Finding an asset that can protect a portfolio in times of extreme market stress is often seen as a ‘Holy Grail’ of investing, but these are much rarer than investors might expect.
Recent months have seen some quarters of the investment community grow increasingly cautious on the outlook for markets, given stretched valuations, low levels of volatility and mounting risks – such as the geopolitical tension between the US and North Korea.
Dieter Wermuth, head of macroeconomic research at Wermuth Asset Management, argued earlier this year that the risk of another stock market crash “gets likelier by the day” as monetary policy around the world remains very loose by historical standards.
Performance of gold vs stocks and bonds over 2017
Source: FE Analytics
“As a general rule, markets that have performed very well in the past are unlikely to be the future winners. Hands off expensive assets,” he said.
“It is precisely at times of complacency and supportive economic policies that crises begin. Expensive assets such as stocks, bonds or real estate imply that the scope for future capital gains is limited.
“When financial investors become aware of this simple arithmetic, some of them will try to lock in their paper gains and take profits. A downward spiral begins as the herd follows the leaders to the exit.”
As the chart above shows, gold has performed strongly at times in 2017 as investors flocked to the yellow metal in times of uncertainty – such as when the US/North Korea spat over missile testing and its nuclear weapons programme heated up. However, it has been dropped by investors more recently after the Federal Reserve unveiled plans to start unwinding its massive quantitative easing programme.
Fawad Razaqzada, market analyst at Forex.com, pointed out that investors appear to be ignore as an “insatiable appetite for risk continues”. US index futures have hit new record highs while European equities – except in Spain – have also risen; at the same time, gold has fallen out of favour.
“But are risk-seeking investors being a bit reckless?” he asked. “Sentiment could turn sour very quickly, especially given the overstretched US equity market rally. Any sudden drop in the equity markets should see demand for gold rise again on safe haven flows.
“I think it is only a matter of time before this happens. But so far a Wall Street sell-off hasn’t materialised and there is no point in trying to predict when this will happen. But when it does, it will be very obvious.”
Performance of assets during S&P 500 sell-offs
Source: MitonOptimal
However, MitonOptimal head of quantitative research Simon Morrison warns investors against thinking that any one asset will be able to protect their portfolios all the time. The above chart shows the performance of some of the assets that are often considered to offer protection in periods where the S&P 500 fell 20 per cent of more over the past 50 years.
“During the savings & loans crisis/Latin American debt crisis in the early 1980s, gold would have lost you twice as much as equities. In fact, apart from the 1973-1974 crash (collapse of Bretton Woods), gold didn’t even come close to negating equity losses in other bear markets,” he noted.
“During the global financial crisis of 2008, the bulk of the gold rally happened after the fact, only reaching new highs two and a half years after equity markets had already started to recover. The US dollar depreciated in three out of the six events highlighted and the Japanese yen did not do much better, making Treasury bonds the only asset that never lost you money, even though returns in many cases were mediocre.”
Morrison cautioned against taking a purely backward-looking quantitative analysis approach to identifying safe havens. He screened more than 3,000 indices to see if any can be considered a ‘one-size-fits-all’ market protection trade and found evidence to be lacking.
On a pure quant basis, the somoni – the currency of Tajikistan – offered the best protection during the bursting of the dotcom bubble as it appreciated by 68,000 per cent. However, this was a pure coincidence as it replaced the Tajikstani ruble on 30 October 2000 at a ratio of 1:1,000.
Within commodities, cacao has offered the best protection on average. However, this is also probably down to coincidence – Morrison pointed out that it is unlikely cacao doubled in value during the early 2000s because of excessive speculation in tech stocks.
The Swiss franc emerges as potentially the best currency, which seems like a sound conclusion from a fundamentals perspective, but he noted that it has lost ground to the dollar in some periods of equity market correction.
Global macro and managed futures hedge fund strategies are another area that have offered the best protection of portfolios. However, investors need bear in mind that their managers can make the wrong calls and rigorous attention to their underlying structures is essential, as demonstrated by the 2008 financial crisis.
In the end, Morrison concluded that no single asset can be considered a catch-all safe haven against all risk events. Much better, in his view, is to own a diversified portfolio that is tilted towards the opportunities identified by proper research but protected by appropriate assets based on current risks.
“An obvious conclusion has to be that there is simply no single place to hide; every crisis has different driving forces,” he said. “The best protection at any given time is having a solid understanding of the current potential of events that can derail markets, and for you to be holding the appropriate assets to protect against that particular risk event.
“In the real world, it is not that easy to always spot those significant risk events. For instance, John Paulson in ‘the greatest trade ever’, traded credit default swaps during the sub-prime crisis and made a fortune. Subsequently, he has been struggling though, as none of the other ‘troubled chickens’ he has spotted have come home to roost yet.
“This highlights the other risks, the ones we are not aware of, the ones that tend to emerge out of nowhere and cause havoc in the markets. For instance, I can think of no indicators that could have warned you about Black Monday, which was triggered by mass panic and automated trading strategies spiralling out of control.”