The financial bubble of the past few years, which was notable for its crypto, tech and housing bubble, made alternative investments all the rage. In the early 2000’s it was hedge funds and private equity that captured investors attention. Each bubble seems to produce another fixation on various alternative ways to grow and increase wealth.
Not all of these investments end up being busts when the downturn comes. Especially when they become ever more well known, research usually follows to give credence to or debunk their market beating myths. From past bubbles the use of alternative strategies has developed some theoretic underpinnings.
Some examples of this include investments that offer higher returns due to their illiquid nature. Private equity and real estate come to mind here. Others offer value not necessarily through higher returns but with their low correlation with traditional investments such as stocks and bonds. Equity neutral strategies and event driven funds come to mind when thinking of correlation.
In my humble opinion, one of the serially under appreciated characteristics of financial innovation in the past 30 years has been the advent of ETF’s and their ability to use derivatives, fixed income and equity to mimic alternative strategies once only available only to sophisticated institutional investors or the very wealthy through their high net worth advisors.
In April of 2021, I made a post called More ETF’s to Profit from Volatility. In the post, I talked about various strategies which could benefit in some way from volatility, which especially tends to increase when markets are falling. These basically fell into 3 categories:
1. Covered call writing which can be tracked by ETF’s like QYLD and XYLD
2. Volatility Futures which can be tracked in the short term by ETF’s like VIXY and VXZ
3. Mixed option and fixed income strategies, the one I featured being the ETF SWAN
I would like to take a look at how these strategies performed in the recent bear market of 2022, to see if they offered some type of haven in a year of falling fixed income and equity prices and also explore some of their risks which I may have missed in my initial analysis.
Finally, I will explore even further some alternative factor strategies that could potentially be the new frontier for ordinary retail investors in order to diversify their returns across different strategies.
How the Volatility Strategies Performed in 2022
Covered Call ETF’s
The first strategy followed an ETF that wasn’t intended to work necessarily as a complete loss hedge but more so as a loss mitigation. The covered call ETF’s for both the S&P 500 and Nasdaq 100 offered by funds company Global X offer a lazy way for an investor to benefit from a covered call strategy.
In short, this strategy writes calls on the 2 indexes and generates higher income in exchange for giving up much up the price appreciation upside. This strategy works best in a flat market (see below for the payoff chart). Yet it does have some positives when markets fall. Prolonged bear markets usually mean higher volatility and that increases the value of options. Although the underlying index may fall, the increased income from the options offsets some of those losses.
This can be seen in the total returns of these ETF’s versus the underlying index. In the case of XYLD the total return was -12% versus an 18% loss for the S&P 500 in 2022. For QYLD that loss was 19% while the Nasdaq 100 fell around 29%.
The verdict on these is that they may be decent tools for years when the market seems particularly bubbly and would limit the downside in a prolonged bear market. But don’t expect them to save you from the ravages of a bear market, they will fall when the index falls, they just have some relatively high income to offset that fall.
VIX Futures
Don’t want to go through the hassle and due diligence of opening a futures account to trade volatility? The folks who make ETF’s have you covered. Volatility can be traded through the VIXY and VXZ offered by ProShares and iPath respectively. VIXY holds a portfolio of 1 month VIX volatility futures. This ETF tends to increase in value if volatility increases above what the market is expecting near expiration.
VIXY is more of a high conviction short term trade. I wish I had known about this ETF before the pandemic because I knew the market was under appreciating the effect of the pandemic in January of 2020 but I wasn’t sure of how to take advantage of it. VIXY saw it’s value triple in the span of 2 months while the market fell 30%.
The downside of VIXY is that the contracts roll on a monthly basis. This means that updating the price to new contracts eats away at the value over time due to the roll cost. Think of it like continuously paying for 1 month volatility insurance. For this reason, the ETF is less effective over the course of many months.
VXZ is actually an exchange traded note originated by Barclay’s and seeks to mimic returns of holding medium term futures which have mixed terms of 4, 5, 6 and 7 months. Think of them as a bet on volatility in the medium term. How this works as a hedge is that if volatility is relative low, you can hold this ETN for months until there is an event that suddenly sees volatility and expected volatility increase. This is exactly how the ETN performed during the pandemic:
The one drawback is volatility. Even before 2020, the ETN regularly saw price swings of 0-25%. If you can manage that kind of volatility in return for a big payout when volatility spikes, then this may be the tool for you.
There is one additional note of caution on this security as well. It is an ETN not an ETF. An ETN is actually a debt security issued by a financial institution, that in exchange for your funds, provides the return of the underlying index. The risk here is that you actually take on the credit risk of the financial institution issuing the securities as well, in this case Barclays. When I worked in finance up until last year, Barclays and UBS were some of the largest issuers in this space. Also take into account that some ETN’s have maturity dates so you should read the prospectus carefully. There are also some tax benefits to holding ETN’s if you use them smartly. This Wikipedia page gives a pretty fair overview if you want to know more about ETN’s.
The SWAN Strategy
If there ever was an example of things are different this time with investing the SWAN ETF turned out to be a classic example in 2022.
I have to admit, I was quite excited about this strategy that appeared as an ETF in late 2018 and the brief market turmoil at the end of 2018 seemed to prove the strategy right.
The basic idea behind SWAN was based off of observed market behavior over the past 25 years in the US: when equity markets fell, treasuries increased in value, but when treasuries fell, equity markets increased in value. The actual strategy of the ETF is to hold 90% of the fund in treasury securities with a target duration of 10 years to match the price and yield behavior of the bedrock risk free global investment: the 10 year U.S. treasury security. The remaining 10% of the fund consists of LEAPS or long term options that track the S&P 500. This gives the ETF some of the upside of the S&P 500 while hopefully maintaining or even increasing its value in conditions of extreme market volatility.
The name and the investing hypothesis are based on the concept of a Black Swan market event, popularized by Economics professor Nassim Nicholas Taleb who published a book by the same name. He described black swan events as events of extreme consequences but impossible to predict and it is important to assume that these are always a possibility.
So based off of observed market behavior in the decades past (when equities fall in value, treasuries rise) it seems that the 90/10 strategy of treasuries and options of this ETF could have a place in many portfolios. Indeed, you’ll notice that from peak to trough during the beginning of the pandemic, the SWAN ETF only fell 8.6%.
During this same time, the S&P 500 fell 32.2% from peak to trough. Although SWAN did not offer as much upside as the S&P 500, it also had much less downside. The return versus volatility can be measured by something called the Sharpe ratio and observers of the SWAN ETF noted its Sharpe ratio was higher than the index while offering better returns than simply holding bonds, something Amplify, the company running the ETF, often noted in their marketing material.
However both their analysis as well as my initial analysis left out a glaring risk: all these assumptions of risk and return rested on a foundation of low inflation. If inflation were to significantly pick up, we could see both bond values and equity values fall as the Fed increased rates, something that up until 2022 had only happened 3 times in the modern history of the US market.
It turns out 2022 was the 4th time. This sent the value of the 10 year treasury as well as the value of LEAPS options tumbling. Consequently, the SWAN ETF fell 34% from peak to trough in 2021-22 while the S&P fell as much as 25%. Only the Nasdaq did slightly worse from peak to trough of 35%. As a hedging tool, given the circumstances, SWAN turned out to be a disaster.
That is not to say that SWAN should be totally avoided. It has to be emphasized that 2022 was an exceptional year and market expectations tend to quickly adjust to a new reality. There are some doubts about inflation being more “sticky” going forward, meaning that there is a risk it could stay at levels higher than the Fed’s 2% target for longer and yields reflect this. The 10 year yield is at 3.94% and the 30 year is at 3.93%. Both of which are at 16 year highs.
The risk for an ETF like SWAN going forward is that inflation does not fall back down and even increases in the medium term, maybe by the Fed changing policy and adjusting up to a new target level of inflation like 3% or 4%. In this scenario, SWAN would risk seeing a big slide.
Alternative Indexes
The other area I wanted to explore in terms of alternatives was that of alternative factor models.
Factor models are a new spin on actively managed funds which started to decline precipitously after the popularity of indexing started to really take hold about 10-15 years ago. The difference in this case is that rather than going with the research or hunch of a single manager, these funds rely on rules based investing according to factors.
These factors are usually loosely based on the Fama-French model developed by 2 professors in the early 90’s and updated in 2014. The Fama-French model seeks to explain excess returns to the market portfolio (say, the S&P 500 in this case) to factors such as size, momentum and value. What’s important for investors to understand is that the authors acknowledge that some strategies such as small cap investing and momentum investing are observed to outperform the market over periods of time stretching to years, but that these are due to human factors which are predictable.
For example, small cap stocks tend to have less visibility to research analysts and therefore more potential to surprise to the upside. These have been seen to consistently offer returns higher, although with more volatility over long periods. Likewise, stocks that have seen high returns have been observed to continue to have high returns over subsequent periods, this is the momentum effect.
My favorite provider for (least) biased opinions on fund strategies has always been Vanguard. In 2018, they launched 5 factor funds each with the following factors focuses:
The rationale is fairly simple for each. Value holds stocks lower in value compared to their fundamental price. This is a distinguishment from value funds that just hold low P/E stocks which may include more cyclicals and financials.
Minimum volatility stocks have been shown to outperform in times of high volatility. This may be similar to holding a consumer staples portfolio which has been observed to outperform broad indexes over multi decade periods.
Momentum stocks can outperform in bill markets. The Nasdaq up until 2022 can be looked at as a momentum strategy, handily beating the S&P 500 from 2016-2022.
Liquidity seeks to benefit from shares that have low liquidity, seeking to profit from a liquidity premium, which has been observed in stocks as well as asset classes. This factor fund was liquidated in November of 2022 by Vanguard.
Quality seeks to focus on stocks with good fundamentals and strong balance sheets.
Finally the multifactor portfolio seeks to combine all of these factors. I am a bit more wary of this portfolio since at a glance, it would seem to leave more discretion up to a manager and less rules based but the verdict is still out.
The Results
The invention of new ETF’s tends to be based on past results and there can be a tendency towards what is called data mining when we look into the past. Data mining is a term for manipulating the data in a way that produces the results we want but isn’t a real trend.
Past research has pointed to outperformance for factors both globally,:
and in US markets:
However the results of the Vanguard portfolios have been mixed. Since their inception in 2018, the momentum fund has beaten the benchmark, which is the Russell 3000 for all these funds. The other 4 slightly underperformed. If we ignore the initial fund ramp up year of 2018 and look from 2019 to 2022, 4 of the funds saw returns a few percentage points higher than their benchmark over the period.
Over the past 2 years there has been a marked variation in returns with the minimum volatility and value factors beating their benchmark by 11% and 19% respectively before dividends.
In essence, the jury is still out on whether these funds will deliver on the outperformance they promise over time. What is interesting to note is that they may capture changes in market sentiment.
I have made the point in previous posts that due to the outperformance of growth in the past few years and the uncertainty going forward, we may be entering a period where value tends to be the winning strategy similar to how it was in the years after the dot com bubble burst. This can indeed be seen in the factor performance if you zero in on the period from 2000 to 2008. The outperformance of value in the past 2 years especially seems to support this.
Yet market sentiment changes and this is why Vanguard offers a range of strategies. They readily acknowledge in their disclosures that some of these strategies are high risk and could see long periods of underperformance.
Conclusion
Overall I do think the value factor in particular is worth taking a look at now given the market conditions. The quality and multi factor funds could also be interesting over the next few years.
One important point risk wise is that these funds track the Russell 3000 so you do run the risk of missing out on international performance and you tend to be domestically focused in the US.
While I don’t recommend keeping these as a core strategy, for sophisticated and disciplined long term investors these strategies may offer a strong set of alternative strategies to keep from FOMO on the hot investment, be it minimum volatility or momentum.
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