In any general discussion of investment strategies on TV or in the press, the focus quickly and often turns to correlations, standard deviations, Sharpe and Sortino ratios, etc. What’s not discussed enough is “when.” As in, when you get in or out makes all the difference between good returns and bad. We have written in the past about performance dispersion between stocks and how important that is as an opportunity for managers. Our friends at FlowPoint Capital recently sent us more data on dispersion and volatility that reinforces the point, and should make everyone think hard about “when.”
In the graph below, you can see correlations between sectors is approaching multi-year lows (tech is almost 100% positive YTD and energy is almost 100% negative). FlowPoint notes that approximately 55% of stocks in the S&P are down year to date, and in many cases return dispersion within sectors shows more than a 50% difference between the best performers and the worst, which is something we haven’t seen in a while. This is good news for active managers and bad news for passive investors (we will do a post shortly on the problems lurking in many ETF’s). This dispersion, as we have noted previously, means the opportunity for outsized returns is high. But it also means that future volatility can be near at hand.
A popular gripe on Wall Street and in the financial media is that the “Fear Index” is too low and investors aren’t scared enough of the stock market’s risks. But, as Chuck Trafton from FlowPoint notes, “the futures markets spin the opposite narrative – record high Vix contango means everyone is betting volatility will be higher in the future, and the lack of contango in SPX futures means no one thinks stock prices will be higher in the future.”
So, the futures market is betting on higher volatility and lower stock prices and it has been this way for eight years now. What the market has done of course is the opposite, and delivered lower volatility and higher stock prices. When that changes, Katy bar the door.
Below are two charts, courtesy of FlowPoint. The first is the VIX index level (orange) and SPY realized volatility (blue) which shows the VIX at historic lows. The second chart, which shows the VIX index price (orange) versus the volatility of the VIX index (blue), shows that Vol on the VIX is at a ten-year high. The futures markets are clearly betting on higher volatility. The point Trafton and FlowPoint are making is that this can be a very dangerous time for long equity entry points and a terrific opportunity to press shorts where the payoff is rising dramatically. What Trafton is saying is that the “when” part of investing is now becoming paramount.
When begets how and what. No doubt you’ve been hearing for quite some time how poorly hedge funds have performed relative to the broad market indexes. That viewpoint belies a reckless disregard of history.
The table below shows returns for a number of investment strategies for a 16-year period (I have deliberately left out the specific dates to help make a point). The strategies include tactical mutual funds, a mix of macro hedge funds ranging from fundamentally-driven to technically-driven, a 60/40 SPY/AGG mix, and a 100% long-only SPY approach. The period I’ve chosen includes three years where the long-only SPY strategy had at least a 28% return or higher. Yet, in spite of having three abnormally large returns, for that sixteen-year period, the long-only, passive, buy and hold approach underperformed.
As a group, the hedge fund categories performed extremely well. Their average annual returns were 2-3% better than the 60/40 benchmark and markedly better than the long-only approach. The standard deviation of the hedge fund categories was somewhat higher than the 60/40 benchmark, but inspection shows that the risk-adjusted returns, as indicated by the Sharpe ratios, are on a par with the benchmark Sharpe ratio. This indicates that the hedge funds delivered higher performance at a similar return per unit of risk, which is what they are supposed to do. The maximum drawdowns of the worst of the hedge funds are on a par with the 60/40 benchmark maximum drawdown. Finally, the hedge fund category returns during the time of the max drawdown were substantially better than the return for the long-only, buy and hold benchmark.
You’ve now no doubt now figured out that this performance was from the 1998-2013 time frame. What happens if we remove 2008 from the table? After all, now that systemic leverage has been dramatically reduced in all markets, the likelihood of another Lehman event is low. Doesn’t matter. The long-only buy and hold approach still underperforms every category except 60/40 and the technically-driven hedge funds. Which hopefully makes our point. Had you bought in in 1998, long and strong on the back of the Netscape euphoria and other Silicon Valley miracles, you would have underperformed an actively-managed hedged approach. You remove the worst performing year in the market’s history, which helps long-only returns and hurts hedge funds, and you still would have been better off in a hedge fund.
If you deconstruct the return periods above, you’ll see that absent 2008, the market had down periods of 9%, 12% and 21%, nothing abnormally bad and entirely likely to be reached again. Three periods in fifteen years where markets had a “normal” correction and buy and hold underperformed. That’s all it takes. “When” matters no doubt, but so does what you own.