Building Portfolios That Weather the Storm Through Negative Downside Capture
October 13, 2023 — In his trademark humorous style, Mark Twain offered a whimsical take on the perils of stock market speculation with this memorable quip: “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”
While accurate in his thoughts regarding the danger of stock market volatility this September, given the TSX 60 fell -3.2% and the S&P 500 dropped -4.8% for the worst monthly performance this year, Twain could have said the same regarding long-term bonds, which plunged more than -6%.
Even worse, supposedly “safe” long-term Treasury bonds have blown a giant hole through investors’ portfolios with devastating losses. The current bear market in long-term Treasury bonds is comparable to the drawdowns suffered by stock investors through the worst bear markets of the past 25 years.
During the tech wreck of 2000’s dotcom bust, U.S. stocks plunged -49%. Currently, 10-year U.S. Treasury bonds have fallen -46% in value.
During the global financial crisis of 2008, the S&P 500 dropped -57%. Currently, 30-year Treasury bonds are down -53% from their peak.
Things are not pretty in Bond Land.
And there is more pain to come. Accelerate’s “house view” has been bearish of bonds for several years. We believed that rock-bottom yields did not compensate investors for the tremendous risk of portfolio impairment if interest rates rose to historically normal levels. While our prognostications proved to be correct, the move is not over and we continue to hold our bearish outlook on bonds given the likelihood of higher long-term interest rates.
Over the past 65 years, the 10-year Treasury yield has averaged 5.8%. Based on historical data, 2020’s sub-1% yield was an aberration and today’s 4.8% Treasury bond yield is still low. A jump in long-term yields above 6% would not be unusual or surprising. The current rising interest rates that have devastated 60/40 portfolios are still well below their historical average.
In her latest hit single, Barbie World, Nicki Minaj raps, “Yellin’ out, we ain’t sellin’ out. We got money, but we ain’t lendin’ out”. Even she’s bearish on bonds.
But don’t take her or my word for it. The legendary “Bond King”, Bill Gross, has staked his claim in the bond bear market. In his latest memo, Neither a Lender Nor a Stockholder Be, Gross states, “I’d pass on stocks and bonds in terms of future total returns. Best bets are arbitrage situations such as ATVI (Activision) and CPRI (Capri) that yield annualized returns of 10–20%.” As arbitrage continues to trounce bonds in terms of total returns (with lower risk), given Gross’s forecasts we may have to rename him the Arbitrage King. (Note that the Accelerate Arbitrage Fund is long of both ATVI and CPRI).
With bond yields still unappealing, and the supposed diversification benefit of bonds gone the way of the dodo bird due to their positive correlation with stocks, diversified portfolios should have far less than a 40% allocation to traditional fixed income.
As bond allocations decline, and cash allocations take some of the weight, investors require genuine portfolio diversifiers. When considering diversification, the ideal investment strategy should act like a portfolio airbag by generating positive performance while stocks decline. This effect is known as negative downside participation.
On average, negative downside participation strategies go up when stocks go down.
Last year, the S&P 500 declined by -18.3%. Unfortunately, for 60/40 investors who thought they were diversified, the double-digit loss suffered in bonds made for much worse investment results for traditional portfolios. Negative downside capture strategies can provide positive returns during market declines like last year’s. For example, absolute return (HDGE) gained +15.3% in 2022, nearly offsetting all last year’s stock market losses when utilized as a portfolio diversifier. Since its inception, HDGE has had downside participation below zero, meaning when stocks go down, HDGE has gone up more often than not. Ditto for last month too.
Studies show that on average, investors sacrifice 1.4% to 4.3% of annual returns by letting their emotions get the best of them. To combat this, investors need to be mindful not to succumb to the fear of missing out (FOMO) mentality dominating speculative assets, damaging cognitive biases, and selling at the lows. Instead, investors should focus on robust, systematic asset allocation that minimizes the opportunities for mistakes. Do not dance in and out of asset classes, try to play short-term economic movements, “go to cash”, or other near-term panicked thinking. A well-diversified portfolio with at least 10 uncorrelated asset classes (the “holy grail of investing”) will minimize drawdown potential in any environment and maximize long-term success in investing.
Negative downside capture strategies, such as HDGE, can augment portfolios by acting as airbags during a stock market crash and mitigating downside volatility. By including negative downside capture strategies that can exhibit positive investment performance during stock market downturns, allocators can construct portfolios with a smoother return profile with lower drawdowns without sacrificing return.
We often hear of spooked investors selling their entire stock portfolio at the depths of the bear market in March of 2020, never to return to investing. Loss aversion is an extremely powerful human psychological phenomenon. When portfolio losses, temporary or not, are minimized, the visceral reaction of loss aversion and the accompanying costly mistake are likely to be eliminated. Reduced volatility means fewer (hopefully, none) opportunities for panicked moves knocking investors off course. By preventing emotional mistakes by reducing downside volatility, investors will likely attain the best long-term financial results from their portfolios. Including negative downside participation strategies in portfolios means downside volatility may be reduced without sacrificing returns.
While Mark Twain did denounce stock market speculation, likely due to his inherent loss aversion, we can only assume that he would have a favourable view of robust portfolios that mitigate drawdowns through the inclusion of negative downside capture strategies.
Accelerate manages four alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): Cash Plus
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Portfolio Protector
- Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Portfolio Stabilizer
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Canadian 150/50
Please see below for fund performance and manager commentary.
ARB gained 0.7% for the month while the S&P Merger Arbitrage Index gained 0.3%. Merger arbitrage as an asset class gained when traditional asset classes fell markedly, continuing to showcase the alternative strategy’s uncorrelated nature. Since its inception, ARB has exhibited a 0.1 correlation with equities with a downside capture of -30%. Its negative downside capture indicates that when equities had a monthly decline, more often than not ARB had a positive performance.
In September, four merger arbitrage investments were successfully exited while four new merger arbitrage positions were initiated (including one subscription receipt arbitrage). No SPAC IPOs occurred, however, the Fund remained active in the secondary market, opportunistically adding discounted blank check companies above the Fund’s investment hurdle rate.
Currently, ARB is allocated 71% to SPAC arbitrage and 29% to merger arbitrage (with 7% in leveraged buyouts and 22% in strategic M&A) with gross exposure of 138.9%.
For the third time since its launch as a hedge fund ETF, ARB increased its quarterly distribution paid to investors. The distribution stands at $0.26 per quarter, representing an annual yield of 4.0%.
HDGE gained 1.6% last month as all long-short factor portfolios generated positive performance.
As equities faced a broad-based decline, an absolute return approach (long-short) provided attractive results, despite all long and short portfolios declining. The benefit for absolute return investors is that all of the short portfolios declined more than the long portfolios, leading to positive performance for each factor portfolio.
The U.S. long-short value factor led the Fund’s positive performance, as overvalued stocks fell -11.6% while undervalued securities dropped -3.7%, causing the long-short value portfolio to gain 8.1%. The U.S. long-short quality and price momentum factors exhibited the same dynamic, with longs outperforming shorts despite both declining, leading to gains for these factor portfolios of 7.0% and 6.0%, respectively. HDGE’s 110% long and 50% short exposure reduced its return compared to the AlphaRank Factor Performance analytics.
Since its inception, HDGE has had a correlation with equities of 0.1 with a downside capture of -1.3%.
ONEC declined -1.6% in September, as its alternative allocations generated mixed results.
In a higher interest rate environment, we believe “cash plus” liquid alternatives and private credit will produce the best results for investors.
This dynamic was exemplified last month as ONEC’s “cash plus” alternative allocations, such as managed futures, absolute return, and arbitrage, produced a positive performance of +4.6%, +1.6%, and +0.7%, respectively. On the private credit side, the Fund’s leveraged loan portfolio gained +0.5%.
The Fund’s inflation protection bucket produced mixed results, with the commodities portfolio gaining +1.0% and the precious metals allocation falling -3.7%.
On the flip side, several allocations produced negative returns, with real assets and global macro getting the worst of it. In the real asset bucket, real estate declined -6.1% and infrastructure fell -4.4%. On the global macro side, risk parity dropped -5.8%. In addition, both the mortgage portfolio and the Canadian long-short strategy declined -1.5%.
After lagging this year through August, ATSX booked a -1.5% return in September compared to the TSX 60’s -3.2% fall, leading the Fund to pull ahead of its benchmark year-or-date. Given ATSX’s design, the Fund is expected to attain its outperformance in down markets. As the TSX 60 declined, the Fund’s long-short overlay portfolio generated 1.7% of outperformance.
Canadian long-short factor performance was positive across the board last month. Similar to the U.S. stock portfolio in HDGE, the long-short value portfolio added the most incremental performance to ATSX with a 6.3% gain. In Canada, overvalued stocks fell -10.0% while undervalued stocks declined -1.9%.
Much the same as the long-short value portfolio, the quality, price momentum, and operating momentum factor portfolios gained between 5.3% and 6.1% as the stocks shorted dropped far more than the long securities.
During down markets, we typically see overvalued and low-quality securities fall much more than the market, buoying the Fund’s long-short overlay strategy and therefore mitigating downside volatility.
Have questions about Accelerate’s investment strategies? Click below to book a call with me:
Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.