Ground hog day came and went and it seems we have 6 more weeks of winter. For investment bears, the hibernation has been painfully long as March will mark the beginning of the ninth year since the end of the Financial Crisis. By any standard, this bull run has been long and many, including myself, have been crying ‘when, not if’ for more than a year now. After all, valuations are cyclically high and volatility is exceedingly low (which is eerily similar to the peak of the past two market cycles). Yet, as we’ve all learned, momentum can drive prices higher and, true to form, Wall Street strategists are predicting markets will go even higher in 2017. In the meantime, money continues to pour into index-based products.

Is there a case for de-risking?

Clearly, indexing has worked exceedingly well since the market bottom in early 2009, averaging 17.8% p.a. (see blue bars in left chart below). Compare that to a (hypothetical) manager who generated 70% of the upside in the market while exposing investors to only 60% of the downside (red bars). While generating that return profile clearly takes skill, they still would have underperformed significantly on a gross basis and barely eked out an improvement in risk-adjusted returns. That was also the case after the 2000-2002 decline to the peak in October of 2007 (see right chart). It paid to have full market exposure during that phase of the cycle (trough to peak). Part off the reason is basic math as the ratio of up months to down months is always highest during this segment of the cycle (trough to peak) which dampens the impact of a positive upside/downside capture ratio.

Peak to peak performance

But, assuming we’re at (or near) a peak, how does the lower risk portfolio perform relative to the unhedged portfolio from peak to peak? Looking at the two most recent examples, it performs pretty well. For example, from the peak in the market in both December 1999 and October 2007, the hypothetical skillful manager who captured 70% of the upside and 60% of the downside actually outperformed on a gross basis at considerably less risk over both periods. The difference in risk-adjusted ratios (similar to a Sharpe ratio) is now noticeably higher over both periods.

Over the entire period (2000-2016), the lower risk equity portfolio also generated a higher gross return at significantly lower risk (5.3% with a standard deviation of 9.6%) compared to the index-based portfolio (4.5% with risk of 14.8%). As would be expected, the lower risk portfolio also experienced a lower maximum drawdown of -33.5% versus -51% for the index. From a behavioral perspective, building lower-risk equity portfolios at this stage in the cycle makes sense, especially given the risk profile of bonds (the traditional ballast in the overall portfolio) may be more volatile going forward. Finally, apply both return streams to a portfolio in the distribution mode and the case for the lower volatility portfolio becomes even more compelling. Something to consider as we pile into index funds near the top of the cycle.

Source: Data from Morningstar. Performance is based on the S&P 500 Index. Upside/downside capture is calculated based on a percentage of returns in positive months versus negative months. Risk is measured by standard deviation. Ratio is calculated by dividing return by risk.

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