Risk Update – April 2020

We could sum up much of the market chatter through April as the following question: “Is it a good thing, or is it a bad thing, that Central Bank actions have thrown so much support behind markets at this stage of the cycle?” This question is posed under the premise that a “good thing”, presumably, is continued asset price appreciation and consequent further extremes of wealth segregation in societies. Does the Central Bank unlimited intervention (in both size and breadth) make this the greatest equity buying opportunity of all time?

Figure 1: SPX Index (log) and Federal Reserve Balance Sheet
Source: Bloomberg

Or, is the fact ‘they’ are having to do this, so shortly after just turning from the all-time highs, merely indicative of the precarious endogenous risk built up in the system, and but a warning signal of what may come from an ongoing end-of-cycle risk unwind?

Figure 2: SPX Index (log) and US Initial Jobless Claims 4wk Moving Avg. (log)
Source: Bloomberg

The excellent Matt King, of Citibank fame, has some great visual representations of this theme in his latest piece. For the “it is a good thing” he has some pictures such as the following.

Figure 3: Global Credit Creation $tn (rolling 12m) vs MSCI World
Source: Citibank
Figure 4: Global Credit Impulse vs IG Spread Change
Source: Citibank

Those paint the clear picture that the actions must be a “good thing”, at least while, as mentioned in the footnotes, you project private sector credit flow flat for illustration. That, however, seems a somewhat unlikely projection.

Figure 5: US Economic Data Index vs SPX %yoy
Source: Citibank
Figure 6: US Unemployment Rate vs Total New Chapter 11 Filings
Source: Deutsche Bank

Seems like an awful lot of pending defaults for the low man on the capital structure, i.e. equity holders, to walk away unscathed from the current schism in economic activity. Maybe it is a “bad thing”.

The beauty is, we don’t care. The solution to your investment dilemma currently is the same as it always is: fix your convexity. Own things that participate on the topside, protected by efficient, asymmetric, strategies that cut off the downside. Very simply, that is the key to compounding.

As a reminder, compounding is primarily driven by performance in the extremes. One of our all-time favourite visuals is below, showing that for equities it is the 5 percentile monthly returns on either wing that drive over 60% of the contribution to long term compounded annual returns. As we enter what could very likely be the end-of-cycle unwind period, we are already seeing monthly returns moving out into the wings, with SPX down 34.65% over the last week of February through the first three weeks of March, followed by being up 23.32%. A portfolio’s performance through this period will have serious implications on its compounding.

Figure 7: Contribution to Compounded Returns
Source: Deutsche Bank, Convex Strategies

These are the periods where the portfolio with superior convexity pulls away from the competition. The Barbell approach (Long Vol + Long more Equity), that through mundane times might look as if it is simply tracking along against a traditional Balanced Portfolio – but in fact all the time owns more potential upside and better protected downside – starts to show its superior compounding effects when the end-of-cycle’s sharp down and up moves start kicking in. Once the compounding advantage starts to accumulate, there is no catching back up.

You may very well have heard and seen it before, but let’s walk through the process again with an emphasis on how the crisis and post crisis recovery periods, where both of the 5%tile tails occur, trigger the compounding benefit.

We will start with the simple premise of replacing Fixed Income in a balanced portfolio with a simple rule of thumb of a 50/50 allocation to Beta, using SPXT / S&P total return index, and to Long Vol, using the CBOE Eurekahedge Long Volatility Index (an index of the performance of long volatility hedge fund managers/strategies). We will assume yearly rebalancing. For the Fixed Income leg, we will use Barclays US Treasury Total Return Index for comparative purposes.

First, let’s look at the period of Jan 2005 through April 2012, then the subsequent period from May 2012 through April 2020, and finally the combined period. Many will be familiar with this split as it divides nicely regimes of outperformance of the two indices, first Long Vol over Fixed Income and then Fixed Income over Long Vol, at least until the most recent couple of months.

Figure 8: CBOE Long Vol vs US Tsy Total Return Index and US 10y Tsy Yield
Source: Bloomberg

The 50/50 Beta/Long Vol vs the 100% Fixed Income sort of tracks along in parallel, until we go through the crisis in Aug’07 to March’09 but comes out the other side pulling away in its compounding returns. The 50/50 Barbell has a CAGR over the period of 9.24%, while the Fixed Income index turns in a CAGR of 5.44%. Just for reference, the SPXT had a CAGR of 4.10% over the period. Looking at the above chart, this likely shouldn’t surprise folks too much, given the significant outperformance of the Long Vol relative to Fixed Income over that period. Then throw in the very strong negatively correlating behaviour with its portfolio complement of equities, and the rebalancing strategy, and the results speak for themselves.

Figure 9: Barbell 50/50 vs Fixed Income 100: Jan 2005-April 2012
Source: Convex Strategies, Bloomberg

Likewise, in the subsequent period of May 2012 through April 2020, the Barbell 50/50 starts slowly then steadily pulls away, and appears to be accelerating its divergence in recent months. This one might appear less obvious, given the extreme outperformance of the Fixed Income index over the Vol Index for much of this period (Figure 8), but as Figure 10 shows, the Barbell’s compounding pulled away and maintained an advantage even before the absolute outperformance of Long Vol in the last two months. During this period, the 50/50 Barbell generated a CAGR of 6.30%, while the Fixed Income index compounded at just 3.06%. In the previous period, the Barbell’s outperformance could be ascribed to the superior performance of the Long Vol component. During this more recent period, the SPXT index CAGR was a stellar 11.92%, and one might ascribe Beta as the driver of relative outperformance. However, as we say over and over, the truth is that it is just math. It is the benefit of true diversification, truly negatively correlating portfolio component, and the mathematical proof of the effect on compounding of participating in the big up numbers and cutting off the big down numbers. It is, put simply, convexity.

Figure 10: Barbell 50/50 vs Fixed Income 100: May 2012-April 2020
Source: Convex Strategies, Bloomberg

Naturally, if you add superior compounding to superior compounding, when you put the two time-series together and extend the performance over the entire period of Jan 2005 through April 2020, it becomes truly eye-popping. Now the Barbell 50/50 delivers a CAGR over the longer period of 7.70%, versus the Fixed Income CAGR of 4.19%. In terminal capital terms, $1 in the Barbell 50/50 becomes $3.12, while $1 in Fixed Income becomes $1.87. It is probably worth noting that performance differential was while US Treasury 10yr yields declined from pre GFC highs north of 5%, to current historical lows of 0.64%. One could well argue that was a pretty good period of performance for Fixed Income, and something that is unlikely to be matched going forward given where yields stand currently.

Figure 11: Barbell 50/50 vs Fixed Income 100: Jan 2005-April 2020
Source: Convex Strategies, Bloomberg

So, having established a superior risk mitigating solution, let’s go through the same exercise at the overall portfolio level. We will take as our proxy for a Balanced Portfolio the good old “60/40”, with 60% allocated to our Beta proxy (SPXT) and 40% allocated to our Fixed Income proxy. For our Barbell Portfolio, we will follow our above rule of thumb of replacing the fixed income allocation with 50/50 Beta/Long Vol. We will further throw in our past stated rule of thumb, ie always lever the hedge! Levering the hedge is risk reducing, and, given that negative compounds are circa twice as damaging to long term compounding as positive compounds are beneficial, it is the more efficient piece of the portfolio components. Thus, at 2x leverage on the Long Vol component, the 60/40 Balanced moves from 80/20 to an 80/40 Barbell.

So again, splitting it into the two different time periods, we get as below. Again, the differences are hardly noticeable, until we start getting into the disruptions in late 2007, and then really expose themselves as we go into and come out the other side of the GFC. Over the period, Barbell kicks in a tidy 9.44% CAGR, while the Balanced portfolio delivers just 5.44%.

Figure 12: Barbell 80/40 vs Balanced 60/40: Jan 2005-April 2012
Source: Convex Strategies, Bloomberg

Looking at it over the more recent period, May 2012 through April 2020, we see the similar pattern again. The Barbell shows very moderate differentiation over the bulk of the time period, though does manage to maintain a small steady gap in relative performance. The point, however, is very simple: you are getting the same to slightly better performance, during a period of historically declining/suppressed vol and unprecedented Fixed Income positive performance, all the while carrying more potential upside exposure and significantly more downside protection. So, what happens as soon as there is a chink in the supposedly impenetrable armour of the policy setting volatility suppressors? We kick off a couple of months of away from the mean market moves, and like magic the portfolio with more efficient downside protection outperforms in the down month, and, immediately following, the portfolio with more upside exposure (the same portfolio) outperforms in the following month. Just like that, the compounding starts to diverge. For this period, the Barbell has a CAGR of 10.00%, and the Balanced a CAGR of 8.64%, and maybe the marked divergence is just beginning.

Figure 13: Barbell 80/40 vs Balanced 60/40: May 2012-April 2020
Source: Convex Strategies, Bloomberg

Finally, let’s put the two periods together and take a look at the entire series. The CAGR for the Barbell is 9.74%, while for the Balanced portfolio it is just 7.10%. Again in terminal capital terms, $1 in the Barbell has reached $4.15, versus $1 in the Balanced which is now $2.86. It must be noted that that stark underperformance is during a period of truly exceptional performance for the Balanced portfolio, when volatility suppression and interest rate compression has been the near singular order of the day. It has to be said, yet again, it’s just math. Anybody legitimately targeting compounded returns should be focused on improving the convexity of their portfolio.

Figure 14: Barbell 80/40 vs Balanced 60/40: Jan 2005-April 2020
Source: Convex Strategies, Bloomberg

It is worth stressing again the lack of portfolio benefit one currently derives from Fixed Income. As one of our all-time favourite investors recently put it “the 60/40 model is dead”. You didn’t have to be paying too close attention to have noticed that it was the early indications of a meltdown in global fixed income markets back in March that really got Central Banks fired up to put a bid under every conceivable fixed income market under their purview. No doubt, whispers of the challenges of Risk Parity type strategies and their levered holdings of fixed income and other carry strategies are very likely floating very near the truth. Levering the least efficient use of capital in your portfolio is almost certainly not the right answer to a very niggling problem, even if you can convince the overlords that you are TBTF.

So, coming full circle on this month’s Update, are we going to get the market melt-up implied by the unprecedented policy stimulus, or are we going to get the crashing markets indicated by the collapse in economic indicators? We don’t know, but the correct portfolio, either way, is the portfolio with the best convexity. The one that participates in the upside, and protects on the downside. History shows that the compounding benefits of convexity are most relevant into, during and after the end-of-cycle risk unwind period. So, while the best time to improve compounding in your portfolio is as early as possible, right now may be a particularly prudent time to start dealing with it, if you aren’t already there.

Figure 15: Volatility/Correlation Comet
Source: Convex Strategies, J.P. Morgan
Figure 16: SGD/JPY ‘Seasonal’ Indicator
Source: Convex Strategies, Bloomberg

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