Financial TV networks are filled with investors offering their insights into where markets will
move in the future. Will there be a
recession in 2020? Will the S&P hit new
records? The reality is no one knows.
I recently traveled through the
Highlands of Scotland, whose poet
Robert Burns in 1785 wrote the well-
known line: “The best-laid plans of mice
and men often go astray.” That line,
in a verse about a plowman churning
up a field mouse’s nest, is preceded by
the not-so-famous but equally prescient:
“But mouse, thou art not alone in prov-
ing foresight may be vain.”
So why, when our powers of predic-
tion are so inadequate, do we rely heav-
ily on recent past experiences to inform
our decisions about future outcomes,
such as portfolio construction?
From 1978 through September 2009,
the Sharpe Ratio for a typical 60-40
portfolio was 0.45. For the same portfolio in the 10 years since, the ratio, which
tells investors how much excess return
they can expect to earn for the additional risk they’re taking, is 1. 25.
Because the Sharpe Ratio is almost
three times higher than its historical
norm since 2009, while bonds have performed strongly and equity and interest
rate volatility has been low, portfolio
optimization tools now routinely recommend a 60-40 split.
That’s akin to driving while only
looking in the rear-view mirror, because
it fails to take into account constantly
That’s especially so when signals are
mixed. With 40% of S&P 500 companies
reporting third-quarter results, 80% had
a positive earnings per share surprise
and 64% had revenue that exceeded esti-
mates, according to FactSet. That helped
to push the S&P 500 to a record high
close on Oct. 28, yet two days later, even
after third-quarter real GDP came in at a
higher-than-expected annualized 1.9%,
the Federal Reserve cut rates by 0.25% for
a third straight time in a bid to boost busi-
ness investment and exports. Two days
after that, the Labor Department said the
economy added 128,000 jobs in October,
far surpassing the 85,000 expectation.
Given such conflicting data, it would
seem logical to look beyond the recommendations of optimization tools and create portfolios that perform in more volatile
and uncertain circumstances. Further,
rather than “predicting outcomes,” use
scenario analysis to inform your outcome.
If you assume there is an 80% likelihood that equities will rise 10% over
the next 12 months and a 20% chance
that they will decline by that amount,
the inferred forecasted return from
unhedged equity is 6%, versus 4% from a
hedged option such as long/short equity
with 40% downside capture and 60%
upside capture. If that’s your base case,
stick with 60-40.
However, should you assign an 80%
chance of a 10% fall in equities and a
20% probability of a rise of the same
magnitude, a hedged equity option with
the capture ratios used above provides a
forecasted return of -2% versus -6% for
an unhedged strategy.
If you’re like me, and are unsure of the
outcome, then use a 50/50 chance and
you’ll find the hedged equity portfolio is up
1% and an equity portfolio is flat. That’s the
reason why people should diversify using
alternatives like hedged equity: It provides
more predictable and potentially positive
outcomes in the face of uncertainty.
If you are that rare beast with perfect
foresight and you know the bull run will
continue unabated, then go all-in on risk
assets. Or, if you’re convinced the world
is about to fall apart, lose your market
exposure entirely. But if, like most of us,
you don’t know which direction things
might turn, then it’s probably prudent to
look to alternatives like hedged equity to
provide growth now and capital protection when the next recession inevitably
comes — whenever that may be.
That’s one prediction I’m comfortable making.
Josh Vail, CAIA is president of 361 Capital.
By Josh Vail
Are You Protected From Stock Volatility?
As the probability of a market downturn rises, unhedged equity assumes