The Best Strategies for the Worst Crises

Abstract

Hedging equity portfolios against the risk of large drawdowns is notoriously difficult and expensive. Holding, and continuously rolling, at-the-money put options on the S&P 500 is a very costly, if reliable, strategy to protect against market sell-offs. Holding ‘safe-haven’ US Treasury bonds, while providing a positive and predictable long-term yield, is generally an unreliable crisis-hedge strategy, since the post-2000 negative bond-equity correlation is a historical rarity. Long gold and long credit protection portfolios appear to sit between puts and bonds in terms of both cost and reliability. In contrast to these passive investments, we investigate two dynamic strategies that appear to have generated positive performance in both the long-run but also particularly during historical crises: futures time-series momentum and quality stock factors. Futures momentum has parallels with long option straddle strategies, allowing it to benefit during extended equity sell-offs. The quality stock strategy takes long positions in highest-quality and short positions in lowest-quality company stocks, benefitting from a ‘flight-to-quality’ effect during crises. These two dynamic strategies historically have uncorrelated return profiles, making them complementary crisis risk hedges. We examine both strategies and discuss how different variations may have performed in crises, as well as normal times, over the years 1985 to 2016.