The Importance of Downside Protection

Big-Risk = Big-Return is true for individual securities. But not for a portfolio. A common misconception for investors (and traders).

Risk-Reward has a positive correlation, but it’s not perfect.

Risky securities are diversifiable by lower correlated/negative correlated securities. By buying low correlated securities to hedge your risky security, are you lowering your upside? No. You’re lowering your downside.

For investors, capital preservation is more important than the growth of capital. The bigger the investment loss, the greater the gain required to break even. A 20% investment loss requires a 25% gain to get back to the initial investment value. Whereas a 40% loss requires 67% and 70% loss requires 233%. The best offense is a good defense.

The Importance of Downside Protection

If you invest $10,000 in S&P 500 ETF and a recession causes the market to drop 30%, the $7,000 value would need to gain 43% to get back to $10,000.

Let’s look at the following 3 portfolios, each with a different strategy:
  • Portfolio 1 is invested 100% in S&P 500 (SPY).
    • SPY’s annualized standard deviation is 15%.
  • Portfolio 2 is invested 50 and 50 in S&P 500 (SPY) and Investment Grade Bond Fund (FBNDX).
    • Both are 0.31 correlated, based on annual returns.
    • FBNDX’s stdev is 4%.
  • Portfolio 3 is invested 33.34%, 33.33% and 33.33% in S&P 500 (SPY), Investment Grade Bond Fund (FBNDX) and U.S Real Estate ETF (IYR), respectively.
    • IYR is 0.69 correlated to SPY. 0.63 correlated to FBNDX. Correlation is based on annual returns.
    • IYR’s stdev is 21%.

* I initially wanted to backtest them for 30 years, but since IYR was the only real estate ETF I could find with the earliest fund inception date (June 2000), the backtest is from Jan 2001 to Dec 2016.

** Link to the data above can be found here.

Each portfolio is rebalanced annually. Dividends and distributions are reinvested. Taxes and transaction fees are not included.

Here’s the growth of each portfolio over the past 16 years.

3 Portfolio Backtest (Inflation Adjusted). January 2001 – December 2016
  • Port 1 has returned annual growth rate of 3.26%, after inflation.
  • Port 2 has returned annual growth rate of 3.36%, after inflation.
  • Port 3 has returned annual growth rate of 4.75%, after inflation.

Portfolio 1 and 2 have very similar returns. However, the traditional 60/40 portfolio (port 2) took much less risk than all-in portfolio (port 1).

Port 2 had a maximum drawdown of 35% while port 1 had 51%. Portfolio 2’s standard deviation (9%) was almost half the stdev of portfolio 1 (15%).

Port 3, on the other hand, had 45% max drawdown with a standard deviation of 11%, both in the middle of port 1 and port 2. However, they returned much higher.

3 Portfolio Backtest. January 2001 – December 2016. The “Final Balance” and “CAGR” numbers you see above are not inflation-adjusted.

Also, port 3’s Sharpe ratio, Sortino ratio, and Treynor ratio are all higher than the other two.

There are a lot of things to look at when determining which portfolio might be the best for a long-term investor. My favorite is portfolio 3, although the volatility is higher than portfolio 2. REITs (in port 3) provide a strong portfolio diversification with lower exposure to market volatility and attractive dividends.

You can see the backtest here for yourself.

Investors vs. Mr. Market

Downside protection strategies may help prevent investors from their bad habits of overreacting to downside volatility and incorrectly timing the market, missing the boat of high returns. Over the past year, S&P gained 18.10% while an average investor gained half of the growth.

S&P 500 vs Average Investor Return.
1-Year up to September 8, 2017.
Source: Openfolio

If you are a passive investor, consider downside protection strategies to limit volatility and build wealth over the long-term.

Diversify portfolio with:

I endorse the idea of employing a multi-asset strategies that lower the downside protections while increasing the upside potential or even decreasing the upside potential less than the decrease in the downside potential.

I am not saying you should allocate your portfolio to every asset there is. It depends on your goals, lifestyle, risk preferences, your responsibilities, the investment % of your overall capital, etc etc etc.

How you allocate each security is up to you (or your financial advisor), or me me me me.

No portfolio is risk-free, but minimizing the downside can help mitigate the pain inflicted by market “fire and fury” and a changing risk landscape in globalization era.

If you have any questions/comments/suggestions, feel free to contact me personally and/or leave a comment below.

PS: Maybe make Bitcoin/Ethereum/Litecoin 5% of your portfolio.

PS: Active traders should also minimize the downside risk, especially if you work, have school, etc.

PS: Never mind. Thank you for reading. Don’t forget to subscribe.

The Next Big Threat: Illiquidity

Liquidity is the investor’s ability to buy and sell a security without significantly impacting its price. Lack of liquidity in a security can have its consequences. Post financial crisis regulations, such as Volcker Rule (Dodd-Frank), and Basel 3, has made it more expensive and more difficult for banks to store bonds in their inventories and facilitate trades for investors. Regulations designed to make the system more safer have depressed the trading activity.

Lack of supply is one cause for diminishing liquidity. Banks, the dealers of corporate bonds, have reduced their inventories. According to Bank for International Settlements (BIS), “Market participants have raised concerns that regulatory reforms, by raising the costs of warehousing assets, have contributed to reducing market liquidity and could be keeping banks from acting as shock absorbers during periods of market stress.”

Primary Dealer Net Positions (2006 to 2016) Source: MarketAxess
Primary Dealer Net Positions (2006 to 2016)
Source: MarketAxess

According to BIS, “US primary dealers…have continued to reduce their corporate bond inventories over the past years. Since the beginning of the year 2013, they have cut back their net positions in U.S. Treasuries by nearly 80%.

Another big cause of decreasing in liquidity is technology. A technology that has changed the structure of markets, high-frequency trading (HFT), an algorithm computer trading in seconds and in fractions of seconds, account for much larger share of the trading transactions and it leads to low liquidity. Majority of HFTs, if not all, reduces liquidity by pairing selected (self-interest), leaving out others. According to BIS, 70% of U.S. Treasury trading is done electronically, up from 60% in 2012. For both high-yield bonds (not highly liquid asset), it accounts for more than 20%. About 90% of transactions on bond futures take place electronically. I have no doubt electronic trading will continue to increase.

“Greater use of electronic trading and enhanced transparency in fixed income markets typically comes at the cost of greater price impact from large trades.”, BIS said in the report. Bonds now trade in smaller transaction sizes than they did before, “… large trades seem less suitable for trading on electronic platforms because prices move quickly against participants who enter large orders due to the transparency of the market infrastructure.” “It “discourages market-makers from accommodating large trades if they fear that they cannot unwind their positions without risking a sizeable impact on prices.”

BIS in its quarterly review report (March 2015) stated (source: FINRA’s TRACE data), the average transaction size of large trades of U.S. investment grade corporate bonds (so-called “block trades”) declined from more than $25 million in 2006 to about $15 million in 2013.

This is a sign of illiquidity since “trading large amounts of corporate bonds has become more difficult.” Trades facing constrained liquidity puts investors, especially large investors, to a disadvantage.

Capacity to buy/sell without too much influence on the market prices are deteriorating. Lack of liquidity can causes wild swings in the bond prices, which then can affect the rest of the financial markets. Today’s financial markets are so connected just like the economic domino effects.

They are connected, but let me tell you why they are so important. The U.S Treasury securities market is the largest, the most liquid, and the most active debt market in the world. They are used to finance the government, and used by the Federal Reserve in implementing its monetary policy. I repeat, in implementing its monetary policy. Having a liquid market – in which having no problem buying and selling securities without affecting the market price – is very important to the market participants and policymakers alike.

Examples of high volatility in a low liquidity:

  • Flash Crash (May 2010)

In a matter of 30 minutes, major U.S. stock indices fell 10%, only to recover most of the losses before the end of the trading day. Some blue-chip shares briefly traded at pennies. WHAT A SALE! According to a U.S. Securities and Exchange Commission (SEC) report, before 2:32 p.m., volatility was unusually high and liquidity was thinning, a mutual-fund group entered a large sell order (valued at approximately $4.1 billion) in “E-mini” futures on the S&P 500 Index. The large trade was made by an algorithm. The “algo” was programmed to take account of trading volume, with little regard, or no regard at all, to the price nor time. Since the volatility was already high during that time and volume was increasing, this sell trade was executed in just 20 minutes, instead of several hours that would be typical for such an order, 75,000 E-mini contracts (again, valued at approximately $4.1 billion).

May 6, 2010 - SPY Volume and Price Source: SEC Report
May 6, 2010 – SPY Volume and Price
Source: SEC Report
May 6, 2010 - SPY Volume and Price Source: SEC Report
May 6, 2010 – SPY Volume and Price
Source: SEC Report

According to the report, this sell pressure was initially absorbed by HFTs, buying E-mini contracts. However, minutes after the execution of the sell order, HFTs “aggressively” reduced their long positions. The increase in the volume again led the mutual-fund group “algo” to increase “the rate at which it was feeding the orders into the markets”, creating what’s known as a negative feedback loop. That’s the power of HFTs.

This was nearly 6 years ago. Today, there’s no doubt the power of the secretive section of the financial markets, HFTs, are much stronger and powerful and can destroy the markets with “one finger”.

With low liquidity in the bond market and increasing HFT transactions in it, the threat is real. Automated trades can trigger extreme price swings and the communication in these automated trades can quickly erode liquidity before you even know it, even though there is a very high volume. While liquidity in the U.S. bond market is high, it’s not high enough to battle the power of the technological progress.

Let’s not forget. Fixed-income assets such as, corporate bonds, are often traded over the counter in illiquid markets, not in more liquid exchanges, as stocks are.

It’s all about profits. Some, if not all HFTs, act the way they do, to make profit. There’s nothing wrong with that. But, the creators of the algorithms have to be ethical and responsible. It’s not likely to happen anytime soon since profits are the main goal (mine too) in the financial markets. So why should HFT “be fair” to others? I know I wouldn’t.

  • Taper Tantrum (2013 Summer)

In the summer of 2013, the former Federal Reserve chairman, Ben Bernanke, hinted an end to the Fed’s monthly purchases of long-term securities (taper off, or slow down its Quantitative Easing), which sent the financial markets, including the bond market into a tailspin.

On June 19, 2013, Ben Bernanke during a press conference said, “the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year.” That sentence alone started the financial market roller coaster.

Yields skyrocketed. The gravity took down the value of greenback (U.S. Dollar). U.S. long-term interest rates shot up by 100 basis points (1%). Even short-term interest rate markets saw the rate-hike to come sooner than the Fed policymakers suggested. Borrowings costs increased so much, as the markets was expecting tightening of the monetary policy, it “locked up” the Fed from cutting the pace of bond buying that year.

Markets' Reaction To June 19, 2013, Ben Bernanke Press Conference Source: Federal Reserve Bank of St. Louis
Markets’ Reaction To June 19, 2013, Ben Bernanke Press Conference
Source: Federal Reserve Bank of St. Louis

This raises (or raised) whatever the market prices can handle orders that are executed in milliseconds. It points to a lack of supply (dealer inventories), A.K.A illiquidity. I feel bad for funds that have a lot of corporate-bonds in their portfolio. The struggle is real.

An open-ended funds that allow investors to exit overnight are more likely to experience a run, as market volatility increases. A run on funds will force the funds to sell illiquid assets, which can push down the prices lower and lower. Recently example of that is the Third Avenue (“investors’ money are being held hostage”).

Brace for a fire sale. Coming soon in your area.

Market makers, where are you? Come back. I need to sell the investments at a current price, before it goes much lower.

  • October 15, 2014

The financial markets experienced – as the U.S. Department of the Treasury puts it – “an unusually high level of volatility and a very rapid round-trip in prices. Although trading volumes were high and the market continued to function, liquidity conditions became significantly strained.”

On October 15, 2014, the markets went into a tailspin again. The Dow plummeted 460 points, only to recover most of the losses. The Nasdaq briefly fell into a correction territory, only to rebound sharply. The 10-year Treasury yield “experienced a 37-basis-point trading range, only to close 6 basis points below its opening level”, according the U.S. Treasury Department report.

According to Nanex, a firm that offers real-time streaming data on the markets, between 9:33 A.M and 9:45 A.M, “liquidity evaporated in Treasury futures and prices skyrocketed (causing yields to plummet). Five minutes later, prices returned to 9:33 levels.” “Treasury futures were so active, they pushed overall trade counts on the CME to a new record high.”, said the report.

“Note how liquidity just plummets.”

Liquidity in the 10 year as measured by total sizes of orders in 10 levels of depth of book. Source: Nanex
Liquidity in the 10 year as measured by total sizes of orders in 10 levels of depth of book.
Source: Nanex

Again, as I said, “Today’s financial markets are so connected just like the economic domino effects.” The mayhem in in the bond market can spread to the foreign exchange (forex) market.

October 15, 2014 - World Currencies Source: Nanex
October 15, 2014 – World Currencies
Source: Nanex

These types of occurrences are becoming common, or the “new normal”. As the Fed raises rates, the market participants will be adjusting their portfolio and/or will adjust them ahead of it (expectations), these adjustments will force another market volatility. But this time, I believe it will be much worse, as liquidity continues to dry up and technology progresses.

Recent market crashes and volatility, including the August 2015 ETF blackout, is just another example of increasing illiquidity in the markets. Hiccups in the markets will get bigger and will become common. Illiquidity is the New Normal.

Hello HFTs, how are you doing? Making $$$? Cool.

With interest rates around 0 (well, before the rate-hike in December), U.S. companies have rushed to issue debt. With the recent rate-hike by the Fed, U.S. corporate bond market will experience more volatility. Lower and diminishing liquidity will “manufacture” a volatility to a record levels that the financial markets and the economy won’t be able to cope with it.  As said, “Today’s financial markets are so connected just like the economic domino effects.”, the corporate bond market volatility will spread to the rest of the financial markets.

Oh wait, that already is happening. Reversal of monetary policy by the Fed this year, as I believe the Fed will lower back rates this year, will make things worse.

Liquidity: Peace out!

Repulsive Jobs Report

Last Friday (October 2), jobs report for September came out way weaker than expected. Non-farm payrolls report shows 142K jobs were added, vs 200K expectations. Unemployment rate stood unchanged at seven-year low of 5.1%. Not only that, but wage gains stalled, labor force shrank, and July and August gains were revised lower.

July job gains were revised lower to 223K from 245K (-22K) and August job gains were revised lower to 136K from 173K (-37K), totaling downward revisions of 59K. Average jobs gains for third quarter is now at 167K, lower than the 2014 average of 260K. So far, job growth has averaged 198K a month this year, compared with an average gain of 260K a month the previous year.

Total Non-Farm Payrolls – Monthly Net Change
Total Non-Farm Payrolls – Monthly Net Change

Unemployment rate stayed at 5.1% only because people stopped looking for work. In other words, they lost confidence in the labor market. 350K people dropped out of the labor force which took labor force participation rate fell to 62.4%, the lowest in 38 years (1977), from 62.6% in the previous three months.

Labor Participation Rate (Source: @ReutersJamie)
Labor Participation Rate (Source: @ReutersJamie)

Wages also showed weakness. Average hourly earnings fell by a penny to $25.09 after rising 9 cents in September. The average workweek declined by 0.1 hour to 34.5 hours.

There are increased worries that global slowdown is weighing on the domestic economy. The repulsive jobs report knocked down the chances of a rate-hike for this year. Federal Funds Rate (FFR) shows less than 10% and less than 35% chance of rate hike in October and December, respectively. Regardless of weak jobs growth, I still expect 0.10% rate-hike this month. But, I don’t expect 25 basis points for the year. If 0.25% were nothing, the Fed would have raised it already. The Federal Open Market Committee (FOMC) will meet on Tuesday-Wednesday, October 27-28.

Weak jobs report seems to point out a weak third quarter GDP growth following a strong rebound in the 2nd quarter. According to final GDP report released on September 25, second quarter grew at an annual pace of 3.9%, vs previous estimate of 3.7%. Advance (1st estimate) GDP report for the third quarter will be released on Thursday, October 29.

In the first quarter, the economy grew only 0.6% because of strong U.S. dollar, low energy prices, West Coast port strike, and the bad weather. Well, winter is approaching. Who’s not to say that the weather will hamper the growth again? The dollar is still strong and the energy prices are still low.

Energy sector continues to struggle. The mining industry – which includes oil and natural-gas drillers — lost 10K jobs last month, totaling 102K losses of jobs since December 2014. Energy companies continue to layoff workers since low energy prices are hurting companies. Energy companies like Chesapeake Energy and ConocoPhillips continues to reduce its workforce and its operations, and cut capital expenditures to offset higher costs.

Earlier in September, the Job Openings and Labor Turnover Survey (JOLTS) report showed that there were 5.8 million job openings in July, a series (series began in December 2000) record and higher than 5.4 million in May, as employers cannot find qualified workers.

It’s likely to get worse in the longer-term because of higher minimum wages. If employers pay higher wages, more people, especially teenagers, are likely to drop out and work. If states and companies continue to raise minimum wages, jobs that require skills such as programming, etc, will not be filled in the United States, but in countries with higher amount of education. That’s why recent minimum wage increases will batter, not help, the U.S. economy in the longer-term.

Reactions to the jobs report:

US markets fell immediately after the report, but rebounded later. 10-year Treasury yield fell below 2%, to the lowest level since April. US Dollar plunged, but recuperated about half of the losses later.

Standard & Poor 500 ETF ("SPY") - Hourly
Standard & Poor 500 ETF (“SPY”) – Hourly


10-Year Treasury Index ("TNX") - Hourly
10-Year Treasury Index (“TNX”) – Hourly


US Dollar ("/DX") - Hourly
US Dollar (“/DX”) – Hourly