When sitting still is the best investment strategy

New York

DUMP all of your equities and load up on derivatives. Hide out in short-term government bonds until the coming storm recedes. Toss your position altogether, yet be prepared to jump back into risk-parity quant strategies if the market keeps grinding higher.

Advice like this has been blaring forth for months from Wall Street strategists, positioning clients for the Big One - a comeuppance for bulls following the best first-half rally in two decades. But despite all the intellectual firepower spent in the name of hedging, here is what actually worked: sitting still.

That is what Dan Chung is doing - nothing. The chief executive officer of New York-based fund firm Alger says that to make money and even to prevent losses, you pick a bunch of steadily growing companies and forget about them. Defensive areas of the market may not fall as much when the going gets tough, but they will be behind when everything is said and done.

"Usually what happens is investors go in too early, and then they come back too late," said Mr Chung, who has been CEO of the firm since 2006. "And then they absolutely kill their returns."

It is a painful irony that in 2019, amid a rally that has added US$5 trillion to US equity values, Wall Street's biggest obsession has been protecting against losses. All year long, investors have shunned stocks for bonds, sending more than US$250 billion into fixed income while pulling US$144 billion from equities, Bank of America Merrill Lynch research citing EPFR global data show. BlackRock Inc CEO Larry Fink said last Friday that people are under-invested.

Demand has burned brightest for defensive equities, with exchange- traded funds (ETFs) for real estate, communications and utilities companies each taking in more than US$2 billion in the first half of the year. Every other sector, except for consumer staples, had outflows. In the options market, for contracts tied to the biggest S&P 500 ETF, total open interest in puts - the amount of bearish contracts that have not been settled - has risen this year versus that of bullish calls. A ratio of the two has nearly doubled since January.

Whether measures for cushioning losses ever work is a topic of debate on Wall Street. In March 2017, a researcher at AQR Capital Management, Roni Israelov, published a paper showing that even a simple strategy of buying bearish index options to insulate a portfolio from big market drawdowns has a "pathetic" record of effectiveness.

"Unless your option purchases and their maturities are timed just right around equity drawdowns, they may offer little downside protection," Mr Israelov wrote. "Unfortunately, equity drawdowns have lives of their own, which may not conveniently coincide with option expiration cycles. In these cases, the put option's protective armour is easily penetrated."

The S&P 500 fell 1.2 per cent last week while the Dow Jones Industrial Average dropped 0.6 per cent. Banks kicked off second-quarter earnings season, with the likes of Goldman Sachs Group Inc, JPMorgan Chase & Co, Bank of America Corp, and others all delivering results. Big tech is gearing up for a busy week, with Google parent Alphabet Inc, Facebook Inc, and Amazon.com Inc all set to report.

While hedging could easily turn out to have been wise, so far it has been money that might have been spent elsewhere. Not only are US stocks perched near record highs, the dips have grown increasingly shallow - making it harder for investors to capitalise during volatile periods. The average S&P 500 drawdown from the highs so far this month has not even reached 0.3 per cent. That is the smallest since January of 2018, when the S&P 500 shot up almost 6 per cent in the aftermath of US President Donald Trump's tax overhaul.

That has left the benchmark's 12-month forward price to earnings (P/E) ratio trading at 17 times future earnings, the highest multiple of the year and greater than the level seen last September, before stocks spiralled into a near bear market.

"It's really hard. For the most part, everything is rich," said Marvin Loh, global macro strategist at State Street. "But at the same time, cash levels are really, really high. Valuations with all of the known unknowns is not enough to entice people to reduce those cash levels."

Mr Chung said that investors should re-frame how they think about risk. The firm looked at how the performance of two classically safe sectors compared to high-growth industries during the bull market of today and the bear market of 2008.

In short, unless you are possessed of supernatural prescience, the benefits of playing defence do not even come close to offsetting the risk of missing out. BLOOMBERG