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Alternative Market Briefing

Missing the worst days in the stock market is better than missing the best days

Friday, July 08, 2022

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B. G., Opalesque Geneva:

As pension funds are lowering their returns expectations, a New Jersey-based manager says a specific stock market hedging strategy might just be the solution.

According to Tom O'Donnell, 3D Capital Management's managing director and former institutional investor, this is another curious time for public pension funds in the U.S. We have recently experienced the longest and second strongest bull market on record, yet the funding status of pension funds remains historically low. Furthermore, the average assumed rate of return has gradually decreased.

Most state pension funds have at least 65% of their assets in equities and alternative investments, says the Pew Charitable Trusts. As historical stock market returns are unlikely to continue, pension funds have been lowering their return assumptions.


Source: pewtrusts.org


Actual investment returns have been declining since the highs of Q2-2020 (10%), according to the Milliman 100 Public Pension Funding Index (PPFI). In May 2022, the average investment return was 0.2%.

Pew shows a long-term downward trend in state public pension investment returns from 2000.


Source: pewtrusts.org

(See also: Asset Allocation for State and Local Pensions, 2021, here)


Actively managing stock market risks

But passively investing in the stock market and expecting lower returns henceforth is not the answer. As stock market returns are to decrease, the investor - be it a pension fund, a fund manager, or an individual should increase her risk management conversely.

The stock market has proven to be one of the most important and best-performing asset classes over the long term. However, focusing exclusively on the long term is not a good risk management technique, says Tom O'Donnell. Stock market declines represent risk. Risk happens fast in the stock market and actively managing risk is the responsibility of every investment professional.

3D Capital's graph below reminds stock market investors that missing just the 20 best days in the stock market (S&P 500) has a big impact on performance. Fear of missing the best days in the stock market fuels the buy-and-hold mentality, but missing the best days is not the problem. The problem is the worst days in the stock market; the days that represent risk of loss. The graph shows that identifying ways to manage the worst days in the stock market has an even bigger impact on performance.


Source: 3D Capital Management

Opportunities clearly exist to make money on the long and short side of the stock market, and the assets investors have allocated to long/short equity strategies are a testimony to this fact. Unfortunately, attribution analysis shows that many long/short equity strategies do not provide significant profits from their short positions. The negative correlation associated with their short positions primarily helps to reduce risk.

Over the past year (to May 2022), equity long/short funds tracked by Aurum, a hedge fund investment specialist in the UK, lost 10.8% on an asset-weighted basis, compared with a loss of 9.5% in the S&P Global BMI Index, and a loss of 0.2% in the Aurum HF Composite.

Rather than trouble oneself with individual stocks, Tom O'Donnell believes the most logical market to use when managing stock market rallies and declines is the stock market itself. The manager relies exclusively on the E-Mini S&P 500 futures contract to manage the long and short side.

3D Capital's tactical short-only S&P 500 strategy is called 3D Defender. The performance associated with 3D Defender is 100% Short Side Alpha. It provides stock market defence only and is used by clients as a capital efficient overlay. 3D Defender has profitably shorted this historic bull market since February 2011. The program was enhanced in November 2013 and is used as a defensive overlay for clients seeking a solution to stock market declines.

Some of 3D Capital's clients combine 3D Defender with long-only passive S&P 500 exposure in a customised program called 3D Hedged Equity.

3D Capital's 3D Hedged Equity program seeks returns that are similar to the S&P but with less risk. The program customized in a 50% 3D Defender exposure and 50% S&P 500 passive exposure has annualised returns of 10.8% from November 2013 to April 2022, compared to 6.4% for the Eurekahedge Long Short Equities Hedge Fund Index, and 7% for the JP Morgan Hedged Equity fund.

The firm's founder and CIO is Eric Dugan, who has worked fifteen years of his three-decade career at billion-dollar funds Trout Trading and Willowbridge Associates.

"I'm an enthusiastic stock market investor and I don't like losing," he says. "Investors who allocate to long-only equity products are guaranteed to lose money when the stock market goes down. I built 3D Capital Management to change that."

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THERE IS NO ASSURANCE 3D CAPITAL'S PROGRAMS WILL ACHIEVE THEIR OBJECTIVES OR THAT CLIENTS WILL AVOID LOSSES.

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