Summary

• Since the lows of October 2022, the Hedgewise Risk Parity “Max” strategy has gained over 30%. Additional gains of ~25% are expected in the next 1-2 years, and the path to realizing them is straightforward.
• This is because the net prices of the underlying assets in the portfolio remain quite cheap. Bonds remain down 30% since the peak in January 2022, and a passive version of the Risk Parity portfolio remains down 20%.
• Despite this, Hedgewise is close to breakeven over the same timeframe due to the success of its risk management techniques. This differential is expected to drive net new gains as the underlying assets continue to recover.

Introduction: It’s All Gone to Plan, But This Part Is More Fun

All the way back in July 2022, Hedgewise made a couple of bold claims. It predicted that the drawdown of that year would eventually result in "free" gains of 15-25%, and it also advised clients that it presented a great opportunity to either add funds or increase risk levels. Fast forward to today, and these claims have largely been validated.

The easiest way to visualize this is to compare the live Hedgewise Risk Parity "Max" portfolio to a passive version of Risk Parity, which is represented in two ways in the following graph. The first is a model with simple static weights for each asset class based on historical averages, and the second is the live performance of the UPAR ETF, which is broadly similar.

Hedgewise RP Max vs. Passive Risk Parity Benchmarks, 2022 to Present

The Hedgewise portfolio is now just a few percent from breakeven despite losses of closer to 20% in the passive benchmarks. On a relative basis, this is a fantastic outcome, especially given it was driven purely by systematic risk management. Imagine if you could beat the S&P 500 by 20% every few years with no downside! This is essentially what Hedgewise has accomplished viz-a-viz Risk Parity. But it is important to acknowledge that it has not yet 'felt' very successful because the underlying strategy remains underwater. Of course, this also means that the underlying assets remain incredibly cheap.

Recall that Risk Parity in its passive form is not complicated - it is something like 50% equities, 80% bonds, and 30% commodities (which implies about 60% leverage for the portfolio). The current drawdown persists primarily because bonds are still down over 30% since January 2022, with yields rising from 2% to over 4.4% today. The takeaway may seem like this entire stretch was a bad time to invest in Risk Parity, but that's not true. For example, the following table shows returns for the RP Max strategy at various entry points over this time.

Hedgewise RP Max Returns, Various Entry Points Since 2022

Start Date	RP Max Return
January 2022	-4.3%
June 2022	9.5%
October 2022	31.4%
June 2023	19.1%
January 2024	13.8%

Any client that added funds or increased their risk level after the initial drawdown in January 2022 has now made a healthy return. While it is easy to get hung up on how to have maximized this - obviously October 2022 was a better entry point than June - the more important takeaway is that it has all been a good investment even though rates continued rising for much of this stretch. It hasn't been necessary for bonds to recover or for yields to plateau to achieve solid returns.

This is because Risk Parity is not about a single asset class, but all of them together. A drawdown of this diversified mix, no matter the cause, almost always represents an excellent investment opportunity, and that has been the case for the past two years as well.

What is most striking about the prior numbers is that we are not even far along the expected recovery path. Yields are still at 4.4%, and the net underlying asset prices are still cheap. In the next 12 to 24 months, an additional 25% gain is a reasonable expectation, and there are many economic pathways to achieve it.

The Many Paths to Another 25%

On a basic level, the math is easy. As shown in the first graph, the passive Risk Parity portfolio remains down around 20% since January 2022. For that to get back to breakeven, it would need to gain 25% from here (i.e., 0.8*1.25=1). Hedgewise has been regularly outperforming this passive portfolio since that date and should continue to do so. As more time elapses, it becomes fundamentally more likely that this recovery will occur.

This is because the assets in the portfolio literally pay out money over time, in the form of dividends for equities and coupons for bonds. These payments do not affect the current prices of those assets, which are always forward-looking. As a result, the bar to achieve the same recovery gets lower and lower every year. For example, a 30yr Treasury bond has been a breakeven investment since October 2022. As of today, it would gain ~20% if yields dropped to 3.2%. In October 2022, the same gain would have required yields to drop to 2.7%. This effect accumulates further with every year that passes. In a purely mathematical sense, the path to recovery today is much easier than it was two years ago.

Taking this into account, it is surprising that this drawdown has lasted this long. In addition to the automatic lift from coupon and dividend payments, these assets will tend to hedge each other via fundamental economics. Interest rates have only gone up so much due to a mix of runaway inflation and strong growth. In theory, this should benefit both stocks and commodities enough to offset the weakness in bonds. To the extent that this has not happened, it suggests that one or more assets remains underpriced.

A quick look at history helps to highlight this. The following table is a list of every bond drawdown of 15% or more since the 1970s, along with the cumulative returns of the other major asset classes over the same timeframes.

Performance of Various Asset Classes in Every Major Bond Drawdown Since 1970

Timeframe	S&P 500	Bonds	Gold	Copper
Nov 1972 - Aug 1974	-33%	-15%	148%	41%
July 1979 - Sept 1981	29%	-23%	55%	-1%
Oct 1993 - Oct 1994	5%	-17%	9%	68%
Oct 1998 - Dec 1999	50%	-16%	-5%	15%
Jan 2009 - Nov 2011	46%	-22%	52%	214%
June 2012 - Dec 2013	48%	-20%	-24%	4%
Sept 2016 - Oct 2018	32%	-16%	-6%	32%
Present	24%	-27%	49%	3%

Bonds have already lost more than any other time in recent history, and they were down as much as 40% at one point. Given this, a couple of observations stand out. When interest rates have risen during periods of strong economic growth, which applies to all the timeframes from 1998 through 2016, stocks have generally returned 20-25% more than they have in the present episode. When this is accompanied by strong inflationary pressure, such as in the early 70s and 90s, both gold and industrial commodities like copper have outsized returns as well. Yet copper has remained flat since January 2022.

The closest historical analog is the period from 1979 to 1981, when Paul Volcker prioritized squashing inflation above all else. In that environment, there was just so much uncertainty about how high rates would have to go and how long they would have to stay there. This basically depressed asset prices across the board, outside of gold, which served as a catch-all safe haven. It's a reasonably good proxy for today, in the sense that asset prices back then didn't really make sense either. If economic weakness was on the way, rates were going to come back down. If it wasn't, stocks were undervalued. Once the inflation scare was more firmly settled, the removal of uncertainty alone would probably lift both asset classes, though gold would probably lose its luster.

Fortunately, we can see exactly what happened in the years immediately following.

One, Two, and Three Year Returns by Asset Class After September 1981

Years Following	S&P 500	Bonds	Gold	Copper
One Year Return	10%	47%	-8%	-21%
Two Year Return	56%	66%	-11%	-17%
Three Year Return	61%	74%	-21%	-25%

In this case, both stocks and bonds had plenty of room to run once inflation was broken, and more than offset the corresponding weakness in commodities. In retrospect, both assets presented incredible value in September 1981. But investors had to tolerate a great deal of volatility and misvaluation leading up to that point.

The story today is not the same, but it very likely rhymes.

Back to the Present

Extending the historical analogy, assets were stuck in a holding pattern for over two years beginning in 1979. Interest rates officially peaked in June 1981, which was enough to start to unwind some of the asset price dislocation. A similar date now would be the summer of 2024, right before the Fed finally cut rates in September. If the same kind of price dislocation existed leading up to this year, one or more asset classes would have been expected to rally (and more than offset any weakness in the others).

Here is a look at 2024 performance for Hedgewise and the major asset classes.

Performance of Hedgewise vs. Major Asset Classes, 2024 YTD

At the start of this year, markets were predicting six cuts by the Federal Reserve and bonds were expected to outperform. That is not what happened, as stocks and gold had big rallies instead. That's fine! The point is not to predict which assets will rally, only that the net impact will be positive for the Risk Parity portfolio.

Gold is particularly interesting because it didn’t provide much of a hedge in 2022, though in theory it should have because it is a real asset (the price of which will increase with inflation). Then it suddenly started rallying this year without much of a fundamental explanation. This seems mystifying until placed within the perspective of this broader framework - its price was likely dislocated in the initial 'risk-off' period of Fed hikes, but that was bound to eventually correct.

Looking forward, industrial commodities and bonds are the most likely candidates to rally. Copper and energy should benefit from both strong growth and inflation, but those prices have been artificially depressed by the meltdown in China over the past few years. That country is exporting their deflationary problems to the world, and commodity prices are one of the primary ways that is transmitted. If that situation merely stabilizes, there is a high likelihood that copper and energy prices would be 30-50% higher than today.

Bonds are an easy call just looking at scenarios. The following table shows the expected return from today for a 30yr Treasury bond by the end of 2026 for a variety of terminal yields.

30yr Interest Rate Scenarios by End of 2026

Hypothetical 30yr Yield, End of 2026	Exp. Bond Return
4%	21.5%
3.75%	26.6%
3.5%	32.1%

For some additional perspective, bonds would still breakeven over this timeframe unless yields rose above ~5.25%. This is incredibly outlandish given that the market is currently pricing in a Fed Funds rate under 3.5% and inflation under 2.5% by 2026. If somehow this materialized, the economy and/or inflation would have to be completely booming, and equities and commodities would drive the recovery instead. Not my base case, but also not that different than how 2024 has turned out.

The much more likely outcome is that any spike in yields will be short-lived and based on little more than risk aversion. The Fed has made several mistakes over the past few years and has currently unanchored long-term bonds by abandoning future forecasting and relying on very short-term and volatile data. This is why yields are jumping around 50bps on minor economic reports, and this volatility alone contributes to higher risk premiums.

Investors remain wary of bonds because of what happened in 2021 and 2022. Back then, the Fed had promised zero percent interest rates indefinitely and was still engaged in massive quantitative easing. That world of easy money and artificially stimulative interest rates is exactly opposite of the one we face now. Rates are severely restrictive and we are amidst quantitative tightening. The chance of yields staying above 4.5% for long now is about the same as staying under 2% back in 2020. Yet the memory of 2022, in combination with the heavily data-dependent Fed, contributes to a fragile environment where these yield spikes remain possible despite not being meaningful.

Final Thoughts: Evaluating Risk Parity and Hedgewise

Any sustained period of drawdown will generate doubts for investors, and there have been natural questions about whether something has gone 'wrong' with the Risk Parity framework since 2022. This is kind of silly because the passive form is just a mix of equities, bonds, and commodities. If those assets appreciate over time, so will Risk Parity. If the portfolio has a drawdown, it means one or more of those assets is inexpensive. Abandoning Risk Parity now would be akin to abandoning the stock market right after the dot-com crash or the Lehman crisis.

Specifically, bond yields are higher and more restrictive than any time in the past twenty years. Many commodities have failed to appreciate despite the recent surge of inflation. These facts suggest that both asset classes are fantastic investments at present, not that they should be abandoned. Five years from now, it is likely that current prices will look like strange dislocations, just like gold looked in 2022 before its recent catch-up rally.

Any Risk Parity drawdown is driven by this same pattern, and Hedgewise seeks to systematically outperform by limiting losses when it happens. Ideally, if the passive version were down 10%, Hedgewise would be down only half of that. When it recovers, Hedgewise would have a 5% gain. To the extent this happens over a short timeframe, it is easy to track and understand.

Since 2022, the passive version has lost as much as 40%, and Hedgewise did approximately cut that in half. This should eventually be worth 25% of extra gains, which will represent one of the most successful periods of risk management ever. But it has been harder to recognize this as a success due to the sheer size of the drawdown and the length of time it has taken to recover.

Any Hedgewise clients that have simply held since January 2022 will reap this reward, and chances are high that it will happen in the next 1-2 years. In the bigger scheme of the strategy framework, this has all gone pretty much how it is supposed to go. It has taken a little longer than usual to get here, but this last part where asset prices recover should be the most fun.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Since January 2023, the Risk Parity Max strategy has gained almost 10% despite a persistent drawdown in fixed income and heightened market volatility. It has also outperformed its benchmarks by over 6%.
• Equities, gold, energy, and copper have all contributed to net gains in the portfolio since the peak in January 2022. Bonds have also contributed gains since October 2022 despite rising yields, which highlights the resilience of fixed income once rates have become restrictive.
• Bonds are expected to gain at least 25% once rates fall back to 3.5% or below. However, there is no rush for this to happen, as they should yield 5-6% annually through a combination of higher coupons and volatility management.
• Overall, the recovery has gone very well and in line with expectations. Unfortunately, short-term volatility in the bond market can distract from this bigger picture despite it posing little threat to long-run returns.

Introduction: The Big Picture Recovery Looks Excellent

A remarkable feature of the post-pandemic investing landscape has been its short-termism. Between the retail crowd, the dominance of options contracts, and the hyper-short news cycle, there is now much greater interest in what might happen over the next few days rather than the next few years. This has resulted in many bizarre market outcomes, most easily viewed through the lens of “meme stocks”, but also applicable to entire asset classes like Treasury bonds.

For example, last fall, we saw yields on the 30yr bond jump from 4% to 5% almost overnight, only to fall back below 4% a few months later. As discussed in prior newsletters, this had little to do with any fundamental shift to the economy; the best explanation is that a notable hedge fund manager tweeted that he thought yields were too low and set off a panic chain-reaction. Once this subsided, yields quickly reversed.

12 Month Trailing 30yr Treasury Bond Yield

While rates have surged yet again this year, the story rhymes. The dominant explanation this time is that the Fed is going to leave rates higher for longer, but more restrictive short-term rates are designed to slow future growth and inflation. The more time that the Fed leaves rates at 5.5%, the more likely that 30yr rates eventually fall.

Debate will go on about why the market appears frequently hijacked by fast money and irrational prices, but it does not matter from a Hedgewise perspective. This is true across all asset classes, but especially so for Treasury bonds given their formulaic nature. Unfortunately, this meaningless yield rollercoaster can make it much harder to recognize how well the Hedgewise strategy has been performing.

Hedgewise Significantly Outperforming Its Benchmarks Since 2022

Since 2022, Hedgewise has outperformed a passive Risk Parity benchmark (as measured by the RPAR ETF) by over 5% annually, and it has outperformed a passive investment in 30yr Treasury bonds by 14% annually.

We can also zoom in on the period from 2023 to confirm the consistency of this relative outperformance.

A differential of over +6% (compared to RPAR) is remarkable over such a short timeframe.

The Recovery Is Precisely On Track

Back in July 2022, this newsletter projected that Hedgewise would eventually "create" new gains of 5-20% as a function of the drawdown that year. More specifically, since Hedgewise had successfully mitigated losses, it merely had to return to historically average asset weights to generate an outsized recovery. To visualize this, the following chart compares the live RP Max strategy to a model portfolio composed of historically average asset weights at the same risk level.

The gap between the blue and red lines represents these potential "new" gains, or the amount that the Hedgewise Max strategy would expect to gain when the red line returns to breakeven. As of April 16, this is worth around 21%, which is north of the upper end of the original estimates. The key to fully realizing this gain is simply to track the red line as it recovers. The following chart zooms in on how this has gone since January 2023.

This story is simple and compelling. Hedgewise avoided a big drawdown, and is now fully participating in the recovery, which had reached 9% in April. This is a great outcome in a little over a year, and there is still a huge amount of upside remaining.

Every Asset Class Has Generated Net New Gains, Except Bonds

A more granular way to analyze the recovery is to break down how each individual asset class has impacted the Hedgewise portfolio since the peak in January 2022, which is shown in the following table.

Asset	Net Impact on RP Max Since Jan 2022
S&P 500	2.5%
Commodities	9.9%
Bonds	-24.3%
Est. Leverage Cost	-4.1%
Total	-16%

Both equities and commodities have already reached or surpassed their January 2022 peaks. Just as the model predicted, these asset classes have also generated net new gains for the RP Max portfolio. This highlights how the theory is no longer hypothetical; the goal was achieved in line with expectations for these cases. We are simply waiting for bonds, but bonds are unique in how little it matters whether the recovery happens in six months or six years.

Why Bond Math Is Amazing and Often Misunderstood

Once interest rates become restrictive, fixed income has three tailwinds that make it very compelling as an investment. First, investors receive higher coupons. Second, assuming rates truly are dampening economic activity, they will tend to reverse lower once inflationary pressure has abated. Third, and unique to Hedgewise, there is an opportunity to systematically take advantage of bond volatility, as it makes sense to add exposure as rates go higher and vice versa.

Taken together, these factors make it very hard to lose money in bonds over a medium time horizon (i.e., 2 years or longer). However, it can be difficult to see this benefit without the proper perspective. For example, 30yr Treasury bonds have lost over 37% since January 2022. But it is more useful to separate it into two periods - the initial drawdown from January to October 2022, and the period thereafter. This allows for a more accurate assessment of how bonds have performed once rates became restrictive.

30yr Treasury Bond Performance Since October 2022

Since the end of October, 30yr bonds are basically breakeven. This is even though bond yields have risen from a peak of 4.4% back then to 4.8% today. Within the Hedgewise portfolio, volatility management has also added another 3% over this timeframe, making it a net positive investment. If rates merely return to the original level of 4.4%, bonds will have provided north of a 10% gain.

This is why the wild short-term swings over the past year and a half have been relatively meaningless in the larger scheme. Once rates get this high, bonds are a sound investment because there is such a large buffer accruing over time. We take advantage of the volatility on the margins, but these month-to-month movements, however large, do not change the underlying investment thesis.

From this perspective, there isn't much to second guess about how the framework has managed bonds since October 2022. But what about the initial drawdown? It's all part of the same theory, and it's all still going to plan.

Evaluating the Initial Bond Drawdown

The basic idea of risk-managed drawdowns is always the same: the impact of the initial loss needs to be less than the subsequent gain. We explored earlier how this has already been successful for equities and commodities since January 2022. Bonds are replicating the same process, just on a longer timeframe. For bonds uniquely, the length of this timeframe does not really matter.

It is easier to understand this with data and scenario planning. For a moment, imagine that 30yr bonds return to a 3% yield at some point in the future. The following table models the expected net impact to the RP Max portfolio from January 2022 to that final date, with the only variable being how long it takes to resolve. For example, the first row assumes that 30yr rates fall to 3% by this July. In that scenario, bonds would gain a total of +7% in the RP Max portfolio, measured from January 2022 (equal to 2.6% annualized over two and a half years), and 38% measured from today. Note that this is incorporating live data through April, and model assumptions begin looking forward from today.

Scenario 1: 30yr Rates Fall to 3%

Time	Return From Jan 22	Annualized	Return From Today
2 months	7%	2.6%	38%
2 years	16%	3.3%	50%
4 years	26%	3.5%	62%
10 years	59%	3.7%	105%

The longer it takes for rates to fall, the larger the expected annualized return. The math behind this is not complicated - bonds yield somewhere between 5-6% annually in the model through a combination of coupon and volatility management. The longer you get this yield, the higher the final annualized return will be. All these numbers include the initial drawdown, which is more than recovered regardless of when rates return to 3%.

There are a few big takeaways. The first is that much of the work was done during the initial drawdown from January to October 2022, when Hedgewise approximately halved bond losses compared to a passive investment. This is the amount that can be recaptured upon recovery and anchors the numbers in the prior table.

Second, bonds are the unique asset class where time amplifies expected returns. You do not get a higher coupon or the benefit of volatility management in equities or commodities, but this is a systematic feature within fixed income.

Finally, though we are ambivalent to the interim volatility, the fact that rates have swung as high as 5% recently only increases the likelihood that they will fall to 3% or below in the future. Any company or individual that refinances at these punishing levels will be impacted for years, and it is worse the higher rates go. In fact, a recent paper by the San Francisco Fed found tight monetary policy can reduce potential output for over a decade.

Fun With Rate Scenarios

The biggest underlying assumption is that 30yr rates eventually fall to 3%. Considering the Fed pegs its neutral rate at 2.7%, that we spent the better part of a decade with rates under 3%, and that current rate levels have essentially frozen entire parts of the economy (e.g., housing and car loans), I don't think this is a big stretch. To settle at 3.5% or above, productivity and/or population growth would need to surge in the years ahead. But just for fun, we can model a couple other rate scenarios.

Bear in mind that any final rate below today's (roughly 4.8%) represents a gain, and that a 0% return measured from January 2022 is the same as a ~30% gain measured from today.

Scenario 2: 30yr Rates Fall to 3.5%

Time	Return from Jan 22	Annualized	Return From Today
2 months	-2%	-0.9%	26%
2 years	6%	1.3%	37%
4 years	16%	2.2%	49%
10 years	48%	3.2%	91%

Scenario 3: 30yr Rates Fall to 4.5%

Time	Return from Jan 22	Annualized	Return From Today
2 months	-18%	-7.2%	6%
2 years	-10%	-2.2%	17%
4 years	-1%	-0.1%	28%
10 years	31%	2.1%	69%

I think the most interesting number is the 10yr annualized return in the 4.5% scenario. Even in this edge case, bonds will still have contributed a 2% annual gain to the portfolio measured from January 2022. This drives home the bigger picture that the 2-4% annual return range is boringly consistent. If rates settle higher, it just takes longer to eventually get to the same place.

The other notable observation is how high the return from today is across all scenarios. Outside of a permanent rise in yields above 4.8%, bonds should be an excellent investment irrespective of how it compares to January 2022.

Addressing a Few Outstanding Questions

But what if rates do go up to 5% or 6%? Such levels would very likely break the economy and cause a recession like the Volcker-induced slowdown in the early 1980s. Otherwise, you need to assume some combination of permanently higher inflation (3.5%+) and permanently restrictive rates (2.5%+), and it requires mental gymnastics to imagine this realistically. Presuming rates do get this high but only temporarily, the analysis of this article remains the same with a small boost from higher coupons and additional volatility management.

The initial bond losses from January to October 2022 were significant. Could that have been better managed? For reference, 30yr Treasures lost around 33% in those 10 months, compared to an impact of -17% on the RP Max portfolio. Historically speaking, this was both the largest bond drawdown and the most successful loss reduction as far back as data can be modeled. A more aggressive intervention would have required some level of active management and timing.

Finally, why does it make sense to ignore the bond volatility since October 2022 rather than try to take advantage of the swings? Hedgewise has been adjusting exposure throughout, and that is referred to as bond volatility management. It is just in small amounts (i.e., 1-5% monthly) by design. This is because bonds have an asymmetric payoff profile with rates this high. If yields go up another 1%, bonds lose 14%, but they gain 18% if yields fall by the same amount. There are also the tailwinds discussed earlier: a 5-6% annual yield, plus the constant squeeze on the economy from restrictive rates. Lastly, the swings in the market have been rapid and often driven by nothing fundamental - from a risk management perspective, it is much more dangerous to try and time such an environment than to simply wait it out.

Conclusion: But Why Is All This Happening?

Short-term fluctuations have never been very meaningful to Hedgewise, and hopefully this analysis makes it easier to look past the noise. Yet the frequency, extremity, and seeming irrationality of the markets over the past few years has understandably drawn attention. It is not necessary to demystify this for Risk Parity to be successful, but I'd say the crux of it is that the Fed messed up badly, and as a result has become excessively data-dependent and backwards looking. This has fed into post-pandemic market dynamics of leveraged short-term bets and price dislocation that often overwhelms fundamentals over periods of a few months.

The big questions are whether interest rates are restrictive and why it may take a little longer than usual to see the impact. Instead, the Fed is saying "we don't know what is going on", which forces the broader market to react similarly. If one bad inflation print happens, maybe rates are not restrictive, maybe we have to re-think everything. Maybe rates will have to go up even more!

There is a relatively easy story to contextualize this: interest rates are restrictive for the parts of the economy where debt is required, like mortgages and car loans, but not enough of the economy has been impacted yet. It is not realistic to expect growth and inflation to slow down until it affects more individuals and companies. The main question is how long that will take, not how high rates have to be or whether rates matter at all.

If the Fed had strong credibility and conviction, it could explain this. Perhaps it will take 3 years to have enough bite, and inflation will slowly drift down from 3.5% over that time, but there isn't really a way to speed it up that involves interest rates alone. A coherent narrative like this would stabilize long-term interest rates and limit overreactions from month-to-month, but since it doesn't exist, we are left with the current situation.

Interest rates may already be too restrictive, meaning that the parts of the economy that are affected are being punished too severely when they won't meaningfully impact headline inflation either way. This would likely remain true even with higher rates, which would then only matter if they had a psychological impact of pushing the economy into a downturn. Yet inflation may already be on its way to being under control if the Fed could present this forward guidance believably. Unfortunately, it lost too much credibility in 2021 to do so.

If this is happening, rates will stay too high for too long. If the Fed cannot tolerate 3-3.5% inflation while this process plays through, a hard landing may be the only option. Keep this in mind if we do see additional pressure on yields and try not to sweat the volatility.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Real interest rates continue to swing around wildly, despite little news of note regarding the long-term growth and inflation outlook. While this is contributing to significant volatility in the Hedgewise portfolio, longer-term risk is declining every day that rates remain this high.
• The economy is naturally restricted by real interest rates above underlying real growth, which is driven exclusively by worker productivity and population. These factors are unaffected by fiscal deficits, bond auctions, and supply/demand curves. If the current real rate is above this level of growth, the economy will be constricted.
• Long-term real expected GPD growth is estimated to be 1.8%, and the long-term real interest rate is currently near 2.5%. This dynamic will negatively impact the economy, thus limiting its ability to persist. The longer it continues, the more future growth will suffer (and the lower future interest rates will likely be).
• Since these rates are unsustainable, Hedgewise focuses on how to systematically take advantage of the situation. Ironically, the best opportunities arise the longer that rates stay high, and the slower that they come down.

Bonds Feel Scary, but They Are Not

For a moment, put aside the crazy bond market volatility over the past few months, and consider the following. If you invest in 20yr Treasuries at 4.85%, you will gain 12% over the next 12 months if rates fall 50bps, and you will lose 1.1% if rates rise 50bps. Expanding on this, here is a view of expected 20yr Treasury performance across a variety of interest rate scenarios over the next 12 months.

Bond Scenarios Over Next 12 Months

If you have a time horizon of at least one year, it will be very difficult to lose money with these bonds. Even if rates rise all the way to 5.85%, which would be extreme for many different reasons, further losses would be limited to under 7%. This perspective is easily lost amidst the significant volatility over the last two months, but it is far more important than what is happening day-to-day, and a much more accurate picture of true "risk".

This picture improves even further if you add on a layer of probability. Given that real rates are now the highest in the past 25 years, and meant to be restrictive on the economy, there is a much better chance that rates will fall than that they will rise.

If you can maintain this broader perspective, the recent volatility is much easier to tolerate. What happens over a few days or weeks has little to do with the 12-month horizon. To the extent that rates become more restrictive over the short-term, this increases the chance of lower long-term rates because it will tighten financial conditions and threaten growth.

A challenging aspect to this story is that it was already true when rates were at 4%, and the sheer size and speed of the recent losses can create a sense of panic and second guessing. However, it is very risky to try and time losses as rates go from somewhat restrictive to very restrictive. Not only is it unlikely to persist for very long, but you also miss out on higher coupon payments along the way. Instead, Hedgewise avoids these pitfalls by systematically adding to its exposure as rates go higher, which increases long-term expected returns without any timing risk.

A useful way to visualize this is to rewind back to July, when 20yr rates were near 4%, and compare different expected three-year outcomes. In the following graph, the first scenario assumes that rates never exceeded 4% after July and fell slowly to 3.5% by 2026. The second scenario allows rates to rise just as they have over the past few months before falling to the same 3.5% by 2026.

July 2023 Three-Year Bond Scenarios: 4% Peak vs. 4.85% Peak

The difference between the two scenarios is driven primarily by the assumption that bond exposure is increased by 15-25% once rates peak at 4.85%. Provided that occurs, there is no doubt that the higher interest rate scenario is preferred despite the initial drawdown. However, the exact amount of additional exposure depends partially on bond volatility. The longer that bonds are stable near the peak, the higher the chance that the second scenario is fully realized. On the other hand, if rates quickly reverse course, there is less potential opportunity, as shown by the third line below.

July 2023 Three-Year Bond Scenarios: 4% Peak vs. 4.85% Peak vs. Quick Reversal

So, all else equal, we prefer interest rates to overshoot, and we prefer for them to stay there a while. This may be uncomfortable due to the initial drawdown, and dramatic intraday volatility may fray nerves further. Yet it is still the optimal outcome, and there truly is little long-term danger. Even if rates stay at 4.85% until 2026, you will have been paid that coupon throughout while maintaining the potential upside. The logic remains true at a peak rate of 5%, 5.5%, and even 6%.

The single key underlying assumption is that interest rates above 3% truly are restrictive. That isn't really the debate happening in the market right now; most pundits are focused on the fiscal deficit and the inability to find enough buyers for an increasingly large amount of government debt. If that is the main story, it is only making already painful rates hurt even more (because a large debt auction has no offsetting positive macroeconomic impact). There is no ending besides one where the economy slows or reverses.

The only scenario where such high rates are not restrictive is one where real economic growth is extraordinarily strong, which has nothing to do with these supply/demand issues. To provide some context, the Fed estimates the neutral real rate of interest to be about ~1% under real annual GDP growth. To justify a real rate of 2.5% (where it is around now), real GDP growth would need to average 3.5%. Historically, this rate averaged 2.0% in the 2010s, 1.9% in the 2000s, 3.2% in the 1990s, and 3.1% in the 1980s. It is exceedingly difficult to imagine we are entering the fastest period of growth in the past 40 years, but this is what would need to make sense to worry about whether these rates are here to stay.

This may suggest the potential impact of AI, but that theory has several holes in it. If that technology is going to supercharge global growth, it wouldn't only impact the US while Europe and China struggle as they have been recently. It also doesn't follow that the catalyst for higher rates would be increased Treasury debt issuance, as opposed to news about AI's impact on earnings and employment. Even if AI has some real role, the current level of rates would already account for faster growth than the dot-com era.

However, the main takeaway is not about predicting the future or figuring out exactly what is going on with interest rates. The point is that the potential outcomes are lopsided to the upside. Over the next year, even another 0.5% increase in the 20yr rate will be almost fully offset by ongoing coupon payments. If the economy is being restricted at these levels, it is essentially assured that rates will come down. The more restrictive rates become and the longer they persist, the lower the eventual terminal rate is expected to be. Even if AI really is the next coming of the internet, and fiscal spending continues unabated, the current real interest rate already accounts for these factors. It is very hard to envision a world where 20yr bonds are a poor investment over the next few years.

I have no idea what will happen day-to-day, and volatility will likely continue until this all has time to work through the real economy. But from a 12-month perspective, there is little reason to worry and more reason to cheer on the crazy swings so we can take advantage of it - with no timing required.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• The volatility in August was caused primarily by Treasury bonds, where such swings are automatically taken advantage of by the risk model and carry little meaning longer-term.
• Hedgewise has continued to outperform its benchmark this year after beating it by nearly 10% in 2022, which is a testament to the ongoing success of its techniques.
• The primary danger for clients is to overreact to short-term drawdowns which effectively improve the medium and long-term outlook.

Introduction: Looking Through the Noise of August

After a relatively boring summer, August arrived with a bang, especially in the Treasury market. Thirty-year yields have soared from around 3.8% to 4.3% since mid-July, despite relatively little news, and at one point surpassed their highs of last October. It has been a stressful few weeks, not least because there lacks a cohesive and rational explanation. The fact that this happened in August, when liquidity is typically thin, has only added to uncertainty and exacerbated daily swings.

While it is natural to seek an explanation, the fortunate reality is that it does not matter very much, especially from a Hedgewise perspective. For some broader context, maddening volatility has been a feature of the past twelve months. Last October, 30yr yields jumped from 3.25% to 4.25% in three weeks, only to fall back down to 3.5% a month later. A compelling rationale remains elusive and will likely remain that way. The most relevant lesson is not in explaining exactly what happened, but rather in understanding that such events are better off ignored. While this is true broadly, it is even more applicable when seen through the lens of risk management.

From a Hedgewise perspective, the main theme since last year has been how to maximize the potential upside of a recovery after successfully mitigating losses in 2022. Prior articles discussed why a choppier environment would be preferred because it would present additional opportunity for gain. While this is true across all asset classes, it is especially relevant to Treasury bonds.

Earlier this year, the specific scenario that just unfolded in the Treasury market was modeled. The following is an updated graph that compares how bonds were expected to contribute to the Hedgewise portfolio across various interest rate peaks (assuming yields eventually settled at the long-term Fed projected neutral rate of 2.7%). Higher terminal yields resulted in higher expected terminal gains due to bigger interest payments (e.g., 5% vs 4%) and higher expected exposure levels (i.e., as yields go up, implied bond risk goes down, resulting in larger portfolio allocations). The bright green line shows how bonds have impacted the live RP Max portfolio along the way.

Interest Rate Model vs. Live Bond Performance in RP Max Portfolio, From October 2022

Up until July, Hedgewise had been hugging tightly to the 4% peak line. This was notable for how well live performance was matching the simulation, helping to validate the underlying assumptions and build confidence that the final expected gains would eventually be achieved. Over the past two months, we have hopped down to the "5% Peak" yellow line. This effectively increases the expected terminal gain from 28% to 36%, but the reality is nuanced. We can only secure that extra return if rates stay this high and continue to bounce around; that potential will disappear if rates quickly revert to the blue 4% Peak line. This explains why Hedgewise prefers bigger drawdowns that are sustained for longer in the bond market.

Of course, the key assumption is an eventual reversion of 30yr rates to 2.7%. If you know for certain rates will eventually fall to that level, it is easy to look through short-term volatility. When yields are skyrocketing like they have in the past three weeks, this may seem harder to believe. Though the case for 2.7% remains very strong, due to fundamental factors like the plateauing of the US population, the Fed's mission to keep inflation at 2%, and the self-limiting impact of restrictive rates, it is still worthwhile to play devil's advocate and imagine if rates do stay higher.

At the most extreme, let's imagine that 30yr rates rise all the way to 4.5% and never fall back down. Given that rates ended the month at 4.3%, that would imply a total additional loss of about 4%, all of which would be recovered via coupon payments in under a year. Given that, it is hard to argue that bonds are a bad investment even in this worst-case scenario. There is only additional downside if rates rise quickly and permanently above current levels (since coupon payments will continue to offset any losses over time).

The Big Picture on Bonds

With this logic in mind, the basic theme for 2023 is that bonds with 4% yields look like a great investment, and Hedgewise is much more interested in capturing future potential upside than avoiding additional downside. As yields go higher, Hedgewise simply increases its exposure further. The wrinkle is that it can feel like bad timing in the short-term despite adding to your net expected gains in the long-term.

This is a mathematical illusion in a sense. Consider the following hypothetical investment scenario that tracks bond yields and portfolio allocations over four months.

	Bond Yield	Portfolio Allocation
Month 1	4.00%	70%
Month 2	4.25%	80%
Month 3	4.50%	90%
Month 4	4.00%	70%

At the end of four months, you get a total net gain of 2% even though yields start and end in the same place. But at the end of month 2, you have more than a 5% loss because you increased exposure as rates were rising.

Net Performance Impact of Bonds in This Scenario

This exhibits how spiking yields are positive for the portfolio but will feel negative if you freeze frame in the middle. It is crucial to keep this perspective and avoid overreacting to short-term drawdowns, especially if that is happening in the bond market when yields are elevated. This is not a case of bad timing or poor risk management, but rather the opposite.

Not coincidentally, the live Hedgewise portfolio was positioned similarly to this scenario at the beginning of August, and bond yields were close to 4%. A quick look at this month's performance confirms that bonds have been the primary driver and supports the applicability of this example.

RP Max vs. 30yr Bonds, August 2023

In this new light, it should be easier to understand why such a bond-driven drawdown is not a concern for Hedgewise; in fact, it is viewed opportunistically. It would have been preferred if rates stayed as high as they were around August 20, since that would provide the opportunity to add additional exposure. Regardless, it is very human to experience significant stress and doubt at that moment, and to root for an immediate recovery, even though that would reduce expected longer-term gain.

This can be a very dangerous situation for investors, as it is precisely the wrong time to consider selling even if rates plateau or move higher. The only exception would be if rates were going to permanently settle at a higher level and never again fall below where they are today. If either of those conditions fail, Hedgewise will inevitably capitalize on this volatility, and it is just a matter of when.

In addition, from a common sense perspective, it is helpful to understand relative positioning in the live portfolio. In August, bond exposures were very close to the historical average. From a risk perspective, this means the model was assigning around a 50% chance that rates had peaked, which is no more than a coin flip. This leaves plenty of room to add exposure if yields continue to rise, and it also helps to highlight that this is not an aggressive stance.

It can be challenging to shift the mindset for bonds in this way because the implications are counterintuitive. Larger short-term losses beget larger long-term gains which would not be possible without the interim drawdown. The expected opportunity will grow as the drawdown increases. Yields need to stay elevated for months to allow this process to successfully play out. Short-term performance is not meaningful because all that matters is the terminal interest rate. Any time spent above that level is opportunity in waiting, and Hedgewise will be systematically taking advantage of it.

In short, you would need a projection of 5%+ interest rates that last indefinitely and without interruption to justify worrying about this bond volatility. This would imply some combination of a permanently restrictive rate, failure of the Fed to achieve 2% inflation, and successful avoidance of any future recession in the US that would cause the Fed to make substantial cuts.

Evaluating Performance and Wrapping Up

Another tricky element of this framework is that its success does not show up in short-term performance. Rather, it builds over time as Hedgewise takes advantage of volatility. This year has presented a great testing ground for that, as rates have bounced around significantly since January. One way to measure the framework's success is by comparing how Hedgewise has done vs. a passive Risk Parity framework like the RPAR ETF, which holds a more static bond allocation and thus does not benefit from higher short-term rates.

Hedgewise vs. RPAR, January 2023 to Present

Hedgewise has achieved outperformance of over 2% in a relatively short timeframe, and a large piece of that can be attributed to the bond framework just discussed. This differential is much more important than any of the short-term swings, which have been driven largely by interest rates and belie the persistent longer-term recovery potential. Speaking of that, nothing that has happened this year threatens the expected ~40% recovery discussed in the last article. That was based on an eventual return to asset price levels as of January 2022, which included yields returning to the estimated neutral level of 2.7%. Bonds now have an opportunity to increase this total potential because of the rise in rates this month - provided they can stay high for long enough!

This article has focused deeply on bonds because that asset class has been the driver of most of this year's volatility. However, an equally important theme happening behind the scenes is the normalization of exposure across all assets, including equities and commodities. In 2022, Hedgewise was successful in minimizing its drawdown because it was broadly underweight exposure. This could only translate to net new gain if it returned to neutral or overweight prior to each asset's recovery, which has already largely happened. As a result, last year's relative outperformance has persisted into 2023.

Hedgewise vs. RPAR, January 2022 to Present

So long as you can step back from the short-term swings, everything has gone almost exactly as it should in terms of risk management. After a year like 2022, when so many assets have gotten cheaper at once, the preponderance of risk shifts to the ability to participate in any recovery. Considering that alongside the design of the bond framework discussed earlier, this volatility in August is neither a surprise nor a problem. The biggest challenge is remembering that even when yields are jumping and the collective investment community is panicking about the future of fixed income.

Looking forward, the themes have not really changed since the start of the year. Hedgewise continues to prefer a choppier, slower recovery. While asset exposures have all returned near average, there is still opportunity to increase weights further as risk settles or additional drawdowns occur. The possibility of a "higher-for-longer" Fed fits right into this narrative. It should help to more fully stabilize inflation, wring out remaining excesses of fiscal spending and post-pandemic bubbles, and encourage additional market volatility. All in all, Hedgewise had a pretty good August and maintains an excellent medium-term outlook. It just isn't something measured in month-to-month performance.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• In terms of loss avoidance, 2022 was one of the best years ever for Hedgewise. Moving into 2023, the focus is how to optimally translate that success into gains.
• From the October bottom, a 40% recovery is a relatively moderate expectation over the medium term (at the "Max" risk level). Clients have already recovered 7% as of March 1, and had gained as much as 13% at an earlier point in February.
• Ironically, such fast gains are not the preferred path, and the drawdown last month was welcome. From a risk management perspective, a slower and choppier recovery is more likely to amplify the available upside.
• We'll dive into the logic behind this and look in detail at how the various risk management mechanisms have been functioning thus far in 2023.

Overview: A Good Spot or a Better One

From a big picture view, Hedgewise is in an excellent position for 2023, and there is less of a question of 'if' there will be a recovery, and more of a question of how big it will be. This is true despite tumultuous macroeconomic conditions and multiple errors by the Fed that have increased the risk of stagflation and dislocated the 'real world' economy (e.g., a frozen housing market, excessively tight labor markets, continued supply chain snarls) True to form from a hedging perspective, Hedgewise stands to benefit from increased turmoil (and short-term losses!), though it will also do just fine if it all resolves calmly.

The reason for this is because of the relative success of last year. As highlighted in the last newsletter, Hedgewise was at or near minimum exposures in most asset classes throughout the drawdown of 2022. This significantly limited losses, which can be seen by comparing live client performance to a portfolio in which each asset class is fixed at its historical average weight (labeled "RP Max, Historical Avg. Weights below).

Hedgewise vs. Historical Average Risk Parity Portfolio in 2022

The larger the gap between the blue and red line, the greater the opportunity for net new gains over the long run. At any point during the drawdown, the portfolio could be set back to its historical average weights and be guaranteed to pocket the difference as the recovery unfolds. The tricky part is exactly when to do that, and with which asset classes (since additional losses could also accrue).

That said, let's oversimplify. Imagine you could have magically identified October as the bottom in real-time, and you shifted all exposures back to their historical averages at that precise moment. Let's also fast forward to some point in the future when stocks and commodities have recovered to the prices of January 2022 and bond yields have returned to neutral (which the Fed estimates at 2.7%). At that point, this hypothetical portfolio would gain about 40% from the bottom.

Now switch to a worst-case scenario where you remain stuck at the weights immediately prior to October with no opportunity to re-weight. That portfolio would still gain 30% upon the same point of recovery because bond exposure had already normalized before October, locking in much of the potential benefit.

This is why a 30-40% gain represents a conservative expectation over the medium term. Risk assets will almost certainly return to their January 2022 levels within the next few years, though it could also happen within six months. Either way, there will be a significant gain, it is just a matter of how much.

With such a strong outlook, it is ironic yet understandable that many clients remain hesitant to deploy their cash. Worry remains that the worst is yet to come, and Treasury bills yield a hefty 5%. Yet it is vital to differentiate the Hedgewise portfolio from equities in isolation and other passive benchmarks. Hedgewise utilizes risk management techniques that benefit from a choppier recovery and additional drawdowns, the impact of which can already be measured in live performance. "Bad" outcomes like stagflation or a severe recession would only add to net expected returns.

Fortunately, there is now enough data over the past year to examine and better understand this in real-time.

Evaluating the Recovery Since October

Let's return to the baseline assumption that all asset prices bottomed last October. At that point, Hedgewise had succeeded in limiting its drawdown because exposures were lower than average throughout 2022. To most effectively translate this into net new gains, Hedgewise has two available paths. The most obvious is to increase asset weights prior to a recovery. The second is to take advantage of market volatility through monthly exposure adjustments (i.e., selling a little as prices go up, and buying a little as prices go back down).

For both options, a slower and choppier recovery is preferred. This is simple probability: the longer that prices remain low, the higher the chance that asset weights will normalize (and that risk levels will return to average). Similarly, there is no chance of benefitting from market volatility if prices only go in one direction.

The 'historical average' Risk Parity portfolio from earlier is useful to track as a benchmark. While it is not realistic to achieve its performance from the onset of a recovery, since that assumes foreknowledge of the precise bottom, it helps to evaluate how much 'potential' gain Hedgewise has successfully captured. The closer the blue line is to the red line, the more ideal the recovery, and vice versa.

Hedgewise vs. Historical Average Risk Parity Portfolio, October 2022 to March 2023

As of March 1, the Hedgewise recovery has been close to perfect. However, it was much 'worse' at the peaks in December and February, during which Hedgewise had foregone approximately 4% of potential gain. Likewise, the 6.7% gain at the beginning of March is much 'better' than the same gain near the beginning of December. The precise reason varies over time and isn't particularly important; the main takeaway is that gains may be bad and losses may be good in the context of total opportunity.

This is not a matter of market timing, but rather systematic probability. As prices fall, Hedgewise is more likely to add exposure. Risk management techniques take further advantage of the volatility. This dynamic would remain true even if prices fell back to the October bottom or below.

The intuition behind this can be challenging, but it can be more easily understood in the bond market, in which risk is the most obvious to measure and manage.

Live Proof in the Bond Market

Risk in US Treasuries is more definitional than other asset classes because interest rates can only go so high or so low, and you eventually get your money back either way so long as the government pays its bills. As a result, it is easy to categorize a Treasury bond paying 6% as less risky than one paying 2% (since you pay less for it upfront and get higher coupon payments to boot).

Hedgewise adjusts its risk estimates to account for interest rate changes month-to-month, and often shifts its bond weights 3-5% as a result. The more that rates bounce around, the more opportunity there is to benefit.

The following chart shows how recommended bond exposure for the RP Max portfolio has shifted each month since last September alongside realized monthly bond returns. The dotted red line is added for emphasis on the divide between a positive or negative monthly return.

Hedgewise Recommended Bond Exposure vs. Monthly Return, RP Max, September 2022 to Present

Between September and February, 30yr bond yields were little changed overall: they moved from approximately 3.4% to 3.5%. However, significant volatility in the interim provided an opportunity to slightly reduce exposure as prices went up and vice versa. The net result from exposure changes over this six-month period was a net gain of 0.7%. This amount is independent and permanent, in that it depends only on volatility and has already been fully realized.

While this is straightforward, it can be easy to lose track of day-to-day. For example, between last September and November, bonds suffered a loss of 9% before subsequently recovering, which contributed to a drawdown in the Hedgewise portfolio at the time. Yet this was necessary to unlock an extra 0.7% gain that would not have been available if rates had remained steady.

To expand on this idea, it is worth revisiting a model shared in the last newsletter. The following was a simulation for how bonds would be expected to impact the RP Max portfolio over a five-year timeframe. The first part of the chart uses live performance data from last January to October, and then splits into different assumptions for where interest rates will finally peak (the 3% peak assumed that rates fell quickly from their level in October to 3%). At the end of five years, it is assumed that rates had returned to neutral at 2.7%.

Comparing Expected Bond Performance Across Various Interest Rate Peaks From October 2022

This graph represented an 'ideal recovery' as it assumed a high level of bond volatility, and that bond exposure eventually surpassed its historical average after rates peaked. Let's check in on how this has gone with live performance data since October (represented by the green line below).

Interest Rate Model vs. Live Bond Performance in RP Max Portfolio

Rates peaked at about 4.14% in November, and live performance has hewn extremely close to the ideal recovery at a 4% peak. This was enabled by a combination of the volatility benefits discussed earlier and increased bond exposure as rates rose. Nothing surprising, but seeing the live data align so closely with the theoretical concepts helps to build confidence in the model and to unpack some of its counterintuitive elements.

For example, the top orange line represents the fastest potential recovery and worst long-term outcome. Though Hedgewise realized quick gains in November and January, it was better to give them back and return closer to the blue line. What if rates keep going up to 5%? Great, we shift down the graph to the yellow line. What if rates stay higher for longer? Also great, higher coupon payments boost your total returns by the end.

The concepts are simple, but the outcomes are very different than traditional passive approaches. The worst case is a moderate return amidst a fast recovery. It only gets better with higher rates and bigger near-term losses. True to a proper hedge, it doesn’t really matter what happens - all the results are positive to different degrees.

The single core assumption is that rates eventually fall to neutral. The prior figures use a five-year timeframe, but the logic holds for any other length. The exception would be if rates never fall and remain at 4% or above. This would require the Fed to remain permanently restrictive, to fail in meeting its 2% inflation target, or some combination of the two. The economic scenarios get a little weird in trying to imagine this, but the most plausible would be a kind of forever stagflation where inflation sticks at 4%+, and no amount of rate hikes can ever bring it down. The Fed kind of keeps trying by keeping rates higher than 4%, but kind of gives up by not doing anything more radical, and that is the new status quo.

While this is an edge case, we can still model how Hedgewise would be affected just for fun. Over five years, the bond impact on the RP Max portfolio would be expected to remain breakeven all the way up to a terminal 5.5% interest rate. In other words, the effect of the rate increases would likely be offset by a mixture of coupon payments and volatility management until they exceeded 5.5%. This represents a useful strawman for what you'd need to believe to be worried about how Hedgewise will fare with its bond exposure over the next few years. The rate on 30yr Treasuries would need to settle north of 5.5%, then never fall below that point again.

These bond concepts are so useful because they are mathematic, specific to real-world scenarios, and already in motion. It builds confidence to know precisely how these risk management techniques are operating and why they will be effective across such a broad range of outcomes. It is not a matter of believing in Hedgewise or Risk Parity more broadly, but of understanding what makes this specific framework successful, how the benefits have manifested over the past year, and why that is expected to continue.

Wrapping Up: Scenario Planning

Let's return to the earlier base case recovery scenario where stocks and commodities return to their January 2022 levels, and interest rates fall back to 2.7%. This is how the 30-40% gain was estimated from the October bottom, but it assumed a one-year timeline and a smooth recovery across all assets. The prior analysis uncovers why that is among the least preferred outcomes. For example, that kind of bond recovery would be consistent with the top orange line from the interest rate model which had the lowest total expected return. We'll call this the 'soft landing', and then consider other rockier scenarios to see how they compare.

The first might be a 'hard landing': a severe recession akin to the Volcker shock of the early 1980s. The Fed would push rates higher and announce its intention to cause a recession. Assume a 5% bond peak, a retracement in the S&P 500, and that inflation eventually gets under control. Even if stocks fell back to their October bottom and never rose from there, a 30% gain would still be expected in the RP Max portfolio (the increase in bond performance at the 5% peak offsets the lack of recovery in equities). If the S&P 500 eventually returned to its January 2022 level, expected gains would rise to 50-65%.

Next let's consider 'prolonged stagflation': more like the mid-70s, when inflation stayed high, rates stayed elevated, equities did horribly, but commodities at least retained their real value. Assume rates rise to 5% and stay there, equities retrace to the October bottom, but commodities keep track with inflation. Initially, this would be painful. The RP Max recovery would be expected in the 10-15% range so long as inflation remained stuck (coupon payments, vol management, and commodity gains would offset the higher rates, but not by much). Then a binary assumption is required about what happens next. Either the Fed finally does its job, or the world accepts high inflation forever.

If the Fed eventually succeeds, it’s the same Volcker shock with a higher terminal rate, say 6-7% instead of 5%. Inflation is slain, but it takes 5+ years to happen. This would be an amazing outcome for Hedgewise, with expected total gains of 80-90% (these are the best scenarios from the prior interest rate graph), but it would take longer to happen and be scarier in the middle.

If the world accepts 4-5% inflation in perpetuity, inflation hedges would eventually do well (e.g., gold, TIPS, copper), but nominal bonds and equities would do poorly. The net outcome would still be expected in the 35-45% range for RP Max as the hedges kick in, but it would be very volatile as the world would be reckoning with a complete failure and re-orientation of the Fed. Assuming equities eventually recovered to their January 22 level, the expected range increases to 50-60%.

Finally, let's do one rosier economic outcome and call it 'radical expansion'. Some hidden source of real growth is unlocked (artificial intelligence or the like), and rates stay high alongside a humming real economy. Assume equities jump to 20% above their January 2022 level, and rates stick at 4% in perpetuity. Growth commodities like copper and energy do well, but gold does terribly. This generates a 25-40% expected return range for RP Max.

You may have noticed by now that the outcomes are clustered. The soft landing and radical expansion scenarios land in the 25-40% range. The hard landing and stagflation scenarios land in the 50-65% range despite a volatile expected interim period that includes additional short-term losses. The highest potential gain of 80-90% is reserved for a 1970s redux where the Fed fails to reign in inflation for another five years before initiating a shock recession. Across all the scenarios, the upper end of the range is more likely with a slower and choppier recovery, and vice versa.

The main takeaway is that every outcome is relatively good. After last year, the portfolio is already set-up for success. We don't know exactly how much of a gain it will be, or how long it will take, but it will not rely on any single asset class or economic reality. On net, if you are evaluating a specific short-term stretch, it is safer to assume that losses and volatility are beneficial. But it is not about trying to isolate the highest absolute gain, but rather maintaining confidence that the upside is there across many scenarios and only improves when markets seem scarier.

If I were to urge one single piece of advice, it would be to put your cash to work. The current pocket of opportunity is incredibly rare and hasn't really happened since the early 1980s. Back then, you could have gotten a 15% yield on a one-year Treasury bill, and that would have been the mistake of a lifetime compared to buying 30yr bonds (which tripled in value from 1982 to 1987). This is as similar as an environment as we are likely to see in at least a generation. It may be a slow and steady recovery that takes years, but it could just as easily happen in two months. With such a positive outlook whichever way it goes, it is very hard to justify any risk of missing out.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• 2022 has been one of the worst years in the last century for financial markets, but it has provided a huge opportunity for Hedgewise to benefit from its risk management techniques.
• Compared to passive Risk Parity benchmarks, Hedgewise has outperformed by 15% to 20% YTD (at the RP Max risk level), which is among its best years ever from a relative perspective.
• It is difficult to appreciate this outcome so long as the current drawdown persists, but the medium-term outlook is already substantially better than it was in January, present losses included.

Introduction: Yes, This Has Been Crazy

What has happened to financial markets so far this year has been extreme. Not just once-in-a-decade event extreme, not just another financial crisis or pandemic extreme, but worst-in-measurable-history extreme. As Bloomberg noted a couple weeks ago, "Worldwide government bond markets are on course for the worst year since 1949, when Europe was rebuilding from the ruins of World War Two." If you've been feeling confused, shocked, or incredulous about markets for the past few months, that would make perfect sense.

This context is important because as portfolio losses accrue, it is challenging to keep perspective and avoid second-guessing. A 20% loss might be hard to differentiate from 30% despite being a much better outcome. As asset prices drop, it can feel terrible even if you have room to add exposure at much more attractive entry points. You may lose interest in relative performance and future opportunity and prefer to just stop losing money. This year is more likely to be conjuring up such feelings than any time in modern history.

And yet, if you can briefly suspend disbelief, 2022 has been a great year for Hedgewise. With near minimum levels of exposure across most asset classes, Hedgewise has substantially reduced its drawdown while simultaneously improving expected future returns. On a relative basis, September was one of the best single months ever. The three-to-five-year outlook is better now than it was at the market peak in January - really! - and all of this can be shown precisely.

To understand how this could be true, it is useful to provide context for how exceptional markets in 2022 have been.

No Historical Comparison

Many have compared this year to the late 1970s, when Paul Volcker aggressively raised interest rates to slay a decade of inflation. But in terms of tightening financial conditions and asset performance, this has already been much worse.

For example, long-term bonds have now lost over 30% this year alone, with a total drawdown over 40% since July 2020. Going back to 1972 (the earliest that good data was available), here are all the instances when bonds have lost 20% or more.

History of Bond Drawdowns Over 20%

Date Range	Max Drawdown
June 79 to Sept 81	-23.4%
Dec 08 to May 09	-26.0%
July 20 to Present	-43.6%

The datapoint from 2008 is mostly a red herring: rates went from 4.3% in November 2008 to 2.8% in December, as the financial system nearly collapsed, and then completed a round-trip back to 4.3% when the crisis was avoided. This was not a tightening of financial conditions and had little to do with the Fed. The experience in 1979 is more instructive, as 30yr rates went from 8% all the way to 15%, but on a relative basis, this was still much less painful than what is happening today.

The sheer scale and speed of this event has made it much harder than usual to sort through. For example, if bonds lost 10% in a single year, and you lost nothing, that would be a great outcome. But this year, the same relative performance would mean you lost 33% instead of 43%. It is challenging to treat these as two equally good outcomes.

The tricky part is differentiating between simple drawdown reduction and the ability to generate new gains. Losing 33% instead of 43% may be insubstantial if both portfolios return to the same level after a recovery, but it is more powerful if it can be translated into a permanent 10% advantage.

This dynamic is exactly what Hedgewise is optimizing for in a year like this one, and any loss reduction is likely to mirror future potential gain. This has gone exceptionally well so far in 2022, and it has only been possible due to such extraordinary circumstances.

The Good News

In September, RP Max lost about 11%, and this represents a historically excellent outcome for Hedgewise. How can this be?

The following graph shows the Hedgewise weights across asset classes for last month (at the RP Max risk level). Notably, every exposure outside of bonds was at or near its minimum possible level, as represented by the grey bars below.

Hedgewise Weights by Asset Class, September 2022

Outside of bonds - which we'll cover in much greater depth shortly - Hedgewise managed risk last month almost perfectly. Another way to understand this is by measuring the specific amount of potential loss avoided within each asset class. For example, if equities were weighted 25% less than average, and incurred a 10% loss, then that portfolio would have "avoided" a 2.5% potential loss through risk management.

Hedgewise Losses Avoided Through Risk Management, September 2022

Asset	Sept 22 Weight Vs. Hist. Avg.	Sept. Return	Loss Avoided
Copper	-9.2%	-3.5%	0.3%
Gold	-10.1%	-3%	0.3%
Bonds	-10.6%	-12%	1.3%
Equities	-26.8%	-9.6%	2.6%
Energy	-3.5%	-9.6%	0.3%

In other words, Hedgewise "should" have lost 16% last month, but instead it lost only 11%. To further validate this, we can compare Hedgewise performance to the RPAR ETF, which is a more passive risk parity product and has a similar target volatility to the RP High risk level.

RP High Live Performance vs. RPAR ETF, September 2022

After adjusting for volatility, this is almost exactly the delta expected. There is rarely this degree of differentiation in most years, never mind in a single month. In more normal circumstances - say at the end of a year, Hedgewise had gained 15% while most similar funds had gained 10% - it would represent one of the best annual outcomes ever. Though Hedgewise performance in September was no less real or impactful, it can feel more difficult to appreciate alongside a significant drawdown.

This is ironic because successful loss avoidance is such a powerful driver of long-term outperformance. Part of this is simple probability: if an asset was at its minimum exposure during a period of loss, exposure will probably be higher during any subsequent recovery. In addition, you get a mathematical boost because any given loss requires a larger percentage gain to return to breakeven.

For example, in September, the "passive" risk parity portfolio lost 16%, compared to an 11% loss for Hedgewise. For the passive portfolio to return to breakeven, it must subsequently gain 19%. If Hedgewise participates in this, it would wind up with a 6% total gain. The higher the loss differential, the higher the potential future gain.

We can run this same calculation at various points in time this year to see how it has changed as bigger losses have accrued.

Potential Net New Gain Created by Loss Avoidance, RP Max

	Hist. Avg. Loss	Live Portfolio Loss	Potential Net New Gain Post-Recovery
Feb 22	-5%	-2%	4%
May 22	-22%	-12%	14%
July 22	-31%	-18%	19%
Current	-41%	-26%	25%

From this perspective, the 26% drawdown of this year likely represents 25% of net new gain post-recovery. Said differently, whenever markets recover to the levels of January 2022, Hedgewise now has the potential to be 25% higher than where it started this year. This does not require fancy timing or good luck - asset weights need only return to historical average levels, and markets subsequently recover their YTD losses.

Returning to an earlier comparison, performance this year is comparable to a scenario where most assets are down 20%, and Hedgewise is breakeven. The scale of this year's losses just makes it much harder to see.

Hopefully the mechanics are becoming easier to follow. Losses are good if asset weights are low and have a high chance of increasing at much cheaper prices. Outside of bonds, Hedgewise has achieved near the best possible outcome this year. In fact, if you removed bonds from the portfolio, the current drawdown for RP Max would only be about 10%. But if you are going to concentrate a drawdown in a single asset class, bonds are where you want to do it from a systematic perspective.

I'd Rather Lose Money in Bonds

Treasury bonds have a few unique attributes that differentiate them from other asset classes. There is close to zero default risk, meaning if you hold a government bond to maturity, you are guaranteed to make your money back plus interest. As prices go down, interest goes up, so you are instantly paid more going forward whenever you accrue losses today. Because interest rates have such a huge impact on the economy, they will always tend to gravitate towards a "neutral" rate that is consistent with the Fed's mission of achieving 2% inflation alongside stable employment. The higher rates go above the neutral level, the more likely they will subsequently fall in the future, and vice versa.

These factors make bonds much more predictable and systematic than other assets and lead to counterintuitive outcomes where short-term losses can be preferable to gains.

A useful demonstration of this is using three-year government bonds, which began 2022 yielding a 1% interest rate. The Fed's best estimate of the "neutral" rate is 2.7%, so you'd expect that rates will rise. As a passive investor, what would be the best outcome over 5 years - for rates to stay where they are, rise slowly to 2.7%, or jump suddenly above the neutral rate and eventually settle back down to 2.7%?

We can model this easily, and the following shows how a passive portfolio would perform in all three scenarios. The actual three-year rate today is around 4.4%, so we'll use that number to model the final scenario where there is an initial "spike" before rates eventually return to neutral.

3yr Government Bond Model Performance, Various Interest Rate Scenarios

It may be a surprise to see that the sudden rate jump yields a better outcome, despite initial losses of 7%. This is because all three scenarios wind up in the same place, but in the third you are paid a much higher level of interest in the interim. If you were a purely passive investor with a five-year time horizon, you'd prefer the current spike in rates to no rise at all.

Given what we know about how predictable bonds are, though, why would we stop there? As rates move above the neutral rate, there is an increasing chance that they will fall in the future. In a very simple form of risk management, say you decided to hold 33% exposure with rates starting at 1%, and implemented a system to increase that evenly to 100% exposure if rates hit 4%.

3yr Government Bond Model Performance, With Simple Risk Management

It probably feels counterintuitive, but this halves your drawdown and nets you another 3% in final return. Even if you could magically time this curve and move from no exposure to 100% at the exact bottom, you'd only net 5% extra at the end of five years (i.e., 21%). Simple risk management gets close to this ideal scenario with no work or timing required, so long as you can "look past" the initial drawdown and focus on your longer-run returns.

Now imagine that interest rates rise to 6% instead. Would the framework still hold?

3yr Government Bond Model Performance, 6% vs 4.4% Interest Rate Peak

By the end of five years, a 6% interest rate peak yields a better outcome despite the larger initial drawdown. While this math is straightforward, the implications can feel backwards. Revisiting the earlier example, a 4.4% peak with perfect timing (i.e., no drawdown, invest at precise bottom) yields a total return of 21%. A 6% peak with simple risk management yields 23% despite initial losses. A rational investor should prefer the latter, but that means rooting for higher bond losses and foregoing any attempt to time them.

These same lessons apply to longer bonds in a similar manner, just amplified.

How This Works for Long Bonds and Hedgewise

Now let's bring these concepts to life in the live Hedgewise portfolio, which uses twenty and thirty-year bonds in addition to more sophisticated risk management.

Just as in the theoretical discussion, Hedgewise began this year with limited bond exposure and has increased it methodically as rates rose above neutral levels. The following shows the live relative performance of bond exposure in the RP Max portfolio versus passive 30yr bond returns.

Impact of Bonds on Hedgewise RP Max vs. Passive Portfolio, January to October 2022

So far, so good. The drawdown is less than half that of a passive portfolio, while bond exposure has been increasing throughout the year. We can model a few simple hypotheticals moving forward. Imagine that rates have peaked this month, and slowly move down to the neutral level of 2.7% over the next four years with very little volatility. Hedgewise bond exposure is assumed to remain at the historical average level throughout the recovery (which it is close to in live portfolios at present).

Model 1: Rates Peak at 4%, Hedgewise Returns to Historical Average Bond Weights

Note that the highlighted portion is equivalent to the prior graph. In this basic scenario, Hedgewise translates its current loss into a 13% net gain by the end of five years. This is already consistent with the theory discussed earlier despite representing a likely "floor" of potential outcomes.

Bond yields are unlikely to fall predictably in this perfect straight line. Expected volatility is a part of how Hedgewise applies risk management, and this year provides an excellent case study of how this can be used to further boost expected returns.

From July to September, 30yr yields went from 3.1%, down to 2.9%, and back up to 3.4%. It follows that you'd adjust exposure accordingly, and this is precisely what Hedgewise did.

Recommended Bond Exposure by Month in the RP Max Portfolio, July to September 2022

Month	30yr Rates	Hedgewise Weight
July	3.1%	63%
August	2.9%	58%
September	3.4%	68%

Hedgewise is capturing little pockets of gain and avoiding potential losses as rates bounce around. Just the reduction in exposure at the beginning of August alone is worth about 0.5% in "extra" return for 2022. The more bond volatility, the more potential there is amplify these gains. We can model how this opportunity would affect expected Hedgewise returns depending on how choppy markets are over the next few years.

Model 2: Add Bond Volatility Management

The final assumption from the initial scenario that needs revisiting is the level of bond exposure. The historical average weight is conservative, especially with rates already so high above neutral. A more likely outcome is that exposure eventually rises to 20% above this level.

Model 3: Bond Exposure Rises to 20% Above Historical Average Weight

Compared to January of this year, Hedgewise has improved its five-year bond outlook by 13% to 28%, or an annualized 2.5% to 5%. This is a great outcome for any asset class, never mind one during a once-in-a-century crash! Despite that, intuition may still suggest that it would be better if losses were lower or the recovery were faster, but neither is true.

For example, here is the same model with rates peaking at 5% instead of 4%.

Model 4: Rates Rise to 5% Instead of 4%

The near-term drawdown increases by 10% while simultaneously improving the five-year outcome. This is weird, but mathematically true! It is better to be paid 5% interest and it improves the chance of adding extra exposure and benefitting from volatility. Your outlook keeps improving as a mirror image to the initial drawdown.

To emphasize this further, the following graph summarizes the expected performance for interest rate peaks of 3% to 7% (the 3% peak assumes that rates fall from their current level to 3% by end of year). These curves assume increased exposure and high bond volatility, but the relative performance would be similar for other assumptions.

Comparing Expected Performance Across Various Interest Rate Peaks

A rational investor should choose a 7% peak, along with a 40% initial drawdown. This would net you 35% in extra gain by the end of five years compared to an immediate recovery in which rates suddenly fell back down to 3%. Also note how all the curves intersect at around the same time, which reinforces how little meaning this interim period carries. Whether we have an instant recovery in bonds or not, you expect to be in a similar place a few years down the road. At that moment, you'll have a whole lot more upside if rates peak higher.

The implications can feel topsy-turvy, but the intuition is basic. It's good if interest rates rise because you can keep adding exposure and getting paid higher coupons. It's the only asset class where losses can be so systematically converted into eventual gains. This year, the five-year outlook for bonds has only gotten better. It just happens to involve a drawdown upfront.

Wrapping Up: Bad News is Good News

The massive price declines across financial markets in 2022 belie the benefits accruing to Hedgewise along the way. Exposure to most asset classes has been near a minimum throughout, which has mitigated the drawdown and maximized the chance of capitalizing on cheaper entry points. Bonds are responsible for most of the current loss, but higher interest rates are being systematically translated into longer-term expected gains. Hedgewise has outperformed passive Risk Parity benchmarks by 15-20% this year, and it is mostly a question of when this will shift into realized profit.

From a big picture perspective, the recovery of this year's drawdown will likely occur in the same 6 to 12 month timeframe regardless of its size. It will happen when rates fall back to the neutral level, and that must eventually occur because they cannot stay restrictive forever. Whether rates have already peaked or go on to rise further, it will not significantly alter the recovery timeline. (i.e., whether rates peak at 4% or 7%, the portfolio breaks even as rates subsequently approach 3%)

Given that, the size of the current drawdown should be interpreted opposite as you'd expect. Bigger and longer losses yield a greater expected gain than smaller and shorter ones, while still breaking even within the same few months. From a long-term perspective, both outcomes are superior to a scenario where markets never dropped at all.

These mechanics are specific to the bond market and rising interest rates, which may be part of the reason the concepts feel foreign. Interest rates have only ever gone lower for the past 40 years. But from a risk management perspective, bond losses are uniquely positive. Unlike equities or commodities, where you can run into periods of pure wealth destruction (e.g., oil prices briefly went negative in 2020), bonds are simply moving around money in time. This dynamic can be exploited to transform drawdowns into gains with greater confidence than any other asset class, but Hedgewise has had little opportunity to do so until this year.

In hindsight, 2022 may very well mark the start of a great new era for risk management.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• The drawdown of 2022 has been close to ideal from a risk management perspective.
• Hedgewise has had historically low asset exposure levels since January, which has both limited the size of the drawdown and created opportunity to invest at cheaper prices.
• In the most likely scenario of a moderate-to-severe recession, Hedgewise expects the Risk Parity "Max" strategy to gain 30% to 40% over the next 12 to 24 months.

Introduction: Deconstructing "Good" Losses

The last Hedgewise newsletter discussed why this year’s losses were "good" because they were relatively moderate and created opportunity for additional future gain. Counterintuitively, greater subsequent loss would be welcome for the same reason. Fast forward to today, and we've experienced just that. This is positive, but it can be very challenging to grasp how in real-time. We'll analyze this in practical, granular detail to better understand the dynamic and to specifically visualize how the next 12 to 24 months are likely to play out.

At the simplest level, a loss is good if you can subsequently buy-in at a cheaper price. The key question is how your exposure level at the beginning of any drawdown compares to your total potential exposure. For example, an ideal scenario would be moving from 0% exposure at a peak to 100% at a bottom, but this would require perfect timing and foresight. The Hedgewise Risk Parity strategy is built to achieve a similar dynamic systematically, and its success can be measured by how its asset weights compare to historical averages during periods of loss.

Hedgewise 2022 Average Exposure by Asset Class vs. Historical Average, Risk Parity "Max"

Across the board, Hedgewise exposure throughout 2022 has been significantly lower than historical averages. This simultaneously moderates the drawdown as it occurs, while presenting the opportunity to increase exposure once asset prices have fallen.

To better visualize this, the following graph shows how this year's performance in the RP Max strategy compares to the hypothetical "historical average" portfolio from above.

2022 RP Max Live Performance vs. "Historical Average" RP Max Portfolio

Hedgewise has nearly halved the drawdown of this year compared to a more passive approach, but this does not fully capture the potential positive impact. Now that asset prices are so much cheaper, Hedgewise has an opportunity to increase exposure back in line (or even above) its historical averages. This would drive future gains that outsize the initial drawdown, and this potential increases the more that the red and blue lines above diverge.

For example, the "historical average" portfolio has a current YTD loss of 30.6%. It would require a subsequent gain of 44% to return to breakeven (the percentage gains required to offset any loss are always higher mathematically since you are starting from a lower base). If Hedgewise participated in this gain from today forward, it would wind up with a +19% total return, even though asset prices had only returned to the same levels as the start of 2022 (mathematically, this is the -17.5% loss in the live portfolio multiplied by a 44% gain). These potential gains are only "created" because of the initial loss.

To illustrate this further, here is the same math run at various dates this year. In each case, it shows the potential "created" gain for the Hedgewise portfolio given the loss for the "historical average" portfolio.

Potential Future Gain Created by Equalizing Exposure After Losses

	"Historical Avg." Loss	Live Portfolio Loss	Potential "Created" Gain"
Feb 22	-5%	-2%	4%
May 22	-22%	-12%	14%
Current	-31%	-18%	19%

Potential return for the strategy is higher now than it was in January, prior to any drawdown. The additional losses in May and June have only increased it further.

To be clear, this is being discussed from a probabilistic perspective, and these gains are not guaranteed. To capture them, the portfolio must first return to the historical average weights at or near the bottom, and then a full recovery must ensue. But it is still accurate to say that potential opportunity has increased throughout the course of this year, and that it would not exist if these losses had not occurred.

The remaining question is whether Hedgewise will succeed in taking advantage of this. If the portfolio returns to historical average weights but asset prices decline further, additional opportunity will be missed. The same is true if the portfolio fails to increase weights before asset prices recover.

The good news is that there is a systematic way to approach this problem, and it is why so much time has been spent discussing the Fed and interest rates over the past two years. Unlike other assets, bonds have a more specific range of outcomes which allows Hedgewise to greatly increase its odds of success.

Bonds, the Big Picture, and 2022

Stepping back to a bigger macroeconomic picture, bonds are unique compared to riskier assets like stocks or commodities because interest rates are controlled by the Fed and generally operate within a band of stimulative, neutral, or restrictive. The "neutral" rate is continuously predicted and published by the Fed, and everyone expects rates to spend most of their time around this level (because stimulative/restrictive rates are reserved for periods of recession/overheating, which should be infrequent).

The current estimate of the neutral rate is 2.4%. Here is a look at how the interest rates on 30yr Treasury bonds have moved in 2022 compared to this.

30yr Treasury Bond Interest Rates vs. Neutral Rate, 2022 YTD

The Fed has moved from stimulating the economy at the start of this year to restricting it to fight inflation. So long as you believe that the neutral rate is correct and that the Fed will eventually succeed in bringing down prices, this means 30yr interest rates should eventually fall closer to the orange line. If that happens, bond prices would rise by about 18% in addition to the 3%+ coupon paid out in the interim.

While these assumptions could be wrong - maybe the neutral rate is higher, or rates will have to become much more restrictive to beat inflation - bonds are without question a much less risky investment now than they were at the beginning of 2022. With this in mind, here are the monthly bond exposure levels of the Hedgewise RP Max portfolio this year.

Hedgewise Total Bond Exposure in the Live RP Max Portfolio, 2022 YTD

Bond exposure in the Hedgewise portfolio automatically adjusts as rates move from stimulative to restrictive, ensuring that it can capture much of the "potential" gain discussed earlier. However, note how there is significant room to add exposure. If rates continue higher, this would be viewed positively until the "maximum" exposure level is reached. Ironically, this would drive both near-term loss and longer-term expected gain in parallel.

To be fair, this would no longer function if rates rose and stayed high indefinitely, e.g., if the neutral rate were 4% or higher. I believe that is unlikely because it would imply long-term inflation expectations higher than 3%, which is in direct conflict with the Fed's mandate of targeting inflation of 2%. If inflation expectations were that high, the Fed would maintain a restrictive stance to continue to drive down demand until inflation was also subdued. In other words, it is much more likely that the Fed destroys growth than that it permits inflation to exceed 3%, which means a prolonged recession is a much higher likelihood than a neutral rate over 4% (and Chairman Powell has essentially said this outright).

Perspective on the Past and Future

In January 2022, the RP Max portfolio had historically low exposure to both equities and long-term bonds. If you had asked me at the time for the ideal scenario in six months, it would have been for both asset classes to lose 20-30% as quickly as possible. This would enable higher long-term returns for the portfolio and increase the ability of stocks and bonds to properly hedge each other across different economic environments.

Fast forward to today, and we have come close to a perfect landing. On the margins, it would have been nice if it happened a little bit faster and if both asset classes lost a little bit more (they still might, which would be good!). In theory, commodities should have held up more strongly in such an inflationary environment, but their weights have also been below historical averages, so this presents additional opportunity. Overall, this has gone well, but it takes some perspective to understand how this sentiment logically applies to a 20% drawdown.

This is easier to conceptualize when you look ahead. The portfolio is already well-positioned to gain 30-40% whenever the underlying asset classes breakeven with January 2022 (This equates to a net gain of 10-15% if you were measuring from the beginning of this year). My best estimate is that this happens between mid-2023 and early 2024, depending on the specific asset. The outcome has the potential to be even better depending on how market risk evolves and whether prices continue to fall. These gains will have been "created" by the losses of this year, and no timing or judgment is required.

It can be difficult to embrace this process because these concepts do not exist for purely passive investors. If you invest in 100% stocks, you can only make back what you lose, and any drawdown is unwelcome. For Hedgewise, drawdowns can take many different forms, and the present one is already "good" with the potential to be "great", depending on the shape of the recovery.

Some Final Counterintuitive Thoughts

I've frequently advised clients this year that it is a great opportunity to put money to work, and it is only getting better and better along the way. That was as true in January 2022 as it is today, despite the 20% drawdown (at the RP Max risk level) that has occurred since. How can this be?

The simple reason is that return expectations have been consistently positive. In perfect hindsight, if we returned to January 2022, your expected return by mid-to-late 2023 would be 10-15%. Not only does this account for the present drawdown, but those gains are dependent upon it!

In every subsequent month since then, the expected return has only improved, and if you happen to be sitting on cash presently, there is a high likelihood of gaining 30-40% by the end of next year. It is easy to get hung up on predicting the exact bottom, but realistically, these are all good entry points, especially when Hedgewise is systematically taking advantage of additional losses along the way. If you happen to call it perfectly, whether through luck or skill, that is like an extra "active management" bonus. But realizing a slightly lower gain without any judgment or timing is also a great outcome.

The losses incurred this year have been close to ideal. The portfolio has held near-minimum exposures in most asset classes since January and now has an opportunity to take advantage of lower prices, which is already happening systematically in the bond market. A hard landing would be a great outcome and more losses would be welcome. Worst case, the economy recovers too quickly, and you make back your money without as much "extra" gain. This is exactly how a good hedge should work, and all that it requires is the patience and time to see it through.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• This year, global markets have experienced the worst and fastest cross-asset drawdown in modern history due to a mix of uncertainty about the war in Ukraine, "Zero Covid" in China, and runaway inflation.
• While painful in the short-term, these losses are surprisingly a positive development. With a fuller understanding of how Hedgewise functions in the current environment, we can see why bigger short-term losses are preferred.
• The Hedgewise algorithm is built to systematically "convert" every 1% loss into a larger expected long-term gain. We will examine this in-depth in the bond market, where the dynamic can be most easily understood.
• The current Hedgewise drawdown is much smaller compared to similar historical periods as well as major Risk Parity competitors, which further improves future potential upside.
• The prevailing environment of panic alongside Fed tightening is one of the most accurate historical signals that a bottom is close, but any additional loss will only add to total expected returns in time.

Overview: We Knew It Was Coming, But It Happened Fast

For the past two and a half years, Hedgewise has been analyzing how markets would behave against a backdrop of a "Fed-induced bubble" and cautioning against getting involved in its many strange distortions (i.e., meme stocks, negative yields, SPACs, crypto). A culmination of events in March and April has swiftly unwound most of the bubble, and while its speed and depth has been historically unprecedented, global markets – and Hedgewise in particular – will be better off for it.

As a quick, and hopefully final, refresher of how the Fed created a bubble, here is the familiar visualization of how near-zero interest rates affect expected asset returns over time. It literally "pulls" returns from the future into today, and at the extremes, it can create negative future return expectations (for example, negative real yields mean you are guaranteed a negative real loss on your money)

How Passive Expected Total Returns Change Over Time with Zero Interest Rates

The Fed got itself in a mess by pushing the bond market towards the yellow line with its overaggressive stimulus, and then lots of other assets followed suit. They were crossing their fingers that they could leave these policies in place for long enough for the 'real' world to catch-up. This would have looked like a few years going by with moderate inflation, and asset prices would have been mostly flat while they slowly raised rates along the way (i.e., the horizontal yellow line remains flat until it eventually intersects with normal returns).

The trouble is that this required inflation to stay relatively low, and for nothing "bad" – like a war, for example – to happen to the world in the meantime. In 2022, we experienced all of that at once, and markets are moving down the red lines accordingly.

For passive investors this is bad news, as many asset prices are completing a round trip to zero (or worse) compared to before the pandemic began. This is the problem with a Fed-controlled environment: they are moving money around in time, but not increasing the fundamental pie.

For Hedgewise, on the other hand, the potential return that was just pushed to the future will be larger than its near-term losses. This is possible because of specific Hedgewise algorithms that take advantage of this environment and because the portfolio has positioned cautiously throughout this era to account for its likely reversal. In short, Hedgewise will systematically own more of these assets when they recover than it does when they are falling, and this can be shown both in theory and in practice.

Still, this can be a hard pill to swallow, and it can feel wrong to accept another 5% loss now even if it leads to an extra 5% net gain in the future. Why not just avoid the drawdown altogether and re-enter at the bottom? It is crucial to maintain perspective that there is a better chance that markets have already bottomed than that they have not, and that becomes more and more likely as prices fall further. The Hedgewise methodology takes advantage of those losses without having to time them and avoids missing the recovery once we reach the bottom.

As it relates to the present, there is a good case that markets have already overreacted to transitory events like the war in Ukraine and the Covid situation in China. Periods of Fed tightening are also classically volatile because investors tend to fear the worst whenever there is heightened uncertainty, and that effect is being amplified by the Fed's pandemic mistakes. Everyone goes "risk-off" at once, and many assets trade at a discount to fair value simultaneously. These periods have historically predicted some of the best near-term returns for Hedgewise regardless of the final economic outcome.

There is no doubt that this will go down as a historic market event, but it is shaping up to be a good one for Hedgewise so long as you know where to look.

The Big Picture: Measuring "Good" Losses

Periods of loss are fully expected in the Hedgewise framework because it is systematic and involves no judgment or timing. Its long-term success does not come from avoiding loss, but from mitigating the short-term damage through risk management and subsequently taking advantage of cheaper asset prices. From this perspective, the proper way to evaluate any drawdown is its size relative to broader market conditions.

For context, here is year-to-date performance across each asset class.

Performance by Asset Class, 2022 YTD

In 2022, bonds are down 18% and stocks are down 13%, while commodities outside of energy have barely moved the needle. Incredibly, if you look back all the way back to 1950 for any similar period of performance, you will not find one. In fact, bonds have only lost 15% or more one time ever in modern history, and that was when Paul Volcker was breaking the back of stagflation in 1980-1981 and raising short-term interest rates to nearly 20%. Back then, gold doubled in price alongside this as investors sought inflation hedges aggressively, but gold is only up about 3% this year.

To emphasize, cross-asset performance over the past four months has been substantially worse than 1980, when inflation had been raging for a decade alongside multiple recessions and energy crises.

While no other episode has been as bad as this one, there have been a handful of other similar cases which all occurred during periods of aggressive Fed tightening (keep in mind that these are purposefully some of the worst data points in history and very rarely occur) The following table shows comparable asset performance during these times alongside model performance of Risk Parity "Max".

Comparison of Asset Performance During Similar Economic Environments vs. RP Max

	Bonds	Equities	RP Max
Feb-Mar 1980	-7%	-11%	-24%
Jan-Sept 1981	-12%	-10%	-23%
Feb-Jun 1984	-9%	-4%	-18%
Feb-Nov 1994	-14%	-4%	-18%
Current	-18%	-13%	-10%

In every other similar event, RP Max had nearly twice the drawdown as it does currently against less severe backdrops. 2022 will likely go down as one of most successful periods of loss mitigation for Hedgewise ever.

This relative success can also be measured compared to other major benchmarks. For example, here is how Hedgewise has performed against the two largest passive Risk Parity funds (note that the closest historical benchmark to these funds is the RP "High" risk level).

Performance of Hedgewise vs. Passive Risk Parity Funds

We'll dive into greater detail about the mechanics behind this relative outperformance in a bit, but first it is important to step back to the bigger economic picture. Losses driven by Fed tightening are moving gains back to the future. The deeper the cross-asset drawdown, the more "built-in" rebound accrues. For example, here is how each asset class performed in the 12 months following each of the prior similar periods.

Subsequent 1yr Returns by Asset Class During Similar Economic Environments vs. RP Max

	30yr Bonds	Equities	RP Max
March 1980	9%	40%	44%
September 1981	47%	10%	81%
June 1984	45%	31%	78%
November 1994	36%	38%	99%

While these numbers might seem challenging to imagine in the present environment, consider a few interesting facts. TIPS bonds will be paying between a 7-10% annualized coupon for the next year to cover inflation. If long-duration bonds eventually return to the long-term "neutral" rate currently estimated by the Fed, they will rally another 12-15%. Equity returns tend to at least match inflation over time because prices and profits eventually move up alongside one another. For stocks to simply match expected CPI of 6% for 2022 (which would mean a 0% real return), the S&P 500 would have to rally over 20% by December.

This highlights the natural duality of an inflationary environment. It is par for the course to have large drawdowns due to persistent uncertainty and price shocks, followed by large rebounds as all assets catch up with prevailing price levels and uncertainty falls. Knowing this pattern, bigger losses are preferred if you can mitigate their impact since they will tend to precipitate a larger relative recovery.

In this sense, current Hedgewise losses are some of the "best" on record. To see these mechanics more clearly, let's do a deep dive into how the Hedgewise algorithm manages its bond exposure in a near-zero interest rate environment.

Fun With Zero Interest Rates: When More Losses Are Better

The way that Hedgewise manages its bond exposure is intuitive: it decreases its exposure as rates approach zero and increases it as they approach more normal levels. This systematically creates a dynamic where bigger losses are better because you keep on increasing exposure along the way (i.e., you are automatically selling higher and buying lower).

As an example, 30yr bonds began 2022 with an interest rate of 2%, and the Fed currently estimates that the "neutral" long-term rate (which is basically its long-term projected level) is 2.4%. Imagine one scenario – let's call it "Inflation Problem" – where rates first rise to 4% before falling back down to 2.4% at the end of three years. In a second scenario ("No Problem"), rates sleepily go from 2 to 2.4% without much volatility in between. The following graph simulates how the Hedgewise algorithm would be expected to perform in each scenario alongside a purely passive bond investment.

Simulated Bond Performance Scenarios, Rates Rise From 2% to 2.4%, 36 Months

This nicely highlights the various trade-offs. In the "Inflation Problem" scenario, Hedgewise eventually improves its total return by over 10%, but it first must grapple with a 15% drawdown when rates peak at 4%. These two outcomes are inextricably related: you can only get the extra return because of the circumstances created during the drawdown (i.e., you can increase your bond exposure more heavily while receiving a higher coupon payment)

It is interesting to examine this behaviorally. From a financial perspective, this is a solid trade-off, and bigger drawdowns are merely indicators of higher eventual returns. You would not seek to limit it or stop yields from rising even higher. Yet there is a strong human impulse to limit losses however possible, and a common reaction is to ask, "but why not just wait to invest until after the drawdown happened?"

The trouble is that would require knowing precisely when rates had peaked, while Hedgewise benefits no matter where and how that happens. For example, the following graph shows two more scenarios where rates peak at 3% and 3.5% compared to the original 4% we used in the "Inflation Problem". Rates are still assumed to end at the neutral rate of 2.4%.

Simulated Bond Performance Scenarios, Various Rate Peaks, 36 Months

As a reminder, rates are already near 3% right now, and this may well be the peak of this cycle (especially if we hit a recession, which will almost certainly quash inflation and send long-term yields back down). If not, any additional drawdown eventually converts into higher final returns. It is a win-win with no timing required, so long as you can "look past" the necessary drawdown in the middle.

These simulations depend on a terminal rate of 2.4%, but positive total returns would still be expected even if the terminal rate was as high as 4%. If you were intent on making a "bear" case, it would be for rates to reach 4.5%+ perpetually, but it is very difficult to project that realistically given longer-term demographic and technological trends.

This algorithmic approach is unique to bonds in a near-zero interest rate environment, which is why it is such a big deal to understand right now. The current Hedgewise drawdown attributable to bonds falls within this framework, which means the strategy is having a great year in terms of total expected net return.

This dynamic was not available in the similar historical periods highlighted earlier, which explains the much more severe drawdowns that were incurred. However, it is not as if those were "failures" either. At the Max risk level, occasional drawdowns of 20-30% are expected, and do not detract from long-term expected returns. These scenarios are almost always driven by Fed-induced uncertainty, and it is only a matter of time until one or many assets rebound. The same is expected in 2022, but with a significant bonus from the zero-interest rate bond framework.

A Refresher on Fed Tightening

Back in 2018, the Fed underwent a year-long tightening that sent markets tumbling, and Hedgewise published a deep historical analysis at the time that is worth revisiting. The gist is that this almost always happens when the Fed starts increasing rates because investors are paralyzed amidst the uncertainty. There are too many simultaneous bad potential outcomes (i.e., hyperinflation, recession, stagflation, etc.), so investors price all of them at once. This leads some assets to become undervalued because only one scenario can unfold.

This environment tends to happen suddenly and chaotically. It is very difficult to time, but it implies a rapid recovery whenever greater certainty returns. Investors should generally expect deep and quick drawdowns followed by equally rapid recoveries regardless of the actual economic outcome.

To get a better sense of this, the following chart captures every period of disruptive Fed tightening since 1972. The first bar on the graph shows the sum of equity and bond losses over each period to highlight the degree of cross-asset damage. The second bar shows the drawdown in the Risk Parity Max strategy during the same period (note that model data is used prior to 2015, and live data is used since then).

Stock and Bond Performance vs. RP Max Drawdown, Major Fed Tightenings Since 1972

Before this year, stocks and bonds had an average combined 16% loss during these events, and the Risk Parity "Max" strategy had an average drawdown of 19%. In 2022, stocks and bonds have already exceeded the combined loss of all prior events, but the Risk Parity drawdown is the minimum observed.

It is expected that one or many assets will rally sharply following any of these periods, even though it is difficult to predict which one. Bonds will usually rally in a recession, gold will rally if inflation persists, and equities will rally in a soft landing. The following graph shows the subsequent 3 month return across various assets after all the prior events (current datapoint excluded).

Subsequent 3 Month Asset Returns After Prior Events

There has been a major rally in one or more asset classes within 3 months of every event, though it is often different depending on the outcome. In 1974, bonds and gold rallied during an ensuing recession. Commodities did well in 1978 when inflation failed to come under control. Bonds and equities rallied together in the soft landing of 1994. From a Hedgewise perspective, this is all fine! You can see this in how the Risk Parity Max strategy fared alongside these recoveries.

Subsequent Risk Parity Max Returns After Prior Events, Various Timeframes

Whatever the outcome, Hedgewise recovered strongly and quickly, and I expect that to eventually be the case this time as well. The only tricky question is whether we have reached the bottom yet in 2022. We are already well outside historical precedent. 1974 and 1981 were much worse years for the real economy, in many ways, yet we have already surpassed those in terms of cross-asset drawdowns. You could argue that the pandemic bubble helps explain this, but there was a similar level of financial repression in the late 60s and early 70s as well. My guess is that the confluence of the war, the China Covid situation, and inflation have contributed to an unprecedented level of uncertainty, and I doubt that can get much higher than it already is.

Fortunately, Hedgewise can fall back on a few silver linings no matter what happens next. Any additional losses, especially within bonds, will only add to the size of the expected recovery. The current drawdown is much smaller than it could have been, and this will further buffer future upside whenever it comes.

Conclusion: 2022 Is The New 1981

The focus of this article has been to provide perspective on performance as it relates to Hedgewise, but from a human angle, this has been an incredibly tough month. It has been 40 years since America has grappled with this kind of inflation, and it is mind boggling that it could even exist in this way again. That would be earth-shattering enough on its own, but we have a new war on top of it, and somehow China is still implementing lockdowns worse than Wuhan in 2020. This will go down as an incredibly rare, incredibly hard moment in history, and it really has no modern parallel for the financial chaos it has already caused.

We have all been affected by this and losing money alongside it only adds to that stress. It is natural to see markets melting down and second-guess whether you could have handled it differently. It can also feel like some of these threats are existential. Will China ever move on from Covid? Will the war in Ukraine go nuclear? Will the Fed have to raise rates to 5, or 7, or 10% before its done? These are reasonable questions and understandable fears, and they are part of the reason that markets have been so chaotic. The things we feel as individuals are affecting financial decision-makers all over the world in the same way.

There is great irony in that the closer the world feels to falling apart, the more likely it is that many asset classes are on sale. Some of these scenarios may unfold, but not all of them. Inflation will continue raging, or it will stop. A recession will come, or a soft landing. Hedgewise should do quite well as soon as the future is better known. In the meantime, there are a few silver linings if you know where to look.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• 2021 was another great year for Hedgewise, as it successfully navigated rising bond yields and outperformed all major Risk Parity alternatives.
• Despite the rocky start to 2022, there are many indications that Hedgewise risk management techniques have been working effectively.
• As interest rates normalize, it will likely open further opportunity for Hedgewise to outperform despite volatility in equities.

Introduction: Understanding the Start of 2022

The individual narratives of the past two years (Covid, interest rates, government stimulus, and meme stocks, among others) have obscured the simple but slow-motion story playing out beneath the surface. The Fed brought interest rates as low as it possibly could in response to a crisis, which logically fueled bubble-like asset prices and speculative mania. In 2021, markets eagerly assumed that this was sustainable, a belief which was encouraged by the Fed's assertion that inflation was transitory and that it would leave rates lower for longer. Over the past month, it has become clearer that the Fed was mistaken, but markets are still deciphering the size of the mistake and how it will be unwound.

This uncertainty is driving recent market volatility, which is in line with the expectations set out in earlier market commentary. As a quick refresher, Hedgewise summarized this likely narrative all the way back in September 2020 with the following illustration, which shows how artificially low interest rates change return expectations over time. The blue line is the "normal" state of markets with rates above 2%. The orange line is the "expected" behavior after rates hit zero, and the yellow line is what may happen at the extremes.

How Passive Expected Total Returns Change Over Time with Zero Interest Rates

The 'frothy' segments of the market were likely hovering around the yellow line, while the S&P 500 was somewhere closer to the orange one. This month, we are traversing down the first dotted red line as markets digest the possibility that interest rates may need to settle much higher than assumed. For traditional passive investors, this presents a conundrum: you either go along for the ride, which will involve big initial gains followed by mediocre returns at best or significant losses at worst, or you try to time it but risk getting out too early or too late. This isn't a very compelling option set, but the good news is that Hedgewise is built to sidestep it. 2022 presents an excellent opportunity to showcase this in action, and the benefits of the approach can already be seen with the right perspective.

Unpacking Recent Hedgewise Performance

A counterintuitive aspect to risk-managed investing is how short-term losses can be viewed positively in the bigger picture. For example, if a 1% loss significantly increased the chance of an eventual 5% gain, that is a great trade-off. The Fed's response to the pandemic has amplified this dynamic in very specific ways, the most easily of which applies to the bond market.

Bonds are unique because the Fed can force a 'bubble' by pushing interest rates to zero and buying trillions of dollars of securities through quantitative easing. This is how aberrations like negative real yields can persist, which guarantee a long-term loss on a bond investment. Such a performance profile lines up very nicely with the yellow 'growth/bubble' line on the prior illustration.

Since it is easier to observe and predict this kind of bubble, it can also be taken advantage of by reducing bond exposure as interest rates get closer to zero and vice versa. Hedgewise discussed its theoretical approach to this in an earlier article, but 2021 presented an excellent live test. The following graph compares a passive investment in long-term Treasury bonds to the approach used in the Hedgewise Risk Parity "Max" portfolio (i.e., this shows the return of a 100% investment in 30yr Treasury bonds compared to the performance driven by the monthly percentage weighting in the Hedgewise RP Max strategy).

Performance of Passive Bond Investment in 30yr Treasuries vs. Hedgewise Approach, 2021

Hedgewise effectively converted a net 5% loss in Treasury bonds into a 1% gain last year. This outcome played a key role in allowing Hedgewise to outperform all major public Risk Parity alternatives in 2021.

Performance of Hedgewise Risk Parity vs. Major Public Alternatives, 2021

While this is a nice validation of Hedgewise risk management techniques, 2022 will likely present an even greater opportunity to demonstrate their effectiveness. Counterintuitively, the potential for gain increases with volatility and as bond yields move higher. For example, the following simulation shows how bonds would be expected to affect the Hedgewise portfolio if interest rates moved all the way up to 4% over the next 18 months before settling at 2.5% in 3 years.

30 Year Bond Performance Impact Simulation: Passive vs. Hedgewise, 3 Year Period

In this scenario, bonds would boost the Hedgewise portfolio by an average of 6% annually despite a slight overall loss for a passive investment. However, this does require 'looking past' the initial 10% drawdown with a focus on the relative total opportunity rather than absolute point-in-time performance.

This context will help to make greater sense of 2022, as rising interest rates should be a boon to Hedgewise even if volatility and small drawdowns are a natural part of the picture.

Analyzing the Rocky Start to 2022

Here is a quick look at how Hedgewise has performed against the major asset classes as of January 24, 2022.

Performance of Major Asset Classes vs. Risk Parity "Max", 2022 YTD

Hedgewise is down about 4.4% at the Max risk level, while equities have lost 7.6% and bonds have lost 5.4%. Intuitively this seems like a reasonable outcome, but it is still difficult to sustain losses and it is natural to wonder whether this could have been improved.

A deeper dive into historical data reveals how this first impression is deceiving. Since 1970, there have only been three other months in history (!) when stocks have lost 5% or more, bonds have lost 2% or more, and gold has failed to rally. The following graph shows the performance of the RP Max model portfolio in each of these months, alongside how it did relative to the S&P 500. The result in this current month has been highlighted for comparison.

Historical Performance of RP Max Model Portfolio in Similar Months to January 2022

Outside of the current month, the model lost 9% on average, and did 2% worse than equities. In January, the live portfolio has lost 4.4% while outperforming equities by over 3%. This highlights a few neat points.

First, this has been a historically extreme month. All the other data points occurred in the 1970s, and it is no coincidence that is the last time inflation was a major problem. That said, inflation reached well over 10% in that decade, but you still only had three months as bad as what just happened in January. There's strong reason to expect this will be near the worst of the year, especially from a cross-asset perspective.

Second, it is remarkable to have a loss of only 4% given the circumstances, and this reflects the power of neutralizing the risk of rising interest rates.

Finally, the further that rates travel above 2%, the more potential benefits accrue to the portfolio as bonds return closer to normal historical weights. If stocks have further to fall, bonds should provide a more powerful source of diversification. The yield itself is higher, which very directly increases the financial benefit of holding bonds. And as discussed earlier, bond volatility itself can provide an alternative means of gain that is independent of passive returns.

The more serious a threat inflation becomes, the more likely that these benefits will be amplified. While the losses of this month may be uncomfortable, these broader implications are welcome.

You may be wondering why I haven't spoken much about equities yet, but there's a good reason for that. From a Risk Parity perspective, if you can neutralize the impact of rising interest rates in an otherwise inflationary environment, you get a recipe for mostly positive outcomes regardless of what stocks wind up doing.

Why Not to Worry About Stocks

The funny thing about risk management is that it is much easier to see how effective it is when markets are having problems. Equities have had an incredible run on the back of the Fed's artificially low interest rates, but it was inevitable that it would end sometime and Hedgewise is well-prepared for it.

Hedgewise has multiple levers for managing drawdown risk in any given asset class. Equity exposure is not particularly high this month from a historical perspective, and that will continue to adjust as market risk changes. Other asset classes, especially metals like gold and copper, are also likely to provide effective protection against scenarios like a recession or stagflation. In many ways, the Fed had repressed the utility of these levers by keeping interest rates artificially low for so long, and it will be a positive development to see more natural market behavior return.

The current environment is reminiscent of the mid-1970s, though inflation probably won't peak nearly as high as it did then. The Fed kept rates too low in the late 60s, and stocks were the only game in town for many years. This led to a very tumultuous decade for equities once inflation became a problem in 1973, but the Hedgewise Risk Parity model was relatively unaffected.

Annual Performance of S&P 500 vs. RP Max, 1973 to 1981

There were still plenty of drawdowns in this timeframe, but that is expected. The more important points were how uncorrelated those losses were to the stock market, and that the strategy produced a better risk-adjusted return over time.

Cumulative Performance of S&P 500 vs. RP Max, 1973 to 1981

In the present day, there's even greater reason for optimism because of how Hedgewise can effectively neutralize the current risk of rising rates. Taking this into account, drawdowns should be even more moderate and infrequent than they were in the 1970s. The normalization of interest rates should allow bonds, gold, and commodities to play a much more significant and healthier balance in the portfolio than has been possible in this strange pandemic era.

Wrapping Up

From an investment perspective, it is likely that the 'boom' times are over, that volatility and uncertainty will increase, and that outcomes like a recession or stagflation are possible. This will be unfamiliar for many market participants since inflation has not been a problem for nearly five decades, and it is difficult to comprehend a Fed which has 'lost control' of the situation. Fortunately, these are the kinds of circumstances for which Hedgewise Risk Parity was built.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Hedgewise has performed very well in 2021, with YTD gains of 15-20% within the higher target risk levels.
• Many clients worry that the "Fed bubble" and associated market froth will threaten these gains, which can feel especially acute after a month like September when many asset prices fell together.
• The reality is closer to the opposite: cross-asset drawdowns usually reverse, regardless of what happens subsequently to individual asset classes.
• Unlike traditional passive approaches, Risk Parity is far less sensitive to "bubbles", wherever they occur. Leaving cash on the sidelines tends to be a far bigger risk, regardless of current market conditions.

Introduction: A Terrifyingly Great Year

2021 has been a fantastic year of performance against a backdrop of extreme fear. Equity valuations are 15-25% higher than their historical averages, interest rates have nowhere to go but up, and price levels for all kinds of goods - groceries, cars, houses, you name it – have been skyrocketing. Intuitively, this feels like a terrible time to be an investor, and that may be true for individual asset classes. Fortunately, Hedgewise clients do not need to share these concerns.

The brutal contradiction of market bubbles is that it can be a terrible move to try and avoid them. Equities provide a nice case-in-point in 2021: earnings this year have come in about 20% higher than the initial analyst estimates in January, which accounts for almost all the YTD gains. Even if the "overvaluation" were to suddenly correct tomorrow, earnings have already made up for it. It would be painful to suddenly lose 20%, but if you had invested since January, you would merely return to breakeven.

The problem for traditional passive investors is that years like 2000 or 2008 exist as real possibilities: losses of that size can wipe out a decades' worth of gains or take a decade to recover. It seems natural to apply the same caveat to Risk Parity, though that would not be proper. The most powerful aspect of the Hedgewise approach is how dramatically it reduces the possibility of such extremes.

The ideas are simple: reduce exposure to assets as their inherent risk increases and balance the overall portfolio equally against any economic outcome (growth, recession, inflation, or deflation). Over the short-term, it can feel scary to trust how this works. Isn't it still vulnerable to an "everything bubble"? What if it happens suddenly? Yet a vast amount of data and theory demonstrates incredible persistence and shows why Hedgewise Risk Parity remains an excellent option, especially during times like these.

Reviewing 2021 YTD Performance

Here is a quick look at how Hedgewise has done compared to the other major asset classes year-to-date. The following shows the performance of the Risk Parity "Max+1" strategy, which is the active Hedgewise portfolio with the closest target volatility to the S&P 500.

Hedgewise RP Max+1 Performance vs. Other Asset Classes, 2021 Year-to-Date

Hedgewise has managed to keep up with stocks despite an environment of high volatility and significant underperformance in bonds and commodities. Diving a little deeper, it has been a terrible year for gold and 30yr Treasuries, both of which represent significant pieces of the Hedgewise portfolio.

Performance of Gold and 30yr Treasury Bonds, YTD

Both assets showed signs of elevated risk throughout the year, so neither drawdown had a significant impact on the Hedgewise portfolio. The growth assets that rallied alongside this (i.e., industrial commodities and equities) easily compensated for any losses.

These details paint the more nuanced story of the Risk Parity portfolio. At the start of 2021, it was true that bonds and gold were about to lose ~10%, but that also meant that growth would be strong enough to sustain rich equity valuations and drive significant earnings expansion. This balance is inherent in any given economic outcome; an "everything bubble" is only dangerous if they all somehow pop at once.

This can happen over a short timeframe, but it is fundamentally unlikely to persist. Usually, it is a sign that investors fear conflicting possibilities, but only one can happen. Last month presented an excellent case study for this pattern.

Why Did This Happen in September?

Investors are especially jittery about rising interest rates. In September, the Fed was a little more hawkish than expected, which activated a broad "risk-off" move. Bond investors fear higher yields, and stock and commodity investors fear lower global growth. This naturally resulted in a cross-asset drawdown.

Hedgewise RP Max+1 Performance vs. Other Asset Classes, September 2021

This performance suggests confusion because the Fed is raising rates to fight inflation, but inflationary assets like copper and gold are falling because of worries about global growth. This tug-of-war must eventually reconcile; either the economy can tolerate higher real interest rates, or growth slows down so much that the Fed must reverse course. At least one asset class should be rallying, but no one knows which one yet.

While this may need a few months to resolve, it always has. The following chart shows the six-month subsequent performance for each asset class following any month where stocks lost at least 3% and neither bonds nor gold rallied alongside.

Performance of Major Asset Classes, Six Months Following A Cross-Asset Drawdown

While it is difficult to predict which asset class will recover, the Hedgewise approach makes that unnecessary. Since at least one will rally, it is unlikely that Risk Parity will sustain much additional loss. This is in stark contrast to passive equity investors, as exhibited by the following chart.

Performance of S&P 500 vs. Risk Parity, Six Months Following A Cross-Asset Drawdown

Notice how the Risk Parity model mitigates every major drawdown in the S&P 500. This happens because bonds and gold tend to rally if the S&P 500 falls further, and because the strategy minimizes overall exposure in risky conditions. When utilized intelligently, these techniques function in any market environment. That said, "stagflation" (i.e., sluggish growth alongside high inflation) does introduce a few wrinkles, including the ”outlier" Risk Parity drawdown of 1981. This is worth exploring more deeply, especially since stagflation is one of our major present concerns.

What To Expect From Risk Parity During Stagflation

Stocks and bonds generally suffer losses during stagflation, but real assets like gold, energy, and industrial metals can outperform because those raw commodity prices are a significant piece of inflation. Alongside broader risk management, this explains how Risk Parity weathered the decade-long stagflation of the 1970s and provides a template for what to expect if it happens again. Risk Parity consistently outperformed the S&P 500, but also experienced frequent, sizeable drawdowns (the size of each loss is highlighted on the graph).

Performance of S&P 500 vs. Risk Parity, 1974-1982

Notice how the drawdowns were short-lived and happened alongside annual gains of nearly 10%. This makes perfect sense! Investors were incredibly nervous, and the news was frequently bad: profit margins were under pressure, raw material prices were soaring, and no one knew how high interest rates needed to rise to get inflation under control. Amidst the resulting volatility, various asset classes became undervalued, and Hedgewise was well-positioned to participate in the ensuing rallies. To succeed in this environment, investors needed to constantly look past near-term losses with the understanding that these events had fundamental reasons to resolve.

The takeaway is that short-term drawdowns - even drawdowns of 20% or more - are par for the course, especially in an environment of stagflation. Even if you had invested at precisely the wrong moment in 1974, 1975, or 1977, you still accrued significant gains over any three-year period.

The high volatility presents a temptation to time the tops and bottoms, but this requires an immense degree of precision, and overlooks a significant opportunity cost. Whenever you have cash on the sidelines, you miss potential gains in every month outside of the drawdown. For example, the 15% loss from September to December 1978 was preceded by an even larger gain in the two months prior.

To provide broader historical context, the following table calculates this prior "breakeven period" for every major drawdown of the Risk Parity model since 1970. In other words, this shows how many months you needed to invest before each drawdown to completely offset it.

Date	Total Loss	Months Invested Prior to Peak to Fully Offset Loss
September 1974	-17%	13
October 1975	-18%	9
February 1977	-14%	3
December 1978	-15%	2
April 1980	-24%	8
October 1981	-23%	14
July 1984	-27%	8
September 1988	-21%	12
May 1990	-21%	7
December 1994	-17%	9
September 1996	-14%	3
November 2008	-16%	5
November 2018	-14%	4

Even if you had perfect foresight, and could time every drawdown's exact top and bottom, you are usually better off investing earlier and ignoring the subsequent volatility (on average, the breakeven period is 7 months). Consider the experience in 2021: the same set of risks exists today as did back in January, and many investors have been sitting in cash since then in anticipation of bubbles popping. They have now foregone YTD gains of nearly 15% and will need to time a drawdown of at least that size to merely catch up, if such an event happens at all.

Obviously, returns would be better if you could participate in the upside and sidestep every dip, and it is painful to suffer big losses even when you have a large buffer of gains. But if worrying about this keeps you in cash for months or years at a time, you will usually lose much more in opportunity cost than you could ever recover with the most astute timing.

As a final contrast, this same logic does not apply to the S&P 500 in isolation. The crash of 1974 wiped out over 6 years of gains, and the crash of 2008 wiped out over 10 years of gains. The mechanics of Risk Parity dramatically reduce the chance of these extreme outcomes because it is constantly positioned for so many different economic scenarios. While drawdowns are still inevitable, there is a much higher probability that they will be both short-lived and moderate compared to prior gains.

It is sensible for traditional passive investors to fret about bubbles in the S&P 500, but Hedgewise clients have the luxury of different experience.

Wrapping Up

A powerful feature of the Risk Parity framework is how it can empower a shift of mentality. Drawdowns can feel less dramatic, and bubbles can be less important. It becomes easier to embrace this as you more deeply understand the methodology, but it is still difficult to reconcile how a broadly terrible investment environment can be perfectly fine for Hedgewise.

The most important idea is that something will perform well in every economic environment, and that means your portfolio gains protection if you hold everything in equal balance. When investors are highly uncertain, that can lead to pockets where all assets fall together, but this must resolve as the outcome becomes clearer.

Stagflation might seem like an outlier, but this is precisely the environment where gold, energy, and industrial metals do well. Short-term drawdowns may be bigger and more frequent, as they were in the 1970s, because investors are sorting through many conflicting possibilities in a generally stressful environment. However, they do not present the same kind of existential threat that equity investors face because the strategy is built on a different foundation.

The natural intuition may be to avoid these drawdowns, either by timing the market or leaving cash on the sidelines, but it is extremely difficult to overcome the opportunity cost along the way. On average, it takes a mere 7 months to gain more than the size of any subsequent loss. Historically, Hedgewise Risk Parity has never lost money over any three-year period. If you can build drawdowns into your expectation and invest without hesitation, you will almost certainly be better off over the long run.

Equities are probably overvalued. Interest rates will probably go up. The post-pandemic economy may be a twisted mess of snarled supply chains and sky-high prices. For many investors, it seems like there is nowhere to turn. For Hedgewise, it is just another regular year.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• In 2021, Hedgewise has gained 2.5% - 9% (depending on your risk level), keeping up with the performance of the S&P 500 despite its torrent pace and without overexposing clients to a potential equity pullback.
• This performance is especially remarkable compared to bonds, which have lost 10% this year and nearly 30% since last March.
• Though stocks have performed well in 2021, there remains a significant amount of market "froth". Pockets of excessive speculation have already begun to unwind, with many Covid-era favorites down 20 - 40% from their peak in February.
• Inflation is a real threat to market valuations because even a slight normalization could justify a 15 - 20% correction to the S&P 500. There is a high probability that rates will return above 2%, but this is not reflected in current equity prices. The Fed may be erring by allowing the economy to run too hot, which is causing labor shortages and supply disruptions.
• Hedgewise provides a unique haven for its clients by relieving any need to decipher these risks. As we near the tail-end of the Covid crisis and its aftermath, this approach will likely outperform most alternatives.

Introduction: Is There a Bubble or Not?

The chaos of the past year makes it hard to hold on to a consistent narrative. The event itself was terrible, but the economic outcome might be good? Or the economic outcome is bad, but the investing outcome is good? The reality is complex, and there are competing narratives unfolding in parallel.

As previously examined, the combination of enormous fiscal and central bank stimulus has been a primary driver of asset prices over the past year. A single observation sums this up nicely: the S&P 500 is expected to realize earnings in 2021 about 4% higher than what was expected in January 2020, before any of us saw Covid coming. The price of the S&P 500 is now ~30% higher than it was back then. Can both prices be rational at once?

The confounding factors include the impact of near-zero interest rates, government stimulus checks, unemployment benefits, the vaccine and re-opening cadence, and an explosion of speculation. In some segments of the market, this led to definitive bubbles, and many of those have begun to correct. The S&P 500 is more difficult to decipher because of deeper crosscurrents.

The US recovery has been faster than expected this year, with 2021 Q1 earnings beating estimates by over 8%, and this alone has driven most of the YTD gain. Alongside, long-term interest rates have reverted to where they were in January 2020, but there has been little correction of price-earnings multiples to adjust. This latter inconsistency is difficult to reconcile and helps to explain the volatility in equities happening recently. The economy has been snapping back faster than expected, but prevailing prices were anchored to unrealistic interest rate assumptions to begin with.

This "frothiness" will probably continue to unwind, and inflationary pressure is the most likely catalyst. Investors are noticing that a "hot" economy comes with drawbacks, and that higher rates may be both necessary and healthy. In a great final irony, the last act of Covid may be how the return of a balanced, productive economy is directly at odds with inflated asset prices.

If this makes your head spin, take comfort that the Hedgewise approach sidesteps these concerns and is in an excellent position to outperform during this potential unwinding. The strategy is built to withstand any economic environment, and it already anticipates the impact of high inflation, rising rates, or whatever comes in between.

Analyzing Recent Hedgewise Performance

Here is a quick look at how the Risk Parity Max strategy has performed against other major asset classes so far in 2021.

Performance of Risk Parity Max vs. Major Asset Classes, 2021 YTD

Hedgewise has kept up with the S&P 500 despite its excellent performance and the worst start of the year for bonds in decades. While I've published prior research on how Hedgewise manages the risk of higher interest rates, it is still remarkable to see it go precisely according to plan. Risk Parity is often misconstrued as a bond-heavy strategy, but this period firmly refutes that notion.

Widening the perspective to a longer timeframe reinforces how little correlation Hedgewise performance has with bonds, and how Risk Parity has firmly outperformed that asset class over the past half decade.

Performance of 30yr Treasury Bonds vs. Risk Parity Max, January 2016 to Present

Bonds have done quite well since 2016, yielding almost 5% per year, and had a huge spike during the pandemic. That was only sufficient to catch up with Hedgewise, and performance has since regressed with the economic recovery. Risk Parity has exhibited lower volatility, lower drawdowns, and higher returns throughout. This is possible despite bonds having typically been a substantial portion of the Hedgewise portfolio, often at weights of 50% or above. Intelligent use of risk management and diversification transforms a portfolio into something greater than the sum of its parts. Viewed as an alternative "safe" investment to long-term bonds, Hedgewise has demonstrated itself as a consistently superior option.

This story is easy to tell over long stretches of time in which the performance of every asset class has ebbs and flows. It is harder to isolate the benefits for a time period when a single asset class is surging, as the S&P 500 has done recently.

Performance of S&P 500 vs. Risk Parity Max, January 2016 to Present

The missing caveat is that Risk Parity Max is built to target half the overall risk of equities, with the expectation that level can still match or beat stocks over most long-term time horizons. To fairly compare performance, especially over shorter timeframes, both strategies should be set to an equivalent level of risk. The following simulates the Risk Parity strategy set to a similar level of volatility as the S&P 500 during this period (named "RP Max+2").

Performance of S&P 500 vs. Risk Parity Max+2, January 2016 to Present

A Risk Parity portfolio exhibiting nearly identical levels of volatility and drawdown to the S&P 500 has still outperformed it since 2016. Over this stretch, stocks gained over 16% annually and avoided any lasting pullback, market whipsaws dragged on risk-managed performance, and elevated volatility muted Hedgewise participation in the pandemic recovery. None of this has been enough to handicap the strategy relative to equities when compared on an equal basis.

While these results look tempting, remember that the Hedgewise portfolio is designed to outperform stocks over longer-term horizons and to minimize the risk of loss. Whenever stocks next encounter a sustained pullback, Hedgewise should even further differentiate itself because of the strategy's diverse construction. This can be more easily understood by breaking down the source of returns in 2021.

Hedgewise Return Contribution by Asset Class, January to May 1, 2021

Gains in 2021 have been driven by a nearly equal mix of energy, industrial metals, and stocks. Meanwhile, losses in the bond market have been mitigated using the risk management techniques discussed previously. Should stocks switch places with bonds next, the portfolio's resilience will persist.

The takeaway is that Risk Parity has functioned as expected this year and throughout the pandemic. The outlier has been the rapid appreciation in equities and other speculative pockets, which has exacerbated a trend of excessive risk-taking. Much of this is already unwinding with the economic re-opening, and highlighting the inherent dangers of joining in.

Understanding and Navigating Market Froth

The investing story of the pandemic is easiest to understand at the extremes. A flood of money hit the market last year through the Fed and government stimulus, and eventually combined with new financial technology and bored stay-at-home traders to create a tsunami of speculation. Price appreciation eventually snowballed on itself and became disconnected from any real narrative of the economy. Meme stocks and cryptocurrencies are probably the best examples of this, but there have been many other themes, including stay-at-home beneficiaries, high growth stocks, the re-opening trade, SPACs, IPOs, and others.

We have reached a point where these can be clearly labeled bubbles.

Performance of Popular Covid Trades, February 8, 2021 to Present

This is meaningful to observe because it dispels the notion that perhaps the appreciation has been reasonable. Bubbles have absolutely been a part of the story, and there have already been serious losses for those who invested recently. Many of these companies remain up 100% or more compared to last January despite this correction, suggesting additional downside is likely.

This extreme view helps to introduce what is happening in the S&P 500 more broadly. Many of these individual companies are part of the index, so there is some direct crossover. The bigger impact comes from a general lift of stock valuations across the board on a relative basis. This "frothy" spillover effect is not large enough to form an outright bubble, but it is having a measurable impact.

The obvious way to examine this is with price-earnings multiples. The best analytical case for elevated valuations is that low interest rates justify higher prices. You can get a sense of how this trade-off works by modeling a few back of the envelope assumptions. The following table shows what different interest rates imply as a "fair" P/E multiple, the associated "fair" price of the S&P 500, and how that compares with the actual market price today.

Interest Rate	Model P/E	Model Price	Vs. Current
1.65%	21.5	$3,947	-5%
2%	20.0	$3,670	-12%
2.5%	18.2	$3,337	-20%

Currently, 10yr Treasury bonds are hovering close to 1.65%, while 30yr bonds yield closer to 2.5%. Depending on which one you think is the fair interest rate to apply to stock valuations, the S&P 500 is somewhere between 5% and 20% overvalued.

Part of the reason this persists is because the Fed is keeping short-term rates at 0%. Until these come off the ground, prices lack a catalyst to forces revaluation. Inflation is the most likely driver of this, and the market is grappling with whether the Fed will have to act to control it.

In an overheating economy, rising prices come from a shortage of raw materials, labor, and transportation. This slows down production everywhere, and sudden price jumps in staple goods impact the livelihood of families whose income has yet to catch up. This is a "bad" kind of inflation that causes real suffering.

The Fed appears content to tolerate this for the sake of a robust Covid recovery, but the market is seeing that it might be too much, too fast. For example, lumber prices have jumped over 300% in the past year. This creates scarcity across the construction market with no positive spillovers; it may even reduce hiring because firms cannot get the supplies they need to do their work.

The economy will be better off when it returns to a moderate pace in which 2% - 2.5% interest rates are necessary and a sign of health. If it overheats first and rates jump quickly, an equity correction is likely. If it gets there more slowly, prices could bounce around for a year or two until earnings fully catch-up with valuations. Either way this froth will present a headwind until it resolves.

The question is what this all means to you as an investor.

Does It Matter to Your Portfolio?

The answer depends on what kind of investor you are, and what adjustments you made over the course of the pandemic. For Hedgewise clients, none of this requires action or concern. Risk Parity can weather a 20% stock correction just like it weathered the recent bond crash. Avoid the temptation to shift your risk level or portfolio mix in response to this speculative mania. Performance tends to even out over time without the need for excessive risk-taking.

For pure equity investors, a long-term passive allocation remains reasonable despite the current froth. Over 15 years, this probably will not matter much. Periods of muted returns or corrections should be part of the expectation. However, if you do not have the risk tolerance or time horizon for such losses, or you had participated more actively in the speculation of the past year, now may be an excellent time to unwind those bets.

On balance, the competing narratives of the pandemic will settle somewhere between the economic recovery being faster than expected and speculators getting too far ahead of themselves regardless. The pace of inflation will be the key to how it resolves, and the Fed may contribute to unnecessary collateral damage if it waits too long to raise rates to more normal levels. Risk Parity is well positioned for such an environment because of its mix of inflation-sensitive assets and its ability to navigate corrections, as recently witnessed in the bond market. The froth in equities cannot last forever, but that story is only meaningful if you have constructed your portfolio around it.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Hedgewise Risk Parity prioritized stability and returned 3% across most risk levels last year. Maximum drawdowns were less than half those in the S&P 500, and Hedgewise has a systematically brighter outlook than most passive strategies heading into 2021.
• The Fed has made real interest rates negative and effectively transferred profits from the future to the present. Any money made today is lost from tomorrow, which manufactures a de facto "bubble", encourages excessive speculation, and leaves investors with few realistic options.
• Hedgewise purposefully foregoes these kinds of short-term gains to ensure that long-term expectations remain positive and stable. Performance data firmly validates that this approach has driven higher risk-adjusted returns over time, even after a year where it "skipped" historically significant price inflation.
• Moving forward, Risk Parity is uniquely positioned to capture gains regardless of whether bubbles pop, rates rise, inflation spikes, or yet another unforeseen economic shock appears.

Introduction: Zero Interest Rates Are Not Free

As I covered in the last newsletter, the Fed's actions in 2020 represent a bigger economic story than the pandemic itself. It has dropped interest rates further and faster than any other time in history, and promised to keep them down indefinitely. As a result, real interest rates are now deeply negative, meaning investors are paying money to own government bonds, and this has had dramatic ripple effects across the entire investment universe.

In the last piece, my focus was on the broad mechanics of this on the economy, and how it would effectively increase prices, decrease return expectations, and amplify risk across all asset classes. The trouble is that on its face, this message seems similar to whenever the Fed has lowered interest rates, but that's not quite right. We've entered a degree of extremity that is very new, and that is unlikely to follow historical precedents in what happens next.

For a variety of reasons, the Fed threw "everything it had" at the pandemic last year. The scope of its intervention dwarfed anything that came before, and it has also brought the Fed about as far as it can go. If true, interest rates have finally reached a bottom after 30 years of churning ever lower. This creates two novel dynamics: the Fed has little ability to raise bond prices any higher, and current price levels are extraordinarily inflated. This is the end game of an economy over-reliant on the Fed for support, and it comes with a steep cost.

The logical result is asset bubbles with a number of odd properties. Unlike 'normal' bubbles, the Fed literally props these up, and they can persist despite outside investors being fully aware of the circumstances (e.g., the Fed can print money and buy bonds at a certain interest level even if no one else will). Ironically, this anchoring effect enables an inevitable "everything bubble" that is amplified by cascading ripple effects. Interest rates near zero justify explosively high multiples in riskier assets, and the difficulty in establishing an objective "fair price" encourages speculation and irresponsible risk taking. Phenomenal amounts of liquidity injected into the financial system as part of the Fed's mechanical process serve as the perfect enabler to allow this to spiral further.

Investors face an impossible choice. Most assets are already pulling future profits into today's price (because of zero interest rates), so there is no compelling passive option. Meanwhile, the riskiest investments rapidly appreciate due to speculative fervor. Despite increasingly negative long-term implications, there can appear to be no alternative to joining the speculation and hoping you can get out before it breaks.

The glue holding this unstable situation together is the belief that the Fed is in control, and it will not come undone so long as it remains that way. If there is even a tiny inkling that it may lose that grip - any kind of inflation scare would probably be sufficient - the bubbles will lose support. Even if the Fed vows to keep rates at these levels forever, you'd still be vulnerable to any other kind of economic shock, after which the Fed would have little ammunition remaining to buffer the impact.

Fortunately, Hedgewise provides another choice that can still function like a passive investment is supposed to. It has a positive long-term return expectation because it has alternative paths to gains, including commodity exposure and volatility management, and it explicitly minimizes exposure to assets as they become speculative. The trade-off is that you forego some gains along the way, but performance data demonstrates that this is consistently the right move, including in 2020.

Understanding the Fed Bubble Debate

Fed bubbles are tricky because lower interest rates logically inflate prices. If interest rates never rise back up, you could argue that it isn't necessarily a bubble. Mechanically, this is simplest to understand via the Treasury bond market, which now faces a dilemma conceptually like the following graph.

Present Environment of Treasury Bonds

The situation in our present day is historically unique because real yields are negative, and the Fed exhausted its arsenal last year in response to the pandemic. All available future profit has already been pulled into today. The question for thought is whether this picture represents a "bubble".

Consider that you can only lose money from a passive investment in this asset, and that there is no compensation for significant downside risk. While it may not be based in speculation or irrationality because the Fed is controlling it, it's a terrible deal by any other name.

Investors allow this to persist because the Fed can directly control bond prices via money printing, and because a similar dynamic simultaneously applies to most other kinds of investments. In other words, there is no perceived alternative to taking the bad deal.

The "Everything Bubble"

The link between bond prices and interest rates is definitional, but most other asset classes will be similarly affected. This is because you have to decide how to discount future cash flows for an investment in anything; if you discount them by 1% instead of 5%, you get a much higher present fair value. This is always true, but in the same vein as Treasury bonds, we have gotten into uncharted territory with the Fed's actions during the pandemic.

It's not possible to know precisely how much an impact it should have on an asset class like equities, but we can get to some basic estimates with a simple discounted cash flow model. The following chart models how three different types of investments might respond as interest rates fall from where they started 2020 to the lows reached over the summer. This assumes that there are no other changes to earnings, longer-term economic prospects, etc. - this is the impact of interest rate changes in isolation.

Interest Rate Model Impact on Prices in Bonds, Large-Cap Stocks, and Growth Stocks

The reason that growth stocks might appreciate so much faster is a mathematical quirk of fast earnings growth assumptions and low interest rates. In broad strokes, the idea is that a risky asset with a small chance of making a huge amount becomes much more valuable when returns are scarce elsewhere. It requires a degree of naivety to believe this is valid, especially at extreme price levels, but the broad point is that the case can still be made.

Though these numbers are merely "back of the envelope", the similarity to 2020 is notable. 30yr Treasury bonds returned 29.53% from January through August; the S&P 500 returned 43.89% from April through August; Tesla was up 393.23% from April through August.

To emphasize, these gains do not come from any actual changes in total profit. If interest rates stay where they are, you face expected future returns that are lower by an equivalent amount spread over time; if interest rates go back up, you expect to incur identical short-term losses as the situation reverts. It's many different versions of the same bad deal: most assets get unreasonably expensive and face increasing downside risk in cascading degrees.

The wild part of all of this is that as the deal gets worse and worse in terms of the future, you make more and more money today. How is a rational investor supposed to approach this?

The FOMO (Fear of Missing Out) Effect

The basic problem is that no rational investor wants to miss out on profit. Consider this example: today is day zero, and somehow you know for sure that equities are going to yield no greater than 3% a year with a 50% downside risk over the next decade. Is that a compelling investment?

Next, imagine a slight wrinkle. Equities keep the same total return/risk profile, but this time you know equities will gain 30% over the next twelve months. After that, they will yield no greater than 0% a year with an 80% downside risk over the remaining nine years. What's the right approach?

It will be extremely difficult for an investor to forego the 30% gain, despite the fact that this is otherwise a poor investment. Thus, many will pile in on the way up, fearing to sell before the peak and miss this last bit of upside.

This pattern is further amplified in riskier, more illiquid segments of the market where outsized returns are perceived as more likely. Ironically, as an asset price becomes increasingly disconnected from economic reality, it becomes easier to believe that it may be justified as others appear to buy at yet higher prices.

With few compelling opportunities elsewhere, and a broad sentiment that maybe low interest rates make all of this reasonable, this kind of speculative fervor can easily turn the "Fed bubble" into a much more garden variety one. There is little doubt that this is now happening in many fringes of the market, including in penny stocks, cryptocurrencies, and SPACs at a minimum.

The psychology in play is similar to most bubbles in history, but our current conditions provide a uniquely fertile ground for this to happen. There is more cash than ever floating around the system due to a combination of massive fiscal stimulus, direct asset purchases by the Fed, and delayed spending due to the pandemic (trips, entertainment, etc.) The normal "safe" options to park that cash are gone because the Fed has put the same "bad deal" in place across the board. If everything is in a bubble anyway, what option do you have but to buy in?

This is a false choice. Proper risk management is built with just these kinds of situations in mind. It allows you to lean away from risk, rather than into it, without sacrificing long-term gains. It sidesteps the bad deals and the speculation, and focuses on a more stable return stream. These techniques continued to work as expected last year, and create a systematically more positive outlook than most investors face moving forward.

Another Option: Evaluating Hedgewise Risk Parity in 2020

Let's briefly return to the basics of the bond market. For the 2020 calendar year, long-term bonds gained 22.5%, but this also introduced negative real interest rates and the bleak future prospects discussed earlier. Hedgewise missed out on most of that gain on purpose, and as a result, returns were 10-15% lower last year than they might have been (depending on risk level). There is also significant evidence that this was the right move.

Risk management is grounded in the idea that greater stability wins over the long run. It isn't worth chasing potential upside if it introduces future downside. By avoiding environments of excessive risk, you expect to eliminate both big gains and big losses, and you expect that to be a winning trade-off over time.

Last year presents a fascinating case study of this principle because bonds had such large annual returns, but achieved this is in the riskiest possible way (i.e., the Fed eliminated the possibility of future positive real returns). It should be little surprise that exposure to bonds was limited throughout. The question is whether this missed upside is mitigated by other periods of minimized downside.

Fortunately, this question is easy enough to answer, and we do not have to wait to see how the immediate future pans out. If the theory is working according to plan, the benefits of stability should accrue constantly over time, and demonstrate resilience even during a year like 2020. Data shows that this is exactly the case.

Here's a look at the performance of the normal Hedgewise risk model compared to a "simpler" one which does not account for the absolute level of interest rates (see more detail on the specific Hedgewise approach). For context, the simple model generally has 60%+ bond exposure at all times, while the normal model had less than 10% exposure for most of 2020.

Hedgewise vs. Simple Model Performance Since 2010

	Annual Return	Volatility	Sharpe	Max Loss
Hedgewise Model	14.11%	10.42%	1.35	-10.66%
Simple Model	14.19%	13.44%	1.06	-18.57%

Since 2010, the normal risk management algorithm has achieved nearly the same exact return with 30% less volatility and half of the maximum drawdown. Looking deeper into how that unfolded, notice how the simple model outperformed dramatically from 2019 onward, but that only served to make up for its underperformance for three years prior. These periods are two sides of the same coin; you can't have one without the other. In some periods of heightened risk, it limits losses, while in others it misses gains. Over time, the benefits should outweigh the costs, and it's clear that they have.

This is especially impressive considering that bonds likely reached their peak possible price last year. The strategy has foregone as much short-term performance as it likely ever will, and the results still hold up at this moment in time. Meanwhile, the "simple" model is now facing its darkest ever outlook. You can already begin to see this unwind as interest rates have started creeping back up since their lows last August.

Hedgewise vs. Simple Model Performance, August 2020 through January 1, 2021

Every outcome being studied here is not surprising from a financial theory perspective: this is all how it is supposed to work. The challenge is reconciling short-term intuition about what is happening. You do not want an extra 10-15% gain last year in the form that it came; if you had taken it, you would have already lost more than it was worth in the years prior, and now you'd be stuck with a terrible future outlook. Proper risk management is constantly positioned for systematically better performance, but it will be the easiest to second-guess at the height of a speculative frenzy. Ironically, that is also the precise moment when it is more valuable than ever.

Looking Forward: How to Make Money in 2021

Looking ahead, I'd advise extreme caution with any investments that appreciated 100% or more last year, especially where that was not accompanied by an actual increase in revenue or profit. It's too hard to explain any reasonable path back to economic reality, and you face a double risk of excessive speculation alongside a reversion of interest rates, either of which could result in double-digit losses.

Passive fixed income remains a poor choice because any kind of bond, whether corporate or government, is tethered to the negative real interest rates being driven by the Fed. However, there is the potential for volatility-driven gains, especially as interest-rate uncertainty rises. This is the approach which Hedgewise implements and has been discussed at length previously.

The outlook for the S&P 500 is a little trickier. Most large-cap equities have not been subject to as much of a speculative surge as smaller growth companies, but prices are likely inflated by 20-30% due to interest rates, and that will be a headwind if there is any inflationary pressure. If interest rates stay put for a long while, you might still eke out a 4-6% annual gain, but that assumes there are no other negative economic shocks in the interim (stagflation, war, climate change, higher taxes, systemic inequality, among others). The Fed has little ammunition left to support the economy against anything else. It's not a great risk/reward proposition, so I'd tread cautiously and would sooner wrap this exposure into a risk-managed approach than leave it outright.

Commodities are a rare bright spot that have little connection to interest rates while providing an excellent hedge against any inflationary surprises. These prices are determined mostly by supply and demand, so gains and losses generally reflect real changes in economic activity rather than speculation. If we do have a robust bounce back from the pandemic, industrial commodities and energy should do quite well even if interest rates bounce back up.

For most traditional investors, this leaves a barren landscape, and many feel forced to take on excessive risk or speculate. Against this, Hedgewise is uniquely positioned to provide an alternative, as it is built to systematically manage interest rate risk, includes balanced commodity exposure, and is not overly reliant on equities to drive returns.

Speculative environments are always challenging to navigate, and this is especially true during one anchored by the Fed. That doesn't change the basic facts: excessively high prices are bad for future returns, and this applies even if the high prices are everywhere. Hedgewise has an approach to manage this risk that has been effective for decades, and it will likely be even more valuable given the conditions facing the market after 2020.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Many are perplexed by the current state of markets: how can you have a global pandemic and recession alongside gains in nearly every asset class?
• This is being driven by the Fed's bold new experiment of targeting negative long-term real interest rates, which logically inflates the price of every investable asset.
• Unfortunately, this will result in bizarre, risky side effects, including increased volatility, lower expected returns, a more limited ability to diversify, and little buffer against future economic shocks.
• Traditional passive investors are left with unsavory options: either push into riskier assets despite a poor risk/reward ratio, or miss out altogether.
• Fortunately, the Hedgewise Risk Parity product presents an attractive alternative since it diversifies more intelligently than traditional products and can accrue gains outside of pure asset appreciation.
• We'll walk through how the investment environment has shifted, what it means for the future outlook, and how to consider potential changes to your portfolio mix or risk level.

Introduction: The Real Story of 2020

In 2019, if you had told most investors that within a year, the US would have nearly 10% unemployment, a global pandemic, and a worldwide recession, few would have predicted the outcome we have today. Despite the recent bout of volatility in September, stocks remain up over 4% YTD alongside gains of over 20% in bonds and gold. How can this be?

While the weekly media narrative shifts between the impact of retail traders, or a repeat of the dot-com bubble, or the flood of government stimulus, the relatively simple explanation lies with the Fed. The only fundamental economic factor that can cause stocks, bonds, and gold to appreciate at once is the decline of real interest rates, and the Fed has now launched the world into a truly extraordinary state in this regard.

While short-term interest rates were frequently near zero after the Great Recession, long-term rates (i.e., 20yr and 30yr Treasury bonds) never fell below 2%, which makes good sense. Since the Fed's inflation target is 2%, it is reasonable to figure that nominal interest rates will be at least that amount; otherwise, government bonds become a guaranteed losing investment in real dollars (a.k.a., negative "real" interest rates). It also makes sense that most investors want some return on top of inflation, especially for a 20+ year investment, in exchange for taking on the risk of higher than expected interest rates.

Yet the Fed has been on a mission this year to bring long-term rates deeply into negative territory: the real yield on 10yr Treasuries is now -1.1%. On first glance, you might think sure, but it's a recession, so the Fed lowers rates like they always do. But make no mistake, this time is different. We are now far below any historical levels, and this is altering every aspect of the investment world in radical new ways. Some of the expected effects include:

• Significantly increasing price-to-earnings multiples, especially within growth stocks
• Lowering expected returns and increasing volatility across all asset classes
• Eliminating traditional sources of diversification
• Imposing asymmetric downside risk on all passive investments
• Amplifying the negative impact of adverse economic events in the future

There are good reasons why this state has been carefully avoided by the Fed in the past, and though it may be necessary for the time being, the ramifications go much further than the pandemic itself will. Let's dive into the nature of this new landscape and what it means for the future of investing.

Gaining Perspective through the Ugly State of Bonds

Treasury bonds provide an excellent and straightforward primer on how we have entered new historical territory, and why this formulaically creates unfortunate side effects.

On the historical front, the following chart provides a view of how the interest rate on 20yr Treasury bonds changed in every U.S. recession since 1953, with our current one in 2020 included as the final data point. The left y-axis measures how far 20yr rates went down from peak to trough over the course of the recession (i.e., if they peaked at 5% before the recession and troughed at 3% during the recession, it would show -2%). The right y-axis converts this to a measure of the relative distance that rates moved toward the "zero bound", where -100% would mean that rates had gone all the way to zero (beyond which rates are extremely unlikely to travel further).

Historical 20yr Treasury Bond Interest Rate Movements During U.S. Recessions

The aftermath of the Great Financial Crisis of 2007 was already somewhat unique: long-term rates moved down twice as much as they had historically, and traveled to a much lower absolute level. However, that now pales in comparison to this year, which has been far bigger and far bolder than anything that came before as the Fed moves precariously close to the zero-bound.

To give a sense of the impact, here is the current expected payoff diagram from an investment in 20yr Treasuries compared to mid-2019. This shows you the expected real (adjusting for inflation) total return depending on where 20yr rates move, and assumes inflation meets current expectations of 1.9% throughout the holding period.

20yr Treasury Bond Expected Real Returns, Current vs. Mid-2019

Negative real long-term rates essentially turn bonds into "return-free risk" rather than "risk-free return". This is different from anything we saw during the 2010's; low interest rates are not the same as negative rates. The only reason bonds are being bought at these levels is because the Fed is basically using all of its money-printing powers to keep buying them. This creates asymmetric downside risk: best case, you lose a little bit of money, and worst case, you lose a ton.

The mathematical mechanics in play here are important to understand. As interest rates head toward zero, you are effectively moving all potential future profit into today's price. For example, if you had a 1yr bond that yields 10%, you'd pay $100 for it today and get back $110 next year. However, if it yields 0%, it would already cost $110. The Fed is artificially inflating bond prices to near their maximum limits to service its broader goal of stimulating the economy. While this may be a necessary lever for the Fed, it creates a catch-22 for fixed income investors. It's sort of like a bubble, but it has nothing to do with speculative investors or irrational expectations. It's a pre-meditated action by the Fed that inflates asset prices to create a negative yield.

Unfortunately, it is not possible to limit this dynamic to fixed income, as the yield on Treasury bonds sets what is known as the "risk-free rate" on all other asset classes. Let's take a look at the strange ways that negative real yields have been metastasizing.

"Not A Bubble" Bubbles

Equities have been the big mystery for most investors this year because it doesn't really make sense through the lens of a global pandemic. Why would tech company valuations go through the roof based on a temporary event? How can a market with a recession and millions of newly unemployed be worth more than 2019?

If you try to analyze this through the lens of profit and loss, you will likely be confused. If you look instead to the role of negative real interest rates, far more clicks into place.

From an analytical perspective, the value of any given asset in the present moment is the value of its future cash flows discounted to today. For a stock, this means you would take all the future expected earnings of a company and discount them by some reasonable rate of return to adequately compensate for risk. In perpetuity, such a formula simplifies to the following:

The result of this formula will be your rough "fair value" price, which also reveals your expected price/earnings multiple (e.g., if your earnings were $1 and you divide that by 5%, you get a $20 price and a 20 P/E multiple). In other words, the three variables listed here are the main determinants of the price/earnings (a.k.a., "P/E") ratio.

You can use this to "model" a P/E for the S&P 500 using assumptions for each of the values of the denominator, and compare that to the actual P/E in any given year. For example, the following chart uses 10yr Treasury bonds as the risk-free rate, sets the equity risk premium to its historical average of 5%, and uses an estimate of 2% for the earnings growth rate.

S&P 500 Trailing Actual P/E vs. "Model" P/E, 1954 to Present

To first clarify the wild peaks in the blue line, the only long-term P/E data available is trailing 12 months, which results in an inevitable lag given the market is forward looking. For example, the spike in 2009 represents the market recovery right after earnings bottomed out in 2008. Forward earnings also tend to be higher than trailing earnings, so the blue line is somewhat inflated (i.e., if you could use forward earnings instead, the denominator would be higher, and the blue line would be lower).

Rather than delve too deeply into these mechanics, focus instead on the extreme bounce in the model P/E this year. Holding all else constant, the introduction of negative real interest rates theoretically justifies a 30-50% inflation of the price of the S&P 500. While this dynamic existed to some degree in prior recessions and as interest rates slowly fell over the past thirty years, never has it been this fast or steep.

It is confusing to make sense of this. Price multiples are nearing levels that have never been sustainable historically, but they are also quite reasonable compared to the model. You could argue that equities are too expensive but also too cheap in the same breath. The trouble is that interest rates near zero will naturally produce these kinds of bizarre contradictions.

The reason for this is mathematical. As the risk-free rate in the earlier equity pricing formula approaches zero, all you are left with is the equity risk premium subtracted by the earnings growth rate. This number begins to get quite small, especially for high growth stocks. As the denominator approaches zero, the result expands exponentially. For example, here is how your model P/E changes as you adjust assumptions for the risk-free rate and earnings growth while assuming a static 5% equity risk premium.

How "Model" P/E Ratios Change with Risk-Free Rate and Earnings Growth Assumptions

These values justify north of a 40% appreciation this year in "average" stocks, but nearly a 300% jump in "growth" stocks (i.e., from 47.2 up to 178.6). This provides some insight into corners of the market that have seen explosive P/E growth recently, like Tesla currently sporting a multiple north of 900 and Amazon moving from 80 up to 120. The problem is that while these prices may be justifiable mathematically, they are not connected to an actual increase in future expected profits.

This potentially creates a situation similar to a speculative bubble. Despite no change to business fundamentals, assets prices inflate to extreme levels. These prices will functionally reduce earnings yields and future expected returns, and will probably fall substantially if interest rates ever go back up. At the same time, there may be huge near-term gains up until the point of "maximum inflation".

This is the dilemma now facing the world. What is the right way to handle it?

Mapping the Bigger Picture

The following illustration provides an effective roadmap for thinking through these issues at a high level. This shows how the hypothetical total returns of a 10yr passive investment change as interest rates move to the zero bound. The blue line is the "normal" state of markets with rates above 2%. The orange line is the "expected" behavior after rates hit zero, and the yellow line is what may happen at the extremes.

How Passive Expected Total Returns Change Over Time with Zero Interest Rates

Mechanically, notice how all three lines wind up in the same place. This must be true if nothing has changed economically speaking, as there are still the same total profits available over time in all states of the world. All that is happening is a shift of when you realize those profits.

The more sensitive an asset class is to interest rates, the more likely it is to move closer to the yellow line, at which point it becomes "return-free risk". Treasury bonds are here already, along with all fixed income assets in degrees. High growth segments of the stock market may approach this level depending on the degree of price/earnings inflation. These assets are no longer effective investments because near-term gains have exhausted future earnings potential, yet they may ironically seem attractive because of the visibility of short-term appreciation.

While the S&P 500 as a whole is probably closer to the orange line, it still faces much more asymmetric downside risk than it did before. A return to normal interest rates will probably result in a price correction even amidst positive economic conditions. Should any negative economic shock occur, the S&P 500 will have less built-in cushion due both to elevated initial prices and the inability of the Fed to lower rates further.

Against this backdrop, one of the big questions floating around is whether investors should now overweight or even leverage into equities as there are so few other options to pick up a reasonable return. This framework highlights why that is probably a bad idea: you would be risking up right after missing a period of asset price inflation, which will then amplify your losses should any of the above risks unfold with no clear recourse for recovery.

Despite this, many passive, traditionally risk-averse investors are feeling cornered into this option, further exacerbating the potential loop of rising equity prices and market instability. If any negative shock occurs, there will be a much higher likelihood of large losses due to panic selling. Even small changes in risk aversion could spark spiraling moves, which is likely what we've seen so far this September.

The more sensible move is to sit tight at whatever equity weight you began before all of this. You'll wind up in the same place by the end, even if you happen to accrue more of it now and less of it later. You'll also remain consistent with your prior risk tolerance, and avoid the need to speculate on whether and when interest rates will rise.

This advice may feel dissatisfying against a backdrop of lower future returns, and it doesn't address what to do with the cash that used to be in safer instruments like government bonds. There's no easy way out of this knot for purely passive investments. In a Fed-induced bubble, the two best options are either excessive risk-taking with limited upside, or doing nothing at all. Fortunately, there are some more attractive paths in the world of alternative investments, where Hedgewise Risk Parity fits in quite nicely.

Hedgewise Risk Parity, and Other Alternatives

Hedgewise Risk Parity has two unique attributes that help separate it from the dilemma of the passive investment universe. First, it has a built-in method of managing volatility which can accrue gains independent of asset appreciation. Second, it automatically includes exposure to alternative assets, like gold and commodities, that are less sensitive to nominal interest rates. This opens up other paths of potential return, and maintains the diversification benefits inherent to the Risk Parity approach.

Volatility management is a fancy name for something intuitive: if prices are just going to bounce around for a while, buy a little when it goes down and sell a little when it goes up. I discussed this concept in depth in a previous article as it applies to bonds, but one chart is useful to revisit. The following simulates how the Hedgewise "risk-managed" approach compares to a passive investment in 30yr Treasury bonds over 5 years, assuming interest rates begin near their current level of 1.5% and end at the levels shown on the x-axis of the graph.

30 Year Bond Performance Simulation: Passive vs. Risk-Managed Investment

Depending on how volatile bonds are along the way, Hedgewise can usually pick-up a 10-20% gain, regardless of what happens to interest rates. The mechanics of this can be counterintuitive. You are never holding very many bonds, perhaps somewhere between 5-25% in total. You increase and decrease that amount as rates change to yield small gains, but day-to-day, you will only observe the impact of however bonds move. This can make it appear as if you are "long bonds" despite really being "long bond volatility". It also will leave cash on the sidelines because doing this at too high of a percentage would expose you to the downside of rising rates. This cautious, slow and steady approach is the only way to get outside of the passive trap discussed earlier. (As an aside, note that unlike Hedgewise, a purely passive Risk Parity product that never changes its bond weights would be vulnerable to substantial downside)

The second benefit of Hedgewise Risk Parity is the inclusion of alternative assets like gold and commodities as part of your mix. This exposure becomes more valuable as interest rates hit zero because their prices do not inflate to the same degree as stocks and bonds since they are real assets. For example, the price of oil is determined primarily by supply and demand, which helps explain why its current price remains low (alongside that of most energy companies). It can be easy to misinterpret this as a problem when you've seen such huge gains in the broader market, but it's actually evidence of commodities' independence. This means they are not vulnerable to the same asymmetric downside risk from interest rates, and maintain the possibility for significant appreciation in an inflationary environment. Commodities will remain an effective portfolio diversifier as a result, unlike bonds.

The impact of these benefits can be seen by mapping new risk vs. return expectations for each asset class. In the following diagram, the blue markers show the historical realized return and realized volatility for each asset since the 1970s, and the orange markers have shifted this to account for zero-interest rates.

Expected Future Risk vs. Return, Various Asset Classes

A couple of neat things are happening. All traditional passive assets face lower expected returns, the reasons for which we've already explored, and expected volatility goes up because of increased sensitivity to interest rates alongside increased speculative risk. Though Risk Parity will still lose the same expected risk premia from the underlying passive assets, its shift into volatility management along with its inclusion of commodities keep it steadier and less penalized by the environment.

This highlights why the Hedgewise Risk Parity product is an excellent alternative for parking cash that used to be in bonds. While you are still moving up the risk-scale to a degree (compared to holding cash), you don't have to go nearly as extreme as equities, and you don't incur the same degree of asymmetric downside from rising rates.

A more nuanced question is whether you should increase your current target volatility (a.k.a., use more leverage) in Risk Parity against this backdrop. This largely depends on whether you have room to absorb the additional risk this will entail in terms of your time horizon and personal goals. It also requires the understanding that such a move must be viewed with a long-term lens.

Nothing has gotten inherently "safer" amidst all of this. Hedgewise Risk Parity has clever mechanisms to help neutralize the risk of rising rates, and while that makes it relatively more appealing compared to traditional passive assets, it still faces the same potential for loss that it always has. As such, the trade-offs are pretty similar to what they were before. If you can tolerate the additional risk, and you require a higher target return than is currently expected, then such a move may be sensible. (I'd recommend a single move up on the risk scale to neutralize the impact of the new environment, e.g., from Low to Medium, Medium to High, and so on). However, an unpredictable negative shock is always a possibility, after which you need the capacity and time horizon to remain steady.

A more difficult conundrum faces those who require a higher return but have little risk to spare. Unfortunately, this is precisely what is meant by the danger of "excessive risk taking" with rates near zero. While there isn't an easy answer, Risk Parity is a much better vehicle than the passive alternatives if you require it. For example, if you used to yield 2% in 3mth Treasury Bills, Risk Parity Low/Medium is a much better replacement than 10yr bonds. Likewise, I'd sooner move up risk levels within RP than overweight into pure stocks.

In addition to Hedgewise Risk Parity, other alternative, more "active" investment vehicles gain relative appeal amidst this. Any strategy that can gain north of 5% independently of interest rates is suddenly much more valuable, especially with the availability of such cheap financing. This should be somewhat intuitive given the goals of the Fed: ideally, it would like everyone to gain a return by investing capital in real projects using real people. If you have access to the opportunity, the best risk/reward ratio will likely come from this kind of "sweat equity".

Wrapping Up: Preparing for a Strange Ride Ahead

Hopefully this provides a useful template for many of the contradictions of 2020, including the growing separation between the "real" economy and stock market, the "K-shaped" performance of growth versus non-growth stocks, the appearance of "bubble-like" speculative behavior in both individuals and asset prices, and confusing desires to invest in either the safest or the riskiest instruments. These are the results of the Fed's experiment with negative real yields, and will continue to have an influence that goes far beyond the pandemic itself.

Market behavior will remain strange. You could easily see short run-ups of 10-20% in the S&P 500 just as quickly reversed, with the same behavior amplified in high-growth stocks, and little of it may seem connected to fundamentals. Bonds will be a sleepy non-factor so long as the Fed is explicitly controlling yields, but underneath the calm veneer is a new source of "return-free risk" that eliminates the utility of traditional stock/bond diversification and lowers the expected future return of all passive asset classes.

The Fed may have no real choice in seeking its mandate of 2% inflation and maximum employment, but it is treading in very dangerous water. Negative real yields create systemic price inflation and instability, and simply returning to the world as of mid-2019 will risk cross-asset meltdowns. It has also removed any future buffer against economic shocks, which eliminates a key crutch that investors have relied on for almost 40 years.

Against this backdrop, most traditionally "safe" investments are no longer viable, which makes alternatives such as Hedgewise Risk Parity even more valuable as an option. While many investors are stuck deciding between cash and excessive risk-taking, Risk Parity provides a more balanced, independent, and inflation-hedged substitute for shorter-term money that may have previously been parked in Treasury bills or bonds.

In long-term portfolios, passive equities should retain a similar role as they had previously, but they are too dangerous to overweight any further. They are still the best source of passive risk premia available, but this new environment will exacerbate the risks of timing or shifting portfolio weights in the midst of it.

If these new conditions have pushed you below your ideal target return, there's no easy answer for how to improve your outlook, but some options are more appealing than others. Investments with less exposure to interest rates, and more opportunity for independent, "active" gains, should be the first choice if available. Increasing your risk level within Risk Parity is another option, if you have the tolerance, given its built-in volatility management and exposure to alternative assets. However, any changes should be handled with care, and with a recognition that they need to align with a long-term plan and weather near-term drawdowns.

Looking forward, the healthiest path for the world would likely be one in which the pandemic passes, and both productive growth and inflation pop right back up to 2%. The Fed would return rates to normal levels, and remove all these sources of dysfunction. Ironically, doing so would cause asset price deflation, but this would be a good thing and not too difficult to weather with the advice of this article in mind. In the meantime, let's hope for peaceful and positive economic developments - but I wouldn't construct your portfolio to count on it.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Hedgewise Risk Parity+ incurred less than half the drawdown of the S&P 500 in March, and current YTD performance ranges from -4% to +1%, depending on risk level
• The Covid pandemic provides a compelling, real-life case study of how the framework effectively withstands 'black swan' events and relieves clients from excessive worry and decision-making when it matters most
• Longer-term performance is equally impressive, as Risk Parity+ has matched the performance of the S&P 500 for the past 5 years with approximately half the risk (equivalent to a 2x risk-adjusted return)
• Hedgewise has also outperformed all major competitors by over 5% during the pandemic, and from 12-35% longer-term
• Risk Parity+ remains uniquely well-suited to handle the substantial uncertainty of our new virus-ridden, zero-interest, financially unstable world. The framework is fundamentally built to manage volatility, and to generate positive returns regardless of what comes next.

Silver Linings of a Terrible 2020

The Covid-19 pandemic marks the first time ever that an entirely external event has seriously threatened the integrity of the financial system, primarily due to the rare nature of the disease itself and the poor global health response. In my initial commentary in early March, I surmised that even if Covid wound up as bad as the Spanish Flu of 1918, it would still be temporary in nature, and justify no more than a 10-15% decline in equity prices. Fast forward to today, and stocks are down around 12% from their peak in February. Yet this belies the extraordinary chaos between then and now, which highlights threats to the theory of "rational markets" while demonstrating how Risk Parity calmly weathers the unprecedented. As we navigate a systemically precarious future, it is some small comfort to have an investment option built precisely for an uncertain world.

To briefly recap, Covid's mix of asymptomatic spread, extreme contagiousness, and highly variable death rate raises it to a similar severity as the Spanish Flu, at least economically speaking. Even so, the WHO had estimated the global cost of such an event at $3 trillion. As of last week, the latest estimates of the cost of Covid are $6 to $9 trillion. Why is this going so much more badly than expected?

Well, the WHO model assumes that governments and individuals will act rationally to contain the disease and minimize the need for draconian lockdowns. It isn't that complicated: you test, trace, and quarantine early and aggressively. The U.S. and many other wealthy countries have continued to fail at this task and it remains highly worrisome that we are now re-opening without much of an improved testing strategy. This failure raises the possibility that a fundamentally external natural disaster might turn into a permanent financial problem, which sets off a number of other financial dominos.

While central banks and federal governments managed to avert an independently fueled financial meltdown in March, it is highly concerning that this was even a possibility. Markets continue to display an inability to effectively price in the impact of the pandemic, which is deeply intertwined with the inability of the larger population to approach the health threat effectively. This is symptomatic of broad societal dysfunction: what should have been a large-scale, contained, temporary natural disaster has now morphed into a global recession.

Fortunately for Hedgewise Risk Parity clients, there has been no need to unravel the financial meaning of all of this. Clients are at or near breakeven YTD, regardless of risk level. In the depths of the March meltdown, drawdowns were also less than half those in equities. Beyond the numbers alone, this helped relieve clients from being thrust into decision-making under duress, while re-emphasizing why there is no need to time your investment with the Risk Parity approach.

Looking forward, there will be various levers for Risk Parity to accrue future gains, whether from volatile interest rates, recovering energy markets, or inflation hedges. Unfortunately, I'm not nearly as optimistic on the return of broader global stability - but that's why Hedgewise offers an investment strategy that doesn't rely on it.

Evaluating Performance During the Pandemic

Here is a quick snapshot of Hedgewise Risk Parity+ performance thus far in 2020.

Hedgewise Risk Parity+ vs. S&P 500, 2020 YTD

While the end result remains impressive - every risk level continues to outperform the S&P 500 this year, despite the enormous equity recovery in April and May - the journey through March is far more important. Passive equity investors often point out crashes and subsequent recoveries as evidence that the buy-and-hold approach works just as it should. This point ignores two crucial aspects of any real crisis:

• There is always a possibility that this time is different, and stocks will fail to recover and suffer additional losses instead. In mid-March, the idea of a second Great Depression was a real and present danger.
• Passive investors are forced into the position of an active decision-maker as the above possibility becomes more likely.

Risk Parity is designed to mostly avoid this dilemma, but it often takes a crisis like the current one to understand why this is so valuable. This point isn't that traditional equity investing is a bad approach in an absolute sense, but rather that it involves a significant level of risk and decision-making that may be difficult to fully value until you are in the middle of a crisis. The ability to sidestep these situations provides a form of relief on many different levels, both financial and psychological. Even better, this relief is possible without sacrificing long-term returns, which Hedgewise can now demonstrate with years of live performance data.

The Longer-Term Picture

Hedgewise began running the current iteration of its risk management model in 2016. Let's take a look at how the Risk Parity+ Max product (which seeks a similar target return to equities) has performed since then.

Risk Parity+ Max vs. S&P 500 Since 2016

On first glance, both Risk Parity+ and the S&P 500 look reasonably similar, especially in terms of total return. The question becomes how to properly value the lower volatility and drawdown levels that Risk Parity+ offers. What is it worth to be able to avoid the need to predict the outcome of the pandemic? Or the Trump election? Or Brexit?

If it's not clear how to value these events, another way to frame this comparison is against more traditional diversified baskets of stocks and bonds, which have closer levels of volatility and drawdown to Risk Parity than the S&P 500.

Below I've compared the performance of three passive iShares ETFs - Conservative (AOK), Moderate (AOM), and Aggressive (AOA) - that are benchmarked to such traditional mixes.

Risk Parity Max vs. Traditional Passive Mix Benchmarks Since 2016

This paints a clearer picture of the benefit. The Hedgewise framework maintained a level of volatility and drawdown closest to a traditional "moderate" mix, yet more than doubled your total realized return.

While the financial theory driving this performance is conceptually simple, there are still many different methods of implementation. Fortunately, recent events have also provided evidence that the Hedgewise approach is uniquely effective.

A Better and Simpler Understanding of Risk

In previous articles, Hedgewise has shared many of the foundational risk management principles on which it relies, such as balancing assets based on macroeconomic environments, explicitly accounting for "bubbles" and tail risk, and uniquely accounting for specific asset classes (e.g., how to think about bonds in a zero-interest rate environment). These ideas are fairly intuitive, and add up to an elegantly simple portfolio, but there is much disparity among managers on how to think about these concepts. Though Hedgewise gains confidence in its methodology through a great deal of research and historical pressure testing, its ability to consistently outperform the competition across many environments goes a long way towards validation.

The period from 2018 through today has presented a highly challenging risk environment, with multiple asset class whipsaws due to trade wars, Federal Reserve misfires, and of course, the current pandemic. The following shows how the Hedgewise Risk Parity+ strategy performed vs. the competition.

Risk Parity+ vs. Major Competition, 2018 to Present

There was no avoiding a rocky path over this period - nearly any systematic strategy will deal with drawdowns in these environments - but Hedgewise still outperformed every alternative by at least 7% as of today. There are many details of managing risk that drove this difference, but most other providers suffered greater losses during the pandemic specifically because their portfolios are far more complex. The more complex the product, the more vulnerable it will be to a liquidity crisis like we had in March, and the more difficult it is to properly hedge. By limiting its portfolio to only highly liquid, well-hedged asset classes, Hedgewise avoids this pitfall without sacrificing any of the strategy's benefits.

To better prove this point, let's now extend the view back to 2016.

Risk Parity+ vs. Major Competition, 2016 to Present

Hedgewise has outperformed over the longer term by a total of 12% - 35%, depending on the competitive fund and risk level. This was achieved with similar levels of drawdown and a relatively high degree of correlation. Given the tail risk of the extra complexity in the other funds, you'd expect it would at least add to returns outside of crisis periods, but there is no evidence that this has happened.

Risk Parity, in theory, seems easy enough to implement. In practice, there are many more potential pitfalls than a traditional market-weighted index. While the Hedgewise approach may appear simple at first glance, it is based on a foundational understanding of risk that continues to differentiate itself as time goes on.

Looking Ahead: Approaching a Newly Unstable World

So far as Risk Parity+ is concerned, the pandemic has been "just another event," and it is for this very reason that it should continue to perform well. The strategy doesn't rely on any insight into the future, and thus it doesn't require deep analysis to forecast what it might do next. It's provided a rare bright spot in the last few months, and is a uniquely suitable investment option for whatever is on the horizon.

Unfortunately, the same cannot be said for most other traditional investing strategies. I don't have a strong view on how the economy or the health crisis will evolve in the near-term, but I do believe the pandemic has demonstrated worrying fissures in the global fabric of society and forced central banks to inject unavoidable instability into the financial marketplace.

In a largely rational world, Covid should never have had the impact that it has. Despite the fact that the world has now triaged its way back from the edge, it is impossible to deny that this experience indicates a failure of global leadership and individual behavior. This incidence suggests that political fissures around inequality, de-globalization, and partisanship now have a much greater likelihood of boiling over in a destructive manner.

Central banks have been forced to respond to this crisis by injecting incredible amounts of support into the financial system, namely bringing interest rates to zero and backstopping a huge amount of debt that would have otherwise fallen into default. The problem is this eliminates the viability of traditionally safe investments, and lowers the return on the entire investable universe. As a result, even risk-averse investors must pile into increasingly risky investments (e.g., equities, high-yield debt, etc.). Yet the risk inherent in these instruments does not go down simply because interest rates are so low; in fact, quite the opposite. When interest rates are zero in part because the world is handling a crisis really poorly, there's even more reason to suspect future crises will incur excessive damage.

This adds up to unreasonably elevated asset prices (since there are so few low risk alternatives) with lower expected returns and a greater chance of sudden drops. As an example, imagine a very risky company - let's say a cruise company, in our current environment - can sell a bond with a much lower interest rate than it could have before all of this. If that company goes on to default, investors will lose more money than they would have previously (since the bond started at a higher price), and will have received less interest along the way. This company's chance of default is always a constant value - but the Fed is changing the equation so that many more investors will now bear this risk without being compensated for it.

You wind up in a world with a greater likely incidence of damaging external events, and asset prices that are unreasonably high alongside it. How is an investor supposed to handle this?

There are no easy answers, but you essentially need a strategy built with instability and irrationality in mind, or you need to build a much higher degree of volatility and potential loss into your investment horizon than you had previously. Risk Parity is a unique systematic option for handling instability, but outside of that, you are left with various forms of active management along with its pitfalls. On the passive side, equities will still probably be the best long-term choice, but you'll have more frequent periods of loss and long-run returns may not be very high. Traditional diversifiers like Treasury bonds will no longer serve an effective role with interest rates so low, which will drastically limit the options outside of stocks.

It's going to be a challenging new world, and it is definitely not ideal, but the only choice is to navigate the reality in front of us as effectively as we can. I'm hopeful that perhaps global leadership can find its footing, and the populace behind it can rally behind long-term sustainability, mutual support, effective government, and scientific thinking. This may allow us to eventually get back to a more normal state. In the meantime, I'm glad to have Risk Parity as an option.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

It has been quite the week! As of last Thursday, stocks were up 5% year-to-date. Since then, they've undergone the fastest stock correction in history, falling about 13% or so through February 27. Given these extreme events, I wanted to provide a few thoughts on how to think about this situation and how I expect this to play out over the next few months. In short, I attribute a large portion of these losses to panic and uncertainty, as even the worst-case scenarios with the virus should only have about a 10% impact on asset valuations. Regardless, the two Hedgewise frameworks have balanced each other appropriately thus far, and I expect that to continue.

To first address the elephant in the room, let me explain why the Coronavirus isn't quite as scary as the markets might have you believe. This is by definition a temporary event; while it persists, it creates damage, but once it is gone, it is gone. This is different than financial contagion like that of 2008. When the real estate market collapsed, there was a permanent, rather than temporary, loss of wealth. Many mortgages simply couldn't be paid, and the houses were bought at improperly inflated prices. Contrast that to the Coronavirus: once it ends, there's no reason to expect it to continue to impact asset prices. We'll all return to our jobs, pay our bills, and asset prices (whether houses or otherwise) should be worth about what they were beforehand.

Given that, any economic damage must be framed as one-time rather than ongoing. With that in mind, there are three main possibilities for the virus of increasing potential economic damage:

• It is contained and does not become a pandemic. Importantly, containment simply means that new cases dissipate, and it does not go on to infect 10% or more of the general population. China appears to have successfully done this, so far, based on the daily statistics out of Wuhan.
• It becomes a "typical" flu pandemic, where 10-20% of the global population may become infected, but it is not particularly severe in its symptoms and mortality rate. (similar to H1N1 in 2009, which is now just part of the regular crew of seasonal flus)
• It transforms into a far more deadly and massive disease akin to the Spanish Flu of 1918, with mortality rates over 10% and extremely high infection rates.

For the sake of argument, I want to focus on this final scenario. First of all, there is nothing to suggest so far that the Coronavirus is nearly as deadly as the Spanish flu. But let's assume that somehow it becomes that way. Back in the days of the SARS outbreak, the World Bank estimated that:

"Something as bad as the 1918-19 Spanish flu would cut the world's economic output by 4.8 percent and cost more than $3 trillion. "Generally speaking," the report added, "developing countries would be hardest hit, because higher population densities and poverty accentuate the economic impacts."

While $3 trillion is a large number, the S&P 500 also yields a profit of about $1.4 trillion annually. The question becomes what losing about 2 years (i.e., $3 trillion divided by $1.4 trillion) of profit should do to corporate valuations. If you do this via a cash flow analysis, and basically chop off the most immediate two years of earnings for a company, but otherwise leave the future cash flows untouched, you get an expected discount of about 8%. And that's for an outbreak the level of the Spanish Flu!

Yet here we are with stock losses of 13% before we've even entered a full-blown pandemic. I could certainly be convinced that there are bigger indirect impacts at work, or that if this causes a recession directly, there will be other damaging financial ripples. But it would be really, really difficult to envision it lopping off more than 13% of total global asset values, especially if it's a more run-of-the-mill flu.

A more likely story is that investors despise uncertainty, and the recent outbreaks in Europe, Asia, and the US have led to headline-induced panic selling. Companies can't really gauge what the impact will be, and even though it wouldn't be that big of a deal if they lost the entire year of earnings (which they probably won't), investors prefer to sell the unknown.

To buttress this argument, it's worthwhile to do a little data digging. First, to cast a really wide net, I just wanted to look at all possible months where the S&P lost at least 3% in an otherwise solid year of gains. There have been 41 such months, and something happened in each that really got investors on edge. To gauge whether such events manifested in terrible economic outcomes, I looked at the average returns over the subsequent one, three, six, and one year periods.

Average Forward Returns After a Month of >3% Loss in the S&P 500

1mth	3mth	6mth	1yr
1.17%	4.67%	9.08%	13.55%

On average, you fully recover the loss between three and six months, and there's nothing to suggest that these kinds of "sudden" events are good predictors of worse to come. That said, it is interesting to narrow down the data set to only the periods when you did go on to lose money over the next 3 or 6 months to see if some pattern emerges.

All Months of >3% Loss in the S&P 500 that were Followed by Additional Losses

Month	Fed Tightening?	Recession?
8/1/1956	X
9/1/1959	X	X
4/1/1962
5/1/1966	X
6/1/1969	X	X
7/1/1971	X
1/1/1973	X	X
1/1/1977	X
8/1/1981	X
9/1/2000	X	X
7/1/2007	X	X
5/1/2011
10/1/2018	X

Some mixture of inflation, an overheating economy, and a tightening Fed was the culprit in a whopping 85% of the cases! This makes sense since recessions require financial stress almost by definition; there is no modern case of a geopolitical event causing a full recession purely on its own.

Nonetheless, there were two instances of sustained losses that did not revolve around the Fed or the economy that are worth exploring. The first was called the "Kennedy Slide" in 1962, which an investigation by the SEC attributed to "an isolated, nonrecurring incident with precipitating causes that were unable to be confidently ascertained". What a way to categorize a market panic! The second was more recently in 2011, and was due to the European sovereign debt crisis, and more closely resembles the anxiety resulting from the Coronavirus. The fear is that the geopolitical event will set off a chain reaction, eventually setting off a number of financial triggers that will begin to spiral downward independently of the initial catalyst.

While such fears are frustratingly common to market pullbacks, they have never been realized due to geopolitical factors for two important reasons. The first is that such events are very directly influenced by market participants. For example, the higher panic rises about a virus, the more the public may engage in safety procedures and self-quarantines. It is not a self-perpetuating downward cycle in the same manner as financial contagion. The second is that the moment the problem can be called "under control", the negative pressures on the economy are almost instantly lifted because they were very direct.

It's little surprise that this usually winds up in market whiplash rather than anything more nefarious. A look at market performance in 2011 confirms this picture.

S&P 500 Performance, 2011 to 2013

The terrible irony of these situations is that the "panic" is in some ways necessary to drive the appropriate response from policy makers and the public. Investors face a catch-22: they must drive prices down to account for the worst-case scenario, yet as prices are driven down, it becomes more and more likely that the situation will be controlled. This most often results in a frustrating "V" shape which seems silly in retrospect yet terrifying in the midst of it. There's inevitably a point where the level of loss becomes scary enough to drive more selling on its own despite the rational probabilities.

Thus, the question before us is whether this time will really be different. If we do wind up in a real recession caused by the virus, it would be the first of its kind since World War II, at the latest. For my money, I wouldn't bet on it. Fortunately, I don't even need to when I have both Hedgewise frameworks in use.

Evaluating Hedgewise Performance

While any level of loss will be somewhat difficult to endure, this stretch does provide a useful case study of the benefits of the Hedgewise Risk Parity framework. It picked up on elevated risk levels at the beginning of February, and adjusted exposure accordingly. It has successfully limited client drawdowns compared to the S&P 500 as well as outperformed comparable risk parity mutual funds year-to-date.

Hedgewise Risk Parity "High" Performance YTD

The primary benefit of Risk Parity is the ability to minimize deep losses, and this is exactly the kind of scenario in which that happens. It can be difficult to feel "good" about it, since you still usually lose some money as assets are correcting, but avoiding a few larger drawdowns is one of the primary drivers of the framework's long-term performance, and this represents another successful data point.

This also highlights why Hedgewise clients are typically recommended to hold at least 50% of their assets in a Risk Parity portfolio. I doubt we are in a "this time really is different" scenario, but if and when we do come to such a day, it makes sense to have this backstop. It can be easy to lose this insight when you already know how history unfolded.

The Momentum framework has experienced a much larger drawdown, with the "Max" risk level moving from a 6% YTD gain last Friday to an 11% YTD loss as of today. The reason is relatively simple: it is an equity-focused product, and unless risk signals demonstrate a substantial chance of an economic recession, it will be highly exposed. In this particular case, the fundamental macroeconomic trends before the virus broke out were quite positive (and remember it was only last Friday that the stock market was +5% YTD). Unless those fundamental trends change, it will continue to be positioned this way for precisely the logic discussed earlier; short-term geopolitical events have neither a theoretical basis nor a historical trend of being meaningful reasons to get out of equities.

To see how this has panned out historically, the following isolates all months when Momentum had the same level of its current equity exposure while equities lost 5% or more, and then examines the subsequent one month, three month, six month, and one year returns of the Momentum product.

Momentum "Max" Subsequent Returns after Similar Months of Loss

Date	1mth	3mth	6mth	1yr
1971-10-01	3.7%	20.4%	24.8%	40.5%
1975-07-01	-6.2%	-0.7%	23.7%	32.0%
1978-10-01	-4.7%	5.2%	8.9%	25.8%
2002-04-01	0.6%	3.4%	18.5%	20.3%
2010-05-01	-4.4%	4.6%	28.3%	59.5%

Note that there were frequently more losses in the first subsequent month. It is not the goal of the Momentum framework to minimize such events to the extent that they are likely to be short-lived. Market panic often lasts a month or two, but so long as true recession risk stays below a certain level, Momentum holds steady. By the six month or one year mark, the initial losses are easily and consistently reversed.

This logic allows the two frameworks to function elegantly together. Risk Parity is sensitive to expected market volatility, so it has a relatively high chance of proactively minimizing drawdowns from any source. Momentum is only sensitive to more deeply systematic risk, so it has a much higher tolerance to bear losses from temporary scares. One framework will probably be more "right" at a given point in time, though both perform well over the long run for different reasons. By diversifying across the two, you remain effectively hedged.

With this in mind, it is easier to contextualize the Coronavirus. It is a scary geopolitical risk, so Risk Parity exhibits caution while Momentum does not. If you were convinced that this time is really different, and equities were doomed, certainly Risk Parity makes more sense to express your view. Conversely if you think this will resolve without a lasting recession (just as all other geopolitical risks have), Momentum is in an excellent position to benefit. If you have no real clue but you are a long-term investor, you have your bases covered across the two. In the meantime, I suggest spending more time washing your hands than worrying about the market!

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Hedgewise posted strong performance in 2019, with year-to-date returns of 21% and 20%, respectively, in the Risk Parity and Momentum frameworks (at the Max risk level).
• While these gains are consistent with expectations, they were purposefully limited to some degree by various risk management techniques.
• Longer-term, these methods are powerful expected drivers of performance, yet that can be confusing when they appear at odds with the short-term.
• By linking every point-in-time decision to the bigger systemic picture, what appear to be small immediate costs are reframed as strategic foundations.
• We'll examine precisely how Hedgewise has been applying this trade-off to every asset class in 2019, and why that creates such a positive environment for future returns.

Introduction: A Great Year, For Now and For Later

From a risk management perspective, this year has been pretty stellar, but for reasons different than you might expect. Absolute performance was intentionally lower than it might have been due to a number of factors:

• Bond weighting has been consistently under historical averages, and especially so prior to the ~15% rally in August.
• Energy has been a recent drag on performance, and commodities have broadly underperformed for the better part of this decade.
• Equity exposure was relatively low during the whipsaw recovery of the first quarter.

On first glance, these factors all appear negative, but the opposite is true: the same risk management mechanisms driving these decisions are also directly improving future expectations. It's helpful to explain this with a hypothetical example. Imagine you could have a lower realized return this year in exchange for a higher realized return over the next five. This is the direct trade-off being applied in each of the cases mentioned above, but it can be difficult to grasp intuitively.

The key to the approach is not to avoid negative events, but rather to ensure their relative cost is insignificant relative to their benefit. 2019 has been a great outcome because despite all of the circumstances mentioned above, clients still managed to achieve over 20% annual returns! The small opportunity costs incurred this year were all made to significantly improve future return expectations, but like everything with systematic investing, it takes a little patience and understanding to allow it all to play out.

With that in mind, let's examine the story in each individual asset class, with a particular focus on how Hedgewise decisions this year have been intelligently optimizing for what might come next.

Bonds: Understanding the Zero Bound

I want to start with the bond market for a couple of reasons. Clients frequently wonder whether Hedgewise carries excessive interest rate risk, since its strategies usually hold more Treasuries than traditional portfolios. Now seems like an excellent opportunity to explain why this isn't the case and how Hedgewise accounts for a very low interest rate environment. Second, bonds are a perfect illustration of the kind of trade-offs at work in systematic investing because interest rate movements quite literally shift gains between now and the future.

How Future Bond Profit Shifts with Interest Rates

As interest rates approach zero, you've moved all your potential gains to the present, since you are receiving 0% interest by definition. Presuming interest rates can go no lower, you can now only lose money if you remain invested. It wouldn't make sense to continue passively holding this asset (which, by the way, raises a number of problems for traditional passive models if/when this level is reached!)

The problem is that no one knows precisely where the bottom is. It's more of a probability distribution that looks something like this:

Probability of Interest Rate "Bottoming"

The red line highlights our current level of interest rates, and it's important to account for the possibility that we have already reached a bottom here. If you could know this with certainty, you'd already want to divest all bond exposure. If you were wrong, and interest rates were going to dive all the way to 0%, you'd be missing out on significant gains.

This presents a thorny scenario for passive and active managers alike. If you don't try to time anything, you will wind up with bond exposure when you can only lose money on that position. If you do try to time it, then you risk getting out too early or late.

Fortunately, when you view this curve through a lens of risk, it is straightforward: you hold less as risk goes up and vice versa, much like any asset. In this case, you get an added level of certainty because of the zero-bound (i.e., in most markets, you still might have gains in a period of heightened risk, but there's little chance of this if interest rates are at zero). Functionally speaking, this means you sell some bonds as rates go down, and buy some back if rates go back up, and you increase that proportionally until rates approach more normal levels (Note that "normal" levels are a matter of some debate, but the Fed is using all of its tools to try to get it back above 3% or so).

The wonderful part of such a method is that you can accrue gains simply from interest rates bouncing around. Here's a look at a performance simulation which compares a passive bond investment to this risk-managed strategy over five years, with the horizontal axis representing the final level of interest rates. Note that I've chosen 2% as the lowest point initially to align with the Fed's stated goal of 2% inflation. This first model assumes that interest rates move linearly between current rates and the ending state, with a random level of chop determined by the volatility level. (We'll get to why this matters in a moment)

I've included risk-managed performance in both "normal" and "high" levels of bond volatility to emphasize the unique manner in which this framework accrues benefits.

5 Year Bond Performance Simulation: Passive vs. Risk-Managed Investment

The risk-managed approach accrues positive returns even if interest rates jump to 4%, which highlights why Hedgewise isn't particularly worried about interest rates going back up.

The story becomes even more interesting if you consider a scenario in which rates fall below 2% in the middle of the five year period. In other words, imagine rates drop to 1% after two years, but then go back up by the end of five years.

5 Year Bond Performance Simulation, Rates Fall to 1% at Halfway Mark

The overall results are similar, though slightly lower across the board because interest rates spend a longer time at a lower level (so less net interest is paid out). This belies a strikingly different view if you look how performance varies along the way. Here's a look at simulated performance over time when rates end at 3.5%.

Full Return Curve When Rates Fall to 1%, Then Return to 3.5% After Five Years

Even though you are better off using the risk-managed model by the end of this period, you have to forgo about a 30% gain right in the middle. By doing so, you eliminate the eventuality of a 50% loss. This is a precise example of accepting a lower return over the short-term in exchange for a higher one over the long-term, which is the heart of a risk management trade-off.

Returning to this year, here is how the fully operational Hedgewise risk model has performed.

Return Attributable to Bonds, Passive Investment vs. Hedgewise, 2019 YTD

Much like the simulation, in August you might have gained an extra 15% in your portfolio when 30yr interest rates dipped below 2%. This would have felt pretty nice, and it would have also made Hedgewise returns exceed those of the S&P 500 year-to-date. Yet if you step back to the last time that 30yr rates got close to these levels, in mid-2016, you start to see the bigger story at work.

Return Attributable to Bonds, Passive Investment vs. Hedgewise, 2019 YTD

Even if you include the substantial rally of this year, Hedgewise has still yielded overall higher returns from fixed income than a simple passive approach since 2016. Given the possibility that rates continue to go up, the risk-managed approach holds a significant advantage. Even if rates re-touch their lows or fall again in a recession, the story will remain the same: better to give up gains in the short-term to protect your outlook over the long-term.

Commodities: What Are They Good For?

While oil has had a small resurgence in the past few weeks, it has done pretty badly relative to the overall recovery since 2018.

Performance of WTI Oil vs Other Asset Classes Since October 2018

This pattern has been even more pronounced for this entire decade.

Performance of WTI Oil vs Other Asset Classes Since January 2010

You might find it surprising to hear that there's nothing particularly surprising about this performance, nor is does it provide any evidence that energy should be excluded from the portfolio. How can this be?

The answer is that this is precisely how diversification is supposed to work. The decade since 2010 has been highlighted by consistently lower than expected inflation. Interest rates were near zero for a majority of the time, and the Fed has been frequently mystified by the ability of various global forces to keep price levels steady. Since a primary purpose of including energy in the portfolio is to protect against higher than expected inflation, its performance is about what you expect in a decade like this one.

The reason you accept this kind of outcome is because some assets are supposed to do well while others do poorly. On net, you are stabilizing your overall return and reducing expected volatility. A diversified portfolio that includes a mix of all assets (even poorly performing ones) should still keep up with a less diversified portfolio of only the better performing assets, assuming both portfolios are set to the same level of risk.

To test this, we can compare two Risk Parity portfolios set to equivalent levels of volatility. The first includes only stocks, bonds, and gold, while the second contains those same assets plus energy. Both portfolios utilize the exact same underlying Hedgewise algorithms.

Performance of Risk Parity Models With and Without Energy Exposure Since 2010

Just as expected, you can hold what appears to be a vastly underperforming asset with no negative impact to your portfolio! This is because you are reducing the overall risk inherent to your portfolio by always including assets that balance in various environments.

The full benefits of this approach are difficult to appreciate when you look only at a decade of low inflation. The real question is what kind of protection you are afforded when the opposite occurs. Unfortunately, the last prime example of higher than expected inflation occurred in the 1970s, when reliable oil data was not available. However, we can substitute in gold as our inflation-protective asset to get a sense of how you shift your expected outcomes across various macro environments. The comparable portfolios become a Risk Parity model of only stocks and bonds compared to a second that also includes gold.

To set the stage with a decade similar to the 2010s, we can use the 1980s, when the Fed successfully stemmed inflationary pressure. Much like oil recently, gold had a terrible decade as interest rates went down, but that still had a minimal impact on a diversified portfolio.

Performance of Risk Parity Models With and Without Gold Exposure, 1980-1990

Note that the portfolio with gold did do slightly worse, but not nearly to the degree you might expect when you held an asset that lost 30% in a decade. On the other hand, the protection you gained can be seen clearly when you expand the view to include performance during the 1970s, a decade of higher than expected inflation.

Performance of Risk Parity Models With and Without Gold Exposure, 1972-1990

In the 2010s, intuition would suggest that energy has been a drag, but that's essentially untrue. You've done about as well as a portfolio excluding energy because you still increased your ongoing risk-adjusted return through diversification. Should the 2020s wind up being a decade of higher than expected inflation, the benefits of this approach will become even more dramatic, just as they did with gold during the 1970s.

Equities: The Risk Conundrum

Part of the Hedgewise methodology is to dynamically adjust asset exposures based on real-time measures of risk. The underlying idea is that you can further stabilize returns by removing some of the extreme outliers, whether positive or negative. Even if you achieve the same overall average level of monthly returns, you still reduce volatility if you can do so with fewer big swings. Hypothetically, you expect something like the following diagram of monthly returns. The blue data points are all of your model returns, the orange data points are the ones categorized as "high risk", and the grey data points are what remain after excluding the high risk points.

Expected Model Result for Removing High Risk Exposures

The red arrow has been added for emphasis on the desired outcome: you'd like to squeeze all of your data points inward - especially the large negative ones - such that you have a more stable positive return.

Now let's look at this actual diagram for a few asset classes. These graphs are selecting all actual months categorized as high risk using the Hedgewise algorithm over various timeframes, and then removing those data points from the distribution to see how this impacts your outcome. If the theoretical model is correct, the graphs should all look something like the above.

Treasury Bond Return Distribution, High vs. Normal Risk

Energy Return Distribution, High vs. Normal Risk

So far so good. In both these asset classes, the "negative" tail has consistently shifted upward by removing your high risk environments. Strangely, the S&P 500 has been a little different this decade.

S&P 500 Return Distribution, Normal vs. High Risk

It appears that recent high risk environments have resulted primarily in positive returns and removing those data points has not had the desired effect. What does this mean? Has something about risk in the S&P 500 changed? Do these results suggest a problem with the financial theory?

It's worthwhile to provide some additional real-life context about what is happening. A "high risk" month generally means that investors are pricing in the potential for a large market swing in either direction. If market fears come to bear, you incur losses, and vice versa. During a stretch where the consistent outcome during these months is positive, it must either mean that investors were badly pricing risk, or that events are luckily resolving despite a real chance that they might not have.

Anecdotally over the past couple of years, it's difficult to argue that the trade war had little chance of escalating, or that the Fed could not have made some irrecoverable mistake. Even if you were to claim that investors were truly overreacting in these particular cases, that doesn't suggest that some fundamental factor has shifted to make that more likely moving forward.

A more believable explanation is that we've basically gotten lucky. The Fed nearly broke the economy, but backed off just in time. Trump nearly blew up global trade, but mended things just enough to avert disaster. Low employment and higher than anticipated consumer strength provided a nice boost this year that many doubted would materialize. We've also avoided any nasty geopolitical blow-ups like wars or recessions.

To further test this theory, we can look at history to analyze how our current environment of risk compares to historical trends. The following shows the percentage of "high risk" months that occurred in every ten year rolling timeframe since 1954, as well as what percentage of those months resulted in a negative return (i.e., The orange bar shows about how often markets were in a risky state, and the blue line shows how often that risk wound up resulting in a loss).

S&P 500 Historical Risk Environment & Hit Rate, Ten Year Rolling Timeframe, 1954 to Present

What jumps out is that in the most recent decade, more risky events have resolved to the upside than ever in history. On average, somewhere between 30-50% of these events materialize negatively; recently it's been under 15%. It's also been quite peaceful overall; the only other periods to show so few "risky" environments (the orange bar) were the ten years ending 1998 to 2000.

This makes a strong case that this is an outlier of relative global harmony, in which the few major risks (trade war, Brexit, et al) all resolved without doing too much damage. History suggests that this will be an incredibly difficult feat to repeat.

Still, it's worth analyzing how much this has impacted the returns of the Hedgewise portfolio. You'd think that missing months of upside would have a pretty dramatic negative effect, but here's the performance of the Risk Parity model compared to the S&P 500 over the last ten years.

Performance of the S&P 500 vs. Risk Parity Max, December 2009 to Present

The story here is similar to the one of diversification: even when you do 'badly', you still mostly keep up. This is because so many other elements of the strategy have continued to function as they should (like the normal behavior of risk in other asset classes). Yet when some major risk does unfold, you do so much better. For example, simply include the 2008 recession.

Performance of the S&P 500 vs. Risk Parity Max, December 2007 to Present

Notice that these long-term results include lots of individual months that 'felt' like the algorithm was working poorly. You have to deal with multi-year stretches where you underperform the S&P, like 2012 to 2013 or 2018 to today. In the broader scheme, these costs are minimal compared to the benefit you accrue over time.

Historically speaking, there's little chance that the 2020s continue as peacefully as the 2010s. Given that this past decade has been as low risk as it has, it's also pretty remarkable that it cost so little in terms of your net realized return. Hedgewise strategies will likely perform even better relative to the S&P 500 moving forward, but this has been pretty great so far as "bad" outcomes go.

Looking Forward: Grappling with an Uncertain World

In 2019, there's no denying that we've missed rallies, that commodities have lagged, and that no major risks have manifested. Yet all of that can occur without damaging long-term returns, and the same mechanisms driving these outcomes make your portfolio far more resilient for the future.

Moving into 2020, a significant overlooked risk is quite mathematic. Much of the gains in stocks and bonds this year are due to falling interest rates, which literally moves profit from the future into the present. Just as we saw in the modeling of this article, that introduces substantial downside even if rates simply return to where they were back in December 2018. Hedgewise strategies not only consider this possibility, they are probabilistically built around it.

Commodities have also been the key victim of a decade of low inflation, and will be an attractive source of returns if rates do rise again. Most traditional portfolios have no way to benefit from this, yet it will be difficult to generate positive returns without this exposure in a world of resurgent inflation.

Stocks have wondrously avoided most major risks for a very long time, but imagine if Trump or Xi decides to re-escalate, or if the EU shows more serious signs of falling apart. Climate change, presidential elections, and global inequality will all weigh significantly on the future. The world is a fragile place, and Hedgewise strategies behave with that in mind while minimizing the cost if we do manage to avert those risks.

The push and pull of all of these scenarios and probabilities is very difficult to grasp on a day-to-day basis, and it will always be easier to see the immediate decision that might have driven a bigger gain right now. By understanding and accepting these trade-offs, you dramatically improve your long-term return expectations. In 2019, that meant taking a 20% return instead of something higher; in context, that is pretty fantastic for the sake of 2020 and beyond.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Hedgewise has significantly rebounded from the losses of last year, with gains of nearly 20% since the bottom reached last Christmas Eve (for products at the Max risk level).
• Unlike most traditional investment strategies, Hedgewise gains have not been driven by stocks, which remain extremely volatile. This provides a significantly safer outlook for clients moving forward, which has been clearly displayed during recent equity pullbacks.
• It's useful to step back and evaluate the broad effectiveness of the Hedgewise approach over the past few years, as performance during 2018 and 2019 has often "felt" unsteady. However, Hedgewise has effectively kept up with stocks and significantly outperformed bonds since 2016 despite the recent challenges.
• With the events of last year behind us, there's a very high chance that relative performance will be even more impressive moving forward.

Introduction

Amidst the turmoil at the end of last year, Hedgewise advised clients to remain patient and await the inevitable recovery, as the cross-asset drawdown could not fundamentally persist. Fast forward to today, and all Hedgewise products have rebounded substantially from their lows. At the Max risk level, both Risk Parity and Momentum have gained close to 20% since their bottoms on Christmas Eve last year. This is right in line with expectations after periods of similar drawdowns caused by Fed uncertainty, which can be seen in the following graph which exhibits all 1 month, 3 month, and 6 month realized forward returns after every comparable stretch since 1972. The outcome from this year is circled in red, with the "6mth" data point representing January to July 2019.

Risk Parity Subsequent Returns After Fed-Induced Drawdowns (1972 Onward)

Momentum Subsequent Returns After Fed-Induced Drawdowns (1972 Onward)

This outcome highlights the resilience of the Hedgewise strategy, and emphasizes the importance of holding steady during drawdowns. While these results are impressive, they are also rather average historically; there were plenty of times where you had even higher returns after a year like 2018. Before we dive into that further, it's important to emphasize the implication: a 20% recovery in 6 months still represents a relatively middling result. That's certainly comforting in the broader scheme!

Of course, it would be nice if returns were even higher, and there have been a couple of limiting factors this year. First, Hedgewise has had limited exposure to equities because they remained extremely volatile. Second, especially in the last two months, risk has spiked across all asset types, leading Hedgewise to adopt a relatively conservative overall portfolio mix. While this is consistent with how these frameworks are supposed to function, it is easy to feel disappointed whenever you miss a short-term rally. It can be helpful to step back and evaluate the longer-term trade-offs that are constantly in play.

Risk Isn't a Problem, Until It Is

A common adage in risk management is that you purposefully forego potential upside to protect from downside. While this may seem intuitive in theory and over the long run, 2019 has highlighted how challenging this can be over the short run. For example, in the first quarter of this year, equity markets were flashing a reasonably high risk of recession; as a result, Hedgewise limited its exposure. By March, it became clear that the economy was stabilizing, and equities staged a historic recovery. This sequence may create the sense that risk-managed frameworks are doing a pretty terrible job timing the markets (Note that Momentum moves entirely out of stocks in times of elevated risk, while Risk Parity shifts exposure but always holds a mix of all asset classes).

Hedgewise Performance Comparison, January to March 2018

Of course, Hedgewise employs no market timing; the system simply evaluates relative risk across asset classes and re-balances accordingly. The fact that equities gained 10% in under 3 months suggests that the Hedgewise risk signals were accurate. While the economy did stabilize and equities gained, there was a significant chance that it would not and equities could have fallen by the same amount or more.

The challenge of this trade-off is that you can only see the long-term benefit with the passage of time, and it can be difficult to keep the right perspective along the way. It's far easier to judge each event in isolation. Fortunately, 2019 has presented a nice case study as stocks have subsequently pulled back in May and August of this year.

Hedgewise Strategies vs. the S&P 500, May 2019

Hedgewise Strategies vs. the S&P 500, July 26 to August 16, 2019

Again, no timing at work here! It's two sides of the same coin, and the year-to-date view of 2019 helps to demonstrate how the cumulative effect balances out over time.

Hedgewise Strategies vs. the S&P 500, 2019 YTD

Both frameworks have slowly but surely closed the gap with the S&P 500, but that doesn't tell the full story. A majority of the Hedgewise gains this year can be attributed to bonds and gold, since equities have remained quite risky throughout. This highlights the strategies' versatility, as these other assets were positioned to do well even if equities had not. Risk management constantly builds in this tolerance for multiple outcomes so that gains are less vulnerable to sharp corrections like we saw in May and August. While it may be hard to differentiate your absolute returns until the S&P suffers a prolonged crash, there is also no need to worry whether that is right around the corner.

Hopefully, this provides some peace of mind in light of recent market turmoil, but it may still feel hard to make sense of the period since January 2018. After all, last year we dealt with a significant drawdown when so many assets fell together, and this year we have this story of missing some upside. Though this sequence of market conditions is historically uncommon, it is not unexpected. The key assumption is that the relative cost and frequency of such periods is outweighed by the benefits you accrue the rest of the time. Let's take a deeper look at whether this has been the case.

Stepping Back: Evaluating Longer-Term Performance

We'll begin with the initial challenge: performance from January 2018 to today feels somewhat underwhelming.

Hedgewise Relative Performance Since January 2018

There are two parts to giving context to these results. The first is that this has been a very particular - and fundamentally unlikely - sequence of events. An overaggressive Fed is one of the few causes of cross-asset declines, such as those in 2018. If you examine every other similar case, there's only a single comparable period (in 1999) when stocks and bonds then reversed their losses with similar speed and volatility to this year. While I'll examine this other instance in a moment, the initial point is that these events are a natural outlier for very logical reasons: the Fed is rarely at the end of a tightening cycle, and it's rarer still for it to unfold with this degree of confusion and market whipsaw.

Given that, it's proper to treat this event as a risk management "correction", much like you'd view 2008 for the S&P 500. With that parallel in mind, recent performance is fairly impressive. Consider the case when the S&P 500 crashes: you've lost as much as 50%, and you've needed as long as a decade to claw back to breakeven (e.g., 2000-2010). With Hedgewise, you lose less than half of that and recover most or all of it within a year.

This outcome looks even better once you extend your timeframe. Here's a look at the same performance profile since November 2016 (note that this date was chosen as it was the month that the Momentum framework was initially launched, but the results are similar beginning in any other month of 2016).

Hedgewise Relative Performance Since November 2016

These results demonstrate just how quickly the benefits that you accrue in normal market conditions, like during 2016 and 2017, essentially offset even a worst-case series of events for these frameworks. Again, this is still an example of a relatively bad period of performance. If you extend this timeframe further, or choose any stretch that includes an actual bear market for an individual asset class, the benefits of the Hedgewise approach will be even more obvious.

For example, returning to the last time we saw anything like recent events, the stretch from January 1999 to August 2000 had some eerie similarities to the past 18 months. Interest rates peaked in December, and while stocks weren't quite as tumultuous as we saw last year, performance was fairly choppy. As soon as the Fed backed off, stocks and bonds rallied by 20% amidst volatile conditions. The story for Risk Parity was similar to this year, though it lagged further behind equities and less behind bonds.

Performance Comparison, January 1999 to August 2000

Risk Parity Max wound up with a 20% performance gap to the S&P 500. Let's see how long it took to subsequently recover from this "correction". The following expands the prior graph through August 2003, with markers for when you hit one, two, and three years after the original dates.

Performance Comparison, January 1999 to August 2003

It turns out that August 2000 was the peak of the dot-com bubble, but this isn't meant to be a prognostication. A soft landing may still be possible, and I'd actually venture that bonds appear even scarier than stocks at this particular moment in time. The point is that it doesn't really matter; even the worst stretches for risk management eventually pale in comparison to the benefits you go on to accrue, especially relative to whatever asset happens to crash next.

Speaking of crashes, I want to provide one final perspective to tie this all together. The S&P 500 is an inevitable benchmark, and it has had a really tremendous decade. Using that as a sole point of comparison can make it seem as if we "need" a recession to prove that risk management is worth it, and that is not true. A better metric is how well the strategies hold up against whichever asset happens to be performing poorly right now, since that should reasonably extend to whatever crashes next (and eventually they all do).

Despite the recent rally in Treasury bonds, interest rates have only just this month returned to the all-time lows that they hit in mid-2016. Since then, it's mostly been awful for fixed income investors, which provides an excellent test for Risk Parity (especially considering the common fear that Risk Parity won't hold up in periods of rising rates).

Hedgewise Risk Parity Performance vs. 30yr Treasuries, July 2016 to Present

This image demonstrates so many of the relevant themes. Most of the time, Hedgewise is really great at generating steady positive returns regardless of individual asset crashes. Even significant "corrections" like the period since last January look pretty reasonable in comparison and do little to dent longer-term outperformance. This is all true over just a few years, and even when those years include a historic combination of bad outcomes.

Conclusion: Perspective and Probabilities

I have no idea what's coming next, and the current dislocation between stock and bond markets makes it a very scary time for traditional passive investors. Traders are pricing in four interest rate cuts over the next year, which has basically never happened without significant economic turmoil. There's now over 16 trillion dollars in negative yielding debt across the globe, along with yield curve inversions nearly everywhere. Against this backdrop, it's really nice to know that my investment strategy has a plan for most of the possibilities.

In exchange for this comfort, I have to deal with mostly random, infrequent stretches where hedging gets caught by cross-asset drawdowns, or market whipsaws limit some upside. The fact that we just had both those things happens certainly lends weight to the probability that even better times are ahead. For all the recent challenges, though, returns over the past three and a half years have been excellent, and we've basically matched equity performance while maintaining a persistently safer outlook. If this includes a pretty bad part, I think we're doing pretty good.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• 2018 was an extremely difficult year for investors, with losses unfolding across every major asset class. Typical hedges, such as bonds and gold, were ineffective, and an atmosphere of unpredictable volatility diminished returns for nearly all styles of risk management.
• Against this backdrop, Hedgewise frameworks lost between 2% - 14% YTD, which remains substantially better than most comparable funds and within expectations given these circumstances.
• Still, it is natural to wonder whether this environment is radically different than historical precedents, and if it threatens the efficacy of risk-managed frameworks.
• History suggests that this year's returns are relatively similar to other periods when the Fed was reaching the end of its tightening cycle. This tends to drive fear, uncertainty, and lower valuations across all asset classes, despite many inherent contradictions.
• Such fear-driven volatility cannot persist forever, simply because you cannot experience inflation and deflation, or recession and growth, simultaneously. So long as high uncertainty persists, large short-term price swings usually remain, but they have little bearing on your long-term outlook or the efficacy of risk management more broadly.

Introduction: A Crummy, No-Good, Typical Year

2018 was not a good year for investors, of any asset, in any style, living in any country. The last 12 months have often felt like a never-ending deluge of worry, including rising interest rates, peak profits, trade war, Brexit, et al. Yet traditional safe-havens like gold and bonds have suffered losses alongside stocks, and recoveries in any asset class have quickly and violently reversed. That said, as ugly as it's been, it's quite a bit more familiar than it might seem, and quite a bit less scary than you probably feel.

First, to dispel the most worrisome economic myth floating around in the media: asset performance trends this year are not radically different than the past, and remain very consistent with what you'd expect when the Fed is aggressively battling inflation and withdrawing mountains of liquidity via higher interest rates. Higher rates force all assets to be more heavily discounted, and everyone also wonders how high rates will need to go, and whether the Fed is driving us straight towards a recession, deflation, hyperinflation, or some mix. Just like that, all assets start pricing in more risk.

Of course, it feels like there's lots else going on, like terrifying tweets and tariff wars. But it's hard to put much weight on those factors when you saw just as much volatility and cross-asset decline in nearly every other year in history that the Fed was behaving similarly. A more likely explanation is that when investors are particularly on edge, they react more strongly to the news, whatever it might be. While this results in very real price swings, it also makes it far less likely that losses persist.

Ironically, this environment can drive moderately high losses in risk-managed frameworks precisely because many of the perceived risks are unsubstantiated. Hedging will be less effective because each individual asset class begins pricing in a worst-case scenario, despite the fact that all of those scenarios cannot simultaneously co-exist. Risk measurements will often fail to signal much chance of a major crash - which is usually quite correct! - but investors might succumb to panic for a while anyway. Financial theory suggests that the most effective path through such turbulence is to wait for the noise to pass, and while this usually seems quite obvious in retrospect, it will almost certainly test your nerves along the way.

Fortunately, this scenario has played out many times in the past, and has always resolved without any breakdown in fundamental economics or the theory of risk management. Though losses this year are certainly unpleasant, Hedgewise has actually navigated the environment fairly well from a historical perspective and relative to competitive funds. While it's natural to wonder how such a strange, crummy year could fit in the bigger picture, the reality is that it is much the same as all the other strange, crummy years we've had, and will soon pass much like the rest.

Review of Hedgewise 2018 Performance

2018 has certainly been unfamiliar in the context of the recent nine-year bull market. Among other fun headlines, there haven't been more radical daily and monthly swings since the depths of the financial crisis, the last time this many asset classes had simultaneous losses was 1901, and the last time investors felt this nervous was the Nixon era in 1972.

Here's a look at year-to-date returns for every major class:

2018 YTD Performance by Asset Class

Given this picture, it comes as little surprise that most investment strategies have fared poorly; in years like this one, losses are essentially unavoidable. With that in mind, the primary question becomes how well Hedgewise frameworks have helped to mitigate the damage, and whether this calls into question the effectiveness of the underlying financial theories. Fortunately, there is ample evidence that Hedgewise techniques have continued to be effective.

From a 10,000 foot view, the most obvious explanation for this year's negative returns is that Hedgewise strategies are multi-asset, and frequently use leverage to balance risk and amplify potential returns; when most assets are down, this will result in losses. A simple, static example of implementing such a strategy at a moderate risk level might look like 100% bonds, 60% stocks, and 40% commodities. This year, that portfolio would have lost approximately 15%, depending on its exact weighting of commodities.

For comparison, Hedgewise strategies have incurred YTD losses between 2% - 14%, depending on your product mix and risk level. This is a very compelling outcome, especially in a year when many traditional risk management mechanisms were ineffective. To provide a less theoretical comparison, the Hedgewise Risk Parity strategy has also outperformed all comparable mutual funds throughout the year.

Hedgewise Performance Vs. Major Risk Parity Mutual Funds, 2018 YTD

There are a couple of notable highlights from this graph. While it's clear that Hedgewise risk management techniques have largely outperformed the competition throughout the year, no fund was able to escape losses altogether. This adds weight to the idea that losses were inevitable in nearly any form of the strategy framework, but that Hedgewise handled this better than most. While there are some ebbs and flows to each fund's performance, due to myriad differences in the definition of risk and portfolio composition, it's a relatively minor give-and-take that adds up over time (except in the case of Wealthfront, whose performance has continued to raise concerns). Hedgewise will certainly have some months that look better and some that look worse, but the short-term deviations mean much less than the longer-term edge built into each portfolio.

Still, even if Hedgewise has done better relatively, is there something wrong with risk managed strategies more broadly? Why has hedging been ineffective, and how do you know that won't continue? Why can't some of these pullbacks be more nimbly avoided?

To answer these questions, it's helpful to re-examine how the core financial theory is supposed to work and relate that to a few similar historical examples.

The Fed and Peak Uncertainty

When the Fed is trying to figure out how high to raise interest rates - and especially when they are getting close to a level that may cause a recession if they go too high - markets often become quite perplexed. There is simultaneously inflationary pressure, and recessionary pressure, but neither a recession nor high inflation has actually happened. When there are so many different, scary possibilities at once, lots of assets can lose value in contradictory ways while this limbo continues.

From a risk management perspective, this tipping point creates a conundrum. Hedging doesn't work very well, but some assets are becoming inevitably undervalued since only one actual scenario can unfold. Market prices frequently lurch from one worst case projection to another, yet those fears aren't frequently based on any actual events or hard data. Does it make sense to continue operating normally in such an environment, knowing that losses typically result, or is it better to try and avoid it altogether?

There are two key theoretical insights that suggest simply taking the lumps and waiting it out. First, if many assets have begun trading beneath fair value, then it follows that there is a much higher chance of short-term gains than is typical. Second, the longer that losses persist, the more pressure will build to the upside, since value tends to accumulate over time. Together, these ideas imply a fairly rapid but difficult to predict turnaround which easily reverses any net losses. Importantly, note that this does not assume that all assets will recover - oftentimes one bad scenario will unfold - only that some assets are poised for a significant rebound during which risk-managed frameworks will be well-positioned to benefit.

To test this is relatively simple: the pattern you'd need to see is that when many asset classes lose value simultaneously against a backdrop of rising interest rates, you go on to have a relatively rapid and substantial rebound in some of those assets, along with a corresponding rebound in the risk-managed frameworks. Since this should hold true regardless of what event winds up unfolding, this analysis includes every event since 1954 where interest rates were rising while stocks and some commodities were falling. Notice that our current year is included for reference in the final row.

Year	Length (Months)	Stocks	Bonds	Copper	Gold
1957	17	-5.9%	-5.2%	N/A	N/A
1960	2	-5%	-0.73%	-6.4%	N/A
1962	3	-18.8%	-0.7%	-6%	N/A
1966	5	-12.4%	-1.7%	-36.3%	N/A
1970	8	-13.9%	-4.5%	-5.7%	0.9%
1974	5	-22.8%	-2.2%	-46.4%	-9%
1975	3	-11.7%	0%	2.2%	-13.8%
1978	3	-5.9%	-1.9%	4.5%	-6.4%
1980	6	-3.5%	-6.3%	-23.5%	22.8%
1982	2	-5.8%	-2.6%	0.7%	-5.7%
1984	11	-5.5%	-3.2%	-14.8%	-5.4%
1994	2	-8.1%	-10.9%	-2%	0.8%
1997	2	-3.2%	-3.1%	8.7%	1.7%
2015	9	-0.7%	-4.6%	-24.9%	-9.6%
2018	12	-6.0%	-5.2%	-17.4%	-3.6%

Note that this covers a very broad spectrum of history. Sometimes the economy was battling hyperinflation (late 70's), other times it was already in recession (early 70's), and sometimes it was just nervous (2015). Sometimes the Fed was in the midst of raising rates too high, and other times it needed to go on to raise rates more. None of that matters much to our thesis.

Here's a look at how each asset class performed just three months after the end of each of the above periods. It would be natural for some asset classes to continue falling, but also to see significant rallies elsewhere. On net, the rallies should appear more common and larger in size than any additional losses.

Performance by Asset Class, Three Months Forward

Every data point fits the theory, and it's also interesting to note that stocks and bonds both rallied 85% of the time, and losses were relatively light even when they did persist. This traces back to the downward bias of uncertainty; once prices are so cheap, even the asset classes that go on to perform the worst don't have all that much further to fall since such pessimism was already afoot.

Both Hedgewise risk-managed frameworks suffer in these circumstances, but that is by design since these events are quite infrequent, and because this 'rebound effect' provides such an effective antidote. First, let's take a look at how each strategy performed during these same periods. The first column shows the net performance for each strategy, and the second the worst peak to trough drawdown (if worse than the net loss), which gives a better sense of how the 'worst of it' felt.

Year	RP Max	RP DD	MM Max	MM DD
1957	N/A	N/A	-13.3%	-16.2%
1960	N/A	N/A	-8.5%	--
1962	N/A	N/A	-13.2%	--
1966	N/A	N/A	-12%	-13.1%
1970	N/A	N/A	-13.9%	--
1974	-16%	--	-4.5%	-5.8%
1975	-18.3%	--	-19.6%	--
1978	-15.3%	--	-12.2%	--
1980	-12.9%	-24.5%	-0.3%	-19.7%
1982	-5.3%	--	-2.8%	--
1984	-22.9%	--	5.6%	-7.8%
1994	-10.8%	--	-7.1%
1997	-3.2%	-4.5%	-4.4%	-5.3%
2015	-5.9%	-8.1%	-1.9%	-10.8%
2018	-9.3%	-15.8%	-13.7%	-19.8%

Next, let's examine how the strategies performed directly following these months; you'd frequently expect the rebound to be rather fast, but even if not, it should eventually result in large gains since value accrues as you wait. I've separated each strategy into forward looking one month, three month, six month, and one year gains to highlight the speed and size of each recovery.

Risk Parity Subsequent Returns (1972 Onward)

Momentum Subsequent Returns (All Data Points)

For both strategies, the average one month return is over 4%, the average three month return is over 10%, the average six month return is over 20%, and the average one year return is close to 40%. Now, the main caveat to these numbers is that they all measure forward starting after the end of the "peak uncertainty" stretch, and it is impossible to say whether this month will mark that point. However, consider that we are already 12 months into our current stretch, which is far longer than the average duration historically and has only been exceeded once, in 1956, when the pain endured for 17 months total. Eventually, the Fed either breaks the economy, or inflation rockets, or the tightening cycle ends uneventfully, and Hedgewise frameworks have handled every scenario with ease. Until then, you usually run into years just like this one, and while that may provide little comfort, it's important to understand that we are not in uncharted territory, nor has Hedgewise performance been any worse than you'd expect.

If these stretches are always so nasty, can't we just find a way to skip them? The data above provides much in the way of a retort. These periods are really infrequent; you see two to four per decade, and on average they last only a few months. Once they end, the same risk management mechanisms that appeared to be failing suddenly work wonderfully. In a way, this is precisely the environment where you choose to accept losses as the outcome: it's an environment with a rebound literally built-in.

Conclusion: Evaluating 2018

On the one hand, 2018 definitely counts as an exceptional year. It joins the handful of events each decade that stand out for their awfulness, and it absolutely feels unfamiliar because you have to go back to the 1970s and 80s to find a year quite this bad. Then again, those were the very decades when the Fed last had to seriously wield monetary policy to fight potential inflation; perhaps it should be of little surprise that is what we are facing again now. When the central bank is the main concern, it's relatively common to hit these stretches of 'peak uncertainty', when many assets fall together despite inherent contradictions, and markets lurch from one panic to another.

Amidst this, risk-managed strategies like Risk Parity and Momentum will have losses, but this doesn't mean that they are working poorly. In fact, Hedgewise has continued to consistently outperform large competitive products. Historically speaking, a similar magnitude and breadth of cross-asset losses has often resulted in losses of 20%, while current YTD losses remain well-below that. Similarly, even a purely passive hedged portfolio would likely be performing worse. These are all signs that the risk management techniques in place continue to work about as well as they should, despite the difficult reality that these circumstances entail a substantial drawdown.

Looking forward, though, this drawdown is entirely about context. It is being driven by a heightened anxiety that has driven down the price of nearly all risky assets, and given that only one economic reality can unfold, this means that one or many of these assets are mispriced. The same risk management mechanisms that have driven losses, like hedging and leverage, will also be positioned to take advantage of the subsequent rallies that have always resulted with time. This is very different than a loss in a single asset class or speculative instrument (like, say, Bitcoin), which explains why recoveries have been so convincing and consistent when they occur.

Certainly, this year feels crummy, but it's about as crummy as you'd expect it to be, and it's the kind of crummy where you usually have the losses that we have. It will probably continue to feel very crummy until it is finally clear which big mistake is being made, if any. Then, suddenly, it will start to look much better, and it doesn't really matter if we are in a recession or high inflation or neither. It only matters that we finally know, after which 2018 will be just another data point of a typical bad year.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• A significant spike in interest rates has caused steep losses across all asset classes thus far in October, but a mix of higher rates and lower stock valuations bodes extremely well for future returns.
• Periods of Fed tightening are typically quite choppy, but have been consistently followed by rallies in one or more asset classes for structural reasons.
• Hedgewise continues to minimize losses this year via risk management, which has driven outperformance compared to benchmarks.
• This loss reduction will eventually add to a significant boost in long-run returns, but patience is required while the market sorts itself out.

Current Outlook: Little Reason to Worry

Current economic conditions - a bear market in bonds and commodities, largely driven by Fed tightening - have historically preceded excellent returns in both Hedgewise strategies. Unfortunately, these periods also usually include significant volatility, like what we saw in January and are now experiencing again in October. But it is extremely unlikely that these losses will persist over the next six to twelve months.

To understand why, let's first take a look at year-to-date returns in each asset class.

Asset Class YTD Returns, 2018

It's fairly rare to see this kind of dual bear market in bonds and commodities, since higher interest rates usually happen alongside a strong, growing economy which buoys the prices of raw materials. Yet this data suggests that the Fed is essentially pre-empting inflation: it wants to cool off growth before it gets out of control, and so far as inflation is concerned, it appears to be doing a great job.

There have only been three other periods since 1954 with similar economic conditions: 1980, 1981, and 1984. In each, the Fed was also corralling inflation, and asset class returns were eerily similar to today:

1yr Trailing Returns by Asset Class

Date	Bonds	Copper	Stocks
March 1980	-18%	-6%	6%
August 1981	-15%	-13%	5%
April 1984	-9%	-16%	4%

Once the Fed has raised rates enough to produce these outcomes, there are only two logical possibilities for the future: a) the economy is strong enough to sustain it, and stocks do well, or b) the economy is not strong enough, so rates go back down and bonds do well. Here's how the following one-year returns looked for each asset class in the above periods:

1yr Forward Returns by Asset Class

Date	Bonds	Copper	Stocks
March 1980	9%	1%	40%
August 1981	35%	-18%	1%
April 1984	27%	-6%	15%

This is quite consistent with the theory. Stocks did well in 1980, bonds did well in 1981, and both managed to do well in 1984 (this is known as a a Fed "soft landing"). Perhaps most importantly, though, both Hedgewise products also went on to do fantastically in every period.

1yr Forward Returns, Risk Parity Max and Momentum Max

Date	Risk Parity	Momentum
March 1980	44%	45%
August 1981	50%	57%
April 1984	35%	37%

While these numbers are comforting on face value, it's important to emphasize that these periods each came with a ton of volatility, as investors were just as nervous about interest rates and the economy then as they are now. For example, here's how markets looked from April 1979 to March 1980.

Asset Class Performance, April 1979 to March 1980

Note that in October 1979, stocks lost 5%, bonds lost 8%, and copper lost 17% in a single month! Stocks recovered from there, but then went on to fall 10% again in February and March of 1980, while bonds wound up down 18% altogether. Copper dropped 30% in about 2 months. Does it start to feel a bit familiar?

Notably, there was also a huge amount of daily volatility over this stretch. Stocks were down 1% or more on 14 days, including a single day loss of 3%.

Clearly, such years will be stressful, and large single day movements have a high emotional toll. It's hard not to wonder whether it makes more sense to simply sit on the sidelines for a while. But there's a very strong structural case for staying patient, especially as it relates to Fed tightening.

The Structural Case: Interest Rates and Returns

It's very important to differentiate the impact of interest rate movements on asset returns from systemic events (like the mortgage crisis) or economic slowdowns. This is because with the latter categories, volatile markets can sometimes be indicative of more problems lurking beneath the surface. For example, in the mortgage crisis, certain kinds of loans started to default before others, but markets were not yet pricing in the full impact of the issue.

On the other hand, interest rates alone are extremely transparent and the Fed works quite hard to avoid surprising the market much. Interest rates are also not an economic problem in isolation; they only become a problem if companies stop growing sufficiently or generating enough cash flow, etc. As such, if you assume that everything in the economy will stay the same, except for a move up in interest rates, you can calculate quite precisely how much it should impact markets. For example, with the way rates have moved so far in October, you'd expect bonds to be worth about 4% less and stocks to be worth around 3-6% less, simply based on a present value formula and discounted cash flows. As of October 10th, bonds are down 4.04% month-to-date and stocks are down 3.63%.

While those immediate losses are painful, potential gains have been quite literally 'moved' into the future. The expected return on all assets has gone up definitionally, since interest rates are a component of expected return. Little wonder that this is usually a terrible time to sell!

To test this, I've isolated every single rolling twelve-month period when interest rates went up by a similar amount to this year, regardless of what happened in other assets. The following shows the subsequent one-year returns in the Risk Parity Max and Momentum Max products.

1yr Forward Returns in Risk Parity and Momentum, Periods of Rising Interest Rates

There were exactly three months when Risk Parity and Momentum went on to do poorly over the next year, and all of them were prior to Black Monday in 1987. Even if you include that, it still leaves a 94% chance of positive returns. It is also relatively difficult to parallel our current environment to the one in 1987. Most notably, stocks were up about 40% from January through August that year, with almost no downside volatility.

Outside of 1987, annual returns averaged over 20% for both strategies, and it didn't matter much which asset wound up rallying. Either interest rates came down, stocks rallied, or some combination of the two.

Is There A Better Way to Hedge?

While the forward-looking numbers may provide some comfort, it's still fair to ask whether these losses could have been avoided in the first place. If rates are going up, should we just sit on the sidelines to avoid the possibility of market corrections?

The problem with this logic is that you'd need perfect foresight as to when long-term interest rates are about to go up by 1% or more, and even if you had that, you'd still only be right about a pullback about 30% of the time. To illustrate, here's the same graph as above, but with trailing one-year returns instead of forward one-year returns. This shows you what loss (or gain) you would have avoided if you exited each strategy one year before interest rates hit their peak.

1yr Trailing Returns in Risk Parity and Momentum, Periods of Rising Interest Rates

Sitting on the sidelines was still a losing bet about 60% of the time - and this was with perfect predictions of rate spikes!

As a result, Hedgewise generally accepts that you'll have a bad year every now and again, but it still seeks to minimize the damage via its risk management techniques. For example, Hedgewise risk indicators for the bond market spiked in January of this year as well as at the beginning of October, and bond exposure was drastically reduced as a result. The net impact of these techniques continues to drive outperformance for Hedgewise versus all major competitors.

Competitive Risk Parity Funds YTD Performance

Product	YTD
Hedgewise RP High	-0.7%
AQR	-4.8%
Invesco	-4.1%
Wealthfront	-14.3%

Traditional Diversified Mix YTD Performance

Type (Ticker)	YTD
Conservative (AOK)	-2.9%
Moderate (AOM)	-3.4%
Aggressive (AOA)	-3.1%

Wrapping Up: A Typical Volatile Year

While the Great Recession remains fresh on most of our minds, all signs indicate that the economy remains relatively normal. Unemployment is under 4%, interest rates are rising slowly, and markets have all been functioning as they should. While the extreme volatility thus far in October feels exceptional, it is quite similar to the volatility markets witnessed in other periods of Fed tightening. There's also a logical explanation for why markets get re-priced when rates go up, and why this makes future positive returns all the more likely.

Neither a year nor a week like this past one suggests that we are in uncharted territory, or that worse times are imminent. There's a reasonably good chance that markets will continue to be volatile for the next few months, just as they were for most of 1980 and 1984. But there's about a 95% chance that at least one asset class will break significantly higher within the next year. Fortunately, Hedgewise strategies are built so that you don't have to figure out which asset class it will be.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Since the market bottom this spring, Hedgewise Risk Parity has gained 8% and Momentum has gained 10%, demonstrating the resilience of both frameworks and the power of remaining patient regardless of market conditions.
• Generally, most quantitative and traditional frameworks have underperformed Hedgewise over this period, which can be traced to core theoretical principles that give Hedgewise a persistent edge.
• While US equities have been the best performing asset class this year, substantial risks such as the trade war and rising interest rates remain. Protecting against these downside risks has resulted in a slight lag compared to the S&P 500, but that is entirely by design.

Few Winners in 2018 Amidst Market Chaos

If you look anywhere outside of US stocks, 2018 has been a pretty terrible year for investors. Both emerging markets and many commodities have entered a full-fledged bear market, and the general environment of heightened volatility led to many funds taking money off the table and missing the ensuing recovery. Bonds failed to hedge the market pullbacks in February and March given fears of runaway inflation, and other typical safeguards like gold were beaten down by a strong US dollar.

Performance by Asset Class, YTD

Despite this difficult environment, both Hedgewise strategies have performed quite well, with Risk Parity up 5% (at the Max risk level) and Momentum up 7.3%. Given that both frameworks are frequently exposed to bonds and commodities, these results are quite powerful and add significant weight to the narrative that Hedgewise clients have no need to time the markets.

The challenges of navigating this kind of environment can be seen in the poor year-to-date performance across the majority of quantitative funds and even in traditional diversified portfolios:

Competitive Risk Parity Funds YTD Performance

Mutual Fund	YTD
AQR	-2.9%
Invesco	-1.1%
Wealthfront	-6.8%

Traditional Diversified Mix YTD Performance

Type (Ticker)	YTD
Conservative (AOK)	-0.9%
Moderate (AOM)	-0.2%
Aggressive (AOA)	1.4%

The outperformance of Hedgewise products can be traced directly to its hyper-focus on avoiding what is known as "asymmetric risk". Simply, this is when there's a chance that some part of your portfolio will perform badly in isolation, and nothing else in your portfolio offsets it. For example, normally a commodity crash would be accompanied by a rally in bonds, since it would suggest lower overall inflation. But this year, commodities have crashed while bonds have lost money as well. Similarly, international bonds would usually rally when international equities crash, but both are negative year-to-date.

The reason for both trends is that the US dollar has had an incredible rally this year, which lowers the value of international stocks and bonds as well as dollar-priced commodities. This is a classic asymmetric kind of risk, and it is exactly why Hedgewise avoids international exposure and has a measure for asymmetric risk built into every asset class.

However, Hedgewise clients are often less interested in comparisons to competitive funds and more interested in performance versus the S&P 500 itself. After all, the goal is to achieve equity-like returns (at the High and Max risk levels) with substantially less risk. Given that, I want to focus the rest of this analysis on how years like this current one fit into the bigger strategic picture, and why underperformance compared to equities is often exactly what you'd expect.

Risk Parity: Stability Above All

Risk Parity is all about balance; it accounts for every possible economic scenario, and constantly builds in a hedge for each. As a result, it will always be holding a mix of bonds, commodities, and equities. Thus, it is somewhat intuitive to achieve a return lower than equities when bonds and commodities are underperforming. But as soon as you hit one period of recession (when bonds usually rally) or high inflation (when commodities usually rally), you easily make up the difference.

The key is that you are constantly trading near-term upside for long-term stability; you'd rather have a boring, steady 8% return every year regardless of what equities are doing. The rub is that you'll probably underperform equities about 50% of the time! You can also run into lots of bull markets where you'll lag the net performance of the S&P 500 for many years. In exchange, you can worry much less about whether next year is going to be a repeat of 2008. Historically speaking, so long as you've waited at least 10 years, you've outperformed the S&P about 85% of the time at the High risk level and 99% of the time at Max.

Still, it is difficult to gauge the strategy's success in years like this one, as you wonder whether a simple stock portfolio might make sense. Fortunately, there is a way to directly measure the 'stability' effect even over shorter timeframes to gauge how well the theory is working.

The following chart shows the distribution of all daily returns of the S&P 500 thus far in 2018. Notice the long 'left-tail' of negative returns; you had to deal with a couple of single days with losses as high as 4%!

S&P 500 Daily Return Distribution, YTD

Now let's look at the same distribution for the Risk Parity High strategy. If it is working as it should, the distribution should be much tighter, and have a shorter left-tail.

RP High Daily Return Distribution, YTD

Exactly as the theory predicts, the Risk Parity portfolio achieved a far higher level of stability compared to equities. The portfolio had more positive daily returns, and fewer negative ones; it also protected clients from the worst of the equity volatility. These attributes are what will continue to drive the portfolio's resilience over the long-run, though equity underperformance will very frequently be part of the story.

Momentum: Lean Into Safety, Away From Risk

Unlike Risk Parity, the Momentum framework does not rely on underlying balance. While it can hold various asset classes, it is usually dominated by equities, as its goal is to outperform the S&P 500 at a similar level of risk. To achieve this, it is constantly evaluating the current environment for stocks. When it is deemed relatively 'safe', the portfolio will overweight equities, and vice versa.

Importantly, this means that it will often be underweight stocks in risky environments, since this is what helps protect the portfolio from downside. Given the events of this year, perhaps it is little surprise that equity exposure has generally been lighter than it was in 2017.

The theory behind this is that stocks generally yield a positive return in 'normal' environments, since any reasonable investor demands that. However, once in a while, asymmetric risks appear to the downside (e.g. real estate bubble, dot-com crash, junk bond crisis, etc.). Hedgewise simply behaves more and more conservatively as the risk builds. Roughly speaking, Hedgewise trims exposure as the risk of a systemic event reaches between 20-30%; in other words, Hedgewise expects to be wrong about a crash occurring about 70-80% of the time.

To visualize the impact of this, the following chart isolates every year of gains in the S&P 500, and compares the returns of the Momentum "High" strategy over the same period. The dots under the red line mean the Momentum strategy did worse than equities, and vice versa.

S&P 500 Performance vs. MM High Performance, 1972 to Present (Only Stock Gains)

It may initially be surprising to see so many years of underperformance! However, there are very compelling reasons to give up these gains. Notice that you tend to make much more in the good years than you lose in the bad ones, and there are also about 2x as many dots above the red line as below. Even more importantly, playing it safe allows you to avoid the occasional catastrophe, as you can see in a similar chart that isolates all of the years of S&P 500 losses:

S&P 500 Performance vs. MM High Performance, 1972 to Present (Only Stock Losses)

Because the strategy behaves so conservatively in risky environments, it has historically avoided about 90% of stock crashes. Essentially, this boils down to a philosophy of being aggressive in good times but cautious in dangerous ones; you lean into safety, but away from risk.

As a result, you'll frequently underperform the S&P 500 in volatile years like 2018, but the amount you give up will be relatively small compared to your outperformance in better years and your ability to avoid significant crashes.

Comparing this to the available live client performance, the Momentum "Max" product had a return of 31% in 2017 compared to 22% in the S&P 500, or a difference of +9%. Year-to-date, it has a return of 7.3% compared to 9.9% in the S&P 500, or a difference of -2.6%. This is exactly consistent with expectations! Last year's outperformance more than outweighs the lag of this year, and while a more significant crash didn't wind up occurring, the risks were high enough to demand caution.

Looking Forward: Not Chasing the Peak

Perhaps the most consistent theme of 2018 is that the world feels much less steady than it did last year. The Fed is threading a nearly impossible needle of controlling inflation without impeding growth, and no one quite knows what to make of the ongoing trade wars. Various emerging markets are on the brink of crisis, and the Chinese economy suddenly appears quite vulnerable.

None of these risks have weighed much on the US economy so far, and it's entirely possible that they never will. But it feels increasingly likely that we are near a peak, and dangerous to try and predict its top. Luckily, there's no need to do so with either of the Hedgewise frameworks. Clients have continued to accrue gains regardless of external market conditions and have vastly outperformed most competitive funds. While there has been slight underperformance compared to the S&P 500, this is quite consistent with theoretical expectations. So long as you stay the course, the odds remain heavily tilted in your favor.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Hedgewise has incurred losses of 5-10% since late January, depending on your product and risk level, but is only down slightly year-to-date and continues to outperform all major competitors.
• Much of the drawdown has been driven by simultaneous losses across all asset classes, which strongly suggests investor panic and confusion. Such scenarios have never lasted long historically and will likely soon reverse.
• Even if some of the worst-case scenarios come true, like stronger than expected inflation or a recession, both Hedgewise frameworks have held up well in such environments.

Stay Calm and Carry On: Putting Recent Losses in Perspective

Make no mistake: markets have been pretty wild for the past couple of weeks, and if it's started to make you nervous, you are human after all! It has been especially confusing because the swings are quite hard to explain: not all that much has changed in the economy since January, yet markets are suddenly terrified of inflation, government debt, volatility, and valuations. If you can't explain why people are selling now, it's also hard to predict when they will stop.

Since every investor on the planet has this same logic and fear, it's easy to see how it can all quickly turn into a frenzy. And yet, this story also justifies why short-term market volatility shouldn't worry you much at all. If people are panicking for no good reason, you can be almost certain that they are selling assets too cheaply, and that's really the worst possible time to change your approach.

It helps to return to the basics of investment theory, which I discussed in my previous newsletter. Recall that your expected returns should look something like the following, with the blue line being your realized month-to-month returns, and the orange being the underlying "risk premia" - or "fair value" - that you are accumulating over time.

If you look at the past two weeks or so, we've most likely just experienced a very rapid cycle of this diagram, with assets moving temporarily above their fair value and now back below. The reason this is not particularly concerning is that it has no effect on your expected return over time, so long as you simply wait. By focusing primarily on long-term returns, you also minimize the many pitfalls of short-term timing and active management.

Now, Hedgewise still applies various kinds of risk management, but it is all with this long-term focus. For example, balancing exposures across many different assets, like stocks and bonds, tends to minimize the impact of a crash in any single one. But in the span of a few days or weeks when investors are panicking, it is possible they will all move down together. Likewise, there are certain extreme risk environments, like recessions and hyperinflation, that can sometimes be detected beforehand. But short-term market swings most often have very little to do with the economy at all.

With this perspective, the Hedgewise frameworks have continued to be quite effective. For example, since the beginning of 2018, the Hedgewise Risk Parity framework has lost significantly less than comparable major mutual funds. This continues a clear trend of outperformance ever since Hedgewise was launched. Last year, the Hedgewise Risk Parity and Momentum products both significantly outperformed the S&P 500 at the Max risk level, yet neither has lost significantly more than the S&P 500 so far this year.

Periods like these past two weeks will always be uncomfortable, but short-term losses are very different than long-term risk. To further make this case, let's take a deeper look at recent performance trends and how they stack up against history.

2018 Year-to-Date Performance: Unavoidable Losses, But Better Than the Competition

While most of the news is focused on stock returns since the peak on January 26th, equities were up almost 8% before they gave it all back. Trying to make sense of this fast of a reversal doesn't serve much purpose. The more interesting story is how various asset classes have performed year-to-date overall:

2018 Year-to-Date Performance By Asset Class

The bond market has actually been in a more significant correction than equities, as long-term yields have jumped about 0.7% since last September and 0.5% in the past two months alone. This makes some sense, given the Fed has started to more rapidly raise rates and reverse the "Quantitative Easing" program, and Hedgewise risk indicators have been frequently spiking as a result, including last month. The effectiveness of this dynamic risk management can be most easily seen by comparing the performance of the major Risk Parity mutual funds.

Performance of Hedgewise RP High vs Major Risk Parity Mutual Funds, 2018 Year-to-Date

The graph continues to demonstrate a high correlation between the various risk parity products, since they are all investing in the same broad asset classes. The main difference is in how risk is balanced, and Hedgewise has consistently achieved a superior level of performance in the short and long-term, as demonstrated by its comparative performance back through the beginning of 2017.

Performance of Hedgewise RP High vs Major Risk Parity Mutual Funds, 2017 to Current

While the relative performance is excellent, why hasn't any Risk Parity framework been able to better hedge this equity correction? If you glance back at the year-to-date performance across asset classes, you'll notice that bonds, commodities, and stocks have all incurred losses simultaneously. In such an environment, there's really no way to avoid a loss unless you engage in very short-term timing (quick reminder: all active managers do some form of this, and over 90% of them underperform the S&P 500).

This kind of cross-asset correlation is somewhat exceptional, especially during a 10% equity correction, though not entirely unprecedented. Since 1970, there's been exactly four other scenarios where equities have lost 8% or more while safe havens like gold and bonds also suffered losses.

Date	Event
Jul 1974	Beginning of Stagflation
Dec 1980	End of Stagflation; Interest rates peak near 20%
Oct 2008	Beginning of Great Recession
Mar 2009	Great Recession Market Bottom

While these are some pretty scary events, the good news is that Hedgewise frameworks still did fine in all of these scenarios because safe havens eventually kicked in. Let's take a deeper look at how it unfolded.

When Safe Havens Fail: Why It Happens and What It Means

There are only two reasons that investors sell stocks, bonds, and commodities at the same time: either they are in full panic, or they are really confused about inflation. The Great Recession was a great example of 'sell everything' when Lehman went bankrupt. People just moved to cash in a mix of confusion and a need for liquidity. Gold was the logical hedge against a failing financial system, and it went on to rally by 30% by February 2009, but it often won't hold up at the outset.

Stagflation is the other culprit, since it means poor economic growth due to runaway inflation. Both stocks and bonds will lose money by definition (since higher inflation means higher interest rates). While real assets like commodities should do well since the dollar is losing its value, there's often an initial fear that the Fed will pre-emptively raise rates to fight inflation even if it will result in a recession. Ironically, a recession would then mean lower interest rates, so then bonds would actually rally, but you can see how everyone basically gets scared and confused!

In each of these scenarios, equities, bonds, and gold all fell together for a couple of weeks. To see how it eventually played out, though, I looked at the full one year return for each asset class following each event.

One Year Return by Asset Class After Initial Event

Date	Stocks	Gold	Bonds
Jul 1974	15.2%	16.4%	5.6%
Dec 1980	-2.8%	-36.6%	11.6%
Oct 2008	-9.2%	14.1%	7.7%
Mar 2009	62.3%	18.8%	-2.7%

What's really neat is that you can see all of the different possibilities unfold. While these were all pretty awful economic times, at least one of the asset classes eventually rallied. It's the laws of economics at work.

It's also helpful to look at how the Hedgewise models did over this same one year period after each initial event.

One Year Return by Hedgewise Model After Initial Event

Date	RP Max	Momentum Max
Jul 1974	9.8%	14.3%
Dec 1980	-4%	41.5%
Oct 2008	20.4%	6.7%
Mar 2009	22.1%	38.2%

The big idea is that markets work themselves out over time, and that is eventually captured in the Hedgewise frameworks. You can still wind up with some bad years, and performance won't always bounce right back. But the odds are always on your side, perhaps even more so right after the scariest kind of market behavior.

Wrapping Up

While hopefully it's clear that there's no need to panic, whether losses have already bottomed or not, these past couple of weeks are still a wonderful opportunity to reflect on your own goals and risk tolerance. Investing presents a natural conflict between logic and fear. Rationally, targeting a higher long-term return seems like the right choice for many clients, despite the warning that a 20-30% loss is basically inevitable at least once a decade (at the higher risk levels). Yet it can feel quite different in the past couple of weeks when you see 10% disappear, and that's not even a particularly severe event!

On the other hand, the RP Max and Momentum Max product returned about 27% and 31%, respectively, in 2017 alone. Even if losses continue and this is the year of a 30% drawdown, you'd only be slightly worse off than if you had held cash the past year. It all depends on your perspective. Whether next month or next year, the drawdown will eventually come. If you remain patient and calm, it will also almost certainly pass. Either way, this most recent experience should help prepare and inform you.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Year-to-date, Hedgewise continues to outperform equities as well as most major competitive benchmarks.
• Both the Risk Parity and Momentum frameworks have exceeded the 10% return of the S&P 500 (at comparable risk levels) while maintaining the benefits of risk management.
• Many investors have missed this rally or transitioned to cash for fear of potential negative shocks, but Hedgewise client portfolios remain uniquely prepared for changing market conditions.
• Various strategies have done well in this remarkably calm environment, but few are well-prepared if volatility returns. I've examined some of the largest negative events of the last 50 years to explore how Hedgewise frameworks build in protection.

Bull or Bear Market? Doesn't Matter Much

Since the election last November, I read about one article a day discussing equity outflows, stock bubbles, bond bubbles, and every kind of warning in between. Of course, many raise valid concerns and highlight lots of indicators that suggest a downturn is right around the corner. Despite that, stocks have been on an incredible run, gaining over 10% this year and nearly 20% since November. Unfortunately, an estimated 45% of the country has missed out on it, perhaps in no small part due to the warnings around every corner.

Events like 2008 tend to leave an unforgettable mark on investors, and who can blame them? Yet the possibility of a 50% loss - and the corollary temptation to try and wait for the 'right time' to get in - results in an enormous hidden drag on most portfolios. While most investors naturally use the S&P 500 as a benchmark, that is deceptive if they would never be comfortable using a 100% stock portfolio. This is why I consider risk management techniques to be far more than some absolute return; the extra protection can fundamentally change the ability for many to invest at all.

In my last article, I discussed a few of the underlying theories that drive the construction of Hedgewise portfolios. A significant recurring theme in that research is the ability to use a combination of leverage and risk management to add protection to a portfolio without sacrificing returns. This is a departure from traditional hedging techniques, like covered calls, protective puts, or moving some of your portfolio to cash, which all have a substantial expected cost. 2017 has been a nearly picture-perfect example of this concept in action, as both the Hedgewise Risk Parity and Momentum strategies have outperformed the S&P 500 while still retaining significant downside protection.

However, what most excites me is not the absolute return itself, but rather the success of the risk management techniques underlying it and how those factors continue to provide protection that most traditional portfolios do not. For example, Hedgewise frameworks successfully avoided much of the energy correction in the first half of this year, added copper exposure to better hedge against inflation, and remained patiently overweight in equities despite the incessant political turmoil. These systematically-driven adjustments have driven better performance than major competitive funds this year, but I expect their value to become even clearer when stock volatility inevitably returns.

Year-to-Date Performance Review

Here is how Hedgewise products have performed against every major asset class. This is the composite performance across all live clients in Risk Parity or Momentum at the "Max" risk level, which uses a similar target volatility to the S&P 500. All fees and costs have been included.

2017 YTD Performance of Hedgewise Products vs. Major Asset Classes

This performance is particularly notable for Risk Parity, which has beaten stocks despite a significant allocation to bonds and commodities. Momentum has remained heavily weighted to equities throughout the year, ignoring the political noise that has had little long-term impact on the trend.

Hedgewise products have also outperformed most major competitive benchmarks, such as the iShares Core Allocation Funds (AOK, AOM, AOA), the PowerShares and Cambria Momentum Funds (PDP, GMOM), and the AQR and Invesco Risk Parity Mutual Funds (AQRNX, ABRYX).

Hedgewise YTD Performance vs. Comparable Traditional Benchmarks

Product	YTD	Benchmark (Ticker)
RP Med.	7.5%	5.5% (AOK)
RP High	9.4%	6.45% (AOM)
RP Max	12.7%	10.65% (AOA)
MM Max	15.7%	14.26% (PDP)

Hedgewise YTD Performance vs. Risk Parity Mutual Funds

Hedgewise YTD Performance vs. Momentum ETFs

Across every dimension, Hedgewise products have consistently outperformed. While this is very exciting, many of the competitive funds - especially in the Momentum space - are not built with the same level of downside protection. The value of this protection will only become evident during a sustained, multi-month equity drawdown event. Since that hasn't happened recently, we can model history to get a better sense of what this might mean.

Preparing for Shocks: What to Expect in the Next Correction?

Quantitative frameworks like Risk Parity and Momentum can be difficult to evaluate because fund managers often run them quite differently. Above, you can see that despite a high level of correlation, the Invesco Risk Parity fund has returned about 4% this year compared to more than double that for Hedgewise. While that is relatively easy to evaluate, differences are often more muted in normal market conditions. For example, almost every variation of Momentum has had a relatively good year.

The problem with many quantitative frameworks is that they work only within an asset class rather than across multiple asset classes. In the case of Momentum, many strategies invest in the top trending equities at any point in time, but would never invest in a separate asset class like bonds. This can work very well so long as equities as a whole are trending up - a rising tide lifts all boats. In a severe market correction, though, such techniques often provide little protection.

To get a sense of this, I examined the performance of the PowerShares Momentum ETF (PDP), one of the oldest public frameworks available, during the last recession. I also compared this to the simulated model results of the Hedgewise Momentum strategy set at a similar level of risk.

PowerShares Momentum ETF (PDP) vs. Hedgewise Momentum Model, 2007 to 2009

The simple explanation for this enormous difference in performance is that the Hedgewise model moved entirely into bonds prior to the recession, while PDP is limited to always being 100% equities by rule. To be clear, there is absolutely no guarantee that the Hedgewise framework will always catch such events. Yet at least it has a chance to get out of the way, while frameworks like PDP are limited by definition.

Again, there remain a wide range of events in which Hedgewise could not avoid losses, and 2008 performance is more of an exception than the rule. But the strategy frameworks are entirely built with these kinds of events in mind. To get a better sense of the range of likely outcomes, I examined the worst equity pullbacks since the 1970s to see how Risk Parity and Momentum held up (both set to the Max risk level).

Historical Performance of Hedgewise Momentum and Risk Parity Models

Period	Stocks	Mom.	RP
Aug. 08 - Nov. 08	-34.5%	24.1%	1.2%
Jun. 74 - Nov. 74	-27.7%	1.3%	-9.1%
Aug. 87 - Nov. 87	-26.1%	-22.2%	-6.5%
Mar. 02 - Jul. 02	-21.2%	3.2%	7.7%
Jul. 11 - Sep. 11	-17.5%	-3.1%	10.2%
Jul. 01 - Sep. 01	-15.7%	9%	8.6%
Jun. 98 - Sep. 98	-13.8%	-10.3%	14.1%

Across the board, both Hedgewise models consistently outperformed equities over the course of these "worst case" events. There will absolutely be some years, like 1987 or 1998, in which losses are inevitable. If you can successfully hedge even a few of these events, though, the impact on your long-run return will be enormous. Yet this will only be possible if you are using a quantitative framework that is focused on this type of risk.

The important hidden advantage of this approach is how it can shift your mentality as an investor outside of the raw returns. Once you know that a sophisticated quantitative approach is doing everything it can to manage timing risk for you, you can pay far less heed to the hundreds of warnings in the news every day. You won't avoid every loss, but you gain the confidence to stay patient regardless as the probabilities are engineered to be heavily tilted in your favor.

Looking Forward: Late-Cycle Environment

It would be unrealistic to expect the low volatility and stable positive returns of the past year to continue unabated. There's a good chance we will remain in a 'late-cycle' environment for the foreseeable future, which means that the economy will grow fast enough for the Fed to be concerned about inflation, but investors will stay nervous that growth is slowing down or that some geopolitical shock will throw everything into disarray. Against this backdrop, I'd expect quite a bit of chop across all asset classes, but it's unlikely that much of it will be meaningful. Both Hedgewise frameworks remain excellent choices for such an environment, regardless of short-term returns.

While I don't see any major systemic financial risks currently unfolding, I'm far less nervous about that possibility than most since Hedgewise frameworks have been so carefully constructed to account for it. In a sense, this bull market has actually been a challenging stretch because investors may fail to see the value of risk management when stocks continue to do so well. Fortunately, Hedgewise techniques are built to weather all kinds of conditions, and have consistently outperformed equities regardless. Whenever the next bear market does unfold, it will be exciting to observe what I expect to be an even bigger difference between Hedgewise and most traditional benchmarks.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Hedgewise products have significantly outperformed benchmarks in 2017, with YTD returns of over 8% for clients in higher risk levels.
• The tumultuous political environment has pushed many investors to be overly cautious due to a misperception of how much influence the President has on the economy.
• Meanwhile, Hedgewise risk algorithms have navigated the environment quite smoothly, including a significant reduction of oil exposure prior to the recent pullback.
• While Hedgewise performance has been strong, there were moderate losses in the first two weeks of March. However, this was quite natural and no cause for concern. In fact, it presents a great case study for why short-term losses rarely matter within the Hedgewise framework.

Politics Dominate the News, but Not the Economy

Recently, the headlines have been overwhelmed by news coming from the White House. There has already been post-election euphoria, a failed Repeal and Replace effort, an escalation of conflicts in the Middle East, and an endless stream of Russian intrigue. Given that, many pundits have naturally attributed the stock market rally since November to optimism over President Trump, and now worry that recent turmoil will quickly reverse the gains.

While this makes for a good story, it doesn't hold up in the real world. Outside of major economic crises requiring government intervention, like the bailouts in 2009, policy doesn't have all that much to do with Wall Street. Investors are largely rational, and value every individual company based on its bottom line and future growth prospects. Given that, it's hard to imagine that every company was suddenly worth 10% more because Trump might reduce regulation, cut taxes, and invest in infrastructure. Even if all of this happened - and everyone knows that is a big if - it wouldn't come close to justifying such an increase in valuation.

The reality is that the US economy had significant tailwinds up until the last month or so. Unemployment continued to drop, inflation finally started to pick up, and the Fed became confident enough to significantly accelerate interest rate increases. This explains most of the stock rally, as well as the dramatic correction in bonds last October and November. The macroeconomic data coming in for the first quarter has cooled off a bit, though, and stocks along with it.

The point is that it makes far more sense to follow the data than to follow the news. Thus far, the numbers say that investors aren't particularly worried about Trump destroying the economy. He would need to bungle something major (like starting a trade war) to have any real impact, but nothing that has happened so far has caused much worry.

Against this backdrop, it has actually been a relatively stable few months in terms of risk. Since the Hedgewise framework is entirely quantitative, there was no chance of overreaction to the news, leading to significant gains for most clients. To better frame relative performance, I've compared Hedgewise products to more "traditional" portfolio mixes, represented by the iShares Conservative ETF (AOK), the iShares Moderate ETF (AOM), and the iShares Aggressive ETF (AOA). I've also shown a separate graph of the Hedgewise Risk Parity+ strategy compared to the largest competitive mutual funds.

Hedgewise YTD Performance vs. Traditional Portfolio Benchmarks

Product	YTD	Benchmark (Ticker)
RP+ Medium	4.22%	2.51% (AOK)
RP+ High	5.34%	2.9% (AOM)
RP+ Max	7.51%	5.19% (AOA)
Momentum	8.55%	5.96% (SPY)
L/S Oil	-6.86%	N/A

Hedgewise Risk Parity+ vs. Largest Competitive Mutual Funds

These performance numbers are exactly what you'd want to see: for a given level of risk, clients have generally achieved higher returns. While Long-Short Oil has incurred losses, they are quite typical of the swings inherent to that strategy, which tends to be both streaky and extremely volatile (Note that I generally will not provide more detail on alpha products due to their proprietary nature).

Looking forward, it's likely that one of stocks, bonds, or gold will reverse course, as it doesn't really make sense for them all to have appreciated together. While this may result in a short-term dip, as we saw in early March, this is a natural part of the process and has no bearing on long-term returns. As risk unfolds, Hedgewise algorithms shift to ensure your outlook remains bright regardless.

How Risk Algorithms Are Driving Performance

In the first quarter of this year, risk signals were relatively low in every asset class besides oil, which had its exposure reduced beginning in January. These signals are not meant to be predictive of positive or negative returns; rather, they reflect some possibility of a large correction. Oil provided an excellent example of such a risk unfolding over many months. Even though net losses have not been significant, the system was still accurate in identifying the possibility of severe downside.

Oil Exposure By Month In Hedgewise Risk Parity+ Model

YTD Price Change of WTI Oil

This is a great example of the kind of risk that is the primary focus at Hedgewise. As intended, the system was overly conservative, and reduced exposure to oil all the way back in January. Oil went on to rally slightly from mid-to-late February, but this had little impact on the overall risk assessment since short-term movements are not the focus. By March, the risk had been fully realized, with oil prices dropping by over 10% in a matter of days. Despite a subsequent recovery, the risk assessment was spot on. Even if oil manages to fully recover from its losses, it was still absolutely worthwhile to trim exposure given the general environment.

Conversely, all other major asset classes have been relatively stable (in other words, not demonstrating a risk of a major downside event). This doesn't mean all these assets were expected to appreciate; in normal conditions, you'd expect some to do well and others to do poorly, and thus drive a balanced positive return. However, markets frequently behave oddly over short periods of time, as can be seen by the YTD returns below.

YTD Returns by Asset Class

Asset	YTD
S&P 500	5.96%
Treasury Bonds	2.0%
TIPS Bonds	2.11%
Gold	8.98%
Oil	-2.7%

While these returns suggest some disagreement across markets, they still led to a great few months of performance for Hedgewise clients. That said, it's easy to see that this is not sustainable. If real economic growth is high, TIPS should be doing terribly unless there is a great deal of inflation. However, in that case, Treasury Bonds should be tanking. This generally indicates that the players in the different markets have different views, at least one of which is not correct.

This means that one of these asset classes is probably overvalued, but no one knows which one yet. This is a very different category of risk than the one discussed in the oil markets: this involves short-term price distortion despite a generally solid base. To address it, you'd need to accurately predict weekly directional price movements - which is incredibly difficult and resource-intensive.

Rather than seek such precision, Hedgewise simply waits for these forces to play out and bets on an overall positive return regardless. A good example of this process happened in early March which is instructive to examine in greater detail.

Examining the March Dip

Here's a closer look at the pullback in the Risk Parity strategy in March.

There's three key reasons this particular pattern should raise no concern. First, notice the symmetry in the graph: almost immediately prior to the pullback, there was a nearly equivalent rally. Such fast gains, especially in a balanced portfolio like Risk Parity, often suggest that something is out of balance and will need to correct. Second, there's absolutely no need to try and avoid that correction because it won't matter in the big picture. Finally, attempts to manipulate performance in this short of a time period are very dangerous and can easily backfire.

To better prove this, I took a look at the limited Risk Parity model that runs back to 1972, and isolated all of the years in which there was a single month with losses of 7% or more. I compared that alongside the annual return for that same year to see how much of an effect those large short-term losses had overall.

Impact of Large Short-Term Losses on Annual Returns, Risk Parity Model

Year	Worst Mth	Ann. Return
1973	-7.0%	-7.49%
1976	-7.1%	35.44%
1978	-12.4%	-3.06%
1979	-7.8%	34.94%
1980	-8.1%	44.36%
1981	-10.7%	-11.59%
1982	-8.8%	69.10%
1984	-7.3%	1.56%
2000	-7.6%	9.77%
2003	-8.2%	28.41%
2004	-8.0%	8.95%
2011	-7.8%	31.18%
2012	-7.1%	8.05%
2015	-8.1%	-11.89%
Avg.	-8.28%	16.98%

In years when you lost 8% in a single month, you went on to gain an average of 17% regardless! While this may seem counterintuitive, it all comes back to balance and effective risk management. Since all assets tend to appreciate over time, you almost always win simply by waiting for markets to work things through.

Looking Ahead

Summing all this up, the outlook is generally positive but with expected chop along the way. Too many assets have gone up together in the past few months, but it's impossible to say how long that will last or what is currently overvalued right now. That's perfectly fine, though, as the Hedgewise risk algorithms have continued to catch major events and short-term swings will have little impact by the end of the year.

More importantly, Hedgewise has already driven significant gains for clients in 2017 and beaten most major benchmarks, and I fully expect that trend to continue.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• In 2016, every Hedgewise product exceeded the performance of comparable benchmarks while incurring significantly lower risk of loss. Client portfolios achieved an average return of over 12%.
• The Hedgewise flagship product, Risk Parity, consistently outperformed competitive funds by 2% to 4% due to its superior risk management, lower costs, and tax efficiency. The portfolio remained stable throughout significant geopolitical events, such as the Brexit and the US election, continuing to prove its resilience in any economic environment.
• Hedgewise also launched two new products this year, Momentum and Long-Short Oil, as part of its broader vision to better fulfill any client goal. These products help risk-seeking clients achieve higher expected returns while maintaining the benefits of risk management, and initial results have been excellent.

Overview of 2016: Better Performance, Less Risk, More Innovation

2016 was a fantastic year for Hedgewise, which delivered on its core promise to clients: better returns with less risk of loss, whatever your goals. Here's a summary of how Hedgewise products performed last year compared to the S&P 500.

Product	2016 Performance	2016 Max Loss
Risk Parity+	12.2%	-5.4%
Momentum	24.0%	-6.4%
Long-Short Oil	86.7%	-13.3%
S&P 500	11.7%	-9.1%

These numbers tell the story quite well. For any given level of risk - with risk defined as the maximum amount you might lose - Hedgewise offers products that perform better than traditional alternatives.

Risk Parity is ideal for minimizing drawdowns while achieving equity-like returns. It frees clients from having to worry about the future by hedging for any economic scenario. This year, performance remained steady despite various pullbacks in both the stock and bond market, providing many great examples of the theory working in practice. Hedgewise also outperformed comparable Risk Parity mutual funds throughout the year, further differentiating its risk management techniques.

However, Risk Parity still has an upper limit on risk based on its need for leverage, which has natural caps for a variety of reasons. For clients with a greater tolerance for occasional large losses and a long enough time horizon, it often makes sense to prioritize higher potential returns over minimizing potential losses. To better cater to this need, I created the Momentum and Long-Short Oil Products.

The Momentum framework still takes advantage of the Hedgewise risk monitoring system, but concentrates exposure rather than disperses it. This makes it quite likely that clients may experience losses similar to equity markets, but with the potential for far greater returns. Initial results this year were consistent with this vision, as the Momentum strategy returned 24% overall, along with a higher corresponding level of volatility.

Long-Short Oil is the first Hedgewise "alpha" strategy, which means it has very little correlation to broader markets and is more speculative in nature. If executed well, such strategies are extremely valuable additions to a portfolio because they provide a completely independent return stream and another effective means of diversification. I am planning on developing a number of these strategies and helping clients layer them together to construct even higher performing portfolios.

Overall, 2016 represented another great step forward. Hedgewise now offers multiple risk-managed products, all of which outperformed. Not only that, Hedgewise helps clients combine these products together to create a portfolio which is even greater than the sum of its parts. As time goes on, I believe the benefits of this approach will only become more and more obvious.

Risk Parity Weathers Every Shock, From Stocks to Interest Rates

In theory, a Risk Parity portfolio should create more stable, positive returns over time because it is constantly hedged for any kind of economic scenario. A number of events during 2016 helped to demonstrate that this is working just as it should:

Event	S&P 500	Risk Parity+
Jan-Feb Stock Correction	-9.08%	1.37%
Brexit	-5.57%	-1.08%
Pre-Election Jitters	-3.3%	-1.37%

For most investors to avoid the risk of these events, they must rely on overly conservative portfolios with limited upside. However, the Hedgewise Risk Parity framework achieved this stability while still outperforming the S&P 500 for the year.

This is extremely powerful both financially and psychologically. Prior to the Brexit and the US election, I had numerous clients asking whether they should consider lowering their risk levels or liquidating altogether. My advice was to remain steady, as the strategy was already built to handle such events. However, investors in traditional portfolios had no such security, and were often compelled to jump in and out of the market or to remain in cash. This is a significant hidden cost to most investors. Risk Parity eliminates the need for this kind of timing concern and thus protects investors without sacrificing long-term returns.

While Risk Parity is an excellent general framework, it can be run in many different ways. In 2016, Hedgewise proved that its approach to managing risk and balancing assets is superior to that of other providers.

AQR and Invesco run two of the largest Risk Parity mutual funds. Last year, Hedgewise maintained a high overall correlation to these funds while consistently outperforming both. Hedgewise also accomplished this while charging half the fees and incurring a significantly lower tax burden for every client.

Hedgewise 2016 Risk Parity+ Performance vs. Competitors

For clients who remain nervous about the future, especially in the stock market, Risk Parity has consistently proven to be a safer way to grow your money.

New Momentum Framework Drives Higher Potential Returns

While Risk Parity is an excellent product, it is naturally somewhat conservative even at the highest risk target. This is because it is hedged across many different assets, which drives stability above all. For younger or more speculative clients, though, stability is often not the primary goal. They might gladly accept a few years of large losses in exchange for a higher overall return. The new Hedgewise Momentum framework helps to address this need.

Generally, "Momentum" refers to the use of various timing signals to reduce the risk of significant drawdown events on your portfolio. Unlike Risk Parity, this means you concentrate risk in certain markets most of the time, rather than diversify. For example, you might stay 100% in equities unless you hit some sort of downside trigger, and 100% bonds otherwise.

However, similar to Risk Parity, the success of any Momentum strategy depends entirely on the quality of its risk management system. Whenever a timing signal fails, you run the risk of incurring significant losses and/or missing potential gains. Since Hedgewise already has deep risk management expertise, though, it made sense to translate that into a timing framework.

While I am planning on publishing additional literature on this strategy later this year, the early results have been excellent. Here's a look at the model's performance for 2016 compared to a couple of the largest competitive Momentum ETFs on the market. You can quickly see how much performance is driven by getting the signals right - or wrong.

Hedgewise 2016 Momentum Performance vs. Competitors

While returns this year were very high, they come with additional risk. You maintain some protection from drawdowns, but it is not nearly as robust or layered as Risk Parity. As such, it makes sense to view this as a more "equity-like" return stream, including the possibility of a year like 2008. However, in exchange for that possibility, you gain the potential for far higher returns - like the 24% achieved in 2016.

This is an especially attractive proposition for investors who have most of their money in equities already. Since they are already assuming the risk of a year like 2008, why not utilize risk management to potentially boost returns further?

When discussing this product with clients, there is often confusion as to how to choose between Momentum and Risk Parity. Luckily you don't have to. Just like diversifying across assets makes a portfolio more robust, so does diversifying across risk management frameworks. This kind of quantitatively-driven portfolio construction is unlike anything you else you can find on the market.

Looking Forward to 2017

While lots of research is continuing behind the scenes, Hedgewise has already become a very powerful investing platform. Each individual Hedgewise product outperformed the competition as well as the S&P 500 last year. Whether your goal is conservative or aggressive, Hedgewise can customize a portfolio to exactly suit your needs. By combining different products together, clients have access to an even more robust portfolio. All of this can be done without any additional fee and in any kind of account - IRAs and even 401ks.

Despite this progress, there is still so much more potential. Unlike ETFs and mutual funds, Hedgewise is constantly continuing its research. Soon, there will be a number of alpha streams to choose from and advice on how to optimally layer them into your portfolio. More improvements will be made to the underlying risk system behind Risk Parity and Momentum. Hedgewise already offers a best-in-class product, but there is always the potential to make it even better.

I'm excited to continue to share the results, and 2017 is already off to a great start.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Long-term government bonds lost over 9% in November, the second largest monthly loss since 1950.
• Hedgewise algorithms automatically detected this risk and moved out of long-term bonds ahead of time, which significantly reduced losses in client portfolios.
• Dynamic risk management will continue to protect the gains of this year, and to take advantage of higher yields and more attractive valuations when the bond market stabilizes.

Hedgewise Avoids Post-Election Bond Correction; Remains Up Over 10% YTD

The result of the election caught many investors off-guard, as most expected equities to collapse and safe-haven assets to soar if Trump won. However, his policy mash-up of "conservative populism" has most investors betting on heavy infrastructure spending, reduced taxes, and higher deficits. This has led to a dramatic crash in government bond prices along with a stronger dollar, which has lowered the value of commodities like gold.

While many Risk Parity mutual funds performed poorly as a result, Hedgewise algorithms nimbly avoided most of the losses in government bonds as a result of the improved risk framework rolled out over the summer. This provides another excellent, real-life example of how the system protects clients from drawdowns regardless of the environment, and further pierces the myth that Risk Parity is overly sensitive to interest rates. By managing risk intelligently, Hedgewise locked-in gains as bonds rallied through the first half of the year, while largely avoiding the subsequent reversal.

In November, Hedgewise portfolios were down approximately 1%. For comparison, a number of Risk Parity mutual funds lost 5% or more.

October Performance Summary, Indexes vs. RP High

Hedgewise Significantly Reduced Bond Exposure As Risk Increased

From January to June of this year, bonds gained over 15% and were one of the main drivers of outperformance for Hedgewise clients. However, as interest rates continued to fall, the risk of a reversal began to rise. The Hedgewise system is constantly monitoring such risks, which led to a dramatic reduction in long-term bond exposure beginning in August.

Long-Term Bond Exposure By Month

These adjustments have helped Hedgewise maintain its strong performance in 2016 despite a complete reversal in the bond market.

Looking Forward, Bonds Will Present Another Opportunity

Though asset class corrections typically result in mild losses for Hedgewise portfolios, they also create significant opportunities for future gain. In the bond market, for example, interest rates are now rising to much healthier levels, and will likely present an attractive entry point when the market stabilizes. This pattern helps explain why Hedgewise portfolios are so resilient. The algorithms are built to avoid the largest asset losses, but then to take advantage of the attractive valuations that ensue.

That said, it is never fun to lose money as we have for the last few months. Historically, however, there are many reasons to believe this will not last much longer or get much worse. Most significantly, the Hedgewise model portfolio has never experienced a maximum drawdown that exceeds the gains of this year. In the Risk Parity "High" portfolio, performance peaked near 14% in September, and has since given back about 3% or so. However, the maximum model drawdown (tested back to 1972) is a little over 12%. This means that if history is any guide, clients will never lose more than they gained in just one year.

It is important to reflect on this last point, as it helps demonstrate how drastically the odds are stacked in your favor. Many clients struggle to invest aggressively because of the fear of an upcoming crash, but within the Hedgewise framework, you will frequently make enough in a single year to offset even the worst-case scenarios. Given that, it really never makes sense to wait on the sidelines.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Risk signals have rocketed in every asset class over the past few weeks, as markets are now pricing in a great deal of uncertainty related to the election.
• Hedgewise strategies continue to strongly outperform YTD despite losses in October.
• Client portfolios are well-prepared for any outcome on Tuesday.

Election Nerves Rattling Markets, But Some Assets Look Worse Than Others

Markets hate uncertainty. This is probably why until mid-October, election news was not having much impact. However, as the race has tightened, the general perception of risk has increased in every asset class, resulting in a sell-off across the board.

October Performance: Investors Selling Everything as Risk Increases

In this kind of environment, losses are inevitable. However, some assets continue to look far riskier than others. Long-term bonds, in particular, are pricing in a greater possibility of continued losses than equities, and Hedgewise models have been adjusting accordingly. This kind of dynamic, asset class-specific risk management is key to long-term outperformance, which has been easy to see so far this year.

YTD Performance: Hedgewise Portfolios Continue to Significantly Outperform Equities

While there will still be months of losses like October, all Hedgewise portfolios remain quite resilient against sustained drawdowns. It is impossible to say whether one will happen due to the election, but by systematically accounting for the possibility, your outlook is better regardless.

Avoiding the Biggest Losses is Hugely Meaningful and Very Possible

It is entirely possible to build a more stable, positive return stream by spreading risk across multiple asset classes and accounting for the possibility of extreme losses.

To help demonstrate this, I took a few different cuts of data going back to the 1970s. First, I examined the distribution of monthly returns of the S&P 500 compared to Hedgewise model portfolios (which use the same algorithms being used today, but a more limited set of asset classes and risk data).

Single month returns are a useful measure because they help show how months of poor performance, like October, are rare events. While they will still occur, they happen far less frequently in Hedgewise portfolios and have a far lower chance of repeating.

Distribution of Monthly Returns, 1972 to Present

The bars in the graph show the frequency of one-month returns within each strategy. I've highlighted the portion of the graph which shows monthly losses. The S&P 500 has both higher and more frequent losses than either Hedgewise framework, meaning you experience many more months of small losses (3 to 5%) as well as a few which are catastrophic (10% or more). Also notice how much more effectively the Hedgewise portfolios cluster positive returns. This is consistent with the theory: we are optimizing for a stable portfolio with more consistent gains.

This remains true if you expand your time horizon to annual returns, which help to better highlight cumulative performance over time.

Distribution of Annual Returns, 1972 to Present

Again, the S&P 500 has a far greater likelihood of loss than either Hedgewise strategy. Risk management helps to eliminate significant drawdowns without decreasing overall returns or limiting gains. Importantly, this also demonstrates how equities often experience many consecutive months of poor returns, resulting in annual drawdowns of 40% or more. Hedgewise strategies show the opposite: poor monthly returns usually reverse, thus limiting your maximum annual drawdowns.

As an aside, notice that Momentum is a slightly more aggressive framework, and thus has a higher average return than Risk Parity but also a higher risk of loss. As such, it is generally only recommended to clients with a longer time horizon and higher risk tolerance.

Finally, I thought it would be a bit more intuitive to look at the realized return in each strategy by calendar year.

Return by Calendar Year, 1972 to 2015

I am particularly fond of this graph for a few reasons. It highlights both the consistency and severity of equity pullbacks, which have historically happened 1-2x per decade. It shows how the Hedgewise frameworks, while not immune to loss, have far fewer bad years and with relatively moderate drawdowns. Finally, it emphasizes one of the most important keys to successful investing regardless of where you have your money: if you just had a bad year (or month, or day), be patient. Historically, you have always been rewarded so long as you stay steady.

Wrapping Up: The Election Is Just Another Day

Markets could very well be surprised this Tuesday, but Hedgewise portfolios are already constructed to help mitigate any losses and to adapt as market conditions change. The reality is that risk is a constant force across all assets, and events like Election Day simply make it more obvious. In a way, such events help to shine a light on why financial risk management continues to gain prominence. While I certainly hope the outcome on Tuesday leads to more stability and economic growth in this country, I'm grateful to have my own money invested in strategies built on the foundation that anything might happen.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• After a stellar start to 2016, driven by rallies in the bond and commodity markets, we examine our expectations for the near future in our Risk Parity strategy.
• While US bonds yields continue to fall into unprecedented territory, they remain higher than nearly all other developed nations. Equities have much greater downside risk.
• Strong returns this year are no reason for concern moving forward.

Equities Remain a Bigger Risk Than Bonds

As bond yields have continued to dip, many clients are again wondering whether the Risk Parity framework is too vulnerable to rising interest rates. However, the reality is that US rates remain the highest in the developed world.

Comparison of 10yr Bond Yields

Country	10yr Yield
United States	1.531%
Italy	1.219%
Spain	1.169%
Canada	1.056%
United Kingdom	0.794%
Japan	-0.257%
Germany	-0.36%

If the economy should run into more significant headwinds, there is plenty of room for bonds to continue to rally. The Fed has precious little ammunition to provide stimulus, but has been concerned enough about tepid growth to delay rising interest rates any further. A number of significant, negative economic shocks have the potential to unfold this year, including the US presidential election, continued fallout from the Brexit, and hidden weakness in China. The risk of rapidly rising interest rates in the near future is almost nonexistent.

Hedgewise Risk Parity is Built to be Nimble

Another common concern is that low future return expectations in both the bond and equity markets make cash a more compelling alternative. However, it is important to understand that our strategy is constantly shifting to account for such risks. The power of these techniques can be more clearly understood by examining the monthly performance of the strategy during the 2008 recession.

Performance During 2008 Recession

If you zoom in on the period from October to December 2008, there is a distinct stretch where both bonds and stocks were losing money simultaneously, yet the impact on the Risk Parity portfolio was relatively muted. How was this possible?

First, the expected volatility in the markets began to skyrocket in late summer. As a result, the overall exposure to every asset class was reduced in the Hedgewise portfolio. This ensured that big swings in either direction would still have a minimal impact on your returns.

Second, interest rates dropped dramatically lower in November 2008, resulting in a huge gain for bonds that month. As interest rates reach certain thresholds, Hedgewise automatically begins trimming exposure by moving to shorter durations and increasing its risk estimates. Thus, the pursuant dip in the following month was muted.

As a result of these adjustments, our strategy still yielded a positive return over this timeframe despite extraordinarily difficult market conditions. This helps to reinforce that Risk Parity is not a bet on any particular asset class; it is simply seeking constant balance between them. Losses only tend to occur when asset classes fall out of balance, but this happens unpredictably and infrequently.

Is There a Risk of Imbalance Moving Forward?

Over the course of 2015, our main message was to remain patient as markets rarely remain out of balance for long. One of our favorite statistics is that Risk Parity has never lost money for two consecutive years. In fact, there have only been 8 years of the past 50 or so when the strategy lost more than 10%. Whenever that happened, it consistently led to positive returns in the year following.

Year	1yr Trailing Loss	Following Year Return
1974	-24%	7%
1981	-20%	40%
1984	-18%	20%
1994	-14%	56%
2013	-11%	9%
2016	-11%	TBD

This is expected because any time a loss occurs in a risk-balanced framework, it suggests that markets are out-of-sync. However, it is fair to then ask the opposite question: do outsized gains mean there is a greater risk of future loss? Fortunately, this isn't the case. Investing is a positive-sum game, which means that positive returns are what you expect. This is easy to see by studying a few historical return patterns.

We isolated every month since 1970 where the prior year's return was 10% or greater. We then looked at the following year's return to see how frequently this predicted a reversal and subsequent loss. The years of gain were followed by a year of loss only 30% of the time; 70% of the time, gains continued to accrue. This pattern remains true no matter how high the prior year return has been.

The takeaway is quite clear: there's no need to worry about a year of gains, but it almost never makes sense to sell during a year of losses.

So What's Coming Next?

At this point, there are two most likely possibilities. Either we are heading into another recession, or we avoid the negative economic shocks and continue to trickle ahead slowly. If a recession is coming, Risk Parity is absolutely one of the best places to be, and there's no reason to expect it will sustain heavy losses. If we continue our pattern of slow growth, Risk Parity will accrue some of those gains without concentrating your risk in any single asset class. In both cases, it is wisest to stay steady and avoid worrying about what might happen next.

While interest rates tend to be a persistent and reasonable concern for our clients, there is no scenario in which they will represent an outsized risk.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Thus far in 2016, Hedgewise has significantly outperformed the equity markets across its new portfolio of products, with YTD returns as high as 16%.
• Our strategies have withstood a number of significant economic shocks, such as the Brexit event, and clearly demonstrated the value of our risk management techniques.
• We have continued to innovate with new product offerings to suit different financial goals, from conservative to speculative, while maintaining our core principles.
• Though many investors are concerned about a poor return environment moving forward, Hedgewise clients can remain confident.

2016 Highlights Need for Risk Management

This year has been a scary one for most investors. The S&P 500 stumbled by over 10% to start the year, and significant events such as the Brexit have caused stocks to fall by as much as 5% in a single day. While equities are still positive year-to-date, nearly every investor is wondering how much longer this bull market can last. For most, this presents a stark choice: brace for a bad few years, or move to cash but risk missing out if the bull finds its feet again.

Hedgewise was founded on the idea that investors need a better option, and we were confident that we could create one by systematically managing risk. Our goal was to create steadier return streams with a far lower chance of dramatic losses. This would effectively remove the need to time the market, providing a drastically more positive outlook for our clients. Far too many investors miss out on potential returns because of the paralyzing fear that another 2008 is right around the corner.

As Hedgewise approaches its two-year anniversary, we are extremely excited to have proof that our products are working exactly as we had hoped. Our initial flagship 'Risk Parity' product has gained from 8% to 16% (depending on your risk level) this year, while providing a significantly smoother return throughout. When stocks lost over 10% from January to late February, our Risk Parity product still gained 2%. On the day of the Brexit, it was breakeven.

Though Risk Parity will always be a bedrock of Hedgewise, 2016 has also been an important year for expanding upon our vision. As we have continued to meet clients with a wide array of goals, we realized we could extend many of our risk management techniques to other kinds of products. We want to become a trusted source for any client need, from the most risk-averse to the most speculative. We will soon be publishing a great deal of research that better describes these new products, how they work, and whether they might fit in your portfolio. However, the theme will always be consistent: better returns with less risk. Here is a look at how our new product lineup has performed this year compared to the S&P 500.

Hedgewise Products vs. S&P 500, 2016 YTD

Product	YTD Return	YTD Volatility
Ultimate Momentum	15.10%	11.10%
Risk Parity (High)	13.83%	7.31%
Long-Short Oil	17.87%	18.50%
Low Risk Yield	8.21%	4.06%
S&P 500	5.89%	15.98%

Despite an ominous economic outlook in much of the world, Hedgewise clients can rest assured that we are taking these risks fully into account and managing accordingly across our entire portfolio.

Unpredictable Markets, Predictable Returns

Back in December 2015, markets were pricing in four rate hikes by the Fed this year. Gold had been losing money for nearly four years straight, and many were predicting it might lose another 50% before stabilizing. Nearly every client in our Risk Parity product, which balances risk through a constant exposure to bonds, had begun asking whether such an allocation still made sense.

Few might have predicted that the Fed would fail to raise rates at all, that gold would be one of the best performing assets, or that Britain would no longer be a part of the EU. Yet these possibilities always existed, and the beauty of a risk-managed portfolio is that they are automatically taken into account. This enabled our Risk Parity portfolios to dramatically outperform so far this year.

Breakdown of Risk Parity 'High' Returns, 2016

The beauty of this approach is that it is not dependent on any single asset, and thus naturally accounts for the unpredictable. Though bonds have certainly become riskier as yields have continued to drop, that is already automatically being taken into account within our systems. It is not necessary to guess which direction different assets are headed next. Return expectations remain positive regardless.

The Value of Not Worrying

The Brexit event was an excellent illustration of the extraordinary role that emotions can play in investing. A huge number of investors exited the market on that day, leading to stock losses as high as 5%. Yet a week later, the market had mostly recovered. The investors that sold are now in the precarious position of deciding whether to re-enter after already missing the bounce.

While moving to cash can feel like a safer decision, its real cost can be extraordinary. Consider the following two scenarios:

Scenario 1

An investor with $100,000 has a thirty-year time horizon, but feels nervous about the current valuation of stocks. He stays in cash for two years until he is more confident about the economic outlook. During those two years, as well as every year thereafter, stocks achieve a return of 8%.

The total opportunity cost of those two years of waiting is over $143,000, or 143% in returns.

This is due to the nature of compound interest. Missing out on a couple years of gains early in your investing timeline can substantially reduce your expected earnings.

Scenario 2

An investor with a thirty-year time horizon has most of his money fully invested, but keeps an average of $50,000 in cash at all times just in case. He doesn't need this money for any immediate purpose, but he considers it part of his rainy day fund and does not want it to be at high risk.

If this investor had been able to yield a conservative return of 4% instead of keeping it in cash, he would have more than tripled those funds and generated over $100,000 in extra returns.

Of course, these examples are not entirely realistic because they do not account for the possibility of immediate loss. It's obviously better to be in cash if you manage to avoid a crash, but you then have to correctly time your exit and re-entry. We believe the key to successful investing is to eliminate this terrible dilemma through more effective risk management.

Using a modified, hypothetical version of our Risk Parity model that runs back to the 1970s, we can compare its risk profile to the S&P 500. All dividends are included and assumed to be re-invested, and these figures include an estimate for commissions and fees.

Risk Statistics: Risk Parity vs. S&P 500, 1970 to Present

Statistic	S&P 500	Risk Parity	Low Risk Yield
Worst 1 Month Return	-22%	-8.5%	-3.3%
# of 1yr Losses > 20%	26	4	0
Max Time To Recovery	6 yrs	3 yrs	1.75 yrs

While a risk-managed portfolio is not immune to loss, historically it has been far less likely and far less painful. In addition, the losses of a risk-managed portfolio are nearly impossible to time. For example, it did not experience a net loss from 2000 to 2003 or from 2007 to 2009, but it did lose money in 2015. Because such losses tend to be fairly random and short-lived, selling never makes much sense. We consider this quite positive in terms of investor psychology: it frees you from having to predict what's next.

While Hedgewise does strive to outperform benchmarks such as the S&P 500 over time, it is important not to understate the value of emotional stability. By simply having the confidence to put more cash to work more consistently, you can drastically improve your outlook.

In a Worried World, Hedgewise Provides a Better Option

While the political events of our time are more nerve-racking than ever, your investment portfolio doesn't have to cause the same stress. There are many ways to help limit your losses without sacrificing long-term returns, and Hedgewise is striving to stay at the forefront of these techniques. We are excited to continue to publish new research and help our clients construct portfolios that are well-aligned with their goals and well-positioned for whatever comes next.

Despite a slow-growing economy, a disrupted European Union, a worried Fed, and a tired bull market, Hedgewise products have had an excellent year across the board. We hope this continues to inspire our clients with the confidence to put more of their money to work while avoiding the pitfalls of traditional portfolio management.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• The Hedgewise Risk Parity strategy is built to endure any economic environment and free you from worrying about what might happen next
• Rising interest rates are still a top concern for most clients
• We examine how the strategy performed in the 1970s, when interest rates experienced one of the most sustained uptrends in our economic history

Hedgewise has had a phenomenal year-to-date. Our Risk Parity "High" portfolio is up nearly 9% while the S&P is up a little over 3%. This is primarily due to significant rallies in both the bond and commodity markets, as the Fed has adopted a more cautious approach in light of continued concerns of a less than robust US and global economy.

YTD Performance of Major Asset Classes vs. Hedgewise Risk Parity "High" (labeled "You")

Our clients have welcomed this outperformance, but the bond rally has raised a familiar worry: what happens when interest rates rise? Given our strategy has a heavier bond allocation than most traditional portfolios, is it time to consider alternatives?

Fortunately, we have decades of historical data that show the approach we use at Hedgewise does well even when interest rates rise. During the 1970s, the US experienced the most severe bond bear market in history. Despite this, the Hedgewise model portfolio managed to outperform the S&P 500 for a majority of that time period. This was possible due to the natural protection against rising rates provided by real assets like commodities, as well as our methods of active risk management. Perhaps more importantly, the use of leverage did not handicap our performance, dispelling the myth that Risk Parity fails when the cost of borrowing is high.

We think this data presents an extremely compelling case for why you can trust our strategy in any economic environment.

Modeling Performance in the 1970s: Risk Parity Still A Great Investment

From 1970 to 1983, the Federal Funds rate rose from 4% to nearly 20%, or a whopping 1600 basis points. The US was facing a vicious combination of rising prices and falling economic activity, also known as "stagflation". This provided an excellent environment to pressure test our Risk Parity framework, which you might expect to do terribly given its heavy bond allocation. However, just the opposite occurred: our model outperformed equities nearly the entire time.

To create the historical model, we had to make a few key assumptions:

• We are using a modified form of our proprietary risk management framework due to the lack of market data available in the 70s compared to today. If more data from this period was available, we expect our framework would perform even better than what this analysis reveals.
• We limited the portfolio to nominal bonds, equities, and gold because inflation-protected bonds (TIPS) did not yet exist, nor did reliable data on the price of commodities like oil and copper. The assets that we had to exclude all tend to perform well in periods of high inflation, and would likely have further buoyed performance within our full model.
• Risk Parity is typically available at multiple 'risk levels', the higher of which amplify expected returns through leverage. We ran an unleveraged "Low Risk" version of the model as well as a leveraged "High Risk" version.
• The portfolios are based on end-of-day index prices. All dividends and coupon payments are included and assumed reinvested. Leverage is assumed to have a cost equal to the rate on one-year treasury bonds. The model does not include the cost of commissions or management fees (however, note that these costs are accounted for in all of our live performance data).

Performance of Hedgewise Risk Parity "Low" and "High" Models vs. S&P 500, 1970 to 1982

Despite one of the worst decades ever for bonds, both versions of the Hedgewise portfolio still outperformed equities for nearly this entire stretch. This was possible for a few reasons. First, ten-year bonds achieved an annualized return of about 6% during this timeframe. Even though rising rates eroded the principal value of the bonds, this was counterbalanced by consistently higher yields. Second, assets that provided protection from inflation, like gold, performed incredibly well as the value of the US dollar plummeted. Finally, the Hedgewise system actively managed the portfolio's bond exposure, and naturally reduced it in the periods of greatest expected volatility.

It is interesting to note that the "High Risk" portfolio outperformed the "Low Risk" portfolio for a majority of this time, despite the fact that it required leverage. This is counterintuitive for many clients, who naturally assume that a combination of high borrowing costs and a bond bear market will result in big losses. However, this is nothing but a myth as it relates to an effectively-run Risk Parity approach. As you can see, our returns were positive throughout most of the decade, despite the fact that rates were consistently rising. Our strategy is not a bet on bonds, but rather a bet on the timeless power of risk management and diversification. It is incorrect to assume that it is poorly suited for any particular environment, or that leverage will fail when short-term rates are high.

That said, the "High Risk" portfolio was clearly subject to much larger drawdowns, which is to be expected. This will be true whenever there is a significant market crash, regardless of the source. Equities were the cause of one big dip in 1974, while bonds were the culprit in the early 80s. If you believe such an event is imminent in any market, it is fair to consider moving to the "Low Risk" level, but it certainly wouldn't make sense to abandon the strategy altogether.

The takeaway from this data is quite significant: even in a rising rate environment, Risk Parity remains a great choice. With that said, recent history in the EU and Asia suggests that rising rates should be the least of your worries.

Where Have the Rising Interest Rates Gone?

Supposedly, the bond bull market in the US has been on the verge of ending for almost 4 years. There was the so-called 'taper tantrum' in 2013, when yields rocketed over 100bps when Bernanke announced the end of 'Quantitative Easing'. To the surprise of many, the US economy continued to sputter along slowly and global weakness brought yields back down. In late 2015, the Fed was expected to raise rates as many as 6 times. A global collapse in commodity prices and rapidly slowing growth in China caused them to back-off again. Meanwhile, ten-year bonds have continued to hover around 2%.

10-Year US Treasury Yields Since 2000

For many, the gut reaction to this graph is to think that we must be near the bottom; however, there is no reason that we can't fall well below a 2% yield for decades. Japan, for example, has had ten-year yields under this level for almost 20 years.

10-Year Japanese Treasury Yields Since 1990 (2% yield emphasized)

Many are quick to point out that our economic history is quite a bit different than Japan's. Instead, let's take a look at Germany:

10-Year German Treasury Yields Since 2000 (2% yield emphasized)

The reality is that the entire world remains in a very fragile state. On a relative basis, yields in the US are actually still pretty high. In the EU, a number of countries have recently introduced negative interest rates to continue to combat recessionary pressure. The point is that we may be at the end of the bond bull market, but it's also entirely possible that we are not.

Conclusion: Rising Rates Are Not a Big Concern

The evidence presented in this article helps clarify some extremely important concerns about Risk Parity. Adding leverage to a bond-heavy portfolio never resulted in disaster even when interest rates were skyrocketing. During the most inflationary period in US history, our model outperformed the S&P 500 for a majority of the time. These facts boldly refute the idea that Risk Parity only 'works' during bond bull markets.

Inherent in a truly diversified portfolio will always be periods when one asset is outperforming the others. In exchange for tolerating this, you get steadier, more reliable returns that do not depend on predicting the future. Your portfolio becomes less vulnerable to a crash in any given market.

One of the core premises of Risk Parity is the ability to endure any economic environment. While its relatively heavy exposure to fixed income and the use of leverage give many pause, there is little reason for concern. If the Hedgewise model portfolio can successfully endure a decade when rates rose by over 16%, we are confident it will remain an excellent investment choice no matter what comes next.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Hedgewise can intelligently manage your oil investments for you at a low fee and with zero commissions.

Introduction: We're Nearing the Bottom

While it's been an atrocious couple of years for the energy industry, many signs are indicating that we are approaching the bottom. Oil prices have already dipped below the total median cost of production in many countries, which will inevitably cause many firms to stop new exploration projects if they haven't already. We break down the numbers to develop a case for the 'absolute lowest' price, at which point oil will basically turn into a little-to-no downside investment play.

Taking a Look at the Cost of Production

Rystad Energy recently released estimates for the total, all-in production cost for one barrel of oil across each of the major oil-producing countries. Note that this includes the cost of discovery, extraction, transportation, overhead, etc.

Median Total Cost of Oil Production per Barrel

The median producer in a number of countries is already at a point where new exploration projects have become unprofitable, including the U.S.

Of course, the median total cost of production doesn't tell the whole story. There's a big difference between the cost of discovering and producing brand new oil and simply extracting current known reserves. For example, Moody's estimates that it costs an average of $13.68 in the U.S. to bring one barrel to the surface at an existing oil field, or about 38% of the total. As such, firms can continue to profitably produce from current reserves even if they stop exploration. There is also a dramatic spread in these costs across different firms and different countries.

With these facts in mind, the median total cost of production is not an obvious lower bound on the price of oil in the short-term. However, it's a great place to start the analysis.

So What Does the Total Median Production Cost Tell Us?

These numbers are most useful in the longer-term (i.e., 3 to 5 years), once enough time has lapsed to feel the supply shock of reduced exploration. Because the U.S. is now the world's top producer of oil, its median production cost of $36.20 is an excellent proxy for an oil floor in this time horizon.

If the U.S. could no longer profitably produce oil, it would eventually lead to about a 15% dip in global supply. To compensate for this, the other major oil producing countries would need to continue to meet world demand at prices below this level. According to the IMF, that's not going to happen, especially not for 5 years:

The International Monetary Fund warned last month that most countries in the Middle East -- including Saudi Arabia, Oman and Bahrain --- will run out of cash within five years if oil prices don't rise above roughly $50 per barrel. -- CNN

If you buy this argument, oil is already a bit below the bare minimum long-term price. In fact, for patient investors equipped with an appropriate strategy (more on this below), there's a good case to buy anywhere below $35/bbl. However, prices could certainly fall further in the short-term.

How Low Could It Go?

At a bare minimum, the price of oil will never fall below the cheapest cost of production in the world, which is $8.50 per barrel in Kuwait, for obvious reasons.

It's also quite impossible that the price would ever fall below the cost of extracting current reserves in the U.S., or the previously mentioned $13.68. If it did, it would lead to a shutdown of operations in most U.S. refineries and an enormous corresponding supply shock.

The next support level depends mainly on how low Saudi Arabia needs oil prices to stay in order to put U.S. shale producers out of business. After all, this is the main reason that the price war was instigated in the first place, and most of the Middle East has enough of a capital cushion to tolerate rock bottom prices until its goal is accomplished. According to CNBC:

Shale muscled into the middle of the cost curve in the $30 to $70 cost level, but the price of producing a barrel of oil is still heading downward... the break-even cost has fallen into the $20s in some counties. -- CNBC

Assuming that Saudi Arabia wants to be as aggressive as possible in bankrupting the future prospects of US shale companies, this means it would be willing to accept a price as low as $20/bbl. However, it would have no reason to let it fall further than that, nor would prices remain there for any more than a few months. This would just be used as a temporary measure until enough companies go bankrupt and loans for new exploration have sufficiently dried up.

Supporting this logic is the recent report from Goldman Sachs quoting a similar number.

Meanwhile, Michele Della Vigna from Goldman Sachs told the "Today" program on BBC's Radio 4 that oil could fall to as little as $20 a barrel. He added, however, that there was only about a "15% probability that this might happen" and that if oil were to fall to this level, it would only be temporary "shock to the system" before the market stabilized again. -- Business Insider

So there you have it: prices could feasibly reach a bottom of $20, but will more likely stabilize around a minimum of $40 within a few years.

What's the right investment strategy?

If prices do approach the low-to-mid $20s this year, it will be a fantastic time to buy. However, it is notoriously difficult to time the bottom, so it may be smarter to consider dollar-cost averaging in anywhere below $35, and incrementally adding to your position if prices continue to fall.

However, it is crucial that you utilize an appropriate long-term investment strategy that doesn't suffer from drag (such as contango). One expert energy investment advisor, Hedgewise, recommends a dynamic portfolio of oil companies with solid balance sheets and a high correlation to the price of oil. Such a portfolio allows you to benefit when the price war ends even if it takes a year or two, and recent performance has proven this approach to be quite effective so far in 2016.

Investments like the United States Oil Fund (NYSEARCA:USO) or the iPath S&P GSCI Crude Oil TR ETN (NYSEARCA:OIL) are not sensible choices for a holding period of any more than a month or two. Broader energy funds like the Energy Select Sector SPDR ETF (NYSEARCA:XLE), the Vanguard Energy ETF (NYSEARCA:VDE), or the SPDR S&P Oil & Gas Explore & Production ETF (NYSEARCA:XOP) are quite a bit more reasonable, but will still suffer from a great deal of tracking error for various reasons.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Investors in our Risk Parity fund have had their patience rewarded this year, gaining anywhere from 3 to 6% (depending on your risk level) while equities have tumbled.
• This highlights the benefit of keeping a properly risk-balanced portfolio, which we expect will continue to shine within the current market environment.
• In all likelihood, we are nearing the end of the current bull market, with many cracks in the economy already beginning to show.
• We discuss why this makes risk parity an even more compelling strategy over the next few years.

Patience Is Rewarded In 2016

In our year-end newsletter, we highlighted that risk parity tends to be countercyclical to equity bull markets. The strategy naturally underperforms when stocks are the highest performing asset class, and vice versa. However, since no bull market lasts forever, risk parity still outperforms over the long-run. You simply need to live through one bear market to see why.

It is easy to see these cycles by examining the relative performance of a model risk parity portfolio to the S&P 500 over time.

Model Risk Parity Performance Minus S&P Performance Since 2003

As highlighted in the graph, the risk parity portfolio tends to look the worst right at the tail end of a business cycle, when stocks are near their peak. As soon as a significant equity correction occurs, though, the performance quickly corrects and tends to remain net positive even through the next down cycle.

While this can be trying during periods like last year, patience has always been rewarded, and it has been again so far in 2016. As the likelihood that our current bull market is coming to an end increases, so does the likelihood that the risk parity approach continues to shine.

Why Is Risk Parity Outperforming?

Last year, global weakness caused an epic crash in the commodity markets, yet the Fed proceeded to raise U.S. interest rates, the Dollar rallied, and the stock market basically shrugged. In our December newsletter, we noted:

"We've had a combination of a relatively strong economy, low inflation, and plummeting global prices for raw materials. Put simply, this situation is not particularly normal. In fact, it has only occurred a handful of times over the past 30 years, almost all of which involved a major geopolitical event, such as the beginning and subsequent end of an oil embargo. Today, we are witnessing a similar economic situation despite the absence of any such event, and there are many reasons to believe it cannot last."

Fast forward to today, and it has become far more clear that the U.S. cannot simply shrug off continued economic weakness around the world. The strong dollar and struggling global economy has left U.S. exports at a five-and-a-half year low, the Dollar has pulled back significantly since the beginning of the year, and interest rates on 10-year Treasuries have nearly returned to their lowest levels ever.

10-Year Treasury Interest Rates since 1962

Against this backdrop, both bonds and commodities have had significant rallies this year, putting markets back into more sensible balance, and driving positive performance in the risk parity portfolio.

Year-to-date performance of Major Asset Classes

Why Does Risk Parity Make Sense Moving Forward?

Our performance reversal this year highlights the fact that although markets can certainly do strange things, they tend to return to balance in a relatively short timeframe. As soon as balance prevails, the risk parity portfolio generally yields positive returns regardless of the economic environment. In recessions, bonds and gold tend to offset weakness in stocks. In expansions, stocks and commodities tend to offset weakness in bonds. During periods of high inflation, real assets like oil hedge the risk of a plummeting currency.

By retaining this constant balance, investors are freed from trying to predict the future. Few might have anticipated such a huge bond rally this year back in December, when the Fed was poised to raise interest rates four times in 2016, but it happened nonetheless. While skeptics of risk parity often point to the certainty of rising interest rates, the first few months of this year have shown that it is far from inevitable.

In fact, various countries around the world have now entered into a negative interest rate environment, a scenario which many economists thought could not possibly unfold. Yet it has, and it means that current U.S. interest rates still have room to drop even further if we face renewed economic weakness.

While the U.S. may not be facing an imminent recession, it is hard to envision a scenario where stocks have much upside. Unemployment is already below 5%, and the current bull market is steadily approaching the second longest in history. While this is a scary prospect for most investors, it is just such situations that show the incredible power of the risk parity approach. As the first few months of 2016 have already shown, weakness in the stock market can still result in gains to your portfolio. It doesn't require short-term market timing, nor does it force you to concentrate your holdings into a single asset class.

We are confident that the wins of this year will be one of many in the near future, and extremely grateful to our clients for maintaining perspective and staying patient. Risk parity remains an excellent investment choice even among volatile markets, and we look forward to continuing to prove it to you.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Nearly all risk parity funds lost money in 2015 due to poor performance across bonds, stocks, and especially commodities
• This has led many to question the viability of a 'risk-balanced' approach, especially in a low interest, low growth environment
• However, a quick look at history reveals that last year was not particularly surprising, nor any indication that the risk parity framework no longer makes sense
• In fact, the current state of the markets makes it increasingly likely that risk parity funds will soon experience a resurgence in both relative returns and popularity

Introduction: A Quick Review of Risk Parity

At its core, risk parity is no more than a broad and well-balanced portfolio. The idea is quite simple: diversification allows you to achieve a steadier return with less risk of loss, which is basically the oldest concept in finance. If you run the numbers for the past 60 years, you'd find that the most optimally diversified portfolio (i.e., with the highest return given its risk of loss) is about 60% in bonds, 30% in stocks, and 10% in commodities like gold.

Risk parity proponents looked at this and observed two things. First, that it was fairly sensible if you considered that bonds are quite a bit less risky than stocks, which are quite a bit less risky than commodities. If your goal was to balance returns between the different asset classes, the proportions roughly made sense. Second, they thought it was odd that this mix didn't look very much like the composition in most investor portfolios, but quickly realized it was probably because a portfolio of 60% bonds won't have very high expected returns, even if they are quite steady. Instead of changing the mix, though, they just recommended adding some leverage to the portfolio while keeping the proportions steady.

We can model the performance of such a portfolio by using a mix of 60% 10 Yr Treasury Bonds (IEF) / 30% S&P 500 (SPY) / 10% gold (GLD) as a reasonable proxy. We can also model the effect of leverage (we chose 50% for illustrative purposes), and we assume its cost is equivalent to the rate on one-year bonds at any point in time. Note that 1970 is the earliest that data is available for all three of these assets, all dividends are included and assumed to be reinvested, and that this is only a hypothetical model based on index data.

Performance of the S&P 500, the 60/30/10 Mix, and the Mix Plus 50% Leverage Since 1970

Perhaps unsurprisingly, the diversified mix tends to be far more steady, with about half the volatility and max drawdowns. You do need to add in leverage to get up to similar returns as the S&P 500, but once you do, you wind up with net outperformance over the long run with less overall risk. Sounds great, right?

Of course, investing decisions are far easier when you are looking at fifty years. In a more immediate timeframe, a few natural issues can cast doubt over the viability of risk parity. First, it will definitely lag the S&P 500 over stretches, like the late 90s, when bull markets are in full swing. Second, it will still experience drawdowns, and they very well may happen when more traditional strategies are performing well. Finally, since its very nature is to hedge your exposures, you will have to constantly tolerate poor performance in a few of your assets.

Nonetheless, you can only achieve the benefits of diversification if you patiently allow all of these things to happen. To help reconcile these facts, we've directly addressed each of the problems raised above, provided context for how it relates to the 2015 performance of risk parity, and presented the case for why risk parity may be one of the best bets for 2016.

Myth #1: It Doesn't Make Sense Because It Lags the S&P

One of the biggest hurdles to maintaining faith in any investment strategy is when everyone else seems to be doing better than you. Since the depths of the last crisis, this is the relative performance of each of the strategies discussed above.

Performance of the S&P 500, the 60/30/10 Mix, and the Mix Plus 50% Leverage Since January 2009

Of course it is difficult to watch this without making changes, or to believe that the diversified mix is still somehow superior. Keep in mind, though, that one asset class is outperforming the rest 100% of the time. You can draw this same graph in the 80s and prove that bonds are the best investment, or in the 70s to prove that commodities are the best investment, and so on and so forth. Diversification continues to be superior because no asset rallies forever, and slow and steady always wins the race.

Not convinced? This will help. Check out the rolling 10 year returns of the risk parity portfolio as far back as the data goes.

Rolling 10 Year Returns of the Leveraged Risk Parity Mix

Next, consider this: if you had started investing in the S&P 500 in December of 1999, you would have gone on to lose 6% over the next 10 years. As illustrated in the graph above, the worst 10 year performance for risk parity was about a 100% gain. The magic of diversification is that it frees you from having to time the markets, and from the horrible possibility that you are about to face an enormous crash. Make no mistake: there will be another recession, and it will blindside most people. You can switch away from diversifying and pray you know when to get in and out, or you can be happy even if you underperform a few bull markets because you'll make it up when the bear returns.

Myth #2: It Doesn't Make Sense Because It Lost Money Last Year

No investing strategy is immune to loss. Even in a diversified portfolio, you will lose money if one asset experiences a significant crash, or all assets have a relatively bad year. In 2015, both things happened: bonds, stocks, and commodities all wound up in the negative and commodities had one of their worst years in history.

This had a particularly negative impact on the perception of risk parity because commodities dragged down its performance, while most traditional strategies have little to no exposure to that asset class. However, when you are diversifying, your goal is to own assets that perform very differently from one another, such that their movements tend to offset over time. Commodities clearly fit this definition, and history has shown that adding them to your mix has clear benefits, especially as a protection from high inflation or currency devaluation.

Consider the following two cases. From January 2008 to February 2009, this is how each of the major asset classes performed:

S&P 500: -50% loss
10yr Treasury Bonds: 12% gain
Gold: 10% gain

When stocks are the culprit, it is quite easy to see the benefits of maintaining exposure to other assets. Let's now compare this to asset class performance during 2015:

S&P 500: -0.14% loss
10yr Treasury Bonds: 1% gain
Gold: -8% loss

Commodities happened to be the worst performer last year, but why should that be viewed differently than what happened to stocks in 2008? In both cases, it helped to own a broad mix of assets. In both cases, you would have lost money for the year. Neither is any indication that diversification is failing to do its job. Such periods are a natural part of the ebb and flow of a balanced portfolio.

Myth #3: But This Time It Might Be Different

Still, there is often a lingering fear that maybe this time, balance will not return - maybe a certain asset class is somehow doomed to an extraordinarily long period of poor performance that will drag everything down.

To assuage those fears, let's zoom in on the return performance of the risk parity mix over a shorter timeframe.

Rolling 3 Year Returns of the Leveraged Risk Parity Mix

If you can afford to wait even 3 years, the diversified portfolio has never lost money. This isn't to say that every asset class always quickly recovers; commodities had a prolonged down period during the 80s, but this was offset by a rally in stocks and bonds. Stocks had a horrible decade beginning in 2000, but bonds and commodities performed quite well. Even when single asset classes fall and fail to recover, balance still eventually prevails.

Here's one more great fact for you. This portfolio has also never experienced two consecutive years of loss. It's not to say that it couldn't happen - anything is possible - but in 45 years, it hasn't yet. Historically speaking, you'd have been 100% wrong if you declared diversification dead after a single bad year.

Nonetheless, our current environment is particularly fear-inducing because interest rates have been so low for so long. What if rates skyrocket amidst a struggling global economy? What if bonds are sure to lose money? What if all asset classes keep performing badly at once, like in 2015?

Even if all of these scenarios have a chance of unfolding, diversification still remains your best bet unless you can predict the future with certainty. If all assets were going to go down at once, your only option would be to go short or move to cash. As we just mentioned though, this bet has been wrong 100% of the time after just experiencing a year of losses. You could remove exposure to particular asset classes, like bonds, but Germany recently witnessed interest rates near 0%, while U.S. rates are still above 2%. How sure are you that rates cannot go lower?

It's absolutely true that the diversified risk parity mix has underperformed stocks for a few years now. This is also exactly why it is a fantastic bet for 2016.

Looking Forward: Is Risk Parity About to Make a Comeback?

When stocks are the best performing asset class, they inevitably outperform any form of diversification until the bull market ends. Because of this, diversified strategies like risk parity will have natural cycles of underperformance and outperformance compared to stocks over time.

The following graph indicates the difference between the total cumulative return of the leveraged risk parity mix to the S&P 500 since 1970. When positive, it means that risk parity is outperforming stocks. When negative, it means that it is underperforming.

Leveraged Risk Parity Performance Minus S&P Performance Since 1970

There are two immediate highlights. First, the leveraged risk parity mix has indeed outperformed the S&P 500 for a majority of the time, but it goes through constant up and down cycles (note that scale distorts this picture; most 10 year spans look similar to the period since 2000). We can zoom in on the period since 2003 to more vividly see the current one.

Leveraged Risk Parity Performance Minus S&P Performance Since 2003

The point is that risk parity tends to look bad in a relative sense if you begin measurement from the start of any bull market. As soon as you expand the horizon to include at least one bear, its outperformance over the long run becomes far more clear.

In short, as soon as the next recession comes along, risk parity will look really smart again. The current bull market is the third longest in history, right behind the 1920s and the 1990s. It may have room to run yet, but it is already facing some stiff headwinds from global growth, the strong dollar, and rising interest rates. When it ends (and it inevitably will), the gains in a non-diversified portfolio will quickly vanish and perhaps take a decade to recover. For risk parity, on the other hand, it will just be another normal year.

If you believe you will live through even one bear market in your investment lifetime that you are unable to avoid, you will do better by staying diversified even through the longest of bull markets. You will have years of losses when others gain, and you will be holding assets that go through crashes, but when the dust settles, you will still wind up on top.

By the time the pundits rally back around risk parity, it will probably already be too late for most investors. So far in 2016, equities are off around 5%, while risk parity is closer to breakeven. If you are already well-diversified, well done and keep faith. If not, it's still not too late - but be sure to make some changes before the next bear market hits.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Commodities have been hit with a rare 'perfect storm' of economic factors over the past 15 months.
• Weak global demand combined with one of the strongest dollar rallies in the past 30 years has brought prices to recession-level lows.
• There are many reasons to believe this cannot persist, making commodities a great play looking ahead to 2016.
• We break down the underlying economic story, its place in history, and how to play this situation in your own portfolio.

Introduction: The Perfect Storm

Since last July, here is a look at the relative performance of the three major US asset classes (stocks, bonds, and commodities):

Performance of Major US Asset Classes, July 2014 - December 2015

We've had a combination of a relatively strong economy, low inflation, and plummeting global prices for raw materials. Put simply, this situation is not particularly normal. In fact, it has only occurred a handful of times over the past 30 years, almost all of which involved a major geopolitical event, such as the beginning and subsequent end of an oil embargo. Today, we are witnessing a similar economic situation despite the absence of any such event, and there are many reasons to believe it cannot last.

Most importantly, the US dollar has been surging in an unsustainable fashion, taking the price of all commodities down with it. This has been tied very closely to expectations of the Fed rising interest rates while the rest of the world continues monetary stimulus. However, since a stronger dollar has a negative effect on the rest of the economy, you quickly run into a catch-22.

The Fed can only raise rates if our economy remains strong, yet the economy will struggle to remain strong with the US dollar at current levels. This basically creates a cap for how much stronger the dollar can get before the economy shows cracks or the Fed backs off. In both cases, the dollar will be forced to reverse its course - buoying commodities along the way.

Perspective on the Current Environment

While most of the headlines have been dominated by the plunge in the price of oil, recent trends are not limited to the energy market.

Performance of Various Commodities, July 2014 - December 2015

These trends can be more easily understood by examining the relative price of the US Dollar over this same timeframe. Keep in mind that since commodities are dollar-based, a stronger dollar will result in cheaper commodity prices.

Trade Weighted US Dollar Index, December 2005 - December 2015 (Emphasis placed since July 2014)

The US Dollar Index has increased from 76 to 95 since July 2014, or a whopping 28% rise. This factor alone explains almost half of the movement of the energy market (which is down 60% total), and basically all of it in the other major commodity markets (which are down between 15% and 30%). While supply and demand and global economic weakness have certainly played some role here, the movement of the dollar has been at least equally important.

Also note that the dollar is now far stronger than it was even in the depths of the 2009 recession, when the world was flocking into US Treasuries for safety. Even stranger is the lack of any recent major geopolitical event, which has historically been an absolute requirement for this kind of dramatic currency movement.

In fact, if we look at commodity prices since 1980, there have only been three other periods that witnessed a simultaneous decline in the price of oil, gold, and copper on the heels of a massive dollar rally.

The first was in the early 1980s, when the Fed just defeated the hyperinflationary pressures in the US caused in part by the "oil shocks" of 1973 and 1979.

The second was in 1991, after the oil price spike that occurred in response to the start of the Gulf War.

The last was after the 1997 Asian financial crisis.

In this case, there has been no oil shock, and inflation certainly hasn't been a problem. The aftermath of the Asian financial crisis probably provides the closest proxy for today - and examining it more closely reveals why our current situation is vastly different.

Relating the Dollar Strength of the Late 1990s to Today

In brief, the Asian financial crisis was the result of a 'bubble' popping in Southeast Asia, leading to the devaluation of many of those countries' currencies and resulting in significant economic repercussions around the world. This global economic weakness deeply impacted the price of raw materials like oil and copper, while raising the value of more stable, developed currencies like the dollar.

Despite the global crisis, the US escaped relatively unscathed. While there was a 'mini-crash' in the stock market in October 1997, markets wound up positive for the year. In short, the US was independently strong enough and isolated enough to weather the storm.

Today, there are a few similarities in that commodity prices are crashing due to weakness in the global economy, and that thus far, the US seems to be relatively unaffected by the struggles in the EU and Asia. Yet far more differences abound.

First, the Asian economies impacted in the 1997 crisis were not even remotely close to representing a large part of the global economy. For example, Thailand's GDP was not even ranked in the top 100 at the time. Let's compare this to GDP size in countries experiencing economic weakness today.

World's Largest Economies, 2014

Which of these countries is currently contributing to global weakness? China? Check. Japan? Check. Germany? Check. The list goes on.

Second, the US was in a period of robust growth driven by the beginning of the dot-com revolution at the time. For the year ending 1997, US GDP growth was over 6%. As of last quarter, US GDP growth is currently around 3%.

If the rest of the developed world is in trouble in our fully globalized and still fragile economy, you can bet the US is going to be in trouble, too. It just isn't realistic to expect that the US can again be an independent and unaffected engine of growth.

Looking Forward, All Signs Point to a Weaker Dollar

With these facts in mind, there's really only two realistic scenarios. Either the signs of global weakness that have been driving up the dollar are overblown, or the US is going to struggle to remain strong. Both cases lead to a weaker dollar.

In the first scenario, the current stimulus efforts across the EU and Asia prove effective in keeping the global economy on a reasonable path. As those economies strengthen, so too will their currencies. The Fed will be relatively justified in its current path of raising interest rates, but it won't be as if the US is the only country on the planet in good shape.

In the second scenario, continued global weakness will inevitably take its toll on US GDP. With the strong dollar already hurting our growth prospects, the Fed will be hard pressed to take anything but a dovish stance. With the strength of our economy in greater doubt, and interest rate expectations held further in check, the dollar will cool off as well.

So far as commodities are related, you could see a rally in either scenario simply as a function of the US dollar. If the global economy appears on a better path, then that will even further push up prices as higher demand expectations return. If not, any additional weakness in demand will likely be offset by changes in the dollar, creating a situation with little further downside.

Wait, But What If the Dollar Rally Continues?

A continued dollar rally would be contingent upon further weakness in other global economies while US GDP strengthens and interest rates rise. Absent some major shift in consumer spending or a new US-led technological revolution, it is extremely difficult to envision this reality. Our economy would have to endure higher interest rates, a strong dollar, and weaker global demand all at once.

It is more likely that investors have piled into US assets with the Fed guiding upward after so many years, but the combination of a stronger dollar and global weakness should quickly ease aggressive expectations for US growth and higher interest rates.

Okay, So What's the Play in My Portfolio?

Commodities as an asset class look like a great bet for 2016, especially with so many dangers lurking in both the stock and bond markets, and an allocation of 20-35% as part of a broader portfolio may be sensible. Stay diversified in order to avoid issues with individual supply and demand curves, but avoid generic ETFs like the PowerShares DB Commodity Tracking ETF (DBC), which suffers badly from problems like contango. Instead, consider building your own basket of the major tradable commodities, such as gold (iShares Gold Trust: IAU), oil (Energy Select SPDR ETF: XLE or United States Oil Fund: USO), and copper (iPath Bloomberg Copper ETN: JJC), and split your exposure evenly across each. This way you can keep an eye on the individual underlying costs and adjust accordingly depending on market conditions.

If this seems too complex, a simple passive basket that avoids the complexities of the futures market might look like 50% in gold (IAU) and 50% in a diversified oil ETF (XLE). Alternatively, strategies like risk parity intelligently build in commodity exposure for you.

It's rare to come across a year of 40% losses in any major asset class. With the US dollar likely at or near its peak, there's even further reason to view commodities as a great bargain and a key piece of any savvy investor's portfolio in 2016.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Despite a 9% drop in equities last month, the Hedgewise strategy lost only 2.2% to 3.5%, depending on your Target risk level.
• By spreading investments across many asset classes and continuously adjusting for risk, the Hedgewise portfolio is far less susceptible to the radical swings of the stock market.
• Still, it has been an extremely challenging year, with every major asset class off 5% or more. While this is difficult in the short-term, odds are that this will look like a great buying opportunity in the long-run.
• Current conditions are likely being driven, at least in part, by fearful investor psychology. We examine similar historical environments to show why these circumstances often lead to positive outcomes using the Hedgewise approach.

Introduction

August was a rollercoaster ride for just about everyone. In our last newsletter, we noted that the commodity markets were signaling a major global event, which either meant that US equities were quite overvalued or that investors were badly overreacting to events in China. Soon after we published, it became impossible for US markets to ignore the real trouble brewing in the global economy.

As the month unfolded, it became clearer that commodity prices were no aberration, with many major export-heavy economies dipping into recession due to weak global demand. Strangely, though, the bond market remained quite out-of-sync. In typical environments, bonds will tend to rally on economic weakness, since both real interest rates and expected inflation will fall. Last month, though, bonds were also off about 1.5%.

This continues a theme that has occurred throughout this year - investors are getting more nervous about everything. The bond market is still pricing in a Fed rate hike this month, even while stocks are predicting a significantly weaker economic outlook. The Fed would probably only raise rates if there is significant inflationary pressure on the economy, yet the core drivers of inflation - oil, base metals, food - have all been rapidly falling in price.

This can be quite frustrating given the Hedgewise strategy is predicated on different assets moving in different directions. What does it mean when they all move down together?

When usual market patterns fail to manifest, there's a good chance that general fear is the culprit. Investors are nervous across the board, and beginning to price more risk into all markets at once. The bad news is that there is nowhere to hide in such conditions - everyone is losing money. The good news, though, is that this means at least one asset class is becoming significantly undervalued, which will inevitably become a boon for your portfolio when market conditions sort themselves out.

Even better, the Hedgewise strategy dynamically manages these kinds of environments for you, which is one of the reasons we outperformed the equity markets last month. When fear is increasing, we reduce investment exposure automatically, and thus decrease the likelihood of experiencing a significant loss.

With these factors in mind, it is actually a great time to stay invested. Historically, periods of irrational investor fear are short-lived, and quite frequently lead to outsized returns over the next year. Even if recent volatility is predicting a larger equity correction, the Hedgewise approach continues to provide far greater protection for your portfolio than the traditional mix.

Below, we further explain our August and YTD performance, and take a look at why history is heavily in our favor moving forward.

Understanding August and YTD Performance

Stocks experienced a number of significant dips over the course of the month, and were off over 10% at one point. Bonds were the most likely beneficiary of the global turmoil, since investors typically flock to them for safety, but that was not the case last month. Clearly, fixed income investors remain worried that the Fed will raise rates in September and potentially again by the end of the year. If the global slowdown continues, though, there is little chance this happens.

Despite the lack of a bond rally, the Hedgewise portfolio significantly limited losses compared to equities, losing less than half as much even at the Target 10% risk level. This is a natural outcome of diversification, which ensures that you are never fully exposed to a crash in a single market.

August Performance by Asset Class Compared to Hedgewise Target 10% Portfolio

In addition, recent losses have been mitigated because Hedgewise dynamically monitors risk, and reduces exposure to any assets that are "flashing red". This year, risk has continued to increase across the board, resulting in a lower overall exposure in every one of our portfolios.

The following chart shows the model "leverage ratio" for a sample Target 10% portfolio over the course of this year, where a ratio of 1.5 : 1 means that you have $150,000 of investment exposure for every $100,000 in assets. Our overall exposure in September is about 33% lower than at the beginning of this year, which also means that August losses were similarly less than they might have been otherwise.

Target 10% Leverage Ratio, Model Portfolio, January 2015 to Present

Though August was certainly encouraging in showing the power of our strategy's underlying concepts, it did little to improve our year-to-date performance, as every asset class is now off 5% or more.

2015 Performance by Asset Class Compared to Hedgewise Target 10%

Unfortunately, there has been nowhere to find safety this year. When investors are selling across the board, it typically indicates that fear is a core driver. The nice part about fear is that it is purely investor psychology, which has little to do with economic fundamentals. As a result, many assets get cheap at once, even though the underlying drivers haven't significantly changed.

While these conditions are challenging, history has shown that this is often a great time to buy, especially in a risk balanced portfolio.

Historical Perspective on Market Fear

Historically, a 60% bond / 30% stock / 10% gold portfolio has been a wonderful proxy for the risk parity approach, as we studied in-depth here. While this is significantly more simplistic than the live Hedgewise portfolio, it still presents a great proxy for identifying periods when different asset classes all lost money at once. Note that this portfolio is hypothetical only and based on index price levels of the S&P 500, 20yr nominal Treasury bonds, and gold. It includes all dividends reinvested but does not include any costs or fees.

We took a look at every 6 month period where the 60/30/10 portfolio lost 4% or more, which is fairly close to our current environment. This has only happened 21 times since 1970. Out of those 21 times, the portfolio achieved a positive return in 20 of the following years. Even more striking, the average return in the following year was 15.9%.

Upon reflection this isn't too surprising, if you agree that cheaper assets generally represent better deals. Still, it is no guarantee, especially in the very near-term. Heightened market fear is often an overreaction, but it can also be a predictor of a more significant crash. In both cases, though, a balanced portfolio remains a great bet.

Case 1: Overreaction in September 1981

In late 1981, the US was just exiting a period of massive stagflation. Yet, it was unclear if the inflationary pressures had truly abated, and if not, it would spell more trouble for both stocks and bonds. By September, every asset class was in a correction, with the possibility of a weak economy and higher interest rates looming.

Performance of Various Asset Classes, 1981 to 1983

In retrospect, the collapse in gold prices didn't make much sense in this context, since gold generally rallies when inflation expectations are high. As it became clear that the country was past the worst of it, bonds began a huge bull market, and stocks followed over the next year.

The 60/30/10 portfolio did quite well after the lows were hit, because gold was near its bottom, while both stocks and especially bonds had significant upside. This is typical of a fear overreaction, as all assets get cheaper, but at least one really should be outperforming given the context.

Case 2: Recession of 2008

In our second case, we'll look at a more familiar worst case scenario. In 2008, markets began to collapse in September after the Lehman bankruptcy. By October, stocks were already off 25% but bonds were strangely flat. Paranoia in the marketplace was pushing down the price of US Treasuries on fears of a full government collapse, as crazy as that might sound now. The US dollar had also spiked as the rest of the world scrambled for safety, deflating the price of gold and other commodities.

Performance of Various Asset Classes, 2008 to 2010

Now, the prospect of the US government defaulting on its debt seems rather outlandish, but we may also look back 5 years from now and think the same about the prospect of the Fed rapidly raising rates this year. As it became clear we were entering into a recession, but that the world wasn't otherwise falling apart, both gold and Treasuries rallied, helping keep the 60/30/10 portfolio relatively flat even during the worst crisis in the past twenty years.

This second case is particularly important because it highlights the power of diversification even in the darkest times. While there may be a few months in which many assets lose value together, a properly hedged portfolio still has a very high chance of retaining most of its value as markets return to balance. Even if you believed that we were heading for another 2008 this year, we are already using a strategy that is greatly equipped for it. On the other hand, if current market fears are overblown, then all assets may be due for a rally.

Wrapping Up

While the losses of this year are understandably difficult, there is great reason to believe they will be short-lived. Broad-based fears in the marketplace have led to an environment where every major asset class has lost 5% or more, but such fears generally lead to positive outcomes over the subsequent year. Even if there is greater market turmoil to come, the Hedgewise approach has shown a great resiliency to endure.

Months like August are stark reminders of the danger of an equity-heavy approach, and it appears likely that volatility will continue over the next 12-18 months. While this might lead to second-guessing in a traditional portfolio mix, there is no need to time the markets when using a risk parity approach. Our August performance helped illustrate how we limit losses during isolated corrections, and history has consistently rewarded portfolio balance - so long as you continue to trust it.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Commodities have officially entered a bear market, as oil and precious metal prices are at decade lows. This is being driven by a slowdown in China and the surging US dollar.
• At these levels, commodities are either a tremendous value or a harbinger of coming trouble for the economy. Either way, a hedged portfolio remains the best bet.
• The Hedgewise strategy has continued to limit losses despite this crash, demonstrating its resilience against bear markets no matter where they occur.
• Remember that all assets tend to appreciate over time, and that downturns present an opportunity to buy low and sell high. We discuss how rebalancing across asset classes turns bear markets into boons for your portfolio over the long-run.

The Commodity Firesale

A surprising string of events has driven commodity prices down to levels not seen since 2005. After adjusting for inflation, commodities have actually gotten cheaper over the past decade. This probably means one of two things: either real assets are now an incredible bargain, or a global recession is brewing and the stock market just has not noticed yet. Luckily, the risk parity framework accounts for either scenario and continues to protect your portfolio regardless.

First, let's take a look at the strange conditions that have decimated real assets over the past month. China is the world's biggest consumer of commodities like oil and copper, but its stock market has lost 30% in the last month on concerns of significantly slowing growth. Commodity prices began to fall as a result, and had an instant ripple effect on the economies of export-heavy countries like Australia and Brazil. This, in turn, is suggesting lower global growth as a whole, further perpetuating the bad news.

Meanwhile, the US has had mostly "okay" news over the summer compared to the rest of the world. The job market is back to pretty good shape, and while corporate earnings haven't been great, they haven't been terrible either. Compared to the Greek crisis and the China collapse, "just okay" has somehow become "the best in the world".

Thus, demand for the US dollar has skyrocketed. It is up over 20% this year and at its highest level of the decade. Since commodities are priced in dollars, a stronger greenback makes them even cheaper still.

While this might sound pretty reasonable, a quick look at history shows that this has become a very extreme environment. Generally, real assets like oil and copper tend to keep up with inflation, since both assets are key components in so many different kinds of goods. At current levels, though, both assets are now less expensive in real terms than they were in 2006.

Change in the Real Price of Oil and Copper since 2006

The US dollar is in a similarly outlandish place. Compared to a basket of six other major currencies, the dollar is at its strongest level of the past decade. For reference, it is about 10% stronger than during the depths of the 2009 crisis, when the whole world was looking for safety. It is also stronger than 2006, when the US was in the midst of the housing boom.

US Dollar Index Since 2006

The Inherent Contradiction

The picture this creates is one in which the rest of the world is falling off a cliff while the US remains basically unaffected. The problem with this scenario is that global economics are unavoidably intertwined, and will eventually affect the US one way or another.

A stronger US dollar means that US products are now more expensive in the rest of the world, which will naturally decrease our exports and increase our imports. If much of the world is also at or near recession, this will even further decrease demand for US goods. Formulaically, this will cause US GDP to fall.

To combat this, the US would have to generate enough internal demand from consumer or government spending to compensate. Yet there is little to suggest this will be possible, with consumer spending growing at a tepid pace and the Fed close to raising rates for the first time in a decade.

If current commodity prices are any true indication of the severity of global conditions, the US economy will soon be affected and our stock market is almost certainly overvalued. The combination of a strong dollar and weakening global demand will simply be too great to overcome.

Of course, there is also the possibility that it's not so bad, and investors are just overreacting. China might have a soft landing, and the quantitative easing efforts in Europe could pay off. Commodities are also notoriously volatile, and these kinds of wild swings in either direction are often poor indicators of the underlying economics. In this case, commodities might be priced at a screaming bargain, as they often have been after similar downturns in the past.

Average Commodity Returns Following a Year of >20% Loss

	Avg 1yr Return	Min 1yr Return	Max 1yr Return
Oil	33%	-36%	132%
Copper	21%	-20%	125%

Of course, it is impossible to know which scenario will unfold, which is why Hedgewise always advises to avoid making bets one way or the other. Nor is it necessary when proper diversification and risk management put you in a position to benefit regardless.

How Hedgewise Fits In

Even though most commodities lost over 15% last month, their effect on the Hedgewise strategy remains relatively muted. By dynamically measuring risk, Hedgewise reduces the chance that a crash in any market will significantly impact your portfolio. Since last summer, we've now experienced one major bond correction and two commodity crashes, yet our performance over this timeframe is near breakeven. In our book, that's a big win.

While it can be hard to recognize any kind of loss as a good thing, the goal of the risk parity framework is to limit your downside in bear markets so you can more fully participate in bull markets. Hedgewise invests more evenly across bonds, stocks, and commodities than traditional portfolios, which are typically quite stock-heavy. As a result, the traditional portfolio will tend to experience huge, infrequent losses during events like 2008, while the Hedgewise portfolio will experience smaller losses more often.

This model has proven quite effective over the long run for two reasons. First, smaller losses are superior by the simple math of investing. If you lose 40% of your portfolio value, you need to then gain 67% to get back to even (since you now have so much less capital). However, if you lose 10%, it only requires an 11% gain to recover.

Secondly, diversification across asset classes allows you to automatically "buy low" and "sell high". As one asset price falls, it naturally becomes a smaller portion of your portfolio. To maintain proper balance, it becomes necessary to buy more of that asset on the way down, while selling assets that have increased in price and thus become a larger portion of your portfolio. This allows you to quite methodically buy the bottoms and sell the tops, without having to time anything at all.

Looking at the live performance of one of our Target 10% clients last month, you can see that our losses are fairly insignificant compared to the size of the commodity crash.

July Performance, Target 10% Portfolio ("You") Versus Benchmarks

This portfolio still has most of its capital intact, as well as the opportunity to shift weight into an asset class that just got 15% cheaper. The bigger the fire sale, the more potential accrues. While you do have to tolerate the short-term loss, you are guaranteed to be collecting some great bargains along the way.

Compare this to a traditional mix, which has very little exposure to asset classes besides equities. While it may have made money this month, it is missing out on every sale and leaving all of its eggs in one very expensive basket. The higher it goes, the less opportunity there is for the future.

Conclusion

There is no mistaking that it has been a difficult stretch in the markets. Given the magnitude of the movements over the past year - two 40% drops in oil, a 15% drop in bonds, a 20% drop in all other commodities - the performance of the Hedgewise portfolio has been right in line with expectations (1% to 5% loss, depending on your risk level). The drawdown is relatively small compared to the steep losses in individual assets, and the portfolio is automatically rebalancing to take advantage of cheaper prices.

Current market conditions have been full of contradictions, and there could be a massive commodity turnaround or a sudden stock crash. Not to worry, though - it doesn't really matter which one happens so long as you remain steady. Every market cycle is just a new opportunity to sell high and buy low, and Hedgewise was built with just this in mind.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

What Happened

Hedgewise has experienced a 0.5-4% YTD loss, depending on your risk level, due to a significant bond correction during which stocks and commodities have remained relatively flat.

Why Not to Worry

Such "unhedged" events are usually temporary and self-correcting, given that the fundamentals in the markets must eventually align. Hedgewise has already moderated your losses by significantly reducing bond exposure as risk increased, and our approach ensures that your portfolio is well-positioned regardless of what happens next.

Looking Forward

Avoid the temptation to move into cash or time the markets. Remember that all assets tend to appreciate over the long run, and that periods of loss are typically short-lived.

Introduction

Hedgewise is built on the premise that diversification across asset classes is the best way to invest. By evenly balancing your risk, you get a steadier return with more upside and less downside.

With that in mind, it can be challenging to understand why losses still occur. In the first half of this year, Hedgewise started strong, but then gave up all of those gains to wind up with a loss between 0.5% and 4%, depending on your risk level.

Hedgewise 2015 YTD Return, Real Client Portfolios

The natural question becomes whether this still makes sense in the context of a hedged portfolio. When does diversification fail, and is there a risk that it will continue to do so? Are there steps that Hedgewise should be taking to "fix" it?

The reality is that even a diversified portfolio can only perform as well as its underlying assets. If there is a significant asset crash, or many assets simultaneously lose money, it is inevitable that there will be a period of loss.

However, such environments tend to be short-lived because the underlying economics must eventually reconcile. When bonds fall, it means investors are building in expectations of faster growth, higher inflation, or both. In those situations, both stocks and commodities should be rallying - yet they haven't. One of these markets is likely undervalued, but it is very difficult to know which one.

Regardless of the outcome, our strategy automatically protects your portfolio in multiple ways. By dynamically monitoring risk, our system began reducing bond exposure as early as January. This has significantly reduced losses compared to an unmanaged approach, and leaves your portfolio well-positioned to take advantage of a recovery, regardless of where it occurs.

Still, losses are difficult to bear, and you may wonder if there are environments in which cash is a better option. History has shown that the underlying principles of diversification are extraordinarily powerful, and that a risk-balanced approach will tend to systematically outperform any attempts to time the tops and bottoms, so long as you remain steady throughout periods like this one.

You don't need to take our word for it, though - we've put together all the data you need to decide for yourself.

Understanding YTD Performance

First, let's take a look at the performance within each class since January, as well as the impact that had on our Target 8% portfolio.

Performance by Asset Class, January through July 1 , 2015

Note the great disparity between the performance in bonds and that of stocks and commodities. Nearly any kind of well-diversified portfolio is bound to experience a loss in this environment. However, these returns are far less balanced than we might expect. Typically, when bonds lose over 8% in 6 months, other asset classes, such as stocks, will also experience radical shifts.

Comparison of Asset Class Returns When Bonds Lose >8%

The typical "mirror image" is what we expect, because markets generally react together. In fact, there have only been three other periods in recent history where stocks have remained relatively unchanged while bonds are plummeting: April 1973, June 1994, and June 2009. Every case provides evidence that suggests this current environment will be temporary.

History Shows This Environment Will Not Last

Period 1: November 1972 to October 1974

In April 1973, inflation fears had begun to grip the country as we had recently moved off the gold standard. Bonds were off about 10% as interest rates began increasing, but stocks were only down 3% or so. If inflation was going to become a major threat, both stocks and bonds would likely struggle, while real assets, such as commodities, would soar. However, stocks took a bit longer to react to this eventuality than other assets, remaining near flat through October. As it became more obvious that the inflation pressures were real, stocks went on to lose over 30% in 1974 while gold continued a phenomenal rally.

Period 2: January 1994 to January 1996

In July of 1994, Alan Greenspan and the Fed were worried about the threat of inflation in a rapidly expanding economy, and began quickly ratcheting up interest rates. While bonds immediately dove, both stocks and commodities remained in a choppy trading range as investors waited to see how higher interest rates would affect the economy and whether inflation would become a continued threat.

In this scenario, there are three possible outcomes: 1) The Fed does not raise rates enough, allowing inflation to become significant, as it did in the 70s, 2) The Fed raises rates too much, causing a significant economic slowdown, or 3) The Fed balances it just right, keeping inflation under control without threatening the growing economy.

In this instance, the Fed struck the right chord. Even though interest rates reached nearly 6% by the end of 1994, the economy kept growing while inflation remained tame. Both bonds and stocks had significant upside moving forward, as interest rates peaked, inflation was reasonable, and the economy remained strong.

Period 3: January 2009 to January 2010

Immediately after the crisis in 2008, investors were worried about pretty much everything. Bonds plunged on fears of a government default or massive inflation and stocks dealt with the fallout of the financial crisis. Only gold began to rally as a last ditch safe haven. However, it didn't make sense for both stocks and bonds to underperform once it became clear the crisis was over. As signs of recovery began to appear, stocks started their current bull run and never looked back.

In all three of these examples, markets regained balance because at least one asset class rallied. History suggests this will happen again, and Hedgewise is in a position to benefit no matter which scenario unfolds.

Why Hedgewise Remains Well-Positioned

While Hedgewise is not "immune" to periods of loss, we provide two separate layers of protection to continuously increase the probability that your account will perform well over time.

First, we always maintain exposure across bonds, stocks, and commodities to avoid the danger of timing the markets and with the confidence that all assets tend to appreciate over the long run.

3 Year Trailing Returns by Asset Class, Since 1953

Over any three year period, both stocks and bonds tend to appreciate. However, a risk-balanced portfolio is dramatically more consistent than any single asset class. For example, consider a simple 60% bond / 30% stock / 10% gold mix.

3 Year Trailing Return, 60/30/10 Portfolio, Since 1970

This portfolio has never lost money over any three year span. Hedgewise further improves on this simple mix by dynamically adjusting for risk and utilizing leverage to give you greater control over your desired return.

This enables us to reduce your exposure to certain asset classes as they become riskier, thus further increasing the chance that your return will remain "balanced". Here's how our overall bond allocation shifted for the Target 8% Index YTD.

Total Bond Allocation YTD, Target 8% Index Portfolio

Unlike the static portfolio, Hedgewise has shifted down your overall allocation to bonds and reduced your losses this year as a result. Looking forward, these methods will continue to limit your downside while giving you an extremely high likelihood of positive returns over time.

While we remain very confident in the continuing power of these underlying principles, we must emphasize that periods of loss are absolutely inevitable. In any given ten year stretch, it is likely that you will experience one year that is far worse than the current one has been. However, because it will be so hard to time when that period will occur, or how long it will last, you will almost always do better by just remaining patient.

Conclusion

Markets this year have been a challenge. Bonds have experienced a major correction, commodities have been extremely volatile, and stocks have remained in a tight trading range. Despite this, Hedgewise losses remain relatively small, and have been moderated by our dynamic approach to risk management. History has shown that current market conditions will not last, and though it isn't yet clear which asset class will rally next, Hedgewise is already well-positioned to take advantage of it.

Still, experiencing losses will always be tough. We know exactly how it feels, because the founder of Hedgewise and his family are 100% invested in this strategy. It is human nature to second guess, and seeing your account value fall is inevitably an emotional experience. While we can't change this, we can give you the information you need to put these losses into context. By analyzing how markets have performed in similar situations in the past and learning how our strategy has optimized your portfolio, you gain a powerful counterweight against any emotional reaction. As challenging as it may be to endure losses, history has always rewarded patience and perspective, and we look forward to proving that again.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Since February, the bond market has been in a major correction, with 30yr bonds now down over 10%
• However, bonds rarely experience losses over the long run, and remain a fundamental piece of any properly diversified portfolio
• The Hedgewise strategy remains near breakeven for the year despite this bond correction, and will continue to be resilient regardless of the environment
• Still, this kind of volatility is a good opportunity to re-evaluate your risk tolerance and seek perspective on what to expect moving forward

Introduction: Understanding Risk Parity During Market Corrections

The past couple of months have seen losses in the Hedgewise portfolio due to the significant bond market correction. Given the goal of our strategy is to balance risk evenly across assets, does this mean something is going wrong?

Though short-term losses are difficult to handle, the strategy is still functioning exactly as it should. To help understand why, consider a different example: imagine in the past three months, the stock market was down over 12%, but your portfolio was far closer to breakeven. In that case, it might seem more obvious that limiting losses during corrections is a victory of its own.

Within any investment strategy, it is impossible to avoid losses when many assets lose value at once, or when a single asset experiences a correction while other assets remain flat. The best that you can do is to reduce your exposure to the worst-performing assets while keeping perspective that crashes tend to be short-lived.

In this case, the Hedgewise system has been reducing bond exposure for months as those markets have been getting riskier. This has helped to limit client losses compared to a purely passive approach. However, it would be extremely dangerous to remove bonds from the portfolio altogether, given it is now far more likely that a different asset class will crash next.

The good news is that over any ten year period all assets tend to appreciate. The risk parity approach simply moderates your losses during volatile stretches. It cannot, however, ensure that every month yields a positive return. If you feel uncomfortable with this most recent stretch, it may be a signal that you are taking too much risk - which you can always adjust by selecting a lower Target Return.

With that in mind, let's take a deeper look at what has been happening in the markets lately.

Understanding Recent Hedgewise Performance

Hedgewise YTD Performance - All Targets

Year-to-date, all Hedgewise portfolios are hovering near breakeven. The lowest risk portfolio has proven quite resilient because of its automatic allocation to less risky assets. This is fairly impressive given that bonds are off more than 12% from their peak, while stocks and commodities remain relatively flat. Moving forward, it is quite unlikely that these other asset classes remain as calm as they've been.

Performance of 30yr Bonds Since Peaking in February 2015

While Hedgewise does not predict the direction of returns, we do continuously monitor the underlying risk of each asset class. Expected bond volatility has been increasing since January, resulting in a lower bond allocation in each of our Targets. To help see the net impact of this adjustment, we've compared the hypothetical performance of a portfolio using fixed asset allocations since December 2014 to our live, risk-adjusted portfolio since then. In other words, what difference has it made to actively adjust for risk?

Performance of Hedgewise 8% Target Index vs. December 2014 Asset Mix

Don't Panic About Bonds

During corrections, there is often an impulse to abandon that asset for fear of continued losses. To help combat that impulse, here are a few fun facts about bond market performance over the long run.

First, consider this: bonds have never, ever lost money over any ten year timeframe. This includes the last period of rising interest rates from the 1950s through the 1980s.

10yr Trailing Returns of 10yr Bonds, Presented Monthly, 1963 to 2015

If you think this doesn't apply to longer duration bonds, especially in rising interest rate environments, guess again.

10yr Trailing Returns of 20yr Bonds, Presented Monthly, 1963 to 1983

Now, these ten year returns are not particularly high, which is to be expected when interest rates are skyrocketing. This is just fine though, since other assets, like commodities, were booming during this timeframe. Bonds still reduced the overall risk of a balanced portfolio, and eventually began booming themselves once interest rates peaked.

Still, it can be hard to think about the next ten years when you are losing money today. Fortunately, there's also an extremely high likelihood that bonds will turnaround in fairly short order. We took a look at every period where 20yr bonds lost 5% or more over 3 months since the 1990s. Then, we plotted that against the following one year return of those same bonds. For some perspective, bonds are now down over 10% since February.

3mth Trailing 20yr Bond Return (X-Axis) vs. 1yr Following 20yr Bond Return (Y-Axis)

Out of 21 data points, bonds only continued to lose money over the following year twice. On average, the return in the following year was 11%. Quite recently, bonds were off about 10% after the 'Taper Tantrum' during the summer of 2013. In the following 12 months, bonds rallied over 10% and were one of the best performing asset classes.

Of course, this is no guarantee, and things may very well get worse before they get better. Regardless, it almost always pays to stay the course. If you still feel uncomfortable with the recent losses in your portfolio, this is an excellent indicator of your own personal risk tolerance. While it is often overlooked, emotions are a huge factor in your investment strategy. When a severe loss might cause you to abandon your long term plan, it is important to take steps to avoid that possibility.

Luckily, with Hedgewise you have just that option. Simply let us know that you'd like to reduce your risk by moving into a lower Target, and it will be done almost instantly. After all, your own peace of mind is often the most important part of the investing equation.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Over the last week and a half, the Hedgewise strategy has experienced a small correction as many different asset classes had simultaneous losses.
• While such periods will be difficult to bear, it is helpful to understand how the underlying investment principles are still working as they should.
• In these environments, Hedgewise helps to minimize your losses while giving you a better chance of a positive return moving forward.
• Losses are typically short-lived, and tend to be followed by positive reversals. Maintaining a long-term outlook is crucial to achieving outperformance over time.
• If you are uncomfortable with the current volatility of your portfolio, you can always choose a lower Target to further minimize your risk of loss.

Overview

It has been a rough week in the markets. Over the past 10 days or so, here's a look at the performance of each of the Hedgewise Target Portfolios.

Figure 1: Performance of Hedgewise Target Portfolios, April 24 - May 5

While this is always difficult to experience, the Hedgewise strategy continues to demonstrate the power of its underlying principles, which maximize the opportunity for a positive return moving forward. By studying the nature of the portfolio's losses this week, as well as their relationship to the underlying economic environment, we can better understand why.

Moderating Losses Across the Board

This was a rare week when nearly every major asset class lost money at once.

Figure 2: Performance of Major Asset Classes, April 24 - May 5

In such an environment, nearly any investment strategy is bound to lose money, unless you are in cash, shorting the market, or betting 100% on oil. Over any long term horizon, however, these strategies are almost guaranteed to underperform.

Given that, the goal in this scenario is twofold: minimize your losses and ensure that the overall risk of your portfolio is in line with your expectations. Hedgewise has continued to do both things for its investors.

By comparing Figures 1 and 2, you'll notice that the Hedgewise Target portfolios outperformed Treasury Bonds, TIPS Bonds, and Small Cap Stocks, while underperforming the S&P 500, Gold, and Oil. This 'hedging' is by design, as by spreading your bets across asset classes, you avoid the risk of a crash in any single place.

Secondly, you'll notice in Figure 1 that losses in our Target 5% portfolio were far less than losses in our Target 12% portfolio. Scenarios like this one are excellent ways to calibrate your personal tolerance for risk, and ensure that you are comfortable with short-term volatility when it occurs. If you find that these recent losses are too much to bear, you have the choice to lower the overall risk of your portfolio at any time.

Still, it is never fun to lose money, even if those losses are hedged. The good news is that such losses are typically short-lived. In fact, the bigger the loss, the more likely it is that returns will be higher in the near future, as counterintuitive as that may feel.

The Impact of Losses on Future Returns

Like any investment, corrections are inevitable. After such a correction occurs, though, it means that many assets are now cheaper, and rebalancing into these cheaper assets will probably 'boost' your return when they do recover. This can be seen from January to March this year, when Hedgewise experienced a sudden downturn, only to recover almost immediately after. While we are experiencing another down period now, it would not be surprising if history continues to repeat itself.

Real Client YTD Performance, Target 10% Portfolio

You can also expand this concept to our longer-term performance since 2005, during which there were many corrections despite strong overall returns.

Target 10% Strategy Index Performance Since 2005

In most investments, crashes are often followed by periods of outperformance. The Hedgewise strategy will follow a similar pattern, but with the advantage of more effective diversification along the way.

Why the Current Environment is Unlikely to Last

These principles would remain the same no matter the economic environment, but there is also reason to believe that the current pattern of losses is unlikely to continue.

The Hedgewise portfolio is balanced to maximize the chance that a crash in one asset will be offset by a gain in another. Most recently, stocks, nominal bonds, and inflation-protected bonds (TIPS) all went down at once, which is a relatively rare situation which limits the effectiveness of hedging. This situation is rare because it implies that investors are worried about different scenarios which are very unlikely to co-exist.

If nominal and TIPS bonds are both losing value, it means that investors are assuming a higher rate of real economic growth. However, a stronger economy would generally boost stocks, which have also experienced recent losses. This suggests that investors are simply unsure, and have moved to the sidelines until the signals get clearer. If the economy is indeed strong, stocks will likely recover, and vice versa for bonds.

No matter which way it turns next, the Hedgewise portfolio remains prepared, and frees you from having to predict the future.

Hopefully this context helps to give you better perspective on the most recent week, and ease any concerns about the future of the Hedgewise strategy. Even in difficult periods like these, Hedgewise is helping you invest safer, smarter, and at the risk you choose.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• Gold is an excellent addition to any portfolio as a hedge against inflation and recessions.
• While the most popular gold ETF physically holds the metal, there is often a hidden benefit to using gold futures contracts instead.
• By using a switching strategy between physical gold and futures contracts, you may be able to boost the return on your gold investment by as much as 5% annually.
• We give you free access to a daily monitor that tracks the current optimal gold investment strategy.

Introduction

As written in a few of our other articles, gold is generally an excellent part of any well-diversified portfolio. It tends to spike when markets are crashing or when inflation is taking off, which are typically the environments when such a hedge is most desperately needed. However, many investors are missing out on additional gold upside that can be gained by using the gold futures market rather than physically holding the metal.

The SPDR Gold Trust (GLD) is far and away the most popular gold ETF, with over $28b in assets. The ETF basically stores gold at a secure facility, making it a fairly close proxy to simply buying a gold bar and putting it in your safe. While this is quite straightforward, it is not always ideal to simply buy and hold the metal. By understanding and monitoring the gold futures market, you can frequently get an extra boost to your gold return, either by investing directly in futures contracts or by using the PowerShares DB Gold ETF (DGL).

We'll break down how this works and when it makes sense to switch into futures. To give you a quick example of the effectiveness of the strategy, here's an example of how the April 2015 futures contract performed compared to the gold benchmark price over the past two months.

Performance of April 2015 Gold Futures Contract vs. Gold Spot Price, March-April 2015

Understanding the Futures Market

A gold futures contract is an agreement to buy or sell gold at a specific price at some point in the future. This 'future price' is almost always different than the current spot price, meaning that the market has an expectation for which direction the price is going to go. If the future price is less than the spot price, this is called "backwardation", and it means the market is expecting that the price will go down. Conversely, if the future price is more than the spot price, this is called "contango".

When the market is in backwardation, you can basically buy gold at a discount. For example, say you can buy a futures contract next month for $1,100 but the spot price of gold is $1,150. Even if the price of gold stays exactly flat, you would still make $50 on that contract.

To give you a sense of how varied futures prices can be, here is a snapshot of gold futures quotes on April 27, 2015.

Gold Futures Quotes, April 27, 2015

Futures Contract	Price	DGL holdings
Apr 2015	$1175.20
May 2015	$1174.80
Jun 2015	$1175.00
Aug 2015	$1176.00
Oct 2015	$1176.80
Dec 2015	$1177.70	100.00%
Feb 2016	$1178.50
Apr 2016	$1179.40
Jun 2016	$1180.30
Aug 2016	$1181.40
Oct 2016	$1182.70
Dec 2016	$1184.10
Feb 2017	$1185.80
Jun 2017	$1189.20

Examining this data, you can see that the May 2015 contract is currently the cheapest, trading around $1,175. If the spot price of gold were currently higher than that, the futures contract would be a better investment than buying the physical metal.

Implementation and Caveats

With this in mind, the strategy is quite simple: monitor the futures curve, and switch between GLD and the cheapest futures contract depending on current prices. Whenever you are able to buy a futures contract at a 'discount', you will likely achieve a higher overall return than you could have otherwise.

In the example at the beginning of the article, the April 2015 futures contract had a return of -0.83%, while a direct investment in gold returned -2.23%.

That is a 1.4% boost in under two months!

However, it is somewhat complex to directly trade futures contracts, since they are typically quite large and you need to understand how to manage them. Luckily, there is an ETF called the PowerShares DB Gold Fund (DGL) that trades them for you. Instead of trading a futures contract yourself, you can just check the current holdings of DGL and then trade that instead.

Performance of DGL vs. Gold Spot Price, March-April 2015

While DGL didn't perform quite as well as the direct futures contract, it was within 0.2%. Note that DGL does have an annual expense ratio of 0.78%.

Even if you use DGL, though, there are still two primary caveats to trading futures. First, you must plan on holding the underlying contract until its expiration date. This is because the futures market is quite volatile, and prices may move in either direction day-to-day. The futures price and the spot price are only likely to converge as the expiration date approaches.

If DGL currently holds the December 2015 contract, then, you would only want to buy that if you were planning to hold gold in your portfolio until that date.

Secondly, the final gain or loss on a futures contract will depend on your exact point of entry and sale. There is no guarantee you will be able to achieve the return expected based on the shape of the futures curve. Still, like any investment, it is simply a matter of trying to make the best bet.

Daily Monitoring of the Gold Futures Curve

If this strategy sounds appealing to you, you can see our daily tracking of gold futures prices and DGL holdings here. This can give you a general sense of which investment is currently optimal, though be wary that the data is not real-time and is meant only as broad guidance.

If you are holding some gold in your portfolio as it is, this strategy may help you boost your return no matter which way prices head.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• With tax season just past, it is a good time to study how Hedgewise helped to keep clients' tax bills down in 2014
• Our average client was able to defer thousands of extra tax dollars compared to an unmanaged account
• Since some assets are usually going down while others go up, the Hedgewise strategy is particularly suited to tax harvesting
• For clients with retirement accounts, Hedgewise further protected gains by intelligently allocating assets according to their tax efficiency

2014 Tax Savings for a Real Client

To give you a sense of how our tax strategy works, we selected a real client example that began an account in July 2014. This account was selected because it was one of our earliest clients which had approximately an equal proportion of assets in retirement and non-retirement portfolios. Here's how the account performed through the end of the year.

Client 2014 Tax Summary

	%	$ in a $100k account	Est. Tax Deferrals
Total Performance	-1.0%	-$1,000	$1,715
Net Realized Losses	-6.2%	-$6,200	$1,550
Tax-sheltered Gains	1.1%	$1,100	$165

While the client did experience a small loss over this time period, their tax deferrals were significantly higher. In effect, a $100,000 portfolio was able to defer over $1,500 in taxes even though its actual loss was only $1,000.

What exactly does this mean? Though you will always have to pay taxes at some point, you can 'defer' them as long as possible through a technique called 'tax harvesting'. This means that you try to avoid paying taxes on your gains while immediately 'realizing' any of your losses. In effect, this pushes your tax liability further into the future, such that you can generate additional returns on that capital in the meantime.

Even better, any realized gains that happen within a retirement account are sheltered. In an ideal world, you could maximize your tax savings by keeping all of your realized gains in your retirement accounts and all of your realized losses in your non-retirement accounts.

Hedgewise automatically 'optimizes' every client account according to these principles, and it went almost exactly according to plan in 2014. Here's how.

Tax Harvesting with the Hedgewise Strategy

While tax harvesting is possible in any portfolio, it only works when you have losses to 'harvest'. This means it will often not be possible if you hold only a single ETF or mutual fund, and it may be less effective if your holdings are concentrated in a single asset class.

However, the Hedgewise strategy is particularly suited to reap the benefits of tax harvesting since it is constantly diversifying your portfolio across many different asset classes. For example, in 2014, the client discussed above had the following returns.

Client's Actual 2014 Returns By Asset Class

Hedgewise was able to continuously realize losses as commodities fell in value, while protecting its gains in bonds and stocks. Thus, the client was basically able to realize this entire loss in commodities, even though they had only a small overall loss in their account.

Moving forward, the natural diversification present in the Hedgewise portfolio will continue to provide such opportunities.

Tax Optimizing Your Retirement Accounts

In addition to tax harvesting, Hedgewise intelligently allocates assets between your non-retirement and retirement accounts, if you have any. By placing the assets with the highest expected tax impact in tax-sheltered accounts, we can even further increase your annual tax savings.

Hedgewise estimates each asset's expected tax impact based on a combination of your personal tax bracket, the underlying attributes of the asset, and the asset's expected annual return. For example, Treasury Bonds pay out monthly coupons that are taxable immediately, so it is usually beneficial to hold these in your retirement accounts. If our logic is working correctly, you'd see more realized gains in your retirement account, where they are tax-sheltered, and more realized losses in your non-retirement account, where they can be harvested.

Last year, this is how it turned out for our sample client.

	Realized Gains	Realized Losses	Total
Retirement Account	$1,150	-$50	$1,100
Non-Retirement Account	$500	-$6,700	-$6,200

In this case, it worked just as expected. The client experienced most of their realized losses in their taxable account, and most of their realized gains in their retirement account. This kind of intelligent optimization is quite unique, as most investment advisors simply manage retirement and non-retirement accounts separately. Hedgewise, however, manages multiple accounts under a single Target while taking into account your broader tax situation.

While the primary focus at Hedgewise will always remain on our underlying investment strategy, we also take every opportunity to further reduce costs and taxes for our clients. In 2014, we are happy to report this worked exactly as planned.

Key Takeaways

• Last year, Hedgewise used tax harvesting and optimization to help defer thousands of tax dollars for the average client
• Losses are continuously harvested while gains are protected, allowing you to push tax payments into the future and invest more today
• If you have both a retirement and a non-retirement account with Hedgewise, your investments are intelligently optimized to increase your tax savings even further

Hedgewise is not a tax adviser and assumes no responsibility to you for the tax consequences of any transaction. There is no guarantee that efforts to minimize taxes or to harvest losses in your account are successful. Hedgewise does not consider any of a client's personal accounts besides those which are directly under its management. This may create a conflict for tax purposes. You should confer with your personal tax adviser about all of your trading activities. Tax harvesting does not reduce your taxes, but rather shifts the tax savings to an earlier year. The primary benefit is the gain you may be able to make on that tax savings by investing it now instead of at a later date.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

• Many remain convinced that bonds should no longer be part of a diversified portfolio in a rising interest environment.
• To refute this, we recently showed how a portfolio mix of 60% bonds / 40% stocks outperformed a 100% equities portfolio from 1954 through 1982, even though interest rates soared from 2% to over 15%.
• However, skeptics insist that equities are still superior over a long enough time horizon, and that diversifying with bonds is too risky because it requires the use of leverage.
• We'll prove that a diversified portfolio still outperformed even in the very worst bond bear market in history, and without the use of any leverage whatsoever.
• If your portfolio is currently 100% equities or cash, you are almost guaranteed to underperform over the long run.

Introduction: Keeping Your Free Lunch

Diversification is often referred to as the single true 'free lunch' in finance, meaning it is one of the only guaranteed ways that you can boost your return and reduce your risk. No matter what. No strings attached.

Yet, the concept is persistently challenged by most of the investing public. With interest rates at historic lows and stocks near historic highs, it is easy to see the appeal of cash or a conservative 'blue chip' portfolio. Still, diversification is supposed to work regardless, and never calls for any sudden adjustments. It is supposed to sustain major crashes without sacrificing your return.

But how can it be better to hold a crashing asset rather than to avoid it?

It is a good question, and the answer is both simple and counterintuitive. A crash doesn't hurt you if you have something to offset it. Some things go up, others go down, and you make money either way.

Could you make even more money if you avoided what went down? Yes, but this also requires that you are always right and that you are timing the market. Make one wrong call, and you will quickly be in bad shape. Diversification will tend to beat you without any effort at all.

In our last article, we studied how a portfolio of 60% bonds / 40% stocks still outperformed from 1954 to 1982, despite many major crashes in the bond market. However, such a portfolio assumed that you could use leverage, which is unrealistic for many people.

By more deeply understanding diversification, though, you can adjust the portfolio mix to no longer require leverage while maintaining all of the benefits. We'll break all of this down in the rest of this article, but for the impatient among you, it only requires one simple adjustment.

Just add 10% commodities to your mix. Preferably inflation-sensitive commodities, like gold or oil. Rather than 60% bonds / 40% stocks, you would have 60% bonds / 30% stocks / 10% commodities.

This simple mix has managed to nearly match the performance of the stock market at half the risk in nearly every decade that data is available. This includes the 1970s, which we will study in detail since bonds were performing so badly during this period. We'll also examine how it performed through the decades following to better dispel the notion that 'equities are always better if you wait long enough'.

It's not magic. It's just your free lunch.

Diversification: What It Is and What It Isn't

Diversification helps passive investors achieve a more stable return with a lower chance of losing money in any given year.

Let's unpack this a bit. Passive means that you do not have to predict the future, and that it does not require any active decision-making to manage the portfolio. It places value on stability, with the assumption that an investor would prefer a guaranteed return to a riskier one. It also assumes the future is uncertain, and that any asset has the potential to lose money over even a very long timeframe.

There are two common arguments that attempt to discredit the value of diversification which we'd like to address upfront: first, that active management will consistently outperform any passive strategy, and second, that there is no need to worry about 'risk' if you just wait long enough.

Active management only has the ability to reduce risk and increase returns if you are very consistently right about what the markets are going to do. Even if you are one of the few that is able to do this well, it takes an extraordinary amount of time and effort, and it only takes one bad run to ruin years of good ones. If you do not have the certainty, knowledge, time, and energy to be actively managing your portfolio, then a passive approach obviously makes sense.

The second argument is usually applied to stocks, with the idea that there is no risk of losing money so long as you can wait twenty or thirty years and you do not realize losses in between. The simple fact is that many people cannot afford waiting so long, and often need access to their money in the interim. There is also the emotional toll of seeing a huge loss in your portfolio, which often causes people to become more risk-averse. Finally, and most importantly, there are many very long stretches of time in all kinds of different markets where investors have still lost money. The Japanese stock market provides one of the most notable examples.

Performance of the Japanese Stock Market, 1990 through 2010

The key point here is that uncertainty always exists. It isn't certain that bonds are going to lose money over the next decade, or that stocks are going to boom. If you are already assuming one or the other, you have to accept that this is a form of active management and there is the possibility that you are wrong.

Applying Diversification: Why 60% Bonds/30% Stocks/10% Gold?

If you accept this uncertainty, the focus becomes on creating a portfolio that has the best chance to make money no matter what happens next.

The effect of diversification is maximized when the assets in your portfolio have a good chance of offsetting one another. Ideally, they'd tend to move in opposite directions (i.e., negative correlation), and in roughly similar amounts.

Since correlations can change, though, it is difficult to identify the exact right mix at any point in time. The good news is that you don't need to be exactly right to still get a huge benefit; you can use a couple of basic rules of thumb and still see a dramatic improvement in performance.

To prove this, we're keeping our assumptions incredibly simple and unchanging. We will use three different asset classes that generally tend to be uncorrelated - bonds, stocks, and commodities. We will then fix their weights roughly based on their relative historical volatilities (to increase the chance they will offset one another).

The S&P 500 index will be our benchmark for stocks. We will use 20yr nominal Treasury bonds to show that even long maturity bonds - which do horribly when interest rates rise - have a place in your portfolio regardless. Finally, we will use gold to represent commodities, primarily due to data availability (Note that oil, food, and other assets also experienced a spike in price during this timeframe, so this is somewhat interchangeable).

To get to our final mix of 60% bonds / 30% stocks / 10% gold, we assume that gold is about 3x volatile as stocks, which are about 2x as volatile as bonds. Really basic stuff. (for readers of our past work, note that adding gold is a way of increasing the 'risk' of the portfolio as an alternative to using leverage)

Now we'll study how this mix did - without ever changing - from 1970 onward, which is the earliest point that gold pricing data was available.

Comparing Performance: Diversification Still Wins

As a quick refresher, the interest rates on 20yr bonds started around 7% in 1970 and reached a peak over 15% in 1981. As you'd expect, 20yr bonds performed quite poorly over this period, frequently experiencing large losses.

So a portfolio of 60% bonds did horribly, right? Guess again.

Performance of S&P 500 vs. 60/30/10 Mix, January 1970 through January 1982

Here's another view showing the relative return vs. risk of the portfolios (a.k.a the Sharpe Ratios).

Relative Return Versus Risk

The diversified mix didn't just keep up with stocks - it did it at half the risk.

How could this be?

The answer brings us back to the very fundamentals of the theory. When interest rates are rising this quickly, and bonds are doing this badly, it can only be because of rapid inflation, which will depreciate the dollar and cause hard assets, like gold, to rally. If you diversify correctly, you don't need to worry about something crashing because you own something else that will offset it.

Still, wouldn't you have done better if you had just owned gold and stocks, or even just gold alone?

While the answer is 'of course', consider recommending a portfolio of 50% or even 100% gold right now. You would need some extreme conviction. By just using gold to diversify instead, you were able to achieve great performance without needing to make any bets at all.

You also would have needed to time when to exit gold, which very promptly collapsed and returned almost nothing for the next 20 years. Our diversified mix, however, continued to hold up through the decades (Note that 20yr bond data is unavailable from 1986 through 1994, so we have left that period out).

Performance of S&P 500 vs. 60/30/10 Mix, January 1982 through January 1986

Performance of S&P 500 vs. 60/30/10 Mix, January 1994 through January 2015

The mix has proven amazingly resilient for being such a simple portfolio. It is nearly the textbook model of what you'd want out of diversification - slow and steady upward returns with little risk of loss over nearly 40 years.

Has the stock market outperformed over stretches? Absolutely. It also had two major crashes in 2001 and 2008, and is now in 8th year of a bull market. Are you sure you wouldn't prefer a similar return with much less risk?

Other Caveats: Should You Use This Exact Portfolio?

There are a few significant limitations to this analysis, many of which have already been highlighted, that make it unlikely this will be the exact 'optimal' mix. However, if you are comparing it to a 100% equity alternative, it is absolutely a good starting place.

We purposefully kept it simple and did not take advantage of several readily available tactics that we use in our own client accounts. There are only three assets. There is no leverage being used. There are no advanced analytics. There is no shifting of weights over time. All of these elements could make it even smarter - but you don't need them to still do better than a non-diversified portfolio.

If you are looking for an immediately accessible recommendation, it is extremely likely that a more even mix of stocks and bonds will continue to provide the same benefits shown here. However, if you are uncomfortable with this, consider layering on a smaller amount anyway. For example, 70% stocks / 20% bonds / 10% gold is still much better than no diversification at all - just realize that you are making an 'active' bet by shifting your assets towards stocks.

Conclusion: Diversification Works

We've now demonstrated two different, diversified, bond-heavy portfolios that have matched the performance of the stock market even when interest rates were rising rapidly. Moreover, they have matched this performance with significantly less risk.

The first was 60% bonds / 40% stocks, and used leverage to adjust the performance upward. The second was 60% bonds / 30% stocks/ 10% gold, and didn't need any leverage at all. Both portfolios exhibited a dramatically improved return-to-risk ratio compared to stocks alone, and the ability to maintain this performance across multiple decades.

These portfolios achieved this despite being quite handicapped with an unchanging portfolio mix and only two or three asset classes.

Hopefully, that's enough to make you second guess the recommendations of 'all stock' or 'all cash', and continue diversifying no matter the economic environment. If it isn't, though, we'd love to know what else is holding you back.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Cars and Tesla. Taxis and Uber. Shopping and Amazon. Networking and Facebook. Finance and...?

The past decade has seen a major upheaval of industry after industry. The internet and technology have completely re-shaped the way we relate to the world and the possibilities for our future. Yet, the best known financial upheaval of the past 10 years was when the banking system nearly destroyed our economy in 2008, only to be saved by the government and then to continue on its merry way.

In the next 10 years, the financial industry will experience a revolution.

The early signs are everywhere. It's been a bit slower than other industries, due to its huge footprint, the large incentives for current financiers to avoid change, and heavy regulations. But little cracks are showing.

Mint has changed the paradigm for saving and budgeting. Lending Club has crowdsourced small personal loans. Bitcoin has changed the definition of currency. These innovations, though, have all been largely on the fringe. You still save at your big bank, deal with your same 401k, and invest at the same brokerage.

Get ready for a bigger shift, and soon. Good news: it will all get much, much better.

Here's 5 bold predictions for how the industry will look in 2025.

1) Self-directed brokerages will become a relic, and automated investment management will rise.

In 1999, you paid $40 to make a trade, over the phone, to some guy who called you all the time to tell you about the next hot stock. It was a 'big deal' when you could trade over the Internet for $10 instead.

Today, almost the entire trading ecosystem is automated. Technology has made it nearly costless to execute trades, whether you are trading one share or ten thousand. Institutions pay a few cents, or less, for every transaction. Meanwhile, E-Trade, Schwab, Fidelity, and the rest still charge ~$7 or more.

It is only a matter of time before some smart engineers crack this problem at scale, and level the playing field. You can see this beginning to happen. Robinhood is trying to offer zero commission trades, and major players like Interactive Brokers already charge only $1.

Low commissions will be a race to the bottom, and soon become a commodity. New players will win customers by offering smarter, easier ways to invest instead. Gone will be the days when you had to navigate thousands of ETFs and mutual funds, hire a separate tax advisor, and worry about how to protect your portfolio from the next stock crash. Online advisors, like Hedgewise and Wealthfront, will become the new normal, offering fully automated investment management for less than your commissions in 1999.

2) Mortgages will become crowdsourced.

Lending Club already figured it out for loans up to $35,000. Why shouldn't mortgages go next? Imagine a world where you could give 100 qualified applicants $1,000 each towards their dream home, and make 6% interest with limited downside. They have not been able to get a loan through the big banks even though a tech-savvy intermediary has run their profile through advanced analytics and determined they are 99% likely to repay. When defaults happen, the same intermediary has a system that expedites and automates the foreclosure process, without you having to lift a finger.

There will be less banking inefficiency, less systematic risk, and another reasonable outlet for investors to diversify their portfolios.

3) The current 401k plan model will become obsolete.

I recently advised a friend on a new 401k plan from ADP. I was shocked to find that they had over 100 investment options, and not a single one had a fee under 0.80%. Not even the mutual fund that just benchmarked the S&P 500! You can get the same investment using ETFs at a fee of 0.07%.

Over 30 years, that extra fee would cost you around $200,000 on a $100,000 initial investment.

401k plan administrators are dominated by relics of old regulations, when mutual funds were still allowed to charge 10 different kinds of fees. The same regulations that were meant to help you invest your retirement money are now protecting absurd mutual fund charges in a broken system.

It's a simple problem, and it will be solved, soon. 401k plans will become automated, transparent, and standardized, with access to low-cost ETFs regardless of your employer.

4) Hedge funds will get open sourced (and hopefully, many will disappear).

Hedge funds have managed to continue to charge 20% of profits and 2% management fees for the past 30 years, while contributing net zero to society by definition. Because hedge funds are only in the business of making bets, someone always loses money whenever they make money. It's a zero sum game, except for the 22% of profits they skim off the top, which actually makes it a -22% game for the rest of us.

Interestingly, speaking as someone with experience in the hedge fund world, much of what they do is build algorithms and use technology to solve market inefficiencies. They spend lots and lots of money keeping their work secret, because it would be really easy just to replicate that same technology, which would continue to work just fine.

What if these walls got broken down, and financial technology got open-sourced just like the rest of the coding world? What if high-frequency trading were public knowledge, and everyone knew how to best keep trading costs down? What if these ideas just became coding libraries, open to all and continuously improved by financial engineers around the world? It could be the same as the move from Oracle and IBM to PHP and Python. It would make the investing world better off instead of a select few billionaires.

Hedge funds are a remnant of the closed, secretive companies of the past, desperately holding onto their intellectual property instead of embracing the new age of community and openness. It can't last forever.

5) At least one major new bank will become prominent, founded on technology and transparency.

This already happened a little bit with Simple, who cut out annoying fees, provided a good customer experience, and got a huge amount of momentum with that alone. But, they aren't major, and most people still haven't heard about them.

There's going to be a new bank that decides to do good, basic things for the world and becomes a household name.

They will pay people a real interest rate on their checking account, instead of 0.0002%. They will use technology to automate their systems so they can give people loans at reasonable rates with less paperwork, instead of forcing them to go to a place like Lending Club. They will eliminate the random assortment of client fees because they can make plenty of money in other ways just because they don't have some 60 year old legacy system and 10,000 employees using it.

It will force the other big banks to take notice, and it will be a breath of fresh air.

Those are my five bold predictions for 2025, and personally I can't wait for the new age to arrive. I'm tired of rich bankers and hedge fund managers who are holding the world back. It's time for finance to do some good in the world.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

"The bond market has ended its 30 year bull market."

"Interest rates have nowhere to go but up."

These are the themes of bond market commentary for the past year, and with good reason. Interest rates have been on a fairly steady decline since peaking in 1980, and now rest at their lowest point in nearly all of recent history. Yet if these predictions are absolutely true, why on earth is anyone buying or holding bonds anymore? Stranger still, why have long-term nominal bonds rallied nearly 20% year-to-date?

The long-term bond market is often misunderstood. With the interest rate trends of the past 30 years now on course to reverse, it is difficult to know what to expect. To help sort through all of the doomsday predictions and to better understand how bonds might perform when interest rates do begin to rise, we have gone back to study every major period of rising interest rates prior to 1982 to gain better insight.

In May of 1958, the Effective Federal Funds Rate ("Fed Funds Rate") was a measly 0.68%. It rose over the next 20 years to a peak of approximately 19% in July of 1981, as Paul Volcker used all the tools at his disposal to stamp out the worst period of stagflation in the United States in the past century. This provides an excellent retrospective for the absolute worst case scenario for long-term bonds moving forward, given it appears extremely unlikely that 19% interest rates are coming back anytime soon.

The results are almost certain to surprise you.

As a quick sneak peak, here's the total net performance of 20 year nominal bonds over this timeframe. This data is based on the monthly 20 year bond benchmark rate published by the Federal Reserve and uses the total return methodology published by Morningstar.

The overall return for this 23 year period was approximately 48%, or about 1.7% annually. More importantly, the results were far from consistent, as bonds both rallied and fell for different stretches throughout. We'll explore how this unfolded, and which implications are likely the most relevant for our immediate future.

Performance of 20 Year Nominal Treasury Bonds, May 1958 through January 1982

Period 1: The Recessions of 1958 and 1961

While the Recession of 1958 lasted only eight months, it prompted the Fed to reduce rates drastically, from 3.5% down to near 0.5% in less than a year. However, the downturn was relatively brief, and the Fed began rapidly tightening again in 1959, resulting in yet another recession beginning in April 1960. The economy reached its lows in February of 1961, and had returned to growth by 1962.

Our study begins at the low point of the Fed Funds Rate in May 1958, when it reached 0.68%. The yield on 20 year nominal bonds at that time was 3.17%. Rates peaked in January 1960, with the Fed Funds Rate hitting 4% and the 20 year bond yielding 4.42%.

Effective Federal Funds Rate vs. 20 Year Nominal Bond Yield, May 1958 through January 1962

What is immediately striking is how little the 20 year bond yield moved in relation to the short-term rate. The Fed Funds Rate moved up from 0.68% to 4%, a whopping 332 basis points, in about a year and a half. Yet the 20 year bond yield only moved up 125 basis points over the same period. This leads to our first key insight.

Insight #1: The long-term bond yield will not move in-line with short-term rate changes

This can be understood by examining the fundamentals of the bond market. The yield on a 20 year bond is basically a weighted average of the expected interest rates over the next 20 years, plus some risk premium to account for the long holding period of the bond. Basically, even if short-term rates rise to 3%, investors still take into account the likelihood that they will probably fall again in the future. This also explains why short-term rates can sometimes rise above long-term yields, which is an indication that the market is expecting rates to fall significantly within a few years.

How this applies today

The 20 year yield will change primarily due to long-term expectations about inflation and economic growth, which are only partly influenced by the actions of the Fed. It is not 'inevitable' that yields will rise significantly when the Fed begins raising rates.

Returning to the 60s, here is how the 20 year bond index performed over that time.

Performance of 20 Year Nominal Treasury Bonds, May 1958 through January 1962

It was surprising to see a mere 10% maximum loss, given that yields were up 125 basis points during that period. This loss was mitigated by the fact that bonds continue to pay interest over time, which eases the impact of increasing yields.

Insight #2: The effect of changing yields on bond returns will depend heavily on the speed of the changes.

In the case study above, interest rates rose over the course of about a year and a half. During that time, 20 year bonds paid about 6% in interest. Returns would have been much worse had yields changed by 125 basis points overnight, or much better had it taken longer.

How this applies today

The idea that rates are so low that they 'must go up' is too simplistic. The speed at which they rise will have a significant impact on the rate of return. If the outlook for the economy remains slow to moderate, interest payments may continue to provide a positive return in the meantime.

Meanwhile, it is also worth noting how quickly bonds recovered once another recession took hold in the middle of 1960. The overall return for this period was 1.18%.

Period 2: The boom of 1961 to 1969, the second longest expansion in history

Another recession would not hit the US for almost a decade. The expansion was so strong that the Fed Funds Rate reached over 9% in 1969, and interest rates were rising nearly throughout. In theory, this should represent close to a worst case scenario for bonds. Let's examine what actually happened.

Effective Federal Funds Rate vs. 20 Year Nominal Bond Yield, January 1962 through September 1969

Surprisingly, from 1962 through the end of 1965, long-term yields remained basically unchanged. They began at 4.10% but had only risen to 4.30% in October 1965. The economy provided steady, predictable growth - so predictable that the bond market saw little reason to change their overall outlook.

Insight #3: Bond market yields are based on expectations. If everything continues to go exactly as expected, yields may not change at all.

Even though short-term rates steadily rose through this 3 year stretch, long-term yields were little changed. The most likely explanation for this is that the rate hikes were fairly predictable, and happened as the market expected. The perceived 20 year horizon did not change significantly as this was occurring. It may have seemed that the economy would continue at a 4% nominal growth rate forever. It was only the threat of unexpected inflationary pressure in 1966 that prompted a re-evaluation.

How this applies today

The market already has expectations built-in for every Fed announcement over the next few years. Rather than focus on whether rates change, the focus should be much more intently on whether rates change in a way that is different than the market predicted. There is a real possibility that long-term yields do not change at all even as short-term interest rates move up.

Performance of 20 Year Nominal Treasury Bonds, January 1962 through September 1969

Bonds returned over 13% between 1962 and 1965 as rates remained steady around 4%.

By 1966, however, the strong growth of the past decade had begun to create a strong inflationary tailwind. The Fed began more aggressively increasing rates, only to back off again ahead as the economy headed towards another mild recession. However, it soon became clear that inflation was becoming a serious problem, and the Fed Funds Rate soared from 3.79% in July 1967 to 9.19% in August of 1969. Bond yields rose from 5% to 6.22% over the same period. However, the lessons from earlier in history held true: Bonds only lost about 10% from their peak, as the contraction extended over two years, and yields moved up significantly less than the short-term rate.

The total return of long-term bonds for the decade was about 5%. While this is certainly a poor return on investment, it is worth highlighting an emerging pattern.

Insight #4: The slow-changing nature of long-term interest rates, compounded with the receipt of coupon payments over time, mitigate the impact of bond losses in a bear market.

We have now observed two extremely bearish environments for bonds, but did not experience a loss of more than 10% in either. In fact, returns managed to be net positive from 1958 through 1969, even though the Fed Funds Rate went from 0.68% to over 9%.

How this applies today

The doomsday predictions for the bond market are likely overblown. While it would not be unexpected to experience a 10% loss in a given year, it would require a radical, sudden shift in the economic outlook to experience anything worse.

Period 3: Stagflation rears its ugly ahead, 1969 to 1975

The 1970s began a difficult era for the country. As the Vietnam War raged on and government spending increased, inflation persisted even as unemployment rose. The Fed was caught in a difficult trap, and wavered between combating the pressure on prices and stimulating the economy. OPEC added to the situation by quadrupling prices in the oil crisis of 1973. The US experienced a significant recession from 1973 to 1974, along with the crash of the Bretton Woods system and a dramatic devaluation of the US dollar.

Effective Federal Funds Rate vs. 20 Year Nominal Bond Yield, September 1969 through October 1975

Amidst this, long-term bond yields vacillated as well. As the Fed tried to stimulate the economy in the early 70s, yields dropped slightly. However, once the oil crisis hit and inflation continued to rage, yields began a steady upward trajectory, hitting 8.57% in September 1975. Though the Fed teetered back and forth amidst the recession, it became clear to the bond market that the inflationary pressures were unlikely to abate.

Performance of 20 Year Nominal Treasury Bonds, August 1969 through October 1975

Even amidst this disruption, bonds still managed a net 25% return over this stretch. Though yields went from 6.5% to 8.57%, the economic turmoil and low rate of real growth created an extremely choppy environment. As yields swung back and forth, bonds continued to pay a relatively high interest rate, which more than made up for the downward pressure on bond prices.

Insight #5: A period of unexpectedly high inflation often has a negative impact on the economy as a whole, depressing real growth and creating the risk of recession. This mitigates changes in the bond yield.

While inflation is typically associated with rising yields and bond losses, the broader macroeconomic picture must be taken into account. If inflation becomes a big problem, prices will be going up across the board while wages typically lag behind. This can cause a rapid decrease in real spending, and plunge the economy into a recession. Thus, even as long-term bond yields increase due to inflation, the possibility of low or negative real growth keeps the yield in check.

How this applies today

Inflation hawks speak in terms that are too absolute as it relates to the bond market. If the Fed has really created systemic inflation risk in the economy, stagflation may become a much bigger problem than rising yields, in which case, bonds would remain a better investment than stocks (in particular, inflation-protected bonds). A period of prolonged, steady growth, like the 60s, is likely worse for bonds than high inflation would be.

Period 4: The Volcker Effect and 19% interest rates, 1975 to 1982

Ah, the final frontier. Paul Volcker made a dramatic stand against inflation in 1979 and 1980, raising the Fed Funds Rate to nearly 20% to stamp out the vicious cycle once and for all. While his efforts were successful, he set the stage for the bond market bottom in 1981 which is so liberally referenced nowadays. If this stretch, then, is the absolute worst that could happen, let's see what's in store.

Effective Federal Funds Rate vs. 20 Year Nominal Bond Yield, October 1975 through January 1982

The Fed Funds Rate started at 5.82%, and ended at 12.37%. It peaked around 19% in June 1981. The 20 year bond yield started at 8.35% and ended at 13.73%, peaking at 15.13% in October 1981.

Performance of 20 Year Nominal Treasury Bonds, October 1975 through January 1982

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Don't worry, we'll zoom in a bit on the worst of this graph, but it is certainly worth pointing out that somehow, someway, net returns were still positive over this stretch. Of course, it is no mystery. From 1976 to 1979, yields were little changed. They started at about 8.35% and were barely changed by the end of 1978. Over this time period, they continued to pay interest. This is just another example of the economy moving sideways for a while, and bonds benefiting as a result.

Keeping that in mind, let's shrink the timeline to begin when interest rates took off near the end of 1979.The Fed Funds Rate nearly doubled by 1982, going from 10% to 19%, or a ridiculous 900 basis points. Bond yields went from 9.12% to a peak of 15.13%.

Effective Federal Funds Rate vs. 20 Year Nominal Bond Yield, April 1979 through January 1982

Performance of 20 Year Nominal Treasury Bonds, April 1979 through January 1982

This is likely a picture of about the worst bond crash in the past century. Bonds were off a little more than 17%, once in 1980 and then again in 1981. The first dip happened in about 10 months, one of the fastest bond crashes in history.

Insight #6: The worst bond crash in history happened over the course of 10 months and resulted in a net loss of 17%. It is extraordinarily unlikely that we will witness something worse in the near future.

This period represents a reasonable baseline for the worst that it could get. It is also worthwhile to frame what would have to happen right now to repeat such a scenario.

How this applies to today

Given yields are so low right now, they would have to change much less to result in the same 17% loss. At today's yield of approximately 2.90%, it would take a sudden rise of about 140 basis points, to 4.30%, over the course of 10 months.

We can return to the 50s to better understand what kind of change in the Fed Funds Rate might be expected alongside such a shift. The last time yields were at 2.9%, in 1955, the Fed Funds Rate was 1.64%. Yields did not hit 4.30% until the Fed Funds Rate rose to 4.0% in 1959, or a 236 basis point increase.

That means the Fed today would have to have cause to raise rates 9 times, in a 10 month period (assuming a 25 basis point increase per adjustment). It would take something extraordinary to witness such a move.

Summary: Applying these insights to today

The bond market experienced an extremely strong pullback over the course of 2013, only to recover just as strongly this year. With the insights from 1958 to 1982 in mind, we now have more context to evaluate this shift.

Effective Federal Funds Rate vs. 20 Year Nominal Bond Yield, April 2013 through October 2014

Performance of 20 Year Nominal Treasury Bonds, April 2013 through October 2014

20 year bonds experienced an unbelievably rapid rise in yields without any corresponding shift in short-term rates in 2013. Losing 10% in a matter of months, this crash was on par with historical periods when either inflation or the economy was booming. Expectations were building in an incredibly rapid, and rare, succession of rate hikes that ended up not materializing.

While some bond fears are justified, and there is certainly the possibility of losses again in the future, the market is likely overreacting to the current low interest rate environment. It took over 20 years for rates to reach a peak last time this happened, over the course of which bonds often had positive returns. Many different recessions and expansions occurred throughout, all of which provided different investment opportunities. Just as no one can ever predict the future, don't listen to anyone predicting the imminent demise of long-term bonds. They might not be the best bet for the next 20 years if rates are going to hit 19% again, but does that really seem likely?

Perhaps the only thing that seems certain is that in today's age of sensationalism, markets will probably continue to overreact. Judging by how bonds have performed since bottoming last year, each overreaction may simply present a new investment opportunity.

Hopefully this historical perspective can help you better evaluate the next bond rally or crash.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• The oil futures curve recently shifted from downward sloping to upward sloping
• This is an indicator that speculators and hedgers are no longer expecting prices to drop in the near term
• However, this cannot be relied on as a strong signal that oil prices have bottomed
• If the curve remains upward sloping, the costs of trading oil will increase significantly regardless of how oil performs

The shifting oil futures curve

As a quick refresher, the oil futures market provides a way of locking in oil prices now for some point in the future. It has become one of the most liquid markets in the world, and is heavily influenced by speculators betting on the direction of the price of oil. In the past two weeks, the futures market has experienced a major shift that deserves attention.

Since fall of 2013, the futures curve has been primarily "downward sloping", which means that the market is expecting prices to decline. For example, in August 2013, you could have locked in a 4% discount on the price of oil if you agreed to buy it four months later. This downward curve has persisted for the majority of 2014, and in hindsight, has proven to be an excellent predictor of the recent major oil correction.

You can more easily visualize the changing shape of the curve with the following data, which estimates the shape of the futures curve by comparing the price of the 4 month futures contract (you buy oil 4 months from now) to the price of the nearest oil futures contract (you buy oil within the next month). When the 4 month price is higher, the curve is upward sloping, and vice versa when it is lower. Data points have been collected monthly since 2000.

Historical shape of the oil futures curve

In the past two weeks, the shape of the curve shifted for the first time in over 10 months. Futures prices are now slightly more expensive than the spot price across the board. Many will point to this as a sign that the oil market is bottoming - but can this be considered a reliable indicator?

How good are the speculators at predicting the market?

The shape of the oil futures curve at any point is basically the summation of all the bets on the market. However, this 'net bet' is only the outcome of an extremely complex set of factors, and like any bet on the market, there are always people on both sides. Still, if the majority is betting in one direction, it is worth analyzing how often it has been correct.

To get a sense of this, we have compared the shape of the futures curve (shown above) to the following 12 month performance of the price of oil.

Shape of the futures curve (X-Axis) vs. 12 month oil price performance (Y-Axis)

The futures curve has basically been 'correct' whenever both the X and Y values are directionally the same. A trendline has been added to show that there is indeed some predictive power here. As the futures curve gets more positive, oil tends to perform better over the next year. However, this trendline is not particularly strong, which you can see by the massive scattering of data points. In fact, the futures curve has been 'incorrect' about 40% of the time (i.e., the data points in the top-left and bottom-right of the scatterplot).

Another observation worth noting is how much more random the data points become when the futures curve is roughly flat (i.e., the X-values around 0%). The most likely explanation for this is that a flat futures curve means the market is basically split down the middle, and there is no consensus for what oil will do over the next year. Unfortunately, that is right around where we are today.

While it may be true that the market consensus is 'less bearish' now than it was over the past year, there is little reason to consider this a sign of an imminent recovery.

When will the futures curve matter?

While the current state of the futures curve provides little indication on the direction of oil prices, it is worth observing carefully over the next few months. The key is to track whether the 'net bet' becomes heavily bullish again, at which point its predictive power would increase significantly. This becomes more obvious if we highlight only the areas of the previous graph where the futures curve has been upward sloping by 5% or more.

If you'd like to keep track of this on an ongoing basis, you can find updated information on the current state of the futures curve here.

Oil trading strategies may become much more expensive

Regardless of the future direction of oil prices, the shape of the oil futures curve has immediate implications for your trading strategy. If the curve remains upward sloping, any oil ETF holding futures contracts will begin paying a premium every month, since it has to buy contracts that are more expensive than the spot price of oil. This will be especially impactful for the popular United States Oil ETF (USO) and iPath S&P GSCI Crude Oil ETN (OIL), but will also impact others, such as the PowerShares DB Oil ETF (DBO) and United States 12 Month Oil ETF (USL).

This is a particularly difficult situation because trading oil is becoming more expensive just as the market is becoming more bullish. However, there are alternative trading strategies to help mitigate this issue, which are discussed more in-depth here.

Conclusion

While the oil futures curve has been shifting radically the past few weeks, it provides little information as to the future of oil prices. However, you may need to reconsider your trading strategies if you plan on continuing to get exposure to oil, or the futures curve will start costing you a hefty premium.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Summary

• The Fed officially just ended its bond buying program, marking the close of a financial era.
• With the bull market now in its 6th year, stocks may struggle to continue their run without the Fed's help.
• Many significant warning signs are signaling an oncoming bear market.
• There are smart steps you can take to better hedge your portfolio.

1) There have only been 2 longer bull markets in recent history

Beginning in January 2009, this bull market is now in its 71st month. Only two bull markets have lasted longer in the past century, during the 1920s and the 1990s.

2) Price-to-earnings ratios are approaching 2006 levels

The widely-recognized "Shiller-PE" ratio compares average inflation-adjusted earnings from the previous 10 years to the current price of the S&P 500. This helps to smooth out variance over time caused by natural fluctuations in the business cycle. The current level of the Shiller-PE of over 25 is near that of 2006 and well above the mean of 16.5. While this does not indicate an imminent collapse, history would suggest that the stock market may not be the best investment for the next ten years.

3) The Fed is removing the punch bowl

Effective Federal Funds rate

Interest rates have been at historic lows for the past five years. The Fed just stopped their bond buying program altogether. This has created a sensational environment where stocks are one of the only reasonable investment options. Moving forward, however, the market faces a cruel double-edged sword. Strong growth will prompt the Fed to begin raising rates, causing investors to demand higher returns and businesses to cut back. Weak growth will threaten corporate earnings and spark worries about another recession. Either way, stocks may fall.

4) The worrying volume of recent rallies

October was a rollercoaster ride for the markets. While most of the losses have been offset here at month end, the gains have occurred with relatively light trading volume. This suggests that the major players aren't the ones buying.

5) Global growth is teetering

As recently studied by Larry Summers, India and China may be on the brink of a major slowdown. China has experienced a 32-year streak of extremely rapid growth, perhaps one of the longest streaks in all of history. Its economy is supported by approximately six trillion dollars of 'shadow debt', which may eventually create major systemic issues. While the US may not be the primary source of the next global slowdown, it would still certainly be a victim of the ripple effect.

How to Protect Your Portfolio

The two most likely scenarios for the economy are a rising interest rate environment with moderate growth, or a continued global slowdown which carries the risk of another recession. Unfortunately, US stocks face an uphill battle in both cases. If the Fed begins to raise rates, it will be a drag on both stocks and bonds. If rates remain low, it will probably only be due to a poor overall economic environment.

If you are seeking alternatives for your portfolio, you may want to consider a few contrarian investment options. When the Fed does raise rates, it will probably be on the heels of stronger growth and higher inflation. In that environment, Treasury-Inflation Protected Bonds (TIPS) can help keep you safe from the rising price level, and commodities like gold and oil may outperform due to a weaker dollar and stronger demand. On the other hand, if a significant slowdown occurs, investors may flee back into the safety of Treasury bonds, sending interest rates down yet again. Since it is unclear how the future will unfold, it may be wise to hedge your portfolio with some or all of these investments for the time being.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.