Fear a Market Crash? Look into this ETF.
Over the past month and a half, the market has come roaring back. The S&P 500, represented by VOO, was down 34 percent from the 52-week high (Feb 19, 2020 to March 23, 2020). As of May 7th, the S&P 500 is now only down 16 percent from the 52-week high. If you are not a believer in this new bull run, then you are far from alone. Just look at Warren Buffet’s lack of action so far. Your actions over the next few months could have significant ramifications down the line if you don’t have a plan for the next potential market crash.
What if I told you that there was an easy way to get insurance on the stock market? You probably have car insurance or health insurance, so why not have insurance on your investments? Personally, I have been worried about tail risks and significant market declines ever since I started reading more of Taleb’s work over the past few years. He is a world renowned expert on risk, probability, and uncertainty. If there is one thing I know for sure, it is that I am definitely uncertain about what do to in this crazy market right now.
Looking to Taleb for advice, he advocates for designing your investments to be anti-fragile or resilient in the face of tail events. One of his proposed solutions for designing a resilient portfolio is the barbell approach. The barbell approach involves allocating a large percentage of your portfolio to safe assets, such as short-term bonds or treasury bills. The remainder of your portfolio would be allocated to high risk/reward assets. Unfortunately, Taleb doesn’t come out and say exactly what these high risk/reward assets should be. Even more unfortunate is that many of the stereotypical high risk/reward assets have high barriers to entry. Let’s look at three high risk/reward investment options that might fit the criteria.
Bitcoin. The most famous digital cryptocurrency is a prime example of a high risk/reward option. As of May 9th, 2020, it has grown 53 percent over the last year, 8 percent over the past two years, and almost 4,000 percent over the past 5 years (Source). It has been around for over ten years, which shows optimism that it could last another 10 years if you apply Taleb’s Lindy philosophy. However, even though it has shown significant growth, the high volatility and uncertainty of this cryptocurrency makes it a dangerous investment. Not only that, but the whole concept of cryptocurrency, hash rates, and the blockchain seems incredibly complex. For this investment vehicle, I would consider “understanding bitcoin” a high barrier to entry. Nonetheless, I would still consider a small allocation because Bitcoin has shown to be an asymmetric investment opportunity, but a large allocation would be incredibly risky.
WHAT’S NEXT?
How about private equity? Private equity requires individuals to be an accredited investor, which means you need an annual income of at least 200,000 dollars (300,000 if married) or a net worth of one million dollars or higher. Even if you meet this criteria, it can be difficult to get your hands on the right opportunities without a strong network.
NEXT!
Trading options is another type of investment vehicle that Taleb might have been referring to for the high risk/reward assets. An option is a security that allows you to make a bet that a stock or index price will move up or down past a certain level in the near future. How do you know whether to bet it goes higher or bet that it goes lower? How would you determine how much it could increase or decrease in the near future? How do you define the “near future”? The stock market is incredibly unpredictable in the short term. If you don’t know what you are doing, you could lose A LOT of money investing in options. Just look at this guy who lost almost 2,000 percent in his Robinhood account.
So what should you do to protect yourself from tail risks?
Ironically, the answer is in the question. I would give a serious look at TAIL. This ETF is accessible to anyone with a broker-dealer, such as Fidelity, Vanguard, Robinhood, etc. That means you too, Millennials! This fund “seeks to mitigate significant downside market risk”. It does this by investing in US Treasuries and put options on the U.S. stock market. That means one component of this fund is betting that the U.S. stock market will decline. Fortunately, these options are managed by experienced asset managers who I would trust way more than a novice, such as myself, purchasing options.
This all sounds good and dandy, but how do you know this strategy works? Well, the silver lining of having two significant market declines ($\ge10\%$) over the past two years is the ability to test out this ETF. As seen in the table below, TAIL has performed exactly as intended during extreme market declines. From December 3, 2018 to December 24, 2018, the S&P 500 (VOO) declined 16 percent, while TAIL increased 21 percent. More recently, the S&P 500 (VOO) saw a decline of 34 percent from February 19, 2020 to March 23, 2020, while TAIL increased 28 percent during the same period. These somewhat arbitrary periods of time reflect relative highs and lows of the S&P 500 (VOO).
| Change from 12/03/2018 to 12/24/2018 | Change from 02/19/2020 to 03/23/2020 | |
| S&P 500 (VOO) | -16% | -34% |
| TAIL | 21% | 28% |
If the table doesn’t impress you, then I would take a look at the graphs below to see the stark differences over these time periods.
As any statistics expert would tell you, a sample size of two data points is not enough to make any life changing decisions. As any experienced investor would tell you, Mr. Market doesn’t always make sense. However, the fact that this fund has performed as intended over the past two significant market declines warrants further research and a discussion with a financial professional. There might be a beneficial opportunity here to protect you from the next market crash.
~ The Data Generalist
Disclaimer: I have holdings in TAIL, VOO, and BTC.
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Only two examples…Science would want you to have more data examples to support your positive outcomes in a bear market.
There are more data points if you look at the relationship between the two funds across longer time periods.