March is shaping up to be one of the worst months on record for many equity markets as investors ran for the doors amid the COVID-19 outbreak. When every investor runs for the doors at once, the resulting jam can cause markets to act in crazy fashions as investors madly search for liquidity.
However, even when investors are losing their heads, there are still ways to prevent or offset some of the losses. Government bonds and gold have been the traditional safe-haven assets, but today there are a huge range of options available to turn the losses into gains.
In the second part of this series, our three contributors discuss the best ways to trade during the downside of a bear market. Responses come from Weimin Xie, MX Capital; Russell Muldoon, Reqon Capital; and David Moberley, Paradice Investment Management.
Sell now, buy later
Weimin Xie, MX Capital
If the objective is to make money on a further market decline, the simple way is to short index futures. Historically, a bear market always intertwined with large relief rallies that could range from 10-20% in a short period of time, so a pure short trade can be extremely gut-wrenching. Gold, gold ETFs, and gold stocks are commonly used to hedge market risk. However, they may not be good hedge during the worst part of the market sell-off as investors sell everything to raise cash or to meet margin calls.
For more sophisticated investors, they could bet on the rising spread or risk premium in the fixed income world, such as credit default swap for Italy’s sovereign bond.
Selling stocks that will not benefit from a bear market is the simplest way to protect capital. The opportunity to buy later at a more attractive price will likely come.
ETFs’ time to shine
Russell Muldoon, Reqon Capital
If your equity portfolio is too large to liquidate (a good problem to have) and go to the perfect hedge (cash), then look to protect any possible downside risk via index futures for example. As we have just seen, gold and bonds can also get caught up in the sell-off in times of market stress and extreme events. The one thing that you thought would protect you doesn’t, and you are left even more stressed. The market at extremes will take its liquidity from anywhere it can find it and doesn’t care what asset A or B has done in the past.
That is why we prefer to use a cleaner exposure like index-level hedging. Several quality ETFs have been heavily employed over the last few weeks, including BEAR and BBOZ. BEAR could be used for example when you have a material proportion of your portfolio in large and mid-cap stocks. This is because such bigger and more liquid names are likely to fall broadly in-line with the market when selling develops. In times of market stress however, its well-known and well-documented that small caps often suffer from a dearth of liquidity and can gap up and down violently. If your portfolio has more exposure to small caps, you might find that BBOZ has a similar level of volatility to your underlying portfolio and may provide a better protection tool.
Learn about the different instruments and ETFs. Understand them and their individual features, their costs (some are expensive to use) and have them ready to deploy should you need to.
Nowhere to hide
David Moberley, Paradice Investment Management
In a market crash you typically see liquidation of everything, and in the early stages cash is the only true defensive. This is particularly evident these days with the amount of programmatic trading and ETF/index funds which can be forced sellers and/or buyers of equities subject to price moves. Gold was one example of this in the most recent crash, with leveraged ETFs being forced sellers. Sometimes, the best companies are well held and crowded, these unfortunately can also be what gets sold down as people raise cash levels. Typically, there is nowhere to hide in the early stages of a crash and cash is king.
Our product is an 130/30 or alpha extension style long short and is benchmarked to the ASX200. It is an equity product rather than an alternative asset or true market neutral and as such investors are looking for equity exposure rather than removing it. So, with that in mind when we look to protect downside, we increase cash holdings, reduce beta in the long book and increase shorts on stocks that will underperform in a down market. As discussed above, stocks with bad balance sheets, external funding requirements, poor management and industry or stock specific headwinds are a great starting point.
Credit spreads typically widen in times of market distress as debt holders become worried about defaults and losses. Take out protection in your portfolio via positions that will benefit from this move.
Trading heavily can be problematic during these times and you do not want to get whipsawed. Trying to trade the bounces is also not recommended. If you are very negatively positioned and want to protect against an oversold rally, using futures to cover equity exposure is a lot more sensible than shifting the positioning on the entire portfolio. It’s also easier to sell after the bounce.
More from this series
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Thanks to Bella Kidman for assisting in putting this article together.