Risk Management and Money Markets

I recently watched a video where a Chief Investment Officer stated that by utilizing a risk management methodology that allowed them to go to cash or money markets, “they were making the type of risk management used by large investors available to small investors.”  Let me be clear about this.  Large institutional investors will NEVER take a portfolio to a 100% cash position in order to best manage risk.  I can think of two major reasons why that is the case. 

First, institutional portfolio managers of large state, union, and corporate pension funds, endowment funds, and family offices for very large private accounts, are virtually all well-schooled in modern portfolio theory.  These MBAs, Ph.D.s, and CFAs, believe that time diversification and asset diversification are the best methods to manage risk.  Second, large institutional pension funds use an actuarial approach to managing risk by matching the maturity of their liabilities with the duration of their investment assets.  For employees retiring 25 years in the future the investment with the highest return premium and the longest duration is common stock.  For these investors, owning cash represents an unacceptable risk of mismatching assets and liabilities.  The closest institutional investors might come to “going to cash” is to allocate some small and manageable portion of the portfolio to money managers that run strategies that allow them to zero out their “long” stock positions.  Hedge funds in the market neutral and long-short space often get to 0% long exposure to stocks.  However, these allocations typically represent a small allocation in an institutional size portfolio.  In Pinnacle portfolios we call these managers “eclectic managers” and they currently represent about 10% of our total portfolio allocation.

Pinnacle Advisory Group does not go to 100% cash for reasons that having nothing to do with the views of institutional investors.  I believe the basic idea that stocks will always deliver a premium to bonds and cash over long time periods is a dangerous proposition that can’t be proved by past data.  Buying stocks at high valuations offers the virtual certainty of underperformance over long time periods.  However, the reason that we don’t go 100% to cash is for the simple reason that doing so implies that you have 100% certainty that your forecast is correct and I don’t believe investors should take that risk.  I realize that cash offers safety of principal in volatile bear markets and I also realize that certain investors will find comfort in a timing strategy that allows them to get 100% out of the stock market.  I have no problem with their definition of risk or with a money management firm that offers it to their clients.  I have often stated that active management comes in many flavors and consumers will choose managers that they believe in.   But I do take issue with the idea that implementing extreme asset allocations at market turns is bringing the best risk management techniques of large investors to the masses.  It is the little guys who go to cash.  For the largest investors, it would never happen.

Well…That Was Easy

The Pinnacle investment team has been patiently waiting for a serious correction in the recent torrid bull market for months.  To us, a correction in a bull market means something like a 10% – 15% decline – enough for us to feel good about buying a dip in an upwardly trending market.  Unfortunately, the market has not given investors the opportunity to jump in and buy a dip for months, with the closest thing to a correction being a 7% decline that occurred from June 12 to July 10 earlier this year.  But now, for the first time since July, the tone of the market seems to be changing with the market once again declining 6% from its high of 1097 on October 19^th.  We are going to implement a hedge position as a trade to take advantage of a possible nasty short-term correction.  It seems like it aught to be easy enough to do, but….

• Should we hedge by buying a 2X position in the U.S. dollar assuming the dollar will rally on a market decline, or buy a 2X inverse S&P 500 Index fund that should earn two times the decline in the market, or buy the VIX volatility index (Chicago Board of Options Exchange volatility index)?

• If we choose the VIX, can we be comfortable with the tracking error between the exchange traded note for the VIX Index (ETN available through iPath called VXX) and the actual underlying VIX index?

• If we put on the hedge, where do we get the cash to execute the trade?  We have some cash in our managed portfolios for the buy, but what else needs to be sold to take a 4-5% position in the hedge?

• We first looked at this transaction last week and since that time the VIX has had a big move to the upside.  Is it too late to buy it now that it moved more than 10% higher last week?

• We executed a complicated transaction in our fixed income allocations last week and now we can’t execute the hedge trade until the prior week transactions settle.  Will the market allow us to still get in while we wait the extra days for the prior trades to settle?

• One of our analysts feels like we have seen the ultimate top to this cyclical bull market that began in March of this year and so he likes the hedge trade.  Another analyst is worried that we won’t get much more on this correction and doesn’t like the trade.  Another analyst thinks the trade works as is. 

For Pinnacle’s investment team, the details of this transaction are just business as usual.