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Perspective

Improving Portfolio Correlation & Asset Allocation with Hedged Equity

Executive Summary

During periods of heightened market volatility, like we are experiencing now, it is important to have a portfolio that can reduce drawdowns but also participate in market rallies. Portfolios that fail to reduce drawdowns tend to lead to situations where investors sell at inopportune times, missing out on market rebounds and leading investors to significantly weaker overall performance. It is often assumed that having a well-diversified asset allocation will serve as a dampener to market stress, reducing painful drawdowns. However, we believe this assumption is misguided. Our recent research indicates that it is more important for investment policies to outline a program of correlation management vs. portfolio diversification, and that hedged equity strategies are key to managing correlation.

Our Key Research Findings:

  • The performance objectives set forth in standard financial planning and the actual performance can significantly differ from expectations. The benefits of diversification with multiple asset classes don’t always succeed in making a portfolio better diversified. Standard diversification is based on the premise that beta and correlations stay close to their long-term average values. Not only is this a weak assumption, but it is also a major contributor to the failure of standard allocation during periods of increased market volatility.
  • The notion that a properly diversified asset allocation is a traditional 60/40 or 70/30 portfolio, etc. is potentially flawed (see Figure 1). An appropriately diversified portfolio should have an allocation that reduces drawdowns while maintaining upside capture by properly managing correlation. At first glance, a hedged equity strategy may look like a return dampener, in a blended portfolio looking for resiliency, it is not. This is because hedged equity strategies, such as ours, allow portfolios to increase allocations to higher beta and higher expected return allocations (e.g. private market vehicles and concentrated strategies). We also find that once the initial equity declines occur, the optionality and put position monetization of hedged equity allows for outperformance, even as the equity market starts recovering.
  • To have diversification that benefits a portfolio, an investor should seek to reduce correlation to equity and increase correlation to volatility (VIX). Conceptually, in the same way that hedged equity strategies manage correlation in market stress events, there are opportunities to take advantage of beta expansion and increasing correlation to equity when markets rise, potentially adding to portfolio performance. Results show that any approach that can provide dependable correlation patterns to equities and standard diversified allocations, but can also respond positively to VIX increases, are a potentially beneficial addition to a portfolio.
  • Significant market declines show diversification’s tendency to not always work as intended. The combination of a volatility increase (VIX spike) versus equity declines clearly impacts the level of return improvement. Interestingly, the defensive characteristics of hedged equity strategies like ours, however, remained in place providing a lower degree of correlation as declines ensued. We believe that makes the case for consistent hedge positioning versus tactically hedging. One cannot know when events will occur, so maintaining consistent positioning is a key component to diversification.

Conclusion:

Many have felt for decades that diversification was portfolio management’s universal answer and that if a portfolio is diversified with a mix of asset classes, e.g., bonds, stocks, commodities, investors will be able to avoid significant drawdowns associated with market stress. That, however, as we have found in our research, is not necessarily the case. A well-diversified portfolio, as outlined above and in the whitepaper, can still lead to increased equity correlation during periods of market drawdowns, when investors want it least. A prudent program of correlation management, with a hedged equity strategy, which decreases correlation to equity in periods of rising volatility and increases correlation as markets rise, may prove highly effective at accomplishing one’s investment objectives in turbulent times like these.

Figure 1: The 60/40 Portfolio vs. S&P 500 TR Drawdowns

Glossary:

Beta: A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Upside Capture Ratio: A statistical measure of an investment manager’s overall performance in up-markets. The up-market capture ratio is used to evaluate how well an investment manager performed relative to an index during periods when that index has risen.

VIX: The Cboe Volatility Index (VIX) is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 index (SPX). Because it is derived from the prices of SPX index options with near-term expiration dates, it generates a 30-day forward projection of volatility.

Volatility: The amount and frequency with which an investment fluctuates in value.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund. This and other information is contained in the Fund’s prospectus, which can be obtained by calling 888-814-8180 and should be read carefully before investing. Additional Fund literature may be obtained by visiting www.EasterlyFunds.com.

Past performance is not a guarantee nor a reliable indicator of future results. As with any investment, there are risks. There is no assurance that any portfolio will achieve its investment objective. Mutual funds involve risk, including possible loss of principal. The Easterly Funds are distributed by Ultimus Fund Distributors, LLC. Easterly Funds, LLC and EAB Investment Group, LLC are not affiliated with Ultimus Fund Distributors, LLC, member FINRA/SIPC. Certain associates of Easterly Funds, LLC are registered with FDX Capital LLC, member FINRA/SIPC.

Risks & Disclosures:

The Fund will borrow money for investment purposes. Leveraging investments, by purchasing securities with borrowed money, is a speculative technique that increases investment risk while increasing investment opportunity. Derivatives may be volatile, and some derivatives have the potential for loss that is greater than the Fund’s initial investment. If the Fund sells a put option, there is risk that the Fund may be required to buy the underlying investment at a disadvantageous price. If the Fund purchases a put option or call option, there is risk that the price of the underlying investment will move in a direction that causes the option to expire worthless. The Fund’s ability to achieve its investment objective may be affected by the risk’s attendant to any investment in equity securities.

Shares of ETFs have many of the same risks as direct investments in common stocks or bonds. In addition, their market value is expected to rise and fall as the value of the underlying index or bonds rise and fall. It is possible that the hedging strategy could result in losses and/or expenses that are greater than if the Fund did not include the hedging strategy. The use of leverage by the Fund or an Underlying Fund, such as borrowing money to purchase securities or the use of derivatives, will indirectly cause the Fund to incur additional expenses and magnify the Fund’s gains or losses. Because a large percentage of the Fund’s assets may be invested in a limited number of issuers, a change in the value of one or a few issuers’ securities will affect the value of the Fund more than would occur in a diversified fund.

The opinions stated herein are that of the author and are not representative of the company. Nothing written in this commentary or white paper should be construed as fact, prediction of future performance or results, or a solicitation to invest in any security.

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