Don't Hedge Equities With Equities

A few days ago I bagged on a strategist from Vanguard for telling investors to stick with bonds in a 60/40 portfolio allocation. In that post we put together a 60/10/10/10/10 portfolio with just 10% to bonds and the other 10% sleeves into different alts that each represented uncorrelated return streams. I modeled the strategist's idea for mixing domestic and foreign equities and bonds and also incorporated his idea into our comparison portfolio. We had a small issue being unable to backtest Vanguard Total World Bond (BNDW). A reader left a comment with a work around combining BND and BNDW so I reran it and compared it to 60/10/10/10/10 as follows going back ten years.

And an updated 60/10/10/10/10.

I swapped in the Merger Fund because it backtests a full ten years versus Absolute Convertible Arbitrage which only goes back to 2017. I also took out AQR Alternative Style Premia Fund (QSPIX) because of how poorly it did for four years leading into 2022 and then its monstrous gain in 2022. That sort of unpredictable volatility doesn't really mesh with what we're trying to do. I added QGMIX instead.

The ten year result isn't earth shattering but there was some real crisis alpha in 2022 which is shown in the worst year column. Bonds did well from the start of the back test up until late 2021 and 60/10/10/10/10 was underweight bonds the whole time. Additionally, foreign equities have lagged domestic for many years and 60/10/10/10/10 obviously had much less exposure to domestic than VBAIX. 

What 60/10/10/10/10 did was avoid obvious interest rate risk. Back in July 2014, when our backtest started, the ten year US Treasury yield was hovering between 2.40% and 2.60%. Getting a two handle for ten years made no sense to me back then and in hindsight still makes no sense. Of course yields kept going down but the risk that a year like 2022 would come along at some point never went away. 60/10/10/10/10 captured the effect while avoiding an obvious and serious risk.  

Jay Jacobs US Head of Active and Thematic ETFs at iShares was on this week's ETF IQ and was asked about whether buffer funds are being used as fixed income replacements given how poorly bonds have done lately. He spun out of that saying he thinks their popularity is more about easing people into equity markets. Just don't with the buffer funds. Whatever you are trying to achieve with a buffer fund you can do cheaper, simpler and with fewer things to potentially go wrong.

Kind of related, I registered for a webinar for Thursday morning hosted by VettaFi titled Q3 Fixed Income Symposium. OK, let's see what they have to say. Today I saw a Tweet promoting the webinar that gave more of a hint.

This is such a bad idea. It has come up many times before and it is always a bad idea. A regular equity with a solid dividend can still go down a lot in a bear market or some other sort of event like the 2020 Pandemic Crash. If you want 100% equities, go for it but if you want something, whether bonds are that thing or not, to cushion equity market volatility, don't use plain vanilla (dividend) equities. 

I believe the first dividend ETF was the iShares Dividend Select ETF (DVY). From May 2007 to when it bottomed in March 2009, it fell 60%. It was of course heavy in financials and it started falling seven months before the S&P 500 peaked in October. I pick that one because it is at least a variation on equity income. In that little crash at the end of 2018 it fell 13% versus 17.5% for the S&P 500. It then fell 31% in the 2020 Pandemic Crash, just a hair better than the worst of the S&P 500. In 2022 it did great as did most dividend ETFs, it was up 1.91%.

In terms of being bond like for offsetting equity volatility, I'd say DVY is one for four. Do you think that is good enough? How about the Global X Covered Call ETF (XYLD)? It has plenty of income of course, no equity upside to speak of which doesn't have to be bad but it does capture a lot the downside. It's not as old as DVY, XYLD only goes back to 2013. In the 2018 crash it went down 14%, in the 2020 Pandemic Crash it went down 32% and in 2022 it went down 12%. The 2022 number was a little better than the Aggregate Bond Index but I think comes up short in the context of offsetting equity market volatility. 

If you own any fixed income, why do you own it and what do you hope it will look like?

I believe the blue line is much closer to what most investors want their fixed income allocation to look like. The blue line effect could be created by blending a few things together with different attributes to get that effect but how many advisors and do-it-yourselfers do you think actually do that?

Part of the reason I've been critical of bonds is they take on equity beta in some instances, maybe a lot of instances. Hedging your equity beta with equity beta isn't really hedging. Hedging your equity beta with something that has even more equity beta, like dividend stocks or whatever they are going to talk about on the webinar is a worse hedge than volatile, long term bonds. 

We talk all the time about hedging with uncorrelated, negative beta or no beta diversifiers. The blue line is essentially no beta. 

If it works out that I can sit in on the webinar tomorrow and I am wrong about this, I will write a follow up.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.