When the next crisis comes - 3 strategies for protection

The threat of a further crisis recession may have fallen, but we are far from being in robust growth environment. Any recovery may be slower than anticipated given the slow lockdown adjustment process. Additionally, a recent BofA survey states that 80% of portfolio managers believe equities are overvalued. There is still a "wall of worry", even if the level of anxiety has fallen. Active preparation for the next negative market event or crisis should still exist and be at the forefront of any asset allocation adjustments. 

Portfolio construction for the next crisis should focus on three guiding principles which have been explored in the paper, "The Best Strategies for the Worst of Times: Can Portfolios Be Crisis Proofed" The Journal of Portfolio Management 2019.

• Momentum (trend-following) works in a crisis - This is an effective strategy choice for the simple reason trend-followers are long/short global diversifiers that provide convexity when markets change. The good news for 2020 is that trend-following worked albeit not as well as expected given the sharp turn-around after the end of March. Another dynamic strategy is to increase exposure to the quality factor when a crisis threat increases. 

• Following a flight to quality strategy is effective - Switching to bonds and safe assets when markets turn negative or maintaining a core holding is a core crisis principal. The safe assets are a barbell to risky assets held in the portfolio.  However, the flight to safety rule for bonds has not been stable and the current low yields place a safety drag on any portfolio. The same stability issue exists with holding gold.

• Always protecting for bad times with "put" insurance may wipe-out the good - Investors must be prepared for bad times but paying for "insurance" through a put strategy is costly. A strategy of hedging with puts can be especially costly when there are long periods of "good times". A key risk is being out of the market during good times that last longer than bad times or paying for protection that is not necessary. Of course, if an investor knows whether insurance is necessary, then there is limited risk.

These principles may seem obvious, but it is a good place to start research and focus attention. The questions are clear: 

• How much trend/momentum exposure should be held? 
• What are the risks for holding safe assets? 
• What are the costs of downside option protection?