Are you prepared for the storm season?
posted on June 17th, 2015 by Bellmont Research Team
I was driving past Bunnings on the weekend in torrential rain and gale force winds when a sign caught my eye. “Storm Awareness Week – are you prepared for storm season?.” Too little too late. As we enter storm season it is also a good reminder for investors to prepare and ask themselves, what will happen if the market falls significantly? When we are not prepared we end up scrambling to try take care of an unplanned situation which usually results in poor decision making.
For those who are clients of Bellmont or frequent readers of our material you are aware that we are big believers in adopting a systematic approach to our investment selection. This systematic approach avoids the common cognitive biases that affect most investors, ultimately detracting from their performance (to read more on this please click here). It also allows our strategies to be rigorously tested, enabling a far better understanding of its risk and return characteristics. As a result we do not try time the market and we will remain fully invested even during periods of significant falls.
I will however recap briefly our stock selection process. We have developed an entirely systematic way to construct a diversified, blue-chip Australian equities portfolio, with a high degree of correlation with the ASX200 Index, yet with a distinct value bias – allowing us to profit from the well documented benefits of the ‘value effect’ (read more about the value effect here).
Focusing on the key valuation metrics most commonly examined in the academic literature (Price to Earnings, Price to Sales, Price to Book and Dividend Yield), we generated an adjustment factor that could be applied to market-capitalisation weightings, to systematically adopt over-weight positions in stocks that were trading at below average valuation multiples, and under-weight positions in stocks trading at above average multiples. That is, buying less of stocks that are overpriced and buying more of stocks that are underpriced. For example we are currently underweight the Australian banks compared to the ASX200 index.
The first point to make is that when markets fall so will the value or our portfolios. As long term investors we are comfortable with this. We understand markets will go up and down and no one is able to predict when markets will fall. However through our systematic approach of adopting over-weight positions in stocks that are trading at below average valuation multiples, and under-weight positions in stocks trading at above average multiples, the portfolio naturally provides a small cushion of protection during weak markets. This is because overpriced stocks will fall greater than underpriced stocks during periods of depressed markers. During testing of our portfolio we were able to examine all the negative years of return for the ASX200 over the past 20 years. As you can see in the table below each negative year the portfolio was able to provide a cushion of protection compared to the underlying market.
|Year||ASX200 Accumuation Index*||Bellmont Core Equities||Difference|
*The ASX200 Accumulation Index (XJOAI) is the ASX200 Index including dividends.
I must stress that as long term investors we must put negative years into perspective. Anyone who views this numbers just by themselves would never invest in shares. When we zoom out an examine the past 20 years adopting this systematic approach the return has been an exceptional 13.58%.
|Average Return (1994-2013)|
|Bellmont Core Equities Portfolio||13.58%|
|ASX 200 Accumulation Index||10.59%|
The above results are based on testing using Factset. Inception date is March 2014
For investors with lower risk tolerance we do offer a protected portfolio, the Bellmont Buy-Write Portfolio. As in the section above I will not cover a complete breakdown of the research and academic material behind our portfolio, this information is presented on our website here & here.
By combining a diversified blue-chip Australian share portfolio with a buy-write overlay, the Bellmont Buy-Write Portfolio is able to generate equity-like returns, but with far lower volatility and downside risk. We implement a conservative strategy using index options (read more here) that swaps the possibility of ‘blue sky’ returns in any period, for the certainty of regular premium income – serving to reduce overall volatility and significantly decrease downside risk. This will reduce our returns in strong markets but provide significant protection in negative markets.
The impact of this strategy is best understood by examining how the portfolio performs in a neutral, bull & bear market.
|Performance Measures||Bull Market|
|Annual Mean Return||32.21%||26.31%|
|Annual St. Deviation||14.00%||11.33%|
|Annual Mean Return||5.32%||6.32%|
|Annual St. Deviation||13.84%||11.40%|
|Performance Measures||Bear Market|
|Annual Mean Return||-35.28%||-12.02%|
|Annual St. Deviation||31.53%||24.41%|
In bear markets the portfolio recorded an annualised fall of only -12.02% in exceptionally weak and volatile markets, compared with -35.28% for the benchmark index. It is this protection that provides investors with significant protection & peace of mind regardless of market conditions.
We have designed the Bellmont Buy-Write Portfolio & the Bellmont Core Equities Portfolio in a manner that allows for investors to seamlessly switch between the two. Allowing investors to alter their investment based on their risk tolerance.
Given that both portfolios have the same underlying shares (with the difference being the options overlay) investors can switch between portfolios to protect themselves from an anticipated falling market by moving to the Buy-Write, or expose themselves to more upside by moving into the Core Equities portfolio. Switching is virtually cost free and since the portfolio of shares does not change, there are small – if any – tax consequences (There may be a very small sale (0%-5%) of shares when moving to the Buy-Write as it holds a small cash buffer.)
As long term investors we are comfortable in knowing that there will be periods of uncertainty. If we keep our focus on the bigger picture then our reward will be with our patience and disciplined decision making. We also also comfortable in knowing that our systematic stock selection and the use of our protected portfolio will reduced risk and provide protection in volatile markers. As investors we cannot predict when the next storm will come. What we can do is ensure that we are prepared, rather than having to scramble to Bunnings at the last minute!