Risk-Managed Equity Exposure II

One ETF to rule them all?

March 2022. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Relying on single entry and exit signals for trading introduces model risk
  • However, simple tactical asset allocation strategies are surprisingly robust
  • Necessity of signal diversification is questionable

INTRODUCTION

Last week, we explored a simple risk management system for an equity allocation that might be suitable for investors with a cautious outlook on stock markets. Given record-high valuation multiples, all-time high debt levels, and poor demographics in most countries, the stock returns for the next 20 years will likely be less attractive than those of the previous two decades. Caution is warranted (read Risk-Managed Equity Exposure).

Our analysis highlighted that using a simple 200-day trend system would have increased the Sharpe ratios and reduced drawdowns of an equity allocation in the period from 1985 to 2021. Sweet and simple.

However, plenty of questions remain on such a strategy. How robust is this methodology? Is it implementable from a practical and behavioral perspective? 

In this research note, we will continue our journey of exploring a risk management strategy for an equity allocation that is as simple as possible.

WHAT IS THE BENEFIT OF RISK MANAGEMENT FOR EQUITIES?

From a historic perspective, risk management for equities was unnecessary for most investors in the US as bonds provided attractive and mostly negatively correlated returns, which generated attractive diversification benefits over the last few decades (read No Longer Superheroes? Twilight of the Bonds).

However, lower bond yields globally have made fixed-income allocations less attractive. Also, correlations between stocks and bonds were not always negative and in certain periods both asset classes fell simultaneously. Stated differently, investors should consider additional risk management strategies for equities going forward.

A simple strategy is to allocate 100% to equities when the trend is positive, eg by using a 200-day lookba