By Derek Moore
Over the past week or so the markets have been a bit riled up due to the historic rise in interest rates. If you have not been paying attention, no we are not seeing treasury bonds at 1981 with yields of 15%. Instead, we have witnessed a historic rise on a percentage basis on some parts of the treasury yield curve. Take the 5-year treasury which last week saw its yield increase by nearly 40% in one day! Albeit from a paltry 0.60% to 0.80%.
But this sudden rise in rates has also caused some equity volatility as markets digest everything. Growth stocks have sold off a bit from their record highs. Holders of longer duration treasury bonds are down nearly 20% from recent August 2020 highs. Investors are starting to hear more and more talk about inflation and surging rates. What about the 60/40 portfolio? Should I go to cash now and wait?
As the title says, I will be making the case for using a hedge equity portfolio like ZEGA’s own Buy & Hedge. No need to burry the lead. But it is perfectly natural to feel a little worried given how much talk there is that you should be. To be clear, we do not make market predictions. We do not try and time markets for the perfect entry. Instead, we hope to provide the opportunity for investors to sleep a little better at night knowing they have a downside floor in their portfolio. They have the opportunity to participate in a healthy portion of the market’s growth, and they also have a special hedgers opportunity during moderate to major declines. I will remind everyone about this a little later.
Do not Try and Time Your Entries and Exits
You are probably thinking that everyone says this, but with a hedged equity strategy it will resonate more. Looking back at the 2009 period, it was natural for investors to be fearful. Yet we saw again and again those who remained in cash waiting for the next leg down in markets that never came. They wound up missing out on the recovery that took 11 more years out to March of 2020 to come to an end.
As markets traded around all-time highs, we saw some apprehension and decisions to go to cash. Recently Jay Pestrichelli and I did a podcast explaining that surprisingly, markets are within a few percentage points of all-time highs 36% of the time. You can listen to that archive below.
If an investor went to cash 36% of the time near all-time highs, surely that would reduce their compounded growth rate wouldn’t it?
What about Just Using the 60/40 Portfolio as A Hedge?
This traditional portfolio involves using 60% stocks and 40% bonds. This is done based on the inverse relationship of bonds and stocks during times of panic. Books have been written about this as the be all end all. Before I tell you my reservations about it going forward, let me just admit, yeah it did work in Feb/March of 2020 when markets sold off before quickly recouping the losses. The non-correlated feature of these two asset classes moved in opposite directions as stocks went down and bonds went up.
The challenge in this setup, given historic low rates, is that any move higher in those rates could set up a situation where they become positively correlated (move together) and do not offer the same bang for the buck. What if bonds selloff in conjunction with stocks? In good markets you do not capture as much of the equity run because of the 60% allocation. And, given that your interest received is so low on the 40% bond portion, they become less appealing as a source of return.
Now at ZEGA, we use bonds in portfolios. But we use them as a funding source to pay for hedges, not as a pure offset of a non-correlated asset.
Jay and I did a two-part series on the Myth of the 60/40 portfolio given low rates and increased interest rate risk:
Why Hedging Works & The Hedger’s Opportunity
The colorful graphic at the top of the article helps to tell the story. When you lose less, it takes less of a move to make back those losses. Lose 50%, you need 100% in gains to get back to break even. Lose 10%, it only takes an 11% gain to get back to even. If you have real downside protection, not just the hope that things in your account will be non-correlated, you can become more comfortable being in the market. You also can be more comfortable with investing new money as it takes the pressure off trying to get in at just the right time.
The simple fact is even professionals cannot really time the market. If you want to test this theory, simply google market predictions and you will find any number of experts who called for the market to crash only to see it rise. Others predicted a new paradigm in markets like those in early 2000 before the dot.com crash.
Think about how long you have seen those commercials on the financial networks for a free report about the biggest crash of all-time coming. They were probably running each year of the last decade. Here is the thing though, if they are right and you have a downside floor in the portfolio, you only participate in a limited amount of the downside. Plus, the hedger’s opportunity.
I hinted earlier there was a unique benefit from a hedged equity strategy. You see, if the market materially drops and you only participated in the first 8% to 10% down, the avoided loss allows investors to buy in much lower. If markets rebound, you potentially could own more shares on the way back up. At the same time, you still have hedges in place should another leg down happen.
And yes, Jay and I did a podcast that you can listen to below on Why Investors Need A Hedged Equity Strategy.
So, if you are anxious about getting in the market or staying in, consider the benefits of ZEGA’s Buy & Hedge Strategies. For more information I will put the links below.