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The Best Strategies for the Worst Crises: Effective Approaches

Last Updated on 10 February, 2024 by Rejaul Karim

The Best Strategies for the Worst Crises” is a research paper by Michael Cook, Edward Hoyle, Matthew Sargaison, Dan Taylor, and Otto Van Hemert, which investigates hedging strategies for equity portfolios during major market downturns. Hedging against large drawdowns is often difficult and expensive, with notable challenges presented by simple strategies such as holding and rolling at-the-money put options on the S&P 500, or investing in ‘safe-haven’ US Treasury bonds.

Long gold and long credit protection portfolios appear to provide a middle ground between cost and reliability. The authors delve into two dynamic strategies that show potential for positive performance in the long run and during historical crises: futures time-series momentum and quality stock factors.

By examining these strategies and their variations from 1985 to 2016, the study offers insights on how they performed during crisis and normal times, ultimately providing valuable guidance for investors navigating turbulent markets.

Abstract Of Paper

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.

Original paper – Download PDF

Here you can download the PDF and original paper of The Best Strategies for the Worst Crises.

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Author

Michael Cook
Man AHL

Edward Hoyle
Man AHL

Matthew Sargaison
Man AHL

Dan Taylor
Man Numeric

Otto Van Hemert
Man AHL

Conclusion

In conclusion, “The Best Strategies for the Worst Crises” by Michael Cook, Edward Hoyle, Matthew Sargaison, Dan Taylor, and Otto Van Hemert sheds light on the complexities of hedging equity portfolios during large market drawdowns.

Traditional approaches, such as holding S&P 500 put options or relying on ‘safe-haven’ US Treasury bonds, come with their respective costs and uncertainties. However, the study highlights two dynamic strategies with promising results in both the long-term and historical crises: futures time-series momentum and quality stock factors. These strategies exhibit uncorrelated return profiles, making them effective hedges against crisis risks.

By evaluating their performance from 1985 to 2016, the authors present a comprehensive understanding of their behavior during both crises and normal market conditions, providing valuable insights for investors seeking robust strategies to navigate volatile markets.

Related Reading:

Taming Momentum Crashes: A Simple Stop-Loss Strategy

Time-Varying Sharpe Ratios and Market Timing

FAQ

Q1: What is the primary focus of the research paper “The Best Strategies for the Worst Crises,” and what challenges does it address in hedging equity portfolios during market downturns?

The research paper investigates effective hedging strategies for equity portfolios during major market downturns. It addresses the challenges associated with traditional approaches, such as holding S&P 500 put options or relying on ‘safe-haven’ US Treasury bonds, which can be difficult and expensive.

Q2: What are the key findings regarding the two dynamic strategies examined in the study, namely futures time-series momentum and quality stock factors?

The study explores two dynamic strategies, futures time-series momentum, and quality stock factors, which have shown positive performance in both the long run and historical crises. Futures momentum, akin to long option straddle strategies, benefits during extended equity sell-offs. The quality stock strategy involves taking long positions in high-quality and short positions in low-quality company stocks, capitalizing on a ‘flight-to-quality’ effect during crises. These dynamic strategies exhibit uncorrelated return profiles, making them effective hedges against crisis risks.

Q3: How do the authors compare the performance of the examined strategies during crises and normal times, and what insights do they provide for investors navigating turbulent markets?

The authors evaluate the performance of the dynamic strategies and their variations from 1985 to 2016, examining their behavior during crises and normal market conditions. The study offers valuable insights for investors seeking robust strategies to navigate volatile markets, presenting a comprehensive understanding of the strategies’ performance and effectiveness in different market environments.

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