Will Diversification Survive Zero Interest Rates?

July 29, 2020

Dominick Paoloni, CIMA®
CIO & Founder
Portfolio Manager, IPSAX
Adjunct Professor, University of Denver
& University of Colorado

At the time of writing this article, 32% of the global government bond market and 24% of the global aggregate bond market trade at negative yields. Foreign money is pouring into US Treasuries as one of the last places on Earth offering positive yields. These huge asset flows into the US bond market has pushed rates closer and closer to zero creating the lowest yields in history. Additionally, trade wars with China and a slowing global economy has put increased pressure on the Fed to drop rates with the hope of re-inflating the economy. This flies in the face of investor concern over deflation or stagflation, which is the bane of all economies. A zero-interest rate world has devastating effects on savers, pensions, and endowments, which all rely on debt as an income stream as well as a portfolio diversifier. This counterweight has traditionally protected the equity side of portfolios; however, many professionals are voicing their concerns.

“The Fed is keeping volatility down and rates rangebound. As a result, …they will have to look to other instruments- currency, gold and/or options – as additional tools in their arsenal.” – Russ Koesterich MD and Portfolio Manager at BlackRock Global Allocation Group.
For the last 10 years the correlation of weekly total returns between the S&P 500 and the Bloomberg Barclays U.S. Treasury 20+ Year Index was negative 0.36*. This historically negative correlation coupled with falling interest rates has made the financial advisor extremely comfortable with a traditional 60/40 stock, bond portfolio going forward. The portfolio manager is of the assumption that past performance is an indication of future performance. However, as interest rates approach zero in bond markets, the question that must be asked is, “Will the correlation of stocks to bonds hold going forward and, if it doesn’t, what does that mean to the traditional portfolio mix?”

In March of this year markets became very volatile and stocks and bonds converged meaning assets across the entire landscape lost their diversification benefits simultaneously. Meanwhile, advisors have increasingly used back testing software to predict futures correlations. I equate this to driving down the road using the rear-view mirror to steer. To quote John Rekenthaler of Morningstar,
“Few, if any, would accept a nominal return of slightly more than 1% in exchange for accepting the risk that inflation would not be entirely dormant throughout the next 30 years. At today’s prices, long bonds are a fool’s purchase, to be re-sold to greater fools.”

With all these facts out in the open, my question is simple: how is it acceptable the average financial advisor can put 40% of their clients assets into something earning 1% with a 30 year holding period that they hope will hedge off a true market downturn and not these V-bottom corrections we have seen over the last 10 years?

The Inverse ETF

Many financial professionals have recognized this dilemma by moved to inverse ETF’s instead of bonds to hedge their portfolios. The problem with adding an inverse ETF to a portfolio, is that the ETF just reduces the beta or linear slope of the portfolio. For example, let us assume your portfolio has .60 beta, this means you are capturing 60% of your portfolio benchmark on the upside and 60% of your benchmark on the downside. Remember, a diversified portfolio tends to have a negative skew, which means because of asset convergence in volatile markets, the downside beta is higher than the upside beta. Reducing your linear portfolio beta, for example, from .60 to .30 by adding an inverse ETF would mean you are capturing only 30% of the upside and 30% of the downside when you add the inverse ETF. Many advisors fail to realize this methodology is no different than moving a percentage of your portfolio to cash or essentially market timing.

An advisor may feel that markets are about to have a downturn, so they add an inverse ETF or worse a leveraged ETF. If market timing is an advisor’s answer to portfolio management, then all power to them. After 30 plus years in the industry, I personally do not believe that market timing is the answer to managing risk. If market timing is the answer then why is the amount of money that has flowed into money markets over the last several months, according to Morningstar, nearly $3.3 trillion, surpassing the highest levels since the Credit Crisis?

Defined Risk Investing 

In my professional opinion, if bonds end up being a poor diversifier going forward, then the only true answer to stable portfolio returns are with defined risk tools, i.e. options. When correctly implemented, these tools can cut off the left tail when markets crash while at the same time delivering uncapped upside returns competitive with the traditional 60/40 stock/bond mix.

IPS Strategic Capital has dedicated itself to building low-cost, defined hedging solutions that use long optionality to build portfolios with mathematically defined covariance through all market conditions. This stable covariance or correlation removes portfolio uncertainty in volatile markets which takes the guess work out of portfolio management and relieves the advisor from the impossible task of trying to time the market.

IPS Bear Strategy 

Building a viable hedging solution with a protective put strategy is very mathematically defined but the carry cost (the expense for holding the hedge) is far, far too expensive over time. IPS Strategic Capital has developed a suite of defined hedging strategies with a low cost of carry to deliver a portfolio solution that provides a much higher degree of certainty than hoping bonds or market timing can achieve. Through the recent market downturn, a 20% notional exposure to the IPS Bear Strategy and 80% long the market delivered the returns a defined risk hedge should deliver. The following chart are actual returns since inception of our strategy.

The red line represents the performance of the S&P 500 since March 2019. During Q1 2020, the S&P fell almost 35% over fears surrounding a global pandemic. During this time, a 20% notional overlay to the IPS Bear Strategy had maximum drawdown of only 11.9%. The beauty of a defined hedge overlay is it keeps your clients invested through market volatility allowing investors to not sell equities at unfavorable prices. The S&P 500 delivered a 0.15 Sharpe ratio though this time period while the 80% stock and 20% IPS Bear Strategy delivered a Sharpe ratio of 0.44, almost three times that of the market.

The 60/40 stock bond mix has been a great portfolio for the better part of the last 40 years. This 40 year period coincides with a 40 year bull market in bonds beginning when interest rates topped at 15% in 1982. With interest rates at zero and the Fed trying to re-inflate the economy, the future of holding debt through inflation or worse stagflation is a recipe for disaster. We feel that advisors should familiarize themselves with alternative tools to protect their portfolios from market volatility in the case that bonds are unable to match the stellar performance investors have become accustomed to over the last 40 years.

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Dominick Paoloni, CIMA is an adjunct professor at the University of Denver and the University of Colorado. He is a member of the OIC Advisory Counsel, and the TD Ameritrade Trading Panel. He is a published author and is frequently quoted in financial journals.
He can be reached at dominick@investps.com

Disclaimer

Please note that the information contained in this piece is intended for investment professionals. This information should not be misconstrued as an offer to buy or sell, or a solicitation to buy or sell securities. Any performance contained in this article is strictly informational and is not necessarily indicative of the future performance of investments. Past performance is not indicative of future investment performance and investors should always consult a financial professional prior to making any investment decisions.
The performance of the IPS Bear Strategy is representative of the performance of the IPS Bear Strategy composite. This composite is managed via separately managed accounts. The performance data is shown net of fees. The performance of the accounts comprising the IPS Bear Strategy was scaled to a 20% exposure to represent a hypothetical portfolio that was invested 80% to the S&P 500 and 20% to the IPS Bear Strategy. This is purely a hypothetical portfolio that is intended to illustrate how the IPS Bear Strategy can be combined with equity exposure to provide reduced drawdown and volatility. Any performance relating to the S&P 500 is representative of the price returns of the index. Please note that the S&P 500 is an index and therefore not a directly investable asset.
The IPS Bear Strategy trades options contracts on the S&P 500 index. Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options. Put options give the purchaser the right, not the obligation, to sell a specified number of shares of the underlying security at a specified date in the future. The seller of a put option has the obligation, not the right, to have a number of shares delivered to them at a specified price at a specified date in the future in exchange for receiving a premium upfront for the risk.
The results shown here are strictly for informational and educational purposes. All investments have the potential for profit and the potential risk of loss. Changes in investment strategies, contributions or withdrawals may cause the performance results of one’s portfolio to differ materially from the reported composite performance. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s portfolio. One should always consult an investment advisor before making any investment decisions.

DISCLAIMER: The information on this website should not be misconstrued as an offer to buy or sell, or a solicitation to buy or sell securities. The performance data represents past performance data. With any investment, past performance is not necessarily indicative of future performance. The Absolute Return Strategy performance is representative of a size-weighted composite of the accounts managed by the firm classified as the Absolute Return Strategy-Moderate composite. The returns represent net returns of clients invested into the strategy, accounting for the 1% annual management fee. Please note that all performance in 2011 represents one non-fee paying account comprised of the firm’s capital. Due to the nature of composite performance, it cannot be guaranteed that an investor in a specific composite will receive the same gains as the size-weighted average of the composite. As of April of 2016, the separately managed accounts in the ARS–Moderate composite gain their exposure to the ARS through a 40 Act fund that utilizes the Absolute Return Strategy. The performance of the ARS shown on this sheet still represents the size-weighted average of the SMA’s that are part of the ARS-Moderate.

The Absolute Return Strategy invests in derivatives securities. Specifically, the fund sells and buys put and call options and sometimes utilizes leverage; these factors can cause portfolios invested in the strategy to show greater fluctuations than investments in the underlying assets. Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options. Put options give the purchaser the right, not the obligation, to sell a specified number of shares of the underlying security at a specific date in the future. The seller of a put option has the obligation, not the right, to have a number of shares delivered to them at a specified price at a specified date in the future in exchange for receiving a premium upfront for this risk. The seller of a call option has the obligation, not the right, to deliver a specified number of shares to the buyer at a specified price at a specified date in the future in exchange for receiving a premium upfront for this risk. The risk of buying either a put or call option is limited to the premium paid for said option.

The performance of the S&P 500 Index is representative of price returns not including dividends over the specified time period.
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