Systematic models offer investor many benefits that can include the automatic and dynamic process of defensively adjusting a portfolio during periods of market duress.  

 

When using cross-sectional or time-series momentum to rank and allocate a universe of ETFs the common rebalancing period is monthly.  I have tested longer and shorter rebalancing periods and the returns degrade significantly. 

 

One of the more common questions I receive is “what happens if there is a significant market event between monthly signals?”.   If there is an Achilles heel to monthly rebalancing, this is it.

 

Nassim Taleb made popular in his book, “The Black Swan”, the idea that important events are both rare and unpredictable.  It is the nature of this unpredictability that causes angst for investors.  

 

One approach to managing this risk, and as practiced by Universa Investments L.P, the firm to which Nassim is an advisor to, is to engage in tail risk (portfolio insurance) through specialized option trading.  (Incidentally, in a recent interview, Taleb sees worse tail risks than in 2007.)

 

Such an approach is more practical to an institution that can afford to engage in such a strategy and who makes the decision to allocate a portion of their portfolio to portfolio insurance. Overall the strategy provides asymmetric, positively-skewed payoffs exposed to small losses when refuted and very large gains when not.

 

For a smaller investor, attempting to construct an option strategy could be both time consuming and costly and assumes one has the expertise to do this on their own.

 

Inverse funds are not a solution either when considered as a permanent allocation given the mathematics of the daily rebalancing.  Inverse funds can and do work to provide a source of positive returns during market declines but should not be used as a permanent allocation as a way to hedge unpredictable market declines.  I have found a way to successfully utilize them into our rules-based strategies but their use is for limited periods of time only.   

 

This begs the question as to what an individual investor can do.

 

Fortunately, a new ETF from Cambria (Meb Faber’s company) may provide a solution for investors who want to make a more permanent allocation in an attempt to mitigate tail risk.  

 

The Cambria Tail Risk ETF (TAIL) invests in a laddered portfolio of “out-of-the-money” put options with a portion of the fund’s assets while the majority of the assets being held in intermediate treasuries.   

 

What I like about this strategy is that the income from the treasuries can help offset some of the costs associated with the put options.   The other potential advantage is that the fund will buy more options when volatility is low and  fewer puts when volatility is high.    

 

What could go wrong?  Since the greatest percentage of assets are held in 10 year U.S. Treasuries, any losses in the credit markets could negatively impact the price of the fund in addition to the expected losses that will occur during rising stock prices and periods of low volatility.

 

Historically, the 30-day correlation between 7-10 year U.S. Treasuries and the S&P 500 has ranged between .58 t0 -.89 with most of the observations since the beginning of 2001 being negative.   This would imply that the USTs are in themselves a non-correlated return stream. And of course, a basket of market puts will also be negatively correlated to a U.S. stocks suggesting that TAIL should provide true diversification for investors looking to add a non-correlated strategy to a long biased portfolio.

 

With the framework of a systematic rules-based approach such as used within Portfolio Cafe models, I see TAIL as a potential tool to help mitigate unpredictable market events that can be easily implemented with minimal costs.    

 

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