Investor Fear Itself Can Help Diversify a Portfolio
It makes sense. When markets fall, measures of investor fear increase. The most commonly accepted way to measure investor fear is using the price investors are willing to pay to buy put options, which offer investors downside risk protection. The price of such options is measured in the market using the VIX index, often referred to as the “Fear Index”.
When we diversify our client portfolios, we naturally use traditional asset classes such as bonds, which tend to increase when stocks fall in value. We also use investments in assets like real estate investment trusts, preferred stocks, etc. When markets fall, these investment classes may help offset stock losses – but sometimes traditional methods of diversification do not work so well. (real estate didn’t fare too well during the financial crisis, for instance).
Knowing that investor fear often increases when stock prices fall, it would seem ideal to be able to invest in fear itself. Well, you can. And we do, by using option strategies to profit from investor fear.
In fact, with bond investments paying such low interest rates, and real estate and other assets near record highs, we are relying more than ever on option based strategies (and the fear index) to offset stock market risk. The primary vehicle we are using at the moment is the Catalyst Hedged Futures Strategy Fund.
What should an investor expect from this strategy? In an up market, the fund makes money (through buying and selling call options) in the traditional manner as the price of the S&P 500 goes up. At the same time, the fund uses put options which allow it to make money when investor fear measurements move higher (typically when the market falls). The fund needs the VIX to remain elevated (above 20 is good) for a period of time (several weeks) before it can reap profits from investor fear.
In August of 2015, the VIX shot up to almost 40, but quickly retreated before the fund could start making money. In 2016, the fear index has been strangely reluctant to increase (although it is up 14% as I write this today, with the S&P down sharply). We have now seen the VIX hanging above 20 for several weeks, almost since the 1st of January, which should allow Catalyst to start reaping profits from its downside options strategy.
We can look to the past for some indication of how well the strategy can work to offset market losses. In 2011, the S&P 500 fell by 19%. The VIX went above 20 in June and stayed above 20 (indicating high level of fear) until late in December. The Catalyst fund earned nearly 10% during those 6 months.
During the financial crisis, the VIX soared to record highs and remained elevated for over 18 months. While this was a terrible period for stocks, this long period of elevated volatility was an ideal environment for the Catalyst Fund strategy – it was up nearly 75% from Jan 2008 to June 2009. (click here to view performance of Catalyst fund vs. diversified stock and bond funds)
Our clients know we take risk management seriously. Minimizing losses in poor markets is almost as important to long term investor success as maximizing gains when the market soars. Using fear to our investors’ advantage is just one tool we use to limit losses during these uncertain times.
We are a little disappointed that, due to the lackluster response of the VIX to the current market correction, the fund has not already started to produce even stronger results. We remain highly confident however that if the fear index remains at current levels, or moves higher, the fund will deliver strong positive returns which will provide much needed support for client portfolios.
Note: Past performance does not predict future results. Diversification does not eliminate risk of loss. Investments described involve risks which need to be fully understood before investing – this is not a recommendation for any investor to buy any fund mentioned. Call our office to learn more about how Financial Pathways manages risk in our client portfolios.