will focus on a shorter-term view, given the current economic, financial, and political uncertainties. They will reject a horizon of fourteen years and say that one cycle is not enough to benefit from a more hedged and diversified approach.
Interestingly, it doesn’t take numerous cycles to realize the benefit of the more hedged “rowing” approach. In the first cycle in Figure 1 (the early 2000s), market followers ended up 6.5%, while the rowing crew lapped them at 15.2%. In the most recent cycle, which includes 167% market gains since the bottom in 2009, buy-and-hold boosted portfolios by 15.4% while the harder working “rowing” investors currently lead with 31.4%.
The hedged “rowing” portfolio not only worked over the past fourteen years, it was successful over the course of the previous secular bear market from 1966 to 1981. After that sixteen years of secular bear, the S&P 500 Index portfolio showed gains of 33%, while the “rowing” portfolio had delivered 44%.
Keep in mind that there are many ways to structure a “rowing” portfolio. It is beyond the scope of Unexpected Returnsand Crestmont Research to develop or present specific alternatives. Nonetheless, rowing-based portfolios often consider—and include when attractively valued—a variety of components, including but not limited to: specialized stock market investments (e.g., actively-managed, high-dividend, covered calls, long/short equity, actively-rebalanced, preferred stocks, etc.), specialized bond investments (e.g., actively-managed, convertible bonds, inflation-protected securities, principal-protected notes, etc.), alternative investments (e.g., master limited partnerships, royalty trusts, REITS, commodity funds/advisors, private equity, hedge funds, timber, etc.), annuities, variable life, and others.
Clearly, some people will be skeptical about structuring portfolios to achieve (or improve upon) fifty percent up and down capture. Others will be looking for this article to present proof of a system that will lock in those results; it does not. But many others will relate today’s discussion to their own or their advisor’s experience. For the last group, this discussion intends to reinforce that good performance is not coincidence; rather it is the product of applying skill to portfolios that historically relied solely upon risk for return.
HOW IT WORKS
Market portfolios are outperformed by hedged portfolios in secular bear markets because of the disproportionate impact of losses in relation to the gains required to recover losses. Most significantly, as the magnitude of the loss increases, the required recovery gain exponentially increases.
In secular bull markets, on the other hand, gains significantly overpower losses. So although cyclical swings deliver the occasional “correction,” the recoveries far exceed the losses. The result is that above-average returns from sailing cumulatively exceed those from hedged rowing. In secular bear markets, however, gains across the secular period are cumulatively fairly modest or nonexistent. The result is that losses during secular bears well overpower the gains. Hedge portfolios mitigate some of the negative effects and enable investors to cumulatively succeed.
Figure 2 presents graphically the dynamic of offsetting gains and losses. As the losses increase, the required gain to reach breakeven exponentially increases. To illustrate the half and half effect within hedged portfolios, note that the required gain for a 20% loss is 25% and the required gain for a 40% loss is 67%. Those two points are chosen because 20% is half of 40%, consistent with the earlier “half and half” illustrations. Note that you will see the same effect with 10% and 20% or with 30% and 60%, etc.
Figure 2. The Impact of Losses
