achieve the same overall average level of monthly returns, you still reduce volatility if you can do so with fewer big swings. Hypothetically, you expect something like the following diagram of monthly returns. The blue data points are all of your model returns, the orange data points are the ones categorized as "high risk", and the grey data points are what remain after excluding the high risk points.

Expected Model Result for Removing High Risk Exposures

Hypothetical model data.

The red arrow has been added for emphasis on the desired outcome: you'd like to squeeze all of your data points inward - especially the large negative ones - such that you have a more stable positive return.

Now let's look at this actual diagram for a few asset classes. These graphs are selecting all actual months categorized as high risk using the Hedgewise algorithm over various timeframes, and then removing those data points from the distribution to see how this impacts your outcome. If the theoretical model is correct, the graphs should all look something like the above.

Treasury Bond Return Distribution, High vs. Normal Risk

Source: Hedgewise Analysis, Federal Reserve Economic Data. Returns include all dividends and coupons paid and assumed re-invested for 10yr Treasury Bonds.

Energy Return Distribution, High vs. Normal Risk

See prior disclosure.
So far so good. In both these asset classes, the "negative" tail has consistently shifted upward by removing your high risk environments. Strangely, the S&P 500 has been a little different this decade.

S&P 500 Return Distribution, Normal vs. High Risk

See prior disclosure.

It appears that recent high risk environments have resulted primarily in positive returns and removing those data points has not had the desired effect. What does this mean? Has something about risk in the S&P 500 changed? Do these results suggest a problem with the financial theory?

It's worthwhile to provide some additional real-life context about what is happening. A "high risk" month generally means that investors are pricing in the potential for a large market swing in either direction. If market fears come to bear, you incur losses, and vice versa. During a stretch where the consistent outcome during these months is positive, it must either mean that investors were badly pricing risk, or that events are luckily resolving despite a real chance that they might not have.

Anecdotally over the past couple of years, it's difficult to argue that the trade war had little chance of escalating, or that the Fed could not have made some irrecoverable mistake. Even if you were to claim that investors were truly overreacting in these particular cases, that doesn't suggest that some fundamental factor has shifted to make that more likely moving forward.

A more believable explanation is that we've basically gotten lucky. The Fed nearly broke the economy, but backed off just in time. Trump nearly blew up global trade, but mended things just enough to avert disaster. Low employment and higher than anticipated consumer strength provided a nice boost this year that many doubted would materialize. We've also avoided any nasty geopolitical blow-ups like wars or recessions.

To further test this theory, we can look at history to analyze how our current environment of risk compares to historical trends. The following shows the percentage of "high risk" months that occurred in every ten year rolling timeframe since 1954, as well as what percentage of those months resulted in a negative return (i.e., The orange bar shows about how often markets were in a risky state, and the blue line shows how often that risk wound up resulting in a loss).

S&P 500 Historical Risk Environment & Hit Rate, Ten Year Rolling Timeframe, 1954 to Present

Source: Hedgewise. High risk environments largely categorized a mix of volatility and recent negative returns. A negative event means the S&P 500 experienced a negative monthly return when markets were in a high risk state.

What jumps out is that in the most recent decade, more risky events have resolved to the upside than ever in history. On average, somewhere between 30-50% of these events materialize negatively; recently it's been under 15%. It's also been quite peaceful overall; the only other periods to show so few "risky" environments (the orange bar) were the ten years ending 1998 to 2000.

This makes a strong case that this is an outlier of relative global harmony, in which the few major risks (trade war, Brexit, et al) all resolved without doing too much damage. History suggests that this will be an incredibly difficult feat to repeat.

Still, it's worth analyzing how much this has impacted the returns of the Hedgewise portfolio. You'd think that missing months of upside would have a pretty dramatic negative effect, but here's the performance of the Risk Parity model compared to the S&P 500 over the last ten years.

Performance of the S&P 500 vs. Risk Parity Max, December 2009 to Present

See full disclosures at end of article. Hedgewise model includes an estimate for all cost and fees and uses the same algorithm currently in use in live portfolios.

The story here is similar to the one of diversification: even when you do 'badly', you still mostly keep up. This is because so many other elements of the strategy have continued to function as they should (like the normal behavior of risk in other asset classes). Yet when some major risk does unfold, you do so much better. For example, simply include the 2008 recession.

Performance of the S&P 500 vs. Risk Parity Max, December 2007 to Present

See prior disclosures.

Notice that these long-term results include lots of individual months that 'felt' like the algorithm was working poorly. You have to deal with multi-year stretches where you underperform the S&P, like 2012 to 2013 or 2018 to today. In the broader scheme, these costs are minimal compared to the benefit you accrue over time.

Historically speaking, there's little chance that the 2020s continue as peacefully as the 2010s. Given that this past decade has been as low risk as it has, it's also pretty remarkable that it cost so little in terms of your net realized return. Hedgewise strategies will likely perform even better relative to the S&P 500 moving forward, but this has been pretty great so far as "bad" outcomes go.

Looking Forward: Grappling with an Uncertain World

In 2019, there's no denying that we've missed rallies, that commodities have lagged, and that no major risks have manifested. Yet all of that can occur without damaging long-term returns, and the same mechanisms driving these outcomes make your portfolio far more resilient for the future.

Moving into 2020, a significant overlooked risk is quite mathematic. Much of the gains in stocks and bonds this year are due to falling interest rates, which literally moves profit from the future into the present. Just as we saw in the modeling of this article, that introduces substantial downside even if rates simply return to where they were back in December 2018. Hedgewise strategies not only consider this possibility, they are probabilistically built around it.

Commodities have also been the key victim of a decade of low inflation, and will be an attractive source of returns if rates do rise again. Most traditional portfolios have no way to benefit from this, yet it will be difficult to generate positive returns without this exposure in a world of resurgent inflation.

Stocks have wondrously avoided most major risks for a very long time, but imagine if Trump or Xi decides to re-escalate, or if the EU shows more serious signs of falling apart. Climate change, presidential elections, and global inequality will all weigh significantly on the future. The world is a fragile place, and Hedgewise strategies behave with that in mind while minimizing the cost if we do manage to avert those risks.

The push and pull of all of these scenarios and probabilities is very difficult to grasp on a day-to-day basis, and it will always be easier to see the immediate decision that might have driven a bigger gain right now. By understanding and accepting these trade-offs, you dramatically improve your long-term return expectations. In 2019, that meant taking a 20% return instead of something higher; in context, that is pretty fantastic for the sake of 2020 and beyond.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

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