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Meb Faber: Should Investors Buy, Hold or Hedge?

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We are closing in on the World Series, about halfway into this year’s football season and have just started hockey play. That means the sports metaphors are flying across the field (i.e., written reports) in the portfolio management business.

Cambria Investment Management’s Mebane Faber goes all out in his comparison of sports and investing tactics in a recent report entitled, “Learning to Play Offense and Defense: Combining Value and Momentum from the Bottom Up, and the Top Down.”

Digesting all the specifics is about as easy as grasping the details of some Major League Baseball rules. But here’s a summary of Faber’s conclusions and a look at the research supporting them.

First, when it comes to offense, value and momentum factors historically “have improved the returns of a buy-and-hold portfolio,” he states.

Second, in terms of defense, value and trend hedging systems historically “have improved the risk-adjusted returns of a buy-and-hold portfolio,” Faber explains, “mainly by reducing volatility and drawdowns.” Buy-and-hold investors, he adds, may want to consider simple hedging rules, which can potentially protect them from long bear markets and large drawdowns.

Third, combining offense and defense – i.e., mixing stock screening and tactical hedging – may lead to outperformance as well as to improved risk and drawdown parameters, according to the recent Cambria report.

Read on the see what the strategies imply for your clients and portfolios.


There’s plenty of research that shows the advantages of investing in cheap/cheaper stocks (value) and those that are going up (momentum), says Faber.

He looked specifically at the top 100 value and top 100 momentum stocks, bought and held for three months, and called this combination portfolio value and momentum (or VAMO). Returns include the reinvestment of distributions/dividends) but exclude trading and management.

Overall, the VAMO portfolio improved 16.7% from 1964 to 2014 vs. about 10% for the S&P 500. (Volatility for VAMO was 19% compared with 15% for the S&P.)

But could investors have stayed with this portfolio, even when it lost more than half its value (and the S&P 500 portfolio was down about 50%)?

Dalbar reports that in 2014, the average 20-year return of the S&P was roughly 10%. But the average mutual fund investor’s return was only 5.2% in same time period – and “psychological factors,” like panic selling, accounted for about half of the underperformance.

This leads Faber to ask: Are there any common-sense rules advisors and investors can use to help to reduce the drawdowns of a buy-and-hold strategy?


To apply this tactic, Faber analyzed a portfolio with about half hedged by shorting the S&P 500 when it was going down or expensive.

“This means the portfolio can be anywhere from 100% long stocks, to 50% hedged, to completely market neutral (long the stocks in the portfolio, but short the S&P 500),” he explained.

Another way to work the timing signals, he says, is to sell stocks and move to cash and/or to the safety of bonds.

“Both the hedging and the cash choice have very similar results. Investors could also use inverse funds, options, or many other hedging vehicles that may suit their individual situation for transaction costs, taxes, etc.,” Faber stated.

It’s also important, when using value and momentum theory, to: (1) exit or hedge stocks when they are in the top 20% overvalued territory, and (2) exit or hedge stocks when they are below the long-term moving average on the S&P 500.

The results?

While the VAMO portfolio outperformed the S&P 500 (from ’64-’14) 16.7% vs. 10%, it did so with more volatility (18.7% vs. 14.9%); and both portfolios has maximum drawdowns of over 50% at some point.

The VAMO hedged strategy, though, produced returns of 15.6%, beating the S&P, but with average volatility of 14.2%, less than that of the S&P.

“The portfolio maintains most of the outperformance of the original stock screen strategy, but with more reasonable volatility and drawdown numbers. The hedging cut the maximum drawdown roughly in half,” Faber explained.

Plus, in the worst five-year period, the S&P’s returns fell to -22.5%, and VAMO to roughly -19.5%. However, the hedged strategy “had much more tolerable returns” of about -2.2%, according to the report.

Strong Offense, Strong Defense

Finally, Faber looks at what this analysis would be calling for now.

The outlook for buy and hold is “currently very poor with the U.S. stock market being both expensive and in a downtrend – a six-year bull market will often do that to equity valuations,” he explains.

For investors concerned with being able to stick it out through a big drawdown, it may make sense “to consider hedging their long U.S. stock holdings,” Faber adds.

Foreign developed and emerging-market indexes, like the MSCI EAFE and EEM, are in slightly better territory, being cheap, but also are in a downtrend.

Are you comfortable with “only playing one side of the ball?” he asks. “Are your emotions suited to your system and all of the possible outcomes, or would it make more sense to play both offense and defense with your equity strategy?

“There are many ways to improve or alter these ideas,” he said, “so test your own variants and find a system that works for your own personal situation.”

Read Faber’s paper here.

— Check out Most Downloaded SSRN Paper Ever Says You Should Be in Cash on ThinkAdvisor.


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