Barbell Strategy: Resilient when volatility rises

Adopt a cross-asset barbell strategy to limit portfolio drawdown. This reduces the risk of selling at the worst time and missing out on the subsequent recovery.
Chief Investment Office18 Apr 2019
Photo credit: AFP Photo

What happened?

Volatility, near a record low, can only rise. The recent inversion of the 3M-10Y US Treasury (UST) yield curve triggered wide-spread concerns on whether a recession is around the corner. This is not surprising. After all, an inverted yield curve is historically deemed as a harbinger of upcoming recessions. But, as we have discussed in 25 February’s CIO Perspectives “Ask CIO: Is the flattening yield curve a warning sign to investors?”, the prevalence of weak government bond yields around the world, coupled with years of massive quantitative easing by the major central banks, have led to the “artificial” suppression of long-term UST yields, causing the yield curve to be flatter than expected.

We maintain that the probability of a major recession over the next 12 months is low. That said, we are cognisant that global economic momentum has moderated in recent periods, evident from the Citi Economic Surprise Index (Global) which has retraced from a peak of 43.8 in February 2017 to its current -20.7. Recent macro data are below market expectations and suggest economic momentum is fading.

Using the US economy as a proxy, Figure 1 shows that a pullback in gross domestic product (GDP) growth has historically translated to higher volatility. This time will be no different.

What does this mean?

Complacency is on the rise; Probability of acute market drawdown over next 12-24 months has increased. Currently, the CBOE Volatility Index (VIX) is c.35% lower than its long-term average. Given the advanced stage of the global economic cycle, it is evident that complacency is setting in among global investors.

This is not surprising. The current rally has exceeded seven years and is showing no signs of slowing down. From a portfolio perspective, we believe that there is a need to protect one’s portfolio against potential market drawdown as: (a) The global economic cycle is at an advanced stage; and (b) The recent market rebound has been strong.

Figure 1: Inverse relationship between GDP growth and volatility

Source: Bloomberg, DBS

What should you do?

(1) Have your cake and eat it too – Adopt a cross-asset barbell strategy to maximise upside potential and minimise downside risks. This strategy encapsulates:

  1. Lower volatility
  2. Stronger long-term returns

To validate our view, we constructed a cross-asset barbell portfolio based on the following components:

  • US Technology stocks (25% weight)
  • US Consumer Discretionary stocks (25% weight)
  • US bonds (50% weight)

Our research shows that since 2001, the cross-asset barbell portfolio gained 173% – 58 percentage points higher than the 115% gains registered by the S&P 500 Index. And despite the huge outperformance, our barbell portfolio also had lower volatility. On a monthly basis, the maximum drawdown for barbell portfolio was 9%, in February 2001. In contrast, the maximum drawdown for the S&P 500 was 17%, which was in October 2008 during the Subprime Crisis.

Thus, the above findings underline the superiority of the barbell strategy from a risk-reward standpoint.

Table 1: Barbell strategy generates higher returns with lower risks

Source: Bloomberg, DBS

Figure 2: Cross-asset barbell portfolio has gained 173% since 2001

Source: Bloomberg, DBS

Behavioural finance: Anchoring bias and the likelihood of missing the subsequent market rebound. At the more practical level, having a cross-asset portfolio with 50% equity and 50% bond exposure also has other benefits – especially from a behavioural finance perspective.

During the 2008 Subprime Crisis, the S&P 500 plunged 43% between end-August 2008 and end-February 2009. Given such acute losses, the likelihood of investors “cutting losses” at the trough in February was high. The concept of “anchoring bias” suggests that investors who choose to exit at the trough will unlikely re-enter the market after it starts to rebound.

But the situation could be vastly different for investors with a barbell portfolio that had a 14% loss during the Crisis. The likelihood of investors “cutting loss” when the markets hit a trough is arguably reduced.

A case in point is the very recent selloff in December 2018 in which the S&P 500 corrected 9% whereas the barbell portfolio lost 4%. The smaller drawdown could discourage investors from bailing and missing out on the subsequent rebound. For example, US Technology and Consumer Discretionary, the growth sectors in our barbell portfolio, lost an average of 9% in December, but saw an average gain of 17% in the first quarter of 2019.

Table 2: Barbell strategy is more resilient during periods of market turbulence

Source: Bloomberg, DBS

With all these in mind, investors would do well to adopt a cross-asset barbell strategy to limit portfolio drawdown. This reduces the risk of selling at the worst time and missing out on the subsequent recovery.

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