Beta –
Using a Synthetic Cash
Alternative To Play Defense
Gritting your teeth and hanging on to your stocks through the worst declines of a bear market isn’t for everyone, but Wall Street’s standard approach to reducing downside pain for equity investors is flawed. There’s a better way to play defense while still being able to transition to offense: Synthetic Cash.
Typically, global investment managers deploy two techniques to protect stock portfolios against downside risk in the markets. The first is hedging with futures and options contracts, and the second is holding large cash positions.
If you get the timing right, raising cash to protect against a market drawdown can look brilliant. But if you’re going to time the market, you’ve got to be right two times: When you sell and when you buy back in. Whipsawing markets that dramatically shift between favoring either risk-on or risk-off stances increase the potential to be caught out of position. In such environments, holding either too much or too little in cash can create a substantial lag vs. a traditional benchmark that is always 100% invested in equities. Missing out on just a few of the market’s best days can have a material impact on your portfolio’s long-term value.
The use of futures and options contracts can avoid the risks inherent in timing the market. But such contracts carry heavy transaction costs and often require the use of margin borrowing. The costs of maintaining a desired position are complex to calculate and may spike in times of market stress. For most investors, this approach is highly inappropriate and can actually increase potential risks when the intent is to reduce them.
There is a better way to manage risk: Alter the beta of the underlying constituents that make up the portfolio. And that’s the approach the investment team at Polaris is taking.
We’re deploying an investment management technique that is backed by research to help protect and advance clients’ assets in both volatile and growing markets—creating a synthetic cash position by manipulating portfolio beta. We have employed this risk-adjusted approach to portfolio management across various market cycles and market conditions in our Polaris Focused Strategies.
Creating Synthetic Cash Positions
Our research shows that creating a synthetic cash position can provide an added layer of safety during declines. But how? And what does that really mean?
First off, let’s explain what we mean by synthetic cash. The use of synthetic cash involves repositioning portions of an overall investment portfolio into stocks with historically more defensive attributes. Taking such measures aims to provide similar advantages as selling out and moving to cash—mitigating downside risk—while also reducing the potential outsized impact of not being fully invested when markets dramatically rebound. When employing synthetic cash, a portfolio manager is attempting to reduce overall portfolio risk, or as we know it in the industry, beta.
Beta is the measure of a stock or a portfolio’s volatility compared to the market. A portfolio with a beta of 1.5 can be expected to move 1.5x in the direction of the market, either up or down. The chart below illustrates a situation where three portfolios each experience three consecutive quarters of 10% declines until a market bottom. As you can see, lower-beta portfolios better protect client assets during a sell-off:
- Portfolio 1 with a Beta of 1 moves down with the market, and at market bottom it requires a return of 37% to break even.
- Portfolio 2 with a Beta of 1.3 moves down with 30% more velocity than the market and requires a return of 52% to break even.
- Portfolio 3 with a Beta of 0.7 moves down with 30% less velocity (a 30% synthetic cash position) than the market and requires a return of 24% to break even.
Raising 30% cash in a portfolio provides similar downside protection as Portfolio 3. But cash has a beta of 0. It will not participate in market upside. Remaining fully invested or nearly fully invested while employing synthetic cash for a portion of the overall portfolio enables the portfolio’s journey to breakeven to begin more quickly. Lowering risk in the portfolio without the use of traditional cash also provides our clients with the opportunity to collect larger dividend payments and benefit from the power of compounding.
Sounds good on paper. Does it work in the real world? It does. On the following pages, we compare a high-beta S&P 500 portfolio, a low-beta (low-volatility) S&P 500 portfolio and the S&P 500 during significant market declines. The results speak for themselves.
Historical Context
Tech Bubble: From the bursting of the tech bubble in April 2000 to the market trough in October 2002, despite what otherwise proved to be an extremely perilous environment for investors, the S&P 500 Low Volatility TR Index gained nearly 16%. Over that period, the S&P 500 fell by nearly half (down 47%) and the high-beta version of the index dropped by 79%.
The Great Recession: Unlike when the tech bubble burst in 2000, the Great Recession provided equity investors with nowhere to hide, as every sector of the S&P 500 posted negative returns throughout this period. However, as you can clearly see below, while the S&P 500 fell 54% from peak to trough and the S&P 500 High Beta TR Index lost nearly 80% again, the S&P 500 Low Volatility TR Index fell just 38%—that’s still a rough decline, but it’s a more palatable loss from which to recover.
U.S. Credit Rating Downgrade by S&P: 2011 provided investors with a lesser-known financial crisis, as Greece required substantial help from the European Union to stave off defaulting on its debt and the United States received its first credit downgrade in history by Standard & Poor’s (long-term U.S. debt was reduced from a rating of AAA to AA). During this period, the S&P 500 tiptoed close to the bear market threshold, with declines near 20%. At the same time, once again, low-volatility stocks offered a significant measure of relative safety, as the S&P 500 Low Volatility TR Index lost less than 6%. Conversely, the higher-risk S&P 500 High Beta TR Index lost more than twice as much as the S&P 500 itself, with a loss of 39% in just a few short months.
US Inflation Surge: From the beginning of 2022 to June (the bear market low thus far), the S&P 500 Index posted a decline of more than 22%. Somewhat surprisingly, the S&P 500 High Beta TR Index posted returns that were only marginally worse (though still bad), falling 26%. Lower-volatility stocks once again fared better during broad market declines, with a much smaller loss of less than 14% for the period.
By now, our point should be abundantly clear: Using lower-volatility stocks as a synthetic cash component during adverse market environments can go a long way toward preserving wealth. We should note that adjusting a portfolio’s beta can also be beneficial at other points in a market cycle. Targeting an overall portfolio beta of greater than 1—that is, taking on more risk than the market—can generate significant outperformance coming off a market bottom. There may be no better nor more extreme example than that of April 1, 2020 through March 31, 2021.
The Great Recovery: Coming off an unparalleled COVID-induced market decline during the first quarter of 2020, the markets rallied dramatically over the following 12-month period, with the S&P 500 up more than 56%. While that sounds extremely impressive, you may be shocked to learn that the S&P 500 High Beta TR Index generated an incredible 12-month return of greater than 140%. Conversely, the S&P 500 Low Volatility TR Index only managed a paltry return of 26%.
Conclusion
Polaris’ research allows the investment team to track global markets and shifts in risk sentiment across a broad range of asset classes. Our proprietary quantitative signaling systems are a valuable tool helping our portfolio managers decide when to increase or decrease beta in the portfolios depending on the dominant market trends. These insights paired with our tactical portfolio management facilitate constructive long-term outcomes for our clients. If you have questions or concerns, please reach out to your adviser or contact us at info@polariswealth.com.
