The Old Faithful Portfolio

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Includes: AAL, ALL, AMD, AZO, BAX, CBOE, CTL, DG, DUK, DVN, ETFC, FCX, HUM, LEN, LMT, MCD, MU, NEM, NFX, NKTR, NRG, OKE, PAYX, SO, T, VRTX, WM
by: CFA Institute Contributors

By Gautam Dhingra, PhD, CFA and Christopher J. Olson, CFA

Old Faithful is the most famous geyser in Yellowstone National Park, having earned its name because of the extraordinary reliability of its spectacular water shows.

Since being dubbed Old Faithful in 1870, it has spouted more than one million times, with eruptions occurring roughly every 90 minutes on average. These eruptions can be predicted more precisely based on the duration of the preceding discharge. The longer the previous eruption, the longer the wait for the next one.

Inspired by Old Faithful's reliability, we decided to see if we could replicate a similar level of reliability in a portfolio, one that would perform reliably, especially during turbulent times.

To create our Old Faithful Portfolio, we analyzed the risk characteristics of equities with our Stock Evaluation Tool (SET). Specifically, we used the SET to examine the behavior of all stocks in the S&P 500 Index during times of increased risk.

For this study, we measured risk by observing the VIX index. Colloquially known as the Fear Gauge, the VIX measures the 30-day expected volatility of US stocks based on S&P 500 calls and put options.

The VIX has consistently demonstrated its usefulness. On the morning of 2 February 2018, for example, the US national employment report came out and rekindled inflation fears. As a result, the VIX index increased from 13.5 to 17.3 that day, a jump of 28%. The S&P 500 promptly tanked, closing down 2.2%, implying a robust inverse relationship between the VIX index and stock market performance.

Looking over the data for the last five years, we selected the "worst" 100 days - those when fear in the market as measured by the VIX index spiked the most.

The S&P 500 declined on 91 of these days, posting an average loss of 1.17%. From there, we explored the performance of all sectors and all individual stocks to see which ones held their own and which ones did not.

The table below shows the data for each sector in declining order of resilience during the 100 days when the VIX increased the most over the last five years.

Market and Sector Performance When Risk (VIX) Increases Significantly

Market and Sector Performance When Risk (VIX) Increases Significantly

This data suggest that an Old Faithful portfolio designed to offer protection when risk levels increase should overweight utilities, consumer staples, and telecommunications sectors.

Extending this analysis to individual equities, we employed the SET to identify stocks with defensive characteristics, even in sectors that in aggregate are not defensive.

In the two tables below, we selected defensive equities from each sector that performed relatively well during the 100 days when the VIX increased the most as well as selected volatile stocks that performed relatively poorly during the same 100 days. We also lay out the reasons why these securities may have fared the way they did.

Selected Defensive Stocks1

Selected Defensive Stocks

Selected Volatile Stocks1

Selected Volatile Stocks

Our analysis demonstrates that stocks of entrenched companies that sell essential goods and services and operate in less cyclical businesses hold up well when risk increases, and vice versa.

Moreover, we found that analytical tools can quantify the defensiveness of individual stocks by examining their behavior on days when the VIX index goes up.

Of course, this is not to imply that "defensive" stocks are better than their volatile counterparts. After all, our analysis is based only on the days when the VIX index increased. The VIX also declines on many days and defensive stocks might very well underperform on those days.

Also, valuation and other important risk factors are not accounted for in our analysis. A defensive stock that is too expensive would likely not be a good one to buy.

We believe that equity investors can manage their portfolio risk level better by understanding how individual stocks behave when fear as measured by the VIX index increases.

In today's environment this additional layer of risk management could be valuable, especially with rising concerns about higher valuation, central bank policy reversal, and global debt levels .

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.