3EDGE CIO DeFred Folts' article is featured in WealthManagement.com 2020 Midyear Outlook - the digital resource of all things wealth management for financial advisors. Read more: In Investing, Defense Still Wins Championships.
DeFred G Folts III, Chief Investment Strategist
3EDGE Asset Management
After the stock market’s steep declines in February and March and the ensuing relief rally, it appears that market volatility may be one of the few things that investors can count on in a world of global pandemic, social unrest and extreme unemployment. In such an environment, it may well be that an investors capacity to play defense could be beneficial.
As the current relief rally in equities from the March 23rd low continued into June, the disconnect between the market (Wall Street) and the economy (Main Street) has seemed to become even more stark. Gains across U.S. equity indices have been accompanied by widespread social unrest, an ongoing global pandemic, massive unemployment and new tensions with China. Perhaps, global markets are simply making a rational decision to look to a post-COVID-19 economic future and seeing light at the end of the tunnel. Markets have certainly been buoyed by a massive infusion of liquidity into the financial system, combined with seemingly explicit support for financial markets from the Fed. However, it appears that investors may be discounting a best-case scenario for the future of the post-COVID world – a world where fiscal and monetary policy serve as a bridge to a time when people return to work, the economy is able to fully re-open, a vaccine is discovered, and life returns to normal.
At 3EDGE Asset Management, our stated investment objective is to seek to generate attractive, risk-adjusted investment returns over full market cycles (through both up and down markets) and we are less sanguine about a best-case scenario being the most likely outcome in the near future. Therefore, as a tactical, multi-asset investment management firm we are more comfortable with our current positioning across our strategies, maintaining broadly diversified portfolios which hold an appropriate amount of both U.S. and ex-U.S. equities, as well as gold and short to intermediate term U.S. Treasuries in order to hedge equity exposure.
Why being able to play defense when appropriate matters when investing for long-term success.
In spite of widespread investor anxiety during equity market downturns, financial professionals often advise their clients to just “hang in there,” even during periods of steep market declines in order to not miss out on periods of major market upswings. However, as we know, that is easier said than done when investors see their liquid net worth in decline, and it may feel as though the market is going to zero. This is consistent with Loss Aversion Theory1 that teaches us that for most investors the pain of losing money in the market is far greater than the positive emotion from investment gains.
*Monthly average annual return for the S&P 500 Total Return index from 12/31/1971 through 04/30/2020. Source: Bloomberg
The other side of the same coin.
Let us examine what would happen if we came at this from a different angle? What if an investor were able to avoid the worst months of market performance over that same period of time? How would this impact overall investment performance over the long- term? Figure 2 below illustrates that by avoiding the worst 12 months of investment returns for the S&P 500 index, an investor would have actually outperformed the index by over 350 basis points per year, and also outperformed the investor who was able to hang in there and capture the best 12 months of market performance. Interestingly, the bottom row of the chart shows that if an investor missed out on the 12 best months but also avoided the 12 worst months of performance, they still would have outperformed the S&P 500 Total Return Index.
Figure 3 below provides a different, and perhaps even more compelling, way to look at the same information that is provided in Figure 2 by looking at the growth of a $100 investment in the S&P 500 Total Return Index based upon the different scenarios from Figure 2.
Growth for the S&P 500 Index Total Return Under Different Scenarios:
Dec 31,1971 - Apr 30, 2020
So, while it is certainly true that an investor who didn’t participate in the best periods of investment performance over an extended period of time would not have kept up with the performance of the S&P 500 index, it is also true that by avoiding the worst 12 months of investment performance of that same index an investor would have actually outperformed the S&P 500 index fairly dramatically.
As a tactical, multi-asset investment firm, we have the capacity to increase or decrease the amount of exposure to a variety of asset classes that make up our investment universe, including equities. Our tactical approach also provides us with discretion over the amount and types of hedges that we may utilize as part of our overall broad portfolio diversification, since different asset classes may be better hedges than others depending on where we are in the market and economic cycle. We seek to actively play defense when appropriate to minimize the impact of steep equity market declines on our clients’ portfolios. However, it is also true that our approach to portfolio construction means that we will always hold some amount of equity exposure at all times and therefore would not expect to eliminate all equity market risk from our strategies. In addition, we are not always able to time portfolio adjustments perfectly when seeking to minimize equity exposure, particularly when equity markets may be declining.
In the end, our risk-managed approach is consistent with our stated investment objective of seeking to generate attractive, risk-adjusted returns over full market cycles on behalf of our clients (through both up and down markets), and we believe that in the long-term in investing, defense does win championships!
DISCLOSURES: The opinions expressed by DeFred G. Folts III of 3EDGE are provided for informational purposes only and are subject to change without notice. They are not intended to provide personal investment advice. Investors should only seek investment advice from their individual financial adviser. Observations include information from sources 3EDGE believes to be reliable, but the accuracy of such information cannot be guaranteed. Investments including ETFs, common stocks, fixed income and commodities involve the risk of loss that investors should be prepared to bear. Past performance may not be indicative of future results.