The Experiment

 

Blood_donation_(test_tubes) (1)Hedge Funds are able to trace their roots back to the 1920’s stock market.  At that time, the most common Hedge Fund strategies were the equity long-short strategies of today. To over simplify it, the funds took long (bought) positions in equities that they felt would appreciate and short positions (borrowed other investors shares and sold them to buyback at a later time at a hopefully lower price) in equities they felt would decline. If the hedge funds were equally balanced in between their long and short positions, they were thought to be market-neutral.

On the face of it, this appears to be a hedged strategy. The problem lies in the fact that financial managers may choose the wrong positions to long and short actually magnifying losses in markets with high volatility and this does not take into account the leverage that most funds use to attempt to get Alpha. Today, there have been a proliferation of strategies well beyond this basic premise, but I would argue the majority of them attempt to return Alpha as opposed to protect from downside risk.

So what’s a risk averse investor to do? Different asset class distributions can create a natural hedge against equity market volatility. As a gross generality, stock and bond prices typically move in opposite directions. In times of stock market declines, active fund managers flee to the safety of bonds causing them to appreciate. In times of stock market gains, bonds sell off for active managers to return to their prior equity positions. There is a certain zen to it, an ebb and flow of the great herd. At market bottoms, all asset classes lose value as fear causes a movement into cash to preserve value.

There are many mutual funds that split their allocation between stocks and bonds. A typical split is “balanced-growth” which would be 60% equities and 40% bonds.  An example of this type of fund would be Vanguard’s Balanced Index Fund (VBINX). I am partial to Vanguard funds because of their low expense ratios, but I will have separate post on fees in general upcoming.

When I take a look at any fund, I like to look at how it performs during times of extreme market turmoil or fear. The depths of the recent financial crisis of 2008-2010 serves as a great back test as every major asset class (stocks, bonds, real estate) had declines. If you are new to investing or a veteran investor, the question each of you have to answer is: how much capital are you able to see disappear during a time of extreme market fear? And the answer may change depending on the circumstances in your life. I think this is one of the most important questions any investor needs to make prior to putting a dollar to work in the markets. It’s also important to be honest with yourself, because if you aren’t it will lead to a premature exit from your positions at the most inopportune time. There is no wrong answer to this question, and it will lead some to invest all of their savings in laddered Certificates of Deposit and others to invest in triple leveraged exchange traded funds based on commodities.

It takes a special person to stick to their convictions when half of their capital has been lost (think Warren Buffett). After some introspection, I realized I am not one of these people. So in order to stay the course, my allocations must match my risk appetite, and the returns I see will not match that of others taking on greater risk for greater return, and I happily accept this.

Taking a look back to the extreme stress of 2008-2010, a portfolio holding only an S&P500 index fund (VFINX) would have lost 47% of its value between its 2008 peak and its 2009 trough. This compares with a balanced growth fund (VBINX – a 60/40 split between equities/bonds) which lost approximately 31% of its value between its 2008 peak and its 2009 trough. My risk aversion dictates that even a relatively conservative balanced growth allocation entails more risk than I would like to take on. This brought me to look at even more conservative allocations, and I stumbled upon a 40% equity / 60% bond income fund from Vanguard and Wellington (VWINX). This fund lost approximately 18% of its value between its 2008 peak and its 2009 trough.

As you might expect, between its 2008 peak and today, the portfolio holding the S&P 500 (VFINX) out performed the balanced growth portfolio (VBINX) but only by about 7% (that’s not annually that’s aggregate over the eight year period). Oddly the highest total market return between its 2008 peak and today was earned by the 40% equity/ 60% bond allocation (VWINX) which outperformed the S&P 500 (VFINX) by about 5% and the balanced growth portfolio (VBINX) by about 12% in aggregate (to be fair the S&P 500 was a bit ahead until the recent market turbulence of February). The Vanguard-Wellington Fund (VWINX) is actively managed and does carrier a slightly higher expense ratio but in this case I believe it is justified.  The total return of each of the funds between their 2008 peaks and today are below:

(the returns stated below assume reinvestment of dividends) 

S&P 500 (VFINX): 64% aggregate return

Balanced Growth (60/40) (VBINX): 57% aggregate return

Vanguard-Wellington (40/60) (VWINX): 69% aggregate return

After coming to terms with my own risk aversion, I have decided a 30-35% equity / 70-65% bond ratio matches my risk appetite. That being said I did consider just investing in the Vanguard-Wellington fund. However, I am investing through a taxable account and wanted to concentrate my bond position in municipals to boost my post tax return. More on the implementation in the next post, but hopefully the peak to trough numbers will get you thinking about your own risk appetite.

 

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