How to Get Defensive with Your Portfolio

Last week, we discussed how much the market's recent drawdown was driven by a factor rotation away from the cyclical factors (Volatility, Market Sensitivity, & Momentum) and into the more defensive factors of Size, Value, & Profitability. Though we've seen a market bounceback in the past week, movements continue to be heavily correlated with the factor rotation, as shown below.

% CUM. RETURN 10/11/18 - 10/18/18

With factor correlations potentially dominating near-term market behavior and the possibility of another leg down in the markets, we're going to cover how one can create a basket of US ETFs designed to maximize exposure to the defensive factors and minimize exposure to the cyclical factors.

Basket Construction Methodology:

1. Filter all US exchange-traded ETFs for those that trade more than $50mm in daily volume (72 ETFs qualify)
2. Use Omega Point's portfolio construction technology to find the optimal weighting of these ETFs that maximizes exposure to Defensive factors (Profitability & Value) and Minimizes exposure to Cyclical factors (Volatility, Market Sensitivity).
3. Design three types of strategies:

              1. Long-only — optimal weighting of ETFs for an investor who is looking to buy a new basket to offset his/her portfolio exposure

                 2. Short-only — optimal weighting of ETFs for an investor who is looking to sell ETFs to reduce his/her market exposure.

                 3. Long & Short — optimal weighing of ETFs for an investor who is looking to find the best combination of buys and sells to capture the highest defensive exposures

EXAMINING THE BASKETS

Long-only

‍From the initial list of 72 ETFs, we find a subset of 8 that best position a buy-only strategy into a defensive market.

• Large-cap: Dow Jones Industrial Average (DIA) & S&P 100 ETF (OEF) contribute to a lower Volatility and higher Profitability exposures.
• Sector-blend: FXTO, VFH, XLF, XLK, XLY, KBE, and ITB are broad Financials, Technology, Consumer, and Home Construction ETFs that collectively increase Value and Profitability and lower Volatility and Market Sensitivity exposures.
• Style factor ETFs: the Vanguard Dividend Appreciation ETF, the iShares US Quality ETF (QUAL), and the iShares S&P 500 Value ETF augment the large-cap and sector ETFs with higher Value, Quality and lower Volatility companies

When looking at the highlighted aggregate line below we can see the limitations of having a long-only basket, which captures lower Volatility and higher Value but is unable to capture higher Profitability and lower Beta names — which is a sure-tell sign of how many Bull Market ETFs we have! Below we will see how an optimal blend of long and short greatly improves our ability to capture the defensive market posture.

Short-only

‍From the initial list of 72 ETFs, we find a subset of 10 that best position a sell-only strategy into a defensive market.

• Broad market growth & small-cap: selling Russell 1000 Growth (IWF), Russell 2000 (IWM) & Russell 2000 Growth (IWO) equate to picking up lower Volatility and higher Profitability exposures.
• Sector-blend: FBT, FDN, IBB, IGV, IHI, ITA, and XBI are a blend of Biotech, Medical Devices, Software, and Aerospace & Defense. Selling these ETFs equates to rotating out of high Volatility, high Beta, low Value, and low Profitability industries.

As shown in the aggregate exposures line, a short-only basket achieves a much better defensive posture than a long-only basket.

Long & Short

From our decomposition of the long-only and short-only baskets above, it should be no surprise that an optimal blend of the two would have a higher short-basket tilt. In fact, the optimal blend sits at about a 20/80 long short tilt, as shown below.

In a blended portfolio, notice how the Financials sector remains the only value-add on the long-side, while the high beta, high growth sector blend and Russell 2000 indices remain largely on the short-side.

TAILOR YOUR OWN BASKET

At Omega Point, we have a library of over +40,000 global single stocks and ETFs that can be used to construct individual baskets or augmentations to existing portfolios to capture these factor exposures.

Regards,
Omer