Thinking well is a superpower. It's not a character trait that receives much attention, but I'd argue it's what matters. All other qualities take a back seat to the ability to think well.
Thinking well is a consequence of deep understanding, and it's that understanding which opens up the ability to problem solve and create from different angles. I.Q. matters, but not like an understanding of the subject at hand. If I have a broken bush hog, I don't want the latest Ivy league grad's help. I want the guy in overalls that's farmed his whole life and does his maintenance.
This market is testing investors' ability to think well. The SPDR S&P 500 ETF ("SPY") closed April down -12.99% for the year. The iShares Core U.S. Aggregate Bond ETF ("AGG") closed down -9.43% over the same period. As measured by the iShares 20+ Year Treasury ETF ("TLT"), longer-term bonds are down -19.05% on the year! There's been next to no place to hide.
Think about those numbers. Investors who hold 'balanced' portfolios and are trained that stocks are risky and bonds are conservative have watched both sides of the coin take it on the chin year to date. TLT and its exposures have been in many portfolios to protect against stock declines. I'm afraid the historical definition of what's risky and conservative may be a thing of the past.
Emotionally triggered thinking is not thinking well and can lead to financial decisions that create unnecessary friction on the path to a successful outcome.
No Risk, No Return
Generating a return requires assuming some risk—no risk = no return. If anybody tells you otherwise, run away.
Drawdown risk exists, but positioning purely to avoid drawdown carries an even worse outcome as it exposes portfolios to holdings that will go broke safely. For example, holding a near-zero interest cash position while inflation is what it is, exposes portfolios to a level of negative real rates we haven't seen in decades.
All investors are dealing with this issue and the exact reason for our comments above about the historical definitions of what is risky and what is not.
You're almost forced to hold the historically defined 'risk asset' stocks to generate a return in today's market. We are not in an environment where there's sufficient compensation for the risk embedded in bonds, the historically defined 'conservative asset.'
Consider this, the indicated yield on AGG (a measure of the overall bond market) is right at 2%. Holders of the AGG have lost nearly five years of annual income purely off-price decline just through April. Again, what's been defined as conservative may not be so in the future.
Our entire thesis and portfolio process is designed to help solve the issues of today's market. We aim to hold more stocks and fewer bonds while keeping risk in check by injecting the volatility ownership (more to come on this front).
Windshield vs. Rearview
Our portfolios have held up relatively well this year vs. benchmarks. That's not a pat on the back, as I know negative returns are negative, even if they are 'less negative.'
What matters is what's to come.
We believe stocks have greater return potential, and they can help defend against inflationary pressures. We think bonds continue to have a) poor potential for returns, b) cannot help defend against inflationary pressure, and c) cannot provide correlation benefits as they have in the past.
Therefore, we hold more exposure to stocks as portfolio return drivers. We understand that more stock exposure can lead to more potential for drawdown risk. To address this, we blend in exposure to volatility in the form of market hedges that have been effective so far and positioned for even more effectiveness if the current market drawdown worsens.
Positioning
We believe our portfolios are better positioned to compound capital than traditional balanced allocation portfolios. We have a stronger engine (more stocks) with better brakes (volatility).
Historically, bonds have been used as a risk mitigation tool. Portfolios have been able to dampen volatility by allocating to bonds as a way of driving slower. The need for great brakes was unwarranted. Even though they were a weaker engine, bonds compensated you through yield, price appreciation, and correlation benefits to your stocks. Driving slower was ok. If you are looking through the windshield, allocation decisions of the past should not be as effective in the future.
Our approach is different in that we lack the dependence on bonds in favor of a blend of more stock and convexity through long volatility.
Can we avoid all risks? No, but our portfolios are positioned to:
Have resistance to falling markets
Benefit from rising markets
Our hedges (volatility exposure) are beefed up. We carry elevated notional exposure along with higher deltas. In translation, the effectiveness of our hedges will be more apparent upon April's selloff continuing into May. While we like the protection we have in place, we like that it frees up our ability to seek more returns in other areas of today's market.
Conclusion
The market has been an incredible mechanism for compounding capital over longer periods. This simple fact gets lost in the headlines quickly, even quicker when those headlines are accompanied by negative price action.
There will be bad headlines and potentially more negative price action. None of that changes our belief that the market is the most efficient vehicle for most investors to grow their wealth.
We've seen terrible decisions made during negative markets over the years. The current market and portfolio drawdown level are close to the tipping point where worries become 'ok, I've got to do something.' None of those decisions have improved an investor's ability to compound capital. Emotional thinking is not our best thinking.
We are as confident as we've been in our positioning. We believe our portfolios are prepared for this market to rebound or go through more volatility bouts. Our hedges are primed, and we will be able to monetize and deploy back into cheaper valuations if the opportunity arises.
Disclosures
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward-looking statements cannot be guaranteed.
This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results indicate future investment returns. All investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.
The SPDR® S&P 500® ETF Trust seeks to provide investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500® Index (the "Index")
The iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market.
The iShares 20+ Year Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years.
The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options.