In a recent blog, we addressed the opportunity of funding a long/short equity position from existing fixed income holdings given the less-than-optimistic outlook for that segment of the market. I certainly agree that holding an overweight to core fixed income, at current interest rates and credit spreads, just doesn’t provide the same attractive risk/return trade-off that investors have gotten used to over the last 10 (20? … 30?!) years. Today, we offer a second approach to funding a long/short equity position.
By now, everyone that follows markets knows that this recent sell-off was the fastest move into bear market territory in history, taking just 22 days. This broke the previous record held by the Black Monday crash of 1987 at 55 days. While Black Monday was the fastest move into a bear market at that time (of seven total bear markets since 1957, which is the inception of S&P 500 Index), the recovery from the 1987 crash still took more than two years (645 days)—which was just the fifth fastest move back to a new all-time high.
Interestingly, this 645-day period is the exact average time that it takes to recover the losses of a bear market, which have historically ranged anywhere from 212 days to an astounding 2,423. Looking at these figures, it becomes abundantly clear that there is no correlation between the speed of a market decline and the speed of the subsequent recovery. Will we get back to February’s highs this year? Or will it take until 2026? It is anybody’s guess at this point. While I would agree that 3- and 5-year equity returns are likely to be positive from here, I’m not sure I’d be willing to bet on the magnitude of those numbers. If you can tell me how long the recovery will take, we can work backwards on that math, but history shows that predicting the overall duration is going to be quite challenging.
Equally important to note from the above chart is that historically the average maximum loss in a bear market is 34%. Interestingly, we just barely touched that number, as measured by the MSCI World Index when it most recently bottomed out at -34.10% on March 23rd. While I’d like to think that averages will hold here with no additional pain, when looking at the above chart you will notice that things can get much worse. We all remember 2008 vividly, but many forget that by July of that year the market was already down slightly more than 20% from its high in late September 2007 (technically a bear market), only to fall an additional 35%+ in the months that followed.
As we are all trying to do our best to quarantine safely at home, I know the collective hope is that this historically quick nose dive into a bear market will result in a historically quick recovery, and that the total percentage decline that we have already experienced will not worsen. Unfortunately, there isn’t any concrete data to provide reassurances when looking at past bear markets.
So, what’s the point in sharing some of this data? If nothing else, it’s to implore you to not try to time this market. It’s clearly never been easy to do in any other bear market given the wide disparity on the amount, timing, and duration of past selloffs. Add to that the global uncertainty of this pandemic, and I think it’s fair to say that it will be next-to-impossible on this round. Owning a bunch of equity beta from this point forward, even if you’ve already participated in a good portion of the drawdown, still doesn’t seem like the most attractive option.
Therefore, funding a long/short equity position from equities still makes sense at current levels. Don’t forget that long/short equity has historically outperformed equity markets with significantly less risk (see chart). Only when the markets enter rolling one-year periods of >10%+ do you start to experience much lag. Furthermore, the asymmetric upside/downside capture that long/short equity strategies hang their hat on can potentially be incredibly effective over time, especially if we continue to experience heightened levels of volatility and the wild swings, we’ve seen over the last few weeks. Perhaps we may even get back to a normalized volatility environment and see -5% moves up to three times each year like we have historically? A crazy thought, I know, but we’ve been overdue for the last 11 years…
In our last blog post on this topic, my colleague suggested potentially pulling from fixed income rather than taking from equities, but what if you don’t even need to pull from equities or fixed income? What if you were one of the successful few that timed this market correctly on the front end and increased your cash position in the months, days, and hours leading up to February 19th? What is your plan for redeploying that capital back into the market? We already know that there’s no magic formula for predicting a market bottom – whether in terms of size, speed, or duration of the drawdown. Putting cash to work in equities only to risk another leg down would be a tough pill to swallow given how well you protected clients on the front end. Furthermore, even if equity markets move higher in the months ahead, subjecting clients to potentially wild swings at these volatility levels may make it hard for them to stay invested.
Advisors have loved their 60/40 portfolios for the risk-adjusted returns they delivered since the bottom of the financial crisis. In fact, the Sharpe Ratio of these portfolios was about as high as it had ever been over the last 10 years. Many of these same advisors will deploy cash back into these traditional blended strategies expecting similar results over the next 10 years, but is that a fair expectation? Has a 60/40 portfolio even been the best solution available? The chart below would indicate that it has not been. Indeed, a shock to many.
Past performance is not indicative of future results. Source: Morningstar and Eurekahedge. Long/Short Equity is represented by Eurekahedge. The 60/40 portfolio is represented by 60% S&P 500 Index and 40% Barclays Capital Aggregate Bond Index. Data from 01/01/00-03/31/20. Returns during periods represent average rolling 12-month returns for each investment.
Many investors are surprised to see that long/short equity is much more effective at protecting capital during market selloffs than a traditional 60/40 blend, despite fixed income’s reputation for being such an effective ballast. Add to that the fact that long/short equity still performs in line with 60/40 portfolios during up periods—while outperforming it over time—and it becomes clear that deploying capital back into the market through a long/short strategy has the potential to be much more effective than if it were redeployed back into a traditional blended allocation.
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