Fearing a stock market crash? These are two strategies for surviving them

This post was originally published on this site

© AFP via Getty Images


What portfolio changes should you make if you’re worried about a black swan event?

Gallery: The Rise of Meme Stocks Highlights These 5 Things About the Stock Market (GOBankingRates)

By “black swan,” I’m referring to the phrase popularized by Nassim Nicholas Taleb in a 2007 book, “The Black Swan: The Impact of the Highly Improbable.” Black swans in the stock market are sudden, unpredictable and rare — like a market crash.

Load Error

Given these distinguishing characteristics, you might think you can’t plan for them. But that would be a mistake. Just because you can’t predict when a black swan event will occur doesn’t mean you can’t predict that one is likely at some point.

I hinted at this a month ago, you may recall, when I discussed research by retired Boston University finance professor Zvi Bodie. He calculated what an insurance company would need to charge for a policy that insures against a stock market portfolio losing money. He reported that the cost of this insurance goes up with your time horizon — not down, as is implicitly assumed by almost all financial planners.

Taking this research to heart, you can plan for a black swan — by making more or less permanent changes to your portfolio that will protect you when that unpredictable black swan does occur. In this, my monthly review of the latest Wall Street research, I reached out to Bodie to discuss what those changes could be and what their expected returns might be.

He mentioned that there are two major approaches to hedging your portfolio against black swan events.

Index fund plus puts

The first is to allocate a small portion of your equity portfolio to long-dated, out-of-the-money put options. Those put options are a form of catastrophe insurance, expected to lose most of the time but pay off big during a black swan event. Is that a good tradeoff?

This is the subject of much debate and research among financial analysts. A lot depends on how much you allocate to the puts, as well as their maturities and strike prices.

One illustration of a profitable use of the strategy comes from Michael Edesess, an adjunct professor at the Hong Kong University of Science and Technology. In a simulation he ran a year ago, Edesess calculated the return of a portfolio that allocated 96.67% to an S&P 500 index fund and 3.33% to an S&P 500 put option that was 60% out of the money and with two years left before expiration. The portfolio was rebalanced yearly at the beginning of January.

From January 2006 (the earliest date for which he could get data on the S&P 500 puts) through May 2020, this portfolio produced a 9.4% annualized return, versus 8.2% for the S&P 500 itself, and 7% for a traditional 60% stock/40% bond portfolio. (Those returns include reinvested dividends and interest; the bond portion was invested in the iShares Core U.S. Aggregate Bond ETF )

It’s impressive that this strategy, which is less risky than the market, nevertheless outperforms it. It’s especially impressive that it does so much better than the 60% stock/40% bond portfolio, which is the more conventional approach to reducing risk.

Is there a catch? Of course — there always is.

One catch is that the strategy doesn’t work in the event of long and gradual declines. For example, imagine that the stock market loses 2% or 3% each year for the next decade or two, without any crash or sharp decline along the way. None of the market’s losses would therefore be big enough to make the put options profitable, so not only would the index fund portion of the strategy lose along with the market but the put option hedges would as well.

This is just another way of saying that the strategy hedges against black swan events but not all disappointing market outcomes. To go with this “index fund plus puts” strategy, you in effect are betting that the bear markets that the stock market will incur in the next decade or two are short and sweet rather than long and drawn out. That is, the declines will be more like the waterfall decline in February and March of last year than, say, the stagflation era of the mid- and late-1970s.

Bonds plus calls

The other approach to insuring against black swans that Bodie mentions is to allocate the bulk of your portfolio to short-term Treasuries and to invest the remainder in S&P 500 call options. He points out that, because of what’s known as put-call parity, this second approach in theory should produce similar long-term returns as the “index fund plus puts” strategy.

Consider the performance of the Amplify BlackSwan Growth & Treasury Core ETF This ETF invests 90% in U.S. Treasuries and 10% in S&P long-dated call options. Though the fund itself has been around since late 2018, the index to which it is benchmarked has been calculated back several decades. Over the same period as Edesess’ simulation, this index has almost precisely equaled the return of the S&P 500 on a total return basis.

This return is also impressive. The SWAN ETF’s approach is much less risky than the overall market, with a beta of 0.36, according to the fund. So the approach comes out well ahead of the market on a risk-adjusted basis.

Though this “bonds plus calls” strategy didn’t do as well as Edesess’ simulation of the “index fund plus puts” strategy, that is not a reflection on put-call parity but a function of how these two particular strategies were constructed. The approaches’ returns depend crucially on how much is allocated to options, as well as their maturities and strike prices. I think it’s noteworthy that the “index fund plus puts” and “bonds plus calls” strategies produced largely similar returns over the past 15 years.

The upshot, according to Bodie: “Which strategy to choose depends on your starting point. If you start with a portfolio of stocks, then buy puts.” If not, you can start with Treasuries and calls.

What put-call parity means for the future

I note in passing that put-call parity paints a sobering picture about the stock market’s future return. It’s hard to imagine, with Treasury rates currently so low, that the bonds-plus-calls approach will produce anywhere near the returns it did over the past couple of decades. If so, according to put-call parity, we should not expect the “index fund plus puts” strategy to do very well either.

As Bodie put it: “There’s no escaping the dilemma of low interest rates.”

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

Continue Reading