Some Options for Managing Index Investing Risk (NYSEARCA:SPY) – Looking for Alpha | Candle Made Easy

Courtneyk

Index investments offer lower risk at lower cost due to diversification. Because most investors aren’t good at stock picking, index investing offers a way to track a benchmark’s performance while avoiding costly mistakes.

There is however Known risks associated with passive index investing:

  • Large drawdowns due to bear markets and corrections.
  • Potentially long “time to recover” from drawdowns.

Investors have many opportunities to layer a risk management technique on top of passive index tracking to protect themselves during major corrections and bear markets. In the article, I will focus on the pros and cons of three such methods:

  • Keep money on the side to average after large corrections.
  • A transition from passive investing to market timing.
  • Tail Risk Hedging Strategies.

For comparison, let’s first look at the buy and hold performance of the SPY ETF (SPY) from inception (01/22/1993) to July 23, 2022.

Annual Returns of SPY ETF Buy & Hold (2022 YTD

Annual Returns of SPY ETF Buy & Hold (2022 YTD) (Price Action Lab Blog – Norgate Data)

The largest loss for a single year occurred in 2008 at 36.8%, while the three years from 2000 to 2003 generated a combined loss of 37.3%. Year-to-date (July 22, 2022) the loss is 16.2%. There was a small loss of about 4.5% in 2018. In hindsight, the buy-and-hold performance is impressive, but there was significant stress during the bear market of the dot-com and financial crises. The charts do not reflect how many passive index investors have sold at large losses due to panic. To avoid panic selling, a risk management method is required.

average down

The success of this method is based on the premise that stock prices will rise over the long term. However, execution requires good market timing and performance depends on the level of risk. For illustration purposes only, I’m looking at the method of keeping 20% ​​cash on the side and investing it after the market has fallen more than 10%, which is the average long-term loss of the SPY ETF. If the drawdown is less than 10%, the exposure is adjusted to 80% of equity based on monthly rebalancing.

Average annual performance for SPY ETF

Average Annual Performance for SPY ETF (Price Action Lab Blog – Norgate Data)

In 2008, there is a slight improvement from -36.8% to -32.9% for the annualized return, but over the combined dot-com period, the performance is about 200 basis points worse. Year-to-date performance is almost 200 basis points better. The problem with this method of averaging is timing. With hindsight, it’s easy to see that lowering the average could have yielded better performance, but in practice it’s impossible to know the right timing and level of risk needed to improve performance. Resistance to volatility due to mis-timing is detrimental to returns and can result in serious performance degradation compared to buy and hold. This is one reason why this method is rarely used in practice.

market timing

Market timing is not easy, although the method is simple, because it requires discipline and following rules. Most investors and even traders struggle with discipline and following mechanical rules. In this article, we’ll look at the well-known 12-month long-only strategy, ie buy when the price is above the 12-month moving average and sell when the price falls below the average.

Annual performance of the long-only 12-month price series momentum in the SPY ETF

Annual performance of the long-only 12-month price series momentum in the SPY ETF (Price Action Lab Blog – Norgate Data)

This method has yielded a significant improvement in annual performance and maximum drawdown: in 2008, the strategy was off the market and the combined dot-com loss was only about 2.5%. However, the year-to-date return is -13% and this strategy has failed to cut losses significantly. But there are more problems with this method.

Historically, market momentum has been generous in pricing series momentum with rapid recoveries from bear markets and corrections. However, in the face of an extended sideways market, as in the emerging markets from 2010 to 2015, this particular strategy can generate losses of up to 50% over several years and may take too long to recover. Therefore, the advantage that moving averages offer in limiting losses in downtrends comes with the risk of large losses in the event of a future sideways market. Some investors and traders are aware of these significant risks and balk at price series dynamics. More sophisticated market participants might find this a naïve approach to market timing.

Tail risk hedging

Tail risk is a fancy word for protection against extreme market downside movements. The 1987 crash and the 2020 pandemic crash are two examples of extreme market moves referred to as “tail risk.” The term is borrowed from statistics and describes the left edge of the return distribution.

In practice, tail risk hedgers not only try to protect an asset from a sudden unfavorable move, but also try to extract alpha. That’s easier said than done. It’s an appealing strategy in theory, but one that can only be executed efficiently by someone highly skilled in the art and science.

Most tail risk hedging strategies rely on buying out-of-the-money puts, which benefit immensely during spikes in volatility. However, in uptrend markets, these puts expire worthless and tail hedging costs pile up. Some firms promise cost minimization and efficient hedging, but this is inherently a difficult timing issue. Volatility can spike and then collapse quickly, and puts can appreciate in value and then lose most of it in a matter of days or even hours. Simple methods that invest a small fraction of capital in out-of-the-money puts have underperformed time-series dynamics and buy and hold based on both absolute returns and risk-adjusted returns. An example is the CBOE PPUT Index strategy.

The PPUT portfolio consists of S&P 500® stocks and a long position in a 1-month 5% out-of-the-money put option on the S&P 500 (SPX put). Source: CBOE

Below is the annual performance of the PPUT Index from 29/01/1993 to 21/07/2022:

Annual performance of the PPUT index

Annual Performance of the PPUT Index (Price Action Lab Blog – Data from CBOE)

The combined power loss during the dot-com period was about 31%. For 2008 there was a significant improvement versus buy and hold, but year-to-date the return is -16.3% and there is no improvement versus buy and hold. This is because the market has been delivering slow “pain trading” this year and OTM put options have largely expired worthless. The slow pain trade is the risk with simple tail risk hedging strategies. Protection is in place, but only for large left-tail events near the put option expiry dates. In all other cases, there is a wealth loss effect due to the option costs.

summary

The table below summarizes the performance of the methods discussed above and compares them to buy and hold.

Buy and keep average down momentum PPUT index
Annualized return 9.8% 5.7% 9.0% 7.0%
Maximum drawdown -55.2% -57.6% -22.6% -42.0%
Sharpe ratio 0.52 0.34 0.70 0.51
stock volatility 18.8% 15.6% 12.9% 13.7%
2008 return -36.8% -32.9% 0% -20.1%
YTD return -16.2% -14.4% -13.0% -16.3%

Advantages and disadvantages

advantages Disadvantages
Buy and keep Passive “doing nothing” investing. Large drawdowns and long recoveries.
average down It can use corrections. A timing issue, ex ante risk determination is difficult.
momentum It’s easy to do. It fails in sideways markets. It requires discipline.
Tail risk hedging It can benefit from volatility. A timing and math (options) problem. It underperforms in smooth downtrends.

All in all, even the simpler risk management options in index investing have significant downsides. A combination of methods, e.g. B. momentum and tail risk hedging or averaging down, may have the potential to generate superior risk-adjusted returns. In my opinion, no method other than Tail Risk Hedging, performed by astute professionals, can deliver alpha versus buy and hold. Index investors should choose a method with which they are familiar.

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