This is a summary of a series of nine articles studying protection tactics sector by sector (you can find them here). For each sector in the S&P 500 universe, I defined a fundamental ranking process. Then, I used a strategy consisting of a 4-week rotation of the ten stocks of highest rank. As sectors don't have the same number of companies, it represents a variable percentage of the reference set. This is not one of my investing strategies, but a portfolio model sector by sector using common sense and simple fundamental factors. I find it more relevant than using market cap-based ETFs. The Telecommunication sector has been excluded because it contains only six S&P 500 companies.
For each sector, I have performed three 15-year simulations: without protection ('NP'), with market timing ('MT') and timed hedged ('TH'). The portfolio is rebalanced every four weeks. The timing indicator is the same for market timing and timed hedging. It is defined by a bearish signal when the S&P 500 current year EPS estimate falls below its own value three months ago, and a bullish signal when it rises above this value. The market-timing tactics consists in selling the portfolio and keeping it in cash when the signal is bearish. The hedging tactics consists in taking an S&P 500 short position in a 1:1 ratio with the portfolio value when the signal is bearish (it might be buying SH). Timed hedging is modeled here in a margin account and margin costs are included. However, it can be executed without a margin account, by selling 25% of the portfolio and buying SPXU, or by selling 33% of the portfolio and buying SDS. Another article here shows that the usual decay of leveraged ETFs (beta-slippage) is not a problem when hedging with SPXU and SDS.
Then, I checked out the best protection tactics regarding total return, risk-adjusted performance (measured with the Sortino ratio), and risk (standard deviation and drawdown). For all sectors, timed hedging gives the highest return, and market timing the lowest risk. The best risk-adjusted performance is always with timed hedging, except in Utilities for which it is better with market-timing. The average annual return of the 'TH' portfolio is between 17% and 28%, depending on the sector.
Another interesting conclusion of this study is that only two sectors can be held relatively safely without protection tactics ('NP'): Consumer Staples and Healthcare. For both of them, my model portfolio gives a return in the 20% range, with a drawdown below 35%, a standard deviation (volatility) below 25%, and a Sortino ratio above 0.85.
It gave me the idea to build a dynamic defensive portfolio with the 20 stocks of my Consumer Staples and Healthcare models. Here is the equity curve of the non protected portfolio (in red) compared with SPY (in blue):
Dividends are included. A 0.1% rate is applied for transaction costs.
The next table details 15-year simulation results (1/2/1999 - 1/12/2014):
It is a dynamic portfolio. On average, 3 stocks out of 20 change every 4 weeks. Here are the 4 highest market capitalizations of the current portfolio:
Wal-Mart Stores Inc
Food & Staples Retailing
Merck & Co Inc
Philip Morris International Inc
*Trailing 12 months, extraordinary items included.
Investors who want to protect a diversified stock portfolio should consider applying timed hedging tactics. Investors who are averse to timing techniques should consider limiting their stock holdings to sectors that proved their robustness in market downturns: consumer staples and healthcare.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Past performance is not a guarantee for the future.