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Do You Need Eurozone Insurance?



June 29, 2012 – Comments (2)

Board: Macro Economics

Author: yodaorange

This post is a collaborative effort between Ralph, aka REITnut [1], and Yodaorange. We had been wrestling with this issue privately and thought that others might benefit from the discussion. For purposes of this post, we will lump together Greece, Spain, Italy and all of the countries in the Euro system. We will refer to them as the “Euro” – but keep in mind that there are vast differences among the various Euro countries.

Part 1 [2] attempted to answer:

1. If the Euro collapses, what is the range of outcomes we can expect relative to US markets, particularly equities?

Part 2 [3] attempted to answer:

2. What are the probabilities of different Euro outcomes, and how strongly will they affect US markets?

This post attempts to answer:

3. Is “Euro insurance” a rational investment strategy, do we need it, and how expensive is it? Is it even possible to create such insurance?

We realize that there is no single “appropriate” strategy for all investors, and that not all investors will want or need Euro contagion insurance. Here are a few guidelines that will hopefully help each investor decide if they need, or should consider, insurance.

Who does NOT need insurance

1. You believe that the Euro contagion will have little to no effect on your portfolio.

2. Your investment portfolio is small either as a percentage of your financial assets and/or income. For example, maybe the majority of your income comes or will come from pensions, as opposed to your investment portfolio. Stated different, your investment portfolio is closer to “gambling money.”

3. Your portfolio is already defensively structured, such that it will not be strongly affected even if there is severe Euro contagion. For example, your portfolio might be structured in one of several different ways:

a. Overweight in cash in the form of US dollars. (We will not comment on whether your cash should be under your mattress or not.) It could be in an FDIC insured bank, a money market fund, or in a safe deposit box

b. Your portfolio is tilted towards a much lower US equity position that normal. Maybe you typically have a 60% allocation and you have already reduced it to 30%.

c. You use some kind of long term market timing strategy, e.g., Tactical Asset Allocation, that you are confident will lower your equity allocation before much damage could be inflicted. Long term market timing in this context changes your allocation over a period of a few months to several years, as opposed to short term market timing which is in the microseconds to weeks range.

4. Your portfolio already has what you think is adequate insurance. Maybe you have a high allocation to asset classes that you think will weather the contagion. These might be hedge funds, long short funds, non-US equities, gold, Ohio State parking garages or any number of asset classes you think will have a low Beta, [4] with low correlations with major asset classes.

5. You have a long investing horizon and think that any Euro contagion will heal over time. To paraphrase Bill Clinton, the question is, “how long is long?” We would suggest an investing horizon of 10 years or longer. Stated differently, you are comfortable seeing “depressed” US stock prices for as long as 5 to 10 years before they return to what you consider fair value.

6. You are pretty much immune to negative emotional responses IF the US market declines significantly. Seeing headlines like “Stocks Fall Through the Floor” does not cause any heartburn or distress.

Who DOES need insurance

1. You believe that the Euro contagion will have either a medium or major effect on US equities, and at least one of the following applies to you

2. Your portfolio has a high allocation to asset classes that you think will be strongly affected by Euro contagion. One simple measure of this is the classical Beta. If the Beta of your portfolio is greater than say 0.5, your portfolio is likely to fall by at least 50% of the decline in the SP 500. Please see the footnote to calculate your portfolio Beta. [4]

3. You have a short to medium term investing horizon. Maybe you are already taking regular distributions from your account. We would suggest that anyone who needs a specific minimum account balance over the next 10 years or less should have insurance

4. Large drops in your account value cause significant emotional and/or physical stress.

Different types of insurance and the cost to portfolio return

Recall that this entire exercise is a study on possible effects of a Euro contagion on US markets. The “Minor and manageable effect” case assumed a 5% annual return for the SP 500. When you add in a ~ 2.0% dividend yield, you arrive at a 7.0% total return. This figure can be compared with the following returns that we expect will be obtained with various forms of “insurance” under our three different scenarios. Of course, the total portfolio return under each such scenario will vary with the specific type of insurance chosen, and the amount of such insurance.

[See Post for Table]

BLACK BOX WARNING: The total returns are our best guesses. They were based on our macro forecasts for equities and interest rates, which were also guesses. We polished up the crystal ball and oiled the Ouija board, but the results should be used as guidelines only.

Notes for each asset class:

SP 500 without insurance- Based on our assumptions for the three different scenarios.

Cash in US Dollars- We expect the return to be about the same if you have the money under your mattress or in a bank savings account.

Laddered CD’s- A three part ladder with 1 year yield of 1.1%, 3 year yield of 1.42% and 5 year yield of 1.75%. These are the highest national CD yields as of 6/26/12 from

5 Year US Treasury ETF- This is an attempt to pick up a little extra yield by going to longer treasuries. 5 year US treasury rates are currently ~ .72%.

10 Year US Treasury ETF- This is an attempt to pick up a little extra yield by going to longer treasuries. 10 year US treasury rates are currently ~ 1.6%.

20 Year US Treasury ETF- Another asset class that did very well in the 2008 crash was long term US treasuries. If a major Euro contagion strikes, we expect worldwide investors to continue seeking refuge in US dollars, some of which will go into US Treasuries. We expect medium to long term yields to continue falling if the US economy weakens. Short term yields are already ~ 0.00%, so there is not much room for them to fall. Medium to long term yields can decline further.

Short term corporate ETF- Even high quality corporate bonds have some credit default risk compared to US treasuries. By adding this risk, you can pick up additional yield. The current yield is ~ 1.9%. We assume that corporate bond yields will NOT fall like we expect US treasury rates to.

FNMA-GNMA ETF- In reviewing data from the 2008 credit crisis, we learned that FNMA-GNMA ETF’s performed well. Yes, the yields have come down as mortgage rates came down. At the same time, if mortgage rates continue to fall, there should be small capital gains on these ETF’s.

REIT preferreds- A special asset class that we like, it has some quirks that we will cover in the final section when we list specific issues. One major benefit is that the high quality issues currently pay approximately 6.5% and have a very low “suspended” dividend rate.

Long-Short ETF’s- There a few specific ETF’s and funds that are set up to have an overall Beta of ~ 0.00. While not perfect, these funds in theory will not sink like the SP in the event of contagion.

SP 500 puts- There are many ways to implement this. You have to decide two variables for your insurance. How far do you let the SP 500 drop before your insurance kicks in? And what term of insurance do you want, e.g., 1 month, 3 month, 12 month, etc. For this illustration, we have chosen a 10% drop and a 12 month term. In theory this means that, if your entire portfolio is insured, the maximum loss you can experience is 10% plus the cost of the put. You might chose a different “stop loss” amount and different term, in which case, your numbers will vary.

Inverse SP ETF- These funds are very straightforward with a goal of achieving a return exactly the opposite of the SP 500. You can get them with multiples of 1, 2 or 3. Meaning the SP drops by 10% and the ETF rises by 10%, 20% or 30%. Normally these ETF’s are used by investors making a directional bet on the SP. However, they can be used as insurance. For every $1 of SP 500 equivalents, you would buy $1 of the Inverse SP. This has the same effect as selling SP 500 equivalents. One possible use for an inverse fund would be to hedge a large number of individual stocks. In theory you could insure against the whole basket of them by buying a single inverse fund. The inverse ETF will NOT perfectly offset your individual stocks, but it will offer some degree of insurance.

Gold ETF- Gold ETF’s performed very well in the 2008 crash. We do NOT have a strong opinion as to how they would perform in a major Euro contagion. Gold may be a good hedge vs. money printing by central banks, but may be a poor hedge vs. a major global economic recession. You will have to decide whether gold ETFs are a viable insurance option for your portfolio.

Asset class performance during the 2008 crash

We have compiled an exhaustive list of all ETF’s that traded before the crash, during the crash and still trade today. We are going to show that data in a separate post, “Insurance for Greece/Spain/Euro contagion part 3b.”


Reitnut and Yodaorange

[1] Ralph Block, Bloomberg Book, “Investing in REIT’s”, 4th edition

[2] First Post in the series: Insurance for Greece-Spain-Euro Contagion Part 1

[3] First Post in the series: Insurance for Greece-Spain-Euro Contagion Part 2

[4] Beta-William Sharpe won the Nobel Prize in economics for the “Capital Asset Pricing Model.” He introduced the concept of alpha and Beta in investment portfolios. Further academic research has shown that CAPM was/is not a perfect model for all portfolios. However, it is better than nothing and it useful for estimating how your portfolio will perform in the event of a Euro contagion. Beta is roughly defined as the percent change in your portfolio divided by the percent change in the SP 500. For example if the SP 500 goes up by 1% and your portfolio goes up by 0.5%, you have a Beta of .5. You can measure Beta over any time period you choose, days, weeks, months, etc. One simple estimate is to look at days with large changes in the SP 500, both UP and DOWN to calculate your Beta. Since we are discussing insurance for negative downturns, you might pick one of the days where “everybody sold everything” to calculate your Beta. It is IMPORTANT that you add in all of the financial assets you want to consider when you make this calculation. For example if 90% of your assets are in cash, your Beta is probably going to be extremely low regardless of what equities you own. It is important for you to have a reasonable idea of your Beta in order for you to decide how much insurance to purchase.

2 Comments – Post Your Own

#1) On June 29, 2012 at 12:05 PM, NEMnyWtch (< 20) wrote:

We are using VIXY as a hedge to domestic oversold/value industrials, cyclicals and housing.

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#2) On June 29, 2012 at 12:21 PM, constructive (99.97) wrote:

VIXY, like most leveraged ETFs and ETNs, is a lousy mid to long term asset.  You would be much better off simply reducing your long positions or finding another way to hedge.

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