What is the most effective way to hedge against equity market crashes? In their June 2017 paper entitled “The Best Strategies for the Worst Crises”, Michael Cook, Edward Hoyle, Matthew Sargaison, Dan Taylor and Otto Van Hemert examine active and passive strategies with potential to generate positive returns during the worst crises. They test these strategies across the seven S&P 500 Index drawdowns of more than 15% during 1985 through 2016. They focus on two active strategies:
- Time-series (intrinsic or absolute) momentum long-short portfolio comprised of 50 liquid futures and forwards series spanning currencies, equity indexes, bonds, agricultural products, energy and metals. They consider return lookback intervals of 1, 3 and 12 months. They apply risk adjustments, risk allocations by class and finally a scale factor targeting 10% annualized portfolio volatility. They consider three extensions of the strategy that preclude or restrict positive exposure to equity market beta.
- Quality factor long-short portfolios comprised of intermediate and large capitalization U.S. stocks. These portfolios ares long (short) the highest-ranked (lowest-ranked) stocks, as selected based on one of 18 metrics representing profitability, growth in profitability, safety and payout. Rankings are risk-adjusted and portfolios are equity market beta-neutral. They again apply a scale factor targeting 10% annualized portfolio volatility. They also consider several composite factor portfolios by averaging individual factor rankings and weighting for dollar neutrality, beta neutrality, sector neutrality and/or volatility balancing.
Using daily data for all indicated assets during 1985 through 2016, they find that:
- Based on the 15% S&P 500 Index drawdown, 14% (86%) of days during the sample period are crisis (normal). The annualized S&P 500 Index return during crisis (normal) days is -43.5% (24.5%), compared to 11.0% overall.
- The negative of the returns of the CBOE S&P500 PutWrite Index indicate that put options are too costly as a crisis hedge. While the put options perform well during all seven crises, they are very costly during normal times, with overall annualized return -7.7% in excess of the risk-free rate.
- The negative of the returns of the BofA Merrill Lynch US Corp Master Total Return Index indicate that short credit risk also gains during the seven crises, but less evenly. This strategy is less costly than put options, but still has negative returns on average during normal times, with a small positive return overall.
- Holding 10-year U.S. Treasury notes performs well during post-2000 crises, but not during prior crises. Annualized excess return during crises is 10.7% (driven by post-2000 observations), compared to 3.4% for normal times.
- Holding gold performs better during crises than normal times, but its return over the full sample period is close to zero. Specifically, gold returns are positive during six of seven crises, with annualized crisis return 8.4%. During normal times, gold returns are negative on average. Overall, gold return is marginally positive.
- Time series momentum strategy variations applied to futures mostly perform well during the seven crises, and over the entire sample period. Restricting long equity exposures appears to increase crisis performance at a modest cost to full sample performance.
- Profitability, payout, safety and four-factor composite hedge stock portfolios perform well during crises. Growth and low-beta hedge portfolios do not. A refinement that adjusts for volatility at the individual stock level performs best in most cases.
- Time series momentum and quality hedge portfolios have uncorrelated returns, suggesting joint use. The 3-month times series momentum with no long equity positions and the composite quality hedge, adjusted for estimated costs and scaled to a combined 15% annual volatility target, together enhance S&P 500 Index performance. Specifically:
- A 10% allocation to the combined hedges reduces annualized crises loss from -44% to -36% and improves overall full sample annualized return from 11.0% to 12.6%.
- A 50% allocation to the combined hedges turns crises performance positive and boosts overall full sample annualized return to 18.5%.
- A 100% allocation to the combined hedges has crises (full sample) annualized return 89.0% (24.6%).
In summary, evidence suggests that multi-class futures time series momentum (excluding long exposure to equity indexes) and many long-short quality factor portfolios may be effective, and complementary, as equity market crisis hedges.
Cautions regarding findings include:
- Most analyses are gross, not net. Accounting for the frictions inherent in proposed crisis hedges would reduce reported effectiveness. The authors do apply estimated frictions (“based on live trading experience”) to the final analysis combining time series and long-short composite quality, but this experience is likely lower than many investors could achieve and is likely not representative of the full sample. In other words, had low frictions been available early during the sample period, the market may have behaved differently.
- The paper considers a large number of alternative hedge strategies and strategy variations across only seven crises and employs findings from past research, thereby carrying the potential for considerable inherited and direct snooping bias. The featured strategies/variations are very elaborate, incorporating many modeling decisions and parameters, thereby introducing many opportunities for snooping. The best results likely overstate expectations.
- Featured approaches are beyond the reach of most investors, who would bear fees for delegating to an investment/fund manager.
- The strong performance of the combined time series and long-short composite quality hedges beg the question of why not just invest in them rather than use them to hedge the broad U.S. equity market.
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