With the on-again/off-again conflict in the Middle East, a reader asked:
Does anything offer better downside protection than U.S. bonds?
For most of my investment career, I didn’t think so. I believed that U.S. bonds were the ultimate form of downside protection. While you might own multiple kinds of risk assets (e.g., stocks, real estate, etc.), I always thought that all you needed for the non-risk side of your portfolio was U.S. bonds and cash.
This recommendation is not unwarranted. For decades, U.S. Treasuries have been considered the gold standard (no pun intended) for short-term capital preservation. This explains why Warren Buffett now owns 5% of all outstanding T-Bills.
But recent history has tested this assumption. In 2022, as interest rates surged, the iShares 20+ Year Treasury Bond ETF (“TLT”) dropped by nearly 30%! When you combine this with Moody’s recent downgrade of the U.S. government’s credit rating, you can see why I’m starting to question the ultimate safety of U.S. Treasury bonds.
These developments raise a few important questions: Are U.S. bonds still the best form of downside protection? Or should we consider other assets within our portfolios to hedge against future market corrections?
I will answer all of these questions (and more) in this post. To start our journey, let’s examine non-U.S. bonds and how they can help keep your portfolio safe.
Non U.S. Bonds?
When it comes to downside protection, non-U.S. bonds seem like the natural next choice for hedging our portfolios. An analysis by Alliance Bernstein found that:
Over the 30 years ending August 31, 2023, the Bloomberg Global Aggregate Index (hedged into US dollars) posted an average annualized return of 4.8%, versus 4.6% for the Bloomberg US Aggregate Index. And it did so with less volatility.
Non-U.S. bonds slightly outperformed U.S. bonds over this period because they did well when U.S. bonds did well, but didn’t perform as badly when U.S. bonds declined. As the chart below illustrates, hedged global bonds captured 86% of the upside of U.S. bonds but only 66% of the downside:
As a note, these hedged bonds counteract any of the currency risks associated with investing in non-U.S. bonds. So even if you are worried about the Euro or the Yen collapsing, you can still own non-U.S. bonds without taking such risks.
When we look at the returns of various non-U.S. bonds over time (hedged to USD) we can see that no single country dominates (table from Alliance Bernstein):
This is why owning a basket of global bonds can work wonders for helping you protect on the downside.
Unfortunately, the real difficulty with investing in non-U.S. bonds is finding a way to own them. For U.S. investors, buying individual foreign bonds is either cumbersome or not allowed. Therefore, the only real solution is to invest in a non-U.S. bond fund (hedged to USD).
I won’t name tickers, but you can find non-U.S. bond funds that have diversified exposure to developed and emerging market bonds in various maturities. I prefer short to intermediate-term bonds (whether U.S. or foreign) because the risk-reward ratio has been much better historically. But you should do what works for you.
No matter what kind of non-U.S. bonds you own, their prices will still be sensitive to changes in interest rates. This is known as duration risk and is the primary challenge of holding bond funds (whether U.S. or non-U.S.) over time.
The only other challenge of owning non-U.S. bonds (compared to U.S. bonds) is the increased credit risk. Though there are still 11 countries with a AAA credit rating, none of these countries own the printing press for the world’s reserve currency. This is a privilege strictly reserved for the United States…for now.
As a result of this privilege, the U.S. government has the ability to pay off its debt at any time by printing all the dollars it wants. While this would likely cause hyperinflation, it’s something that the U.S. government can do that other governments cannot.
Now that we’ve looked at how non-U.S. bonds can help protect against the downside, let’s consider another possible downside protector—gold.
Gold?
Gold has been valuable to humans for thousands of years, with its purchasing power holding up better than many realize. As William Bernstein once wrote:
…an ounce of gold bought a fine men’s suit in the time of Shakespeare, and so it does today.
While gold is able to keep its value over long periods of time, is it also a good diversifier when equities crash?
Generally, yes. Over long periods of time, gold’s correlation with U.S. stocks has been near zero (see here and here) along with this chart from Gavekal Capital:
Over the past few decades, however, gold has generally done well when U.S. equities declined. In 2008, gold had a positive return and in 2022 it was basically flat on the year though equities were down around 20%. In late 2018, when the S&P 500 crashed by 19%, gold was up nearly 7%:
The only problem with gold as a diversifier is that it goes through very long periods where it underperforms. Sometimes significantly so.
Though the S&P 500 was down by 19% in late 2018 and gold was up nearly 7%, if we look over a longer time period, gold doesn’t look quite as attractive. Because in December 2018, though gold was up from October of that year, it was still in the midst of a 35% drawdown from its 2012 highs:
Unfortunately, holding gold as a long-term asset class is a challenge all its own. As I previously stated:
From 1981 it took 32 years before gold was back at its all time high, adjusted for inflation.
Looking at a plot of gold’s drawdowns from 1974 to 2024, we can see this more clearly:
Though gold is performing well right now, this is one of the rare times where it does so. Most of the time, it’s in a double-digit drawdown! For this reason, I gave up on owning gold (in any significant size) many years ago. However, over time it’s been harder for me to deny gold’s diversification benefits.
Ultimately, if you can accept that gold is a terrible asset class on its own, but can work wonders in a portfolio, then it might just be the right downside protector for you.
Now that we’ve examined the role of gold as a downside protector, let’s turn our attention to managed futures.
Managed Futures?
Managed futures are an active management strategy that trades future contracts across a wide variety of asset classes including: equities, bonds, currencies, and commodities. Many of these strategies rely on trend-following models to determine when to buy and sell out of their underlying asset classes.
Managed futures have gained popularity in recent years among individual investors for two reasons—low correlation and increased access.
On the correlation front, managed futures tend to have a low (or negative) correlation with most traditional asset classes. For example, from 1990 to January 2018, the Barclays CTA Managed Futures Index had a correlation of -0.1 with the S&P 500 and a correlation of 0.24 with the Hedge Fund Composite Index (according to Morgan Stanley):
More importantly, these correlations tend to go negative during equity bear markets, meaning that managed futures usually perform well as stocks crash. The Hedge Fund Journal noted how this was the case during the two equity bear markets of the 2000s:
I looked at the performance of a popular managed futures ETF (DBMF) starting in 2022 and found the same pattern. This ETF did quite well as equities crashed, but started to underperform as equity markets recovered in the years after:
Besides providing “crisis alpha”, managed futures strategies have become more accessible with the launch of many managed futures ETFs in recent years. Before the managed futures ETF boom, individual investors had to rely on commodities trading advisors (CTAs) or hedge funds to get access to such strategies. These managed futures options were quite expensive relative to the cheaper ETF alternatives that exist today.
Nevertheless, managed futures ETFs are still some of the most expensive ETFs on the market. The typical expense ratios of such funds are in the 0.85%-1.0% range. Additionally, some critics argue that as more money flows into managed futures strategies, their ability to deliver outsized returns during crises may diminish in the future.
The only other gripe I have with managed futures is that they are quite complex and opaque for the typical individual investor. One of my rules for owning an investment is that I have to understand how it generates its return. And though I have some understanding of how these strategies work, they are far more complex than I am comfortable with.
As a result, I tend to pass on managed futures despite some obvious benefits. If you want to learn more about managed futures, I enjoyed this post which analyzed a couple ETFs in the space.
Now that we’ve done a brief review of managed futures, let’s look at our final downside protection asset class—tail risk and long volatility funds.
Tail Risk/Long Volatility?
Unlike managed futures, which try to make money in every market environment by following trends, tail risk/long volatility strategies only try to make money when the world is going to hell. And since the world has almost gone to hell a few times in the last few years (2020, 2022), these strategies have received a lot more attention as a result.
For example, at the market bottom in March 2020, the Cambria Tail Risk ETF (TAIL) was up 30% as the market was down around 30%:
These funds do so well by buying out-of-the-money (OTM) put options on various indices. So, by construction, when markets fall, these tail risk ETFs rise as their put options get closer to being in-the-money. Owning tail risk ETFs is a bit like paying for fire insurance on a house that’s never caught fire. If it ever does, you’ll get paid out, but you pay premiums along the way.
The problem with tail risk ETFs is that they underperform in all other circumstances. As Zachary Evens at Morningstar noted, these funds are likely to underperform in the long-term:
Since extreme market crashes are rare, these funds spend the vast majority of their time underperforming while they wait for a market crisis to strike.
While tail risk ETFs do provide downside protection, this is more than offset by the extended periods where such protection was not ultimately needed. But this brings up a bigger question about the real purpose of downside protection in the first place.
When Downside Protection Goes Too Far
Every investor’s dream is a portfolio with maximum upside and no downside. Unfortunately, such portfolios aren’t the reality for individual investors. Unless you are Ed Thorpe or Jim Simons, you will have periods where you lose money. And as much as I want you to employ every downside protection strategy available, doing so will likely cost your portfolio growth over the long run.
Tail risk ETFs illustrate this better than anything. You can avoid every future drawdown by being long volatility, but then you will inevitably lag behind the market in all other periods.
If you want return, you have to take risk.
There is no avoiding this universal truth of investing. So while you may employ one (or more) of the strategies discussed here to limit your future downside, keep in mind that the possibility of downside is how we earn our long-term returns in the first place.
Of course, if downside protection helps you sleep better at night, that might be worth a few basis points. The key is knowing what you’re paying for such protection and whether it’s worth the cost.
Happy investing and thank you for reading!
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This is post 456. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data
