Bear Market Funds as Hedges or Shorting Indices: Risk and Return
09/26/2011 0 comments
Bloomberg reported Global Stocks Drop 20% Into Bear Market as Debt Crisis Outweighs Profits.
We have been asked by several users on why we do not support bear market ETFs or mutual funds in our asset allocation strategies. To address this question, let's first clarify what we do at the moment:
In both strategic asset allocation and tactical asset allocation model portfolios, we simply ignore any fund that is classified as a bear market fund. Bear market funds short stock indices (such as SH Proshares Short S&P 500), commodity indices and any other asset classes. So we want to be clear that we not only ignore short stock funds, but also other short funds.
So let's look at the implications of using bear market funds in a portfolio. The general impression is that shorting an index that is in bear market can enhance returns. But a less well understood property is that shorting can also increase a portfolio's risk, especially if you just allocate a portion of a portfolio to do so instead of using derivatives such as equity options (ex. purchasing puts). The reason behind this is that bear market funds are negatively correlated with a long only fund, they are not UNCORRELATED with other funds. For example, let's say at the moment, our TAA decides to short S&P 500 while in the meantime, taking a long position in long term government treasury bonds (such as TLT). This simple portfolio consists of SH and TLT. Since SH has had a very high positive correlation with TLT recently (when stock markets are in severe stress, investors flock to long term treasury bonds as a flight to safety gesture (or speculation)). The problem for this portfolio is that when the stock markets bottom out eventually and then turn around, it is highly likely that both SH and TLT are going to experience a loss. So a portfolio that is fully invested in these two funds bears more risk than a portfolio that invests the portion of the short SH position in safer intermeidate term bonds (such as BND or AGG0 as well as CASH, which will be much more stable when the stock markets turn around.
So a long only portfolio with a diverse array of assets as its candidate funds is safer than a portfolio with short position when markets turn into an up trend. This can happen during market bottoms or when a market is in an oscillation range.
The other important property for shorting is that shorting in general has a limited upside since, at best, you can achieve double (100%) return (that only happens when S&P 500 has 0 value in the case of SH). On the contrary, a long only position can have an unlimited upside.
Many investors would like to include bear market funds in our TAA strategy so that during a bear market, they can still earn some nice returns. But as the saying "there is always a bull market somewhere" goes, our TAA (Tactical Asset Allocation) strategy will try to pinpoint and invest in such 'bull' markes in a bear market.
In general, only in extremely clear trends, a long/short heding strategy works well and can enhance returns. In most of other cases, it might under perform a long only portfolio.
We will make bear market funds available in future for expert users. For average users, we believe they are better off to stay with a long only strategy.
Market Overview
All risk assets are experiencing severe stress uniformly. These include commodities (Gold and Silver). Furthermore, all bond ETFs in the riskier spectrum are now ranked below those in the safer specturm.
Observations on major asset trends:
- Gold and commodities had severe loss last week. Gold (GLD) still remains on a top spot.
- However, commodities (DBC) is now ranked below all fixed income ETFs, indicating a downturn trend.
- Silver had a precipitous drop.
The uniform risk asset off is an indication of panic selling. We don't know whether this is a repeat of 2008. Again, we let the market forces tell us instead of trying to be a sage to predict that. For more information on how these assets are ranked, please see here.
Benchmark Portfolios
Let's review Retirement Income ETFs:
Portfolio Performance Comparison (as of 9/23/2011)
| Portfolio/Fund Name | YTD 2011 | 1Yr AR | 1Yr Sharpe | 3Yr AR | 3Yr Sharpe | 5Yr AR | 5Yr Sharpe |
|---|---|---|---|---|---|---|---|
| Retirement Income ETFs Strategic Asset Allocation Moderate | -5.3% | -1% | -7% | 4% | 18% | 2% | 8% |
| Retirement Income ETFs Tactical Asset Allocation Moderate | -0.8% | 3% | 33% | 10% | 82% | 9% | 63% |
| Six Core Asset ETFs Strategic Asset Allocation Moderate | -5.7% | 1% | 8% | 4% | 18% | 5% | 23% |
| Six Core Asset ETFs Tactical Asset Allocation Moderate | -0.59% | 5% | 49% | 10% | 83% | 13% | 89% |
| VBINX | -3.24% | 3% | 203% | 4% | 32% | 3% | 28% |
The strategic asset allocation portfolios are compared unfavorably with VBINX (Vanguard balance fund index 60 US stocks/40 bonds). On the other hand, the tactical asset allocation portfolios have held up well. The all risk off panic selling inflicted severe loss in commodities and international/emerging market stocks, making diversification less useful at least in the YTD (Year To Date) period.
Refer here for more detailed comparison.
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Disclaimer:
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