Given all the talk about market timing - just wanted to post a quick reflection on ways to manage risk to stir the pot a little.
Hold cash. (I do this, currently at about the 5-15% level - it varies based on a variety of factors). The major risk here is the market keeps moving up and we miss out.
Hold some fixed income assets. Major risks are interest rate exposure, term length exposure and credit risk exposure. I do this at about 10% of the portfolio level and use a variety of measures to try to minimize these risks, but have historically held around 40-50% here.
Hold constant short exposure against broad indexes that closely track the stocks being traded (I do this at about 10% of my total portfolio at the moment). Major risk is that my sources of alpha underperform the broad market and my costs of borrowing these indexes rises and I lose out big.
Short specific stocks. I do this at the 5-10% of the total portfolio level now - it varies based on how many stocks I can find that meet my short criteria. Major risks are that these ‘bad stocks’ rally hard on major events or short squeezes and I take big losses on them.
‘Time short exposure based on market conditions’. I add additional short overlays at about the 10-20% of the total portfolio level. Major risks are that the market whipsaws and these hedges are a big drag.
5B. Time long exposure on some portions of the portfolio. Using a variety of rules. (This really allows the cash amount in 1 to dynamically adjust).
Seek out zero (or even better) negative correlation systems and return drivers to add. I do this now with managed futures and asset backed lending and some other ‘event driven’ and market neutral funds I invest in. Major source of risk is that a) these systems underperform and b) their correlations spike in times of peak market stress.
Trade long volatility strategies. Either by trading systems going long vix directly or seeking out ‘events’ that I think the market has underestimated vol on and systematically investing in them. Looking for huge potential payoffs with small, quantifiable losses - where I think the market’s wrong about risk estimates and vol. estimates (underestimating black swan prob). Major risk is death by a thousand paper cuts if and when vol doesn’t spike and I am wrong. John Paulson saw this payoff profile on Collateralized debt, but got lucky on timing. Or trading ‘gold’ or ‘tlt’ or other systems that you believe have long vol. payoff profiles.
Always hedging with out-of-the-money puts. This can be very expensive and the cost rises when you need them most (as vol rises). I don’t do this.
I believe the above are the major sources of risk management. I am doing 1-6. I am curious about other methods people might add, or ways that are not common that people are willing to share and use. Market timing can be added to any of them. But, it is built into 5A and 5B.
Is anyone doing number 7. Not selling vol - but either trading it long only (I know some people are with versions of comparing realized vol. to implied vol) or making ‘black swan’ bets in a systematic way? Like Empirica did or Universa does? Is anyone using options to hedge -and care to share how? Any systematic traders of options here using their systems and willing to share?
P.S. Looks like Universa has a very low liquidity play with an ETF - HUS.U. Their liquidity isn’t good enough for me, but might be interesting play (but need to look at the fund doc’s, I haven’t).
I use predominately bonds and a little cash for risk management. The remainder of the options on your list can be hard to consistently successfully implement, at least for me, with the exception of holding a constant short position. I would rather hold a smaller quantity of stocks and a larger quantity of bonds than a fixed short position as the bond positions have had a positive expected return with the short position having a negative expected return (the positive expected return for bonds may change in the near future so my view on this may change).
I don’t see tangible assets in your list.
Since we are talking about managing risk, there is a risk that I want to mention. All of the above including cash are immaterial numbers. It works as long as the financial system let us exchange these for goods and services. Since you mention tail risks, there’s the big one which is that all of the above become essentially worthless. It’s unlikely but possible.
I personally like tangible assets a lot, because they have inherent value.
I’ll start with the one people might not know about:
Cattle. You can own a herd and have breeders take care of the rest. You’ll get part of the revenues and your investment multiplies as the herd grows. The breeder doesn’t have to put up the seed money so he’s happy, and the investor doesn’t have to do much else than sign a check and keep an eye on the deals the breeder makes.
Farm land. Same story. Some farmers do not have the initial money to buy land. You’ll get revenues either in cash or in crop.
Forests. Same story.
Wine. Buy the latest vintage and let them age to sell them later. You need a proper cellar. And absolute secrecy or you’ll get robbed. This is very lucrative, you can target 15% a year returns if you know what to buy, when to sell and who to sell to.
Art. If you’re rich enough you can purchase traditional (as opposed to modern) work of art, it often appreciates with time.
Real estate. Residential, commercial, business.
Precious metals.
All of the above requires energy to manage, subscribing insurance, going out on the field, talking with people etc… it’s not as easy as clicking on a button but it’s more rewarding too. And it can be kept in the family for generations.
Could be a United States thing referring to preppers who prepare for a situation similar to what Aurelien describes. I actually like reading those kind of fiction books and have read books where the hero stockpiles cigarettes, coffee and other items to trade. Wine is actually a good idea that I had not heard before.
I agree with WINE. I am living near a wine producing area and have stockpiled a few bottles in my cellar. They are not stored there for any “crises” (which may or may not happen), they are stored there for enjoying life and getting away from thinking about the stock market.
Another way I also do but not mentioned here is in your stock portfolio, design strategies/screens specifically for defensive sectors. In my portfolio, I am currently running about 10 stock strategies, out of which 3 are on defensive sectors/industries (healthcare, consumer staples, utilities etc).
I am also holding REITS, which holds up well in some bear markets (e.g. burst of 2000 tech bubble).
That said, market timing still plays an important part in my portfolio, particuarly for 3). I adjust my short market index exposure based on a variety of factors e.g. market valuation, market momentum, market breath and fundamentals (e.g. earnings trend).
Sticking to defensive sectors has worked well in 2014 as it would have gotten you out of the oil stocks which collapsed in 2014. Will it work well in 2015? I don’t know, ask me again next year. For example if oil stops falling and the economy doesn’t go into recession (or if the Euro QE works) then you may wish that you had invested in all sectors. If you have 75% of your money in “all sectors”, putting 25% into defensive sectors is not an effective hedge. You may be better putting 75% in all sectors and 25% in bonds (including high quality treasuries) which may actually go up when the stock market falls.
Personally, I use high quality bonds as my primary hedge. I also use market timing–not because I know it will work, but because the type of timing that I use (which is a unique earnings based formula) may reduce risk and may improve returns and shouldn’t hurt returns (i.e. it shouldn’t cause whipsaws) in strong up markets.
The most powerful risk management tool that Tom didn’t mention here is variable asset allocation. Varying asset sizes (i.e. stocks, bonds, gold, cash and/or hard assets) based on recent volatility and correlation works very well to reduce volatility, drawdowns and fat tail risk. (These are three distinctly different flavors of risk).
If VIX is low you can do a call ratio backspread on VXX 2-3 months to expiration. If VXX decays as usual, you’ll make some money. If the market crashes then VXX should spike and you’ll make a lot of money. Worst case scenario is that VXX goes up a little bit, but you can minimize your loss if you hold for no more than 4-6 weeks. I don’t trade this strategy, but it’s better than just buying puts on the index.
I regularly add a 15-20% short exposure by buying deep in the money puts on S&P500 and other indexes like the German DAX, with a remaining validity of approx. 3 years. Trade exit either with a sharp 10-15% stoploss should the index advance, or trailing stoploss should the index decline.
For timing I use the applicable volatility indexes, entering into the trade when vola is comparatively low (e.g. below 15 or lower for the VIX).
As result of the deep-in-the money level, time value of the put is very low. Hence, even if the index starts dropping after a long time has passed after I entered into the position, I still make nearly the same money, and losses due to time value even when the put nears it’s termination are also far lower.
Downsides:
the lower omega / delta as compared to out-of-the-money or at-the-money options, and
the substantial loss risk, should the index advance strongly and remain there.
No one has mentioned Gas & Oil royalties. Not ETFs, LLPs, or MLPs, but buying directly from the mineral rights owner. Many are willing to sell at deep discounts to intrinsic value for cash up front, especially now that the prices of oil & gas have declined and their checks are getting smaller. Most royalties are around 20 to 25% of the sale price at the well head (at least in Texas). Many will have a 3 to 5 year payback at today’s price and pure profit after that. Although the value of the mineral rights are volatile with the price, you can expect a 20+ year return that will gradually decrease as the wells production falls. You also get a depletion break for your tax returns.
