Portfolio diversification in the COVID-19 era
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| Image by Miroslava Chrienova from Pixabay. |
By Mark Shore/Coquest Advisors
Over my 30 plus years in the capital markets, it appears there is never a bad time to discuss diversification. However, the current market environment suggests a more inviting moment to discuss the topic as noted in Figure 1 of the frequency of Google “stock market” term global searches as equity markets declined. Several of my past articles discussed various concepts of diversification, the current market interest affords another opportunity to review this topic.
Figure 1
Market corrections and/or economic contractions are often related
to structural changes or changes in market confidence. However, in the first several months of 2020,
many economies were government-mandated to shut down and practice social
distancing to fight the COVID-19 breakout except for “essential businesses”.
COVID-19, an exogenous shock to the world economic system; an event-driven global
economic slowdown.
As COVID-19 spread across the globe in 2020, the capital
markets repriced in Q1. During this global crisis equity markets, commodities and
REITs declined as noted in Figure 2. The VIX spot and VSTOXX spot volatility
indices rallied and met or exceeded their financial crisis highs as implied volatility
priced into the 80s. In a normal market environment, VIX and VSTOXX volatility indices
tend to be range-bound between low teens to low 30s. Implied volatility priced
in the 80s usually indicates a nervous market, last seen in 2008/ 2009.
The “lower for longer” interest rate mantra continues. What
is probably the first time in American history (or at least post-WWII) on March
9, 2020, the entire U.S. yield curve temporarily declined below 1%. Except for
the 30-year bond, the yield curve has primarily remained below 1% for the last
several weeks.[1] During
the Great Depression of the 1930s yields were higher, high-grade commercial
paper yielded 0.75% until it moved higher in 1937[2].
2020 Returns
Figure 2
Fig. 2 shows the March 2020 returns for various asset
indices. Except for managed futures, the indices declined. Fig. 3 notes the Q1
returns declined by double digits, except for managed futures experiencing
positive returns.
Figure 3
When examining any index, the result is an average of the
index’s constituents. Meaning some constituents are underperforming and some
are outperforming the index, but it offers an indication of behavior.
Why Did
Managed Futures Experience Positive Returns?
Managed futures, also known as Commodity Trading Advisors
(CTAs), parsing their returns by sub-sectors, the Q1 returns ranged from an
average of -0.18% for discretionary managers to an average of 6.95% for
currency traders, demonstrating not all CTAs are the same.
You may be asking why did CTAs experience positive returns
in Q1? The history of CTAs tends to offer similar results during negative
equity quarters as suggested in “Downside
Analysis of the S&P 500 Index”.
Between Jan 1980 and June 2019, SPX experienced 50 negative
quarters with an average return of -6.3% and a maximum loss of -23.2%. During
those same quarters, CTAs averaged 3.3% returns with a maximum gain of 36.9%
and a max loss of -8.9%.
Quick summary of managed futures:
- CTAs may take long or short positions in multiple futures markets including, equity indices, fixed income, forex, metals, energy, grains, softs, volatility indices and options on futures, allowing for various potential market opportunities.
- Their risk management may be more quantitative relative to say a mutual fund manager. Their risk management may offer positive skewness to a CTA’s return distribution. This could be a value-add to an investor’s portfolio as discussed in my 2019 article, “The Good and Bad of Volatility”.
- CTAs trade in the futures and forex markets versus hedge funds frequently trading in the equity and fixed income markets.
- Their duration of holding periods may range from intra-day to holding positions for several months.
- Their strategies may vary to include from trend-following to spread trading (aka relative value).
- Some CTAs trade one market or sector. Some may trade only commodity futures or only financial futures. Some may trade across a spectrum of financial and commodity futures.
This
is a short-list of items[3],
but it begins to explain why managed futures may offer non-correlation to
equities and many other asset classes including several hedge fund strategies
and why they may experience positive performance in stressful economic cycles.
At
the 2019 Illinois Economics Association, I presented correlation risk research relative
to various hedge fund strategies. Several strategies offer an extension of a
portfolio’s equity exposure and others are more of a diversifier such as CTAs. A
summary of the presentation is found here.
The
correlation rankings in Fig. 4 suggest hedge fund strategies contain various
correlations to equities. The allocation of a given strategy should depend on
the investor’s goal.
Figure
4
I once heard a pension fund CIO mention, to protect the
portfolio, you can’t prepare for the last battle, you must prepare for the next
battle. The current market environment demonstrates
this concept as a different catalyst triggered this crisis is different from the
Great Recession and most other economic contractions in at least modern times.
Yet, the strategy behaviors are finding similarity to past events.
Summary
As the catalyst is different from most market corrections,
the market behavior offers similar results as suggested by historical data.
Equities tend to be highly correlated in selling environments. Long-only
commodity indices and REITs demonstrate their positive correlation to the
economic cycle. We never know when the next downturn will occur, therefore
examining the utility of non-correlated returns may assist to mitigate tail
risk losses.
If you have questions or would like to receive more
information on this topic, please feel free to contact the author at
mshore@coquest.com.
About the Author:
Sources:
[1] https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2020
[2] Bowsher,
N. (1965). Interest Rates, 1914-1965. Retrieved: https://fraser.stlouisfed.org/files/docs/publications/frbslreview/pages/1965-1969/62472_1965-1969.pdf
[3] Shore, M. (2018). Managed Futures Lecture Notes. DePaul University, Chicago.
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