Equity Exposure with Controlled Drawdown for 2021

Stuart Barton, PhD, CFA I December 3, 2020

As 2020 draws to a close with stocks near record highs, investors are understandably concerned by a growing disconnect between stock prices and economic fundamentals. 2021 may give us more clarity on the broader economic impact of COVID-19 and the changes to regulation and taxes introduced by a Democrat president. Given these rising risks, and not knowing how long this disconnect may last, many investors will be searching for ways to limit their exposure to a drawdown while simultaneously maintaining their exposure to further equity upside.

In 2017 and 2018, I published a pair of articles highlighting a stock replacement strategy that could serve to maintain equity exposure while simultaneously limiting downside exposure during severe market pullbacks. Specifically, I proposed using a small allocation to a short VIX futures ETN or ETF as a replacement for an investment in the S&P 500, and showed how an investment of just 20% in one of these short VIX futures products offered investor similar performance to a full 100% investment in equities.

Those findings now look more interesting than ever, primarily because a partial 20% allocation to a risky asset would allow 80% of a portfolio to be allocated to safe havens like cash and cash equivalents - effectively limiting losses in an uncertain market to just 20%. Those original articles can be found on our website here: Volatility as a Stock Replacement Strategy; Volatility as a Stock Replacement Strategy: Part II.

2021 may be setting up to be an ideal year to implement an equity allocation strategy that would limit portfolio downside to just 20%, while at the same time maintaining as much upside potential as possible. The next few months therefore might be a good time to rotate out of equities and into the VIX linked Stock Replacement Strategy I discussed in those articles.

However, since writing those articles two years ago the market for VIX futures ETNs and ETFs has undergone some significant changes that make the strategy's implementation a little less obvious. Most significantly, two highly popular exchange traded products that offered inverse VIX futures exposure have been retired or delevered. On February 20, 2018, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) was retired, and seven days later its cousin product, the ProShares Short VIX Short-Term Futures ETF (SVXY), had its short VIX futures exposure cut in half. These changes have left the market with no -1x VIX futures ETN or ETF available to implement the simplest version of the 20:80 VIX stock replacement strategy I proposed.

However, all is not lost, and there are still ways to implement the strategy in 2021 using short positions in the iPath S&P 500 VIX Short-Term Futures ETN (VXX). Unlike the now extinct -1x VIX futures products like XIV and SVXY, VXX instead offers investors +1x long exposure to the first and second month VIX futures contracts, and selling a short position in VXX offers investors a similar exposure to that previously offered by the -1x products.

So, implementing the strategy using VXX could entail selling a 20% short position in VXX and maintaining the balance of the portfolio in cash and cash equivalents. However, because VXX could theoretically rise by more than 100% on any given day, a 20% short allocation to VXX would expose the investor to significantly more risk than a 20% long allocation to a -1x product, and would therefore be significantly more challenging to manage than the strategy I originally proposed. Specifically, the investor would have to buy and maintain a portfolio of out of the money VXX call options to protect against very large VXX spikes, and would also need to perform daily rebalancing to maintain the desired -1x exposure. This could be expensive and time consuming.

So how can investors access the 20:80 stock replacement approach I originally outlined without needing to actively manage a portfolio of VXX and options? One way is to make a 20% allocation to Smart Vol and hold the remaining 80% in cash or cash equivalents. Smart Vol is an actively managed account offered by Invest In Vol that seeks to outperform equity markets by delivering returns linked to the VIX futures.

Below is a chart of the performance of a 20% theoretical allocation to Smart Vol vs. the S&P 500 Total Return index over the last five years. (The performance assumes a zero return on the 80% cash component, and references the Smart Vol performance here.)

Over the last five years therefore, a 20% allocation to Smart Vol may have performed very similar to a full 100% allocation to the equity market, and importantly may have outperformed during periods of crisis - particularly February 2018 and March 2020.

This appears to be a compelling approach as we head into 2021. With equity markets near all-time highs, holding 80% of a portfolio in cash, while still maintaining exposure to a portfolio that has historically delivered equity beating returns, could offer investors some certainty over their potential maximum drawdown. Furthermore, because Smart Vol has historically performed positively during periods of crisis, it is at least possible that the 20:80 strategy could avoid participating in the worst of a correction. For example, if the equity market saw a 30% correction in 2021, a traditional equity portfolio would likely see a similar sized drawdown, while the losses on a 20:80 Smart Vol replacement strategy would be limited to just the 20% invested, but would potentially lose far less.

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