It may be an awkward concept to grasp, but just focusing on an investment strategy or strategies to make money from positive upward market movements over time may not be enough. Even if you diversify those investments across different areas of the markets and over different investment styles, there is a major component of investing reality that is not being proactively addressed – all markets will have guaranteed periods of declines, bear trends, and severe downturns.
What seems to be needed today, due to the increased volatility, uncertainty, and complexity of our modern investment markets, is a purposeful pairing of strategies that are designed to achieve specific outcomes - hiring investment managers with core strategies to manage the upside and long term, paired with, a manager you hire whose mandate is to specifically focus on the daily, short-term market declines and negative trends. These latter downturns happen all the time but are regularly dismissed as something to be tolerated, which is problematic since declines represent risk and they test investors’ resolve and ability to capture the long-term compounding effects that investing offers.
To explore this further we reached out to Institute member Eric Dugan, Founder and Chief Investment Officer, of 3D Capital Management – an investment management firm that positions itself exclusively as an active, defensive, equity manager for investors who are seeking a proven solution to stock market declines. We asked questions to better understand their different perspective on managing equity risk and to have them illustrate how they apply their unique, problem solving investment strategy.
Hortz: What do you feel are the most important elements to focus on in managing risk in the markets?
Dugan: Before you can be successful at managing risk, you must define risk. Know your enemy. For long-term stock market investors, 3D Capital Management believes the enemy is stock market declines.
We also believe the stock market is an excellent long-term investment, but we take issue with those who say, “Stock market declines are inevitable, and you must endure them.” This defeatist attitude is at odds with studies that show people feel the pain of losing money more than they enjoy gains. It is also at odds with the evidence we presented in a recent article A Different Approach to Equity Risk Management which shows that missing the worst days in the stock market matters more than missing the best days.
Our active investment process does not miss the worst days in the stock market. We actively manage the worst days by seeking to profit from intraday stock market declines. We have profitably shorted the stock market for nearly a decade managing stock market risk head-on by using the stock market itself.
Hortz: Why does this require being able to adapt to the daily narrative of the market?
Dugan: The expression, “The market takes the stairs up and the elevator down” reminds us that risk happens fast in the stock market. The biggest one-day loss in the S&P 500 was -20.47% on October 19, 1987. This infamous day is known as Black Monday and regulators put the first circuit breakers into place following this market crash. Circuit breakers are calculated daily and halt trading on the nation’s stock markets during dramatic drops. The circuit breaks are set at -7%, -13%, and -20%.
We think accepting stock market losses is illogical and losing 20% of one’s stock market wealth in a single day is not acceptable. This underscores the importance of adapting to the daily narrative of the market. Stock market declines represent an opportunity to profit by shorting the stock market. I founded 3D Capital with a single vision to profit and protect stock market investors from intraday stock market declines. Our 3D Defender program invests in one market (the S&P 500), one side (Short), one day at a time (No overnight risk).
Hortz: What are the major tools and systems you built into your investment process to be able to respond to this downside market risk?
Dugan: I have been fortunate enough to be managing global stock market risk one day at a time for the last thirty years. This has given me the opportunity to identify logical, statistically significant patterns and has provided me a different perspective and understanding of what is moving the global markets and the S&P 500.
Our investment process and systems are based on these decades of data and statistically significant patterns that are logical (it has to make sense), symmetrical (it has to work on both sides of the market re buying and selling), and persistent (it has to work through multiple market cycles and volatility regimes). This rules-based approach and system, which is a repeatable process, removes emotion and curve fitting.
While most US equity managers are likely looking at US stock markets and “off the shelf” tools like moving averages, stochastics, valuations, PE ratios, earnings per share, etc., our systems are monitoring logical, statistically significant patterns in the S&P 500 and other markets/asset classes around the globe. I refer to this as the “global-relay race” that begins in Asia, as the first markets to open, then spreads to Europe, and ends in the US as the last markets to open. Understanding how global markets influence each other and provide clues to the price activity in the S&P 500, gives 3D Capital our edge.
Our thesis is that the world is one big global macro flow-chart, and that the global markets can provide valuable information and identify the daily direction of the S&P 500. Days make up weeks, months and years and the data make it abundantly clear that, in managing equity market risk, everyday matters.
Hortz: Any other thoughts or recommendations you would like to offer advisors on the benefits of this focused downside protection approach?
Dugan: Investors are hungry for returns and with interest rates at historic lows, investors are being “forced” into the stock market. The world is more connected now than ever, the stock market is higher now than ever, and, by some metrics, more overvalued now than ever. That means the stock market and investors are more vulnerable now than ever.
Stock market declines are inevitable. Investors need a logical solution specifically built to help them protect their historic gains and profit from stock market declines. Other asset classes might go up when the stock market goes down, but logic dictates that the best way to protect your stock market portfolio is with the stock market itself. For buy-and-hold stock market investors our proven logical solution to their problem is 3D Defender, which only invests in the S&P 500 and is built to profit from intraday weakness in the S&P 500 and step aside during rallies.
Recognizing that there is a lot of money on the sidelines not participating in these historic stock market rallies, we recently decided to provide our clients with complete coverage by adding a long S&P 500 exposure - thru a tailored strategy. We are excited to launch the availability of this new 3D Hedged Equity strategy, which will allow our clients to benefit from both the up and down moves of the stock market. Please contact us to learn more: www.3dcapitalmanagement.com.
If you are responsible for managing risk in your clients’ portfolios and you do not have anything in your portfolio construction that is built to seek profits directly from stock market declines, we welcome the opportunity to begin a dialogue. One thing we can all agree on is the stock market is going to move up and down forever………being prepared for both outcomes is prudent.