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Any good investor should be aware of how potential market corrections could affect their portfolio. If your portfolio is rich in stocks, find out how much you are truly prepared to incur up to 20% in unrealized losses in the short term.
Sometimes getting high returns doesn’t mean chasing performance, but rather hedging your bets. Minimizing portfolio volatility and mitigating those heartbreaking losses can dramatically increase your returns.
Do bonds still work?
The conventional wisdom for many Canadian investors has been to purchase a global bond exchange traded fund (ETF) to complement their equity portfolios. Usually you start with a lower allowance and increase that amount as you get older and get closer to retirement.
A higher allocation to bonds produces lower returns, but reduces portfolio volatility and protects your portfolio in the event of a crash. However, this has not always been the case. During the COVID-19 crash in March 2020, Canadian aggregate bond funds again suffered drawdowns of more than 5%.
While not as bad as the -20% losses suffered by stock indexes, such a loss in an asset perceived to be “safe” can nonetheless leave investors feeling psychologically shaken and vulnerable to panic.
The power of negative correlation
To find the best suitable coverage, we want to look for assets that do two things:
- Trending upward and producing intrinsic value in the form of capital gains or income.
- Have a negative correlation to the stock market.
Your best bet here is BMO Long Federal Bond Index ETF (TSX: ZFL). This ETF contains bonds issued by the Federal Government of Canada with a maturity of +20 years and is as safe as possible with regard to credit risk. It currently has a negative correlation of -0.23.
The best collision protection
We want long-term federal government bonds because they are more volatile than short-term bonds, have no risk of default compared to corporate bonds, and have the highest negative correlation with the stock market. Therefore, they can act as a reliable “counterweight” when stocks go down.
When a crash occurs, investors sell risky assets like stocks and buy safe assets like government bonds – a phenomenon known as the “flight to quality”. This pushes up the price of bonds sharply. We can then sell the bonds at a profit and rebalance our stocks, essentially selling high and buying low.
The following image shows the performance of ZFL vs. IShares S & P / TSX 60 ETF (TSX: XIU) from 2011 to 2021. We find that although the two assets tend to increase over time and have a positive return, they do not always move together. In particular, the value of ZFL has risen sharply on several occasions when XIU has collapsed.
How to build a resilient portfolio
The lesson here is that holding different types of volatile, but uncorrelated, assets actually reduces the overall volatility of the portfolio while increasing risk-adjusted returns. Let’s take a look at the performance of a quarterly rebalanced 80/20 XIU / ZFL portfolio versus a 100% XIU portfolio from 2011 to 2021 to see how it works:
The 80/20 portfolio had much less volatility (standard deviation of 8.80% vs. 11.19%), a lower max drawdown (loss of -15.54% vs. -20.23%) and a return adjusted to higher risk (Sharpe ratio 0.80 vs. 0.68).
Despite the slightly lower CAGR of 7.45% vs. 7.85%, the 80/20 portfolio had a much smoother ride. Over many market cycles, this translates to better peace of mind, more stable returns and less volatility.
Madness to take away
Long-term federal government bond funds like ZFL are great sources of diversification for your portfolio. Its negative correlation with the stock market and positive expected returns can add a layer of protection.
The main risk of this strategy is rising interest rates. Bond prices are inversely related to interest rates, and their degree of fluctuation depends on their duration. Therefore, long-term government bonds like ZFL may lose more value when interest rates rise.
However, it’s important to remember that we consider the ZFL to be crash protection. In a liquidity crisis, there is no better safe haven than long-term government bonds. Investor behavior during corrections should ensure that our hedge increases in value, allowing us to sell it and buy cheap stocks at a discount.