OPINION: Protect Your Upside By Protecting Your Downside
By Kristal .AI, Last updated: 2022-10-14 (originally published on 2020-12-03)
Asset protection. That’s the keyword here. And what this blog talks about.
Let’s say you had a windfall and bought a BMW. (May every one of us have that windfall in our lives!).
The next step is to buy car insurance. God forbid there should ever be a scratch on that sweet pair of wheels, but in the fated scenario that it ever does your insurance will protect you and your asset.
One way of protecting your lovely BMW is to never take it out of the garage, but then why bother owning one in the first place, right? This is akin to the mentality that many investors have regarding hoarding cash and never investing.
Now, we aren’t car salesmen. But this analogy was important to elucidate the importance of preparing for every eventuality and protecting yourself from what you cannot see coming. As investors, that is the first rule we all follow. I’m sure some very widely read book by a known author says the same.
Ever since the markets started to climb post the crash on March 23rd, we have seen many investors come back to the markets with differing sentiments. Some have come back with anticipation and some with more caution, while some are still sure that holding cash and waiting for a big correction is the best way forward.
Our analysts have been hard at work producing customized trade solutions for each and every one of our clients, no matter what their current investing style. With caution and optimism, we have been helping them invest in the upside and mint returns while the bull runs strong.
But we all know the bull gets tired once every while.
And in a market as uncertain as the one we are living in now, the bull seems to be taking breaks to catch its breath every so often. This is where downside protection becomes necessary. Now, to be fair, we are all rooting for the markets to improve and the pandemic to get over. We miss our coffee runs after all. But as advisors, we also have a duty to our clients to keep them sensitised to Mr. Market’s fickle moods.
The amount of quantitative easing and related central bank actions we have seen so far underscore the fact that we are currently in the midst of one of greatest monetary experiments the market has seen. Coupled with the differing monetary policies adopted by various governments across major economies, geopolitical headwinds, and the changing fortunes of stable, powerhouse economies such as the U.S. and China, the conditions are ripe for rising volatility across global markets.
Experienced investors know well that risk-adjusted returns tend to be their strongest in periods of low and low–medium volatility. High-volatility periods sometimes do give good returns, but the risk-adjusted return is generally not as attractive. Maximum drawdown periods of high volatility see sharp corrections, and hence even if returns are high, the level of risk involved increases disproportionately.
Investors with diversified portfolios are already protected. Right?
Umm… comme ci, comme ca we would say. The first tool that every investment manager uses to curtail tail risk is to diversify using asset classes with low correlation. However, just by diversifying global equity with fixed income, for example, a manager cannot do enough to limit tail risk. Diversification does not work foolproof when correlation increases. In March, we saw a simultaneous sharp correction in related assets like bonds, equities, and gold when the markets dropped.
Here’s another instance: Let’s take a traditional portfolio with an asset allocation of 60% equity and 40% fixed income. Now, 85% of the inherent portfolio risk, in this case, is derived from the equity component. True portfolio risk is, therefore, highly concentrated and correlated. This also signifies that investors may not be as well protected as they believe they are.
Fama and French (of the 3-factor investment model) demonstrated in 1989 that expected returns from a portfolio change over time and are likely to rise during periods of market distress, as a way of compensating investors willing to bear the market risk. Expected returns, and the associated risk, are strongly correlated to business conditions. Recent market volatility has followed the same pattern; driving up the returns one can hope to garner from a timely investment but also increasing the benefits of an efficiently run downside protection program.
The upside of downside protection
If investors limit their losses during a significant market drawdown, they can then allocate the saved “dry powder” toward riskier assets after the drawdown. This will help them benefit from rising return premiums.
The chart below shows the historical returns required to recover after a drawdown. As losses deepen after a period of underperformance, the returns needed to recover from the loss also increase significantly.
For instance: a drawdown of 20% requires a return of 25% to recover, whereas a drawdown of 50% would need a return of 100% to regain ground.
As well-protected investors know, a dollar of excess return in a down market is worth more than a dollar of excess return in an upmarket.
To achieve long-term growth, it is therefore important to not only focus on growing the upside, but it is arguably even more imperative to protect the downside.
In fact, our analyst team ran some numbers to see if there was a difference between hedged and unhedged portfolios for the period Q4 2018-Q1 2020. And as you can see below, there was a marked difference in the losses suffered by both portfolio types; more so in the periods when the bull has been lazy.
Q4 2018 if we recall was the period leading up to the meltdown in December. Q1 2020 shows the after-effects of the pandemic on the market.
2019 was a good year for both hedged and unhedged portfolios as we see above, but as time-tested investors know the resilience of a portfolio is not judged by how it fares in good weather, but on how it performs during strange gales. And 2020 has been strange indeed!
Customization: The key to downside protection
The current low-yield environment has led many fixed-income investors to “reach for yield” through investments in lower-rated, less liquid bonds. This strategy would usually bear fruit in normal circumstances – in what was up till the beginning of the year the longest economic expansion in history. But given what the market looks like right now, this would be considered as excessive risk-taking in the current market.
In such situations, investors are wont to withdraw and create a huge pile of cash for a ‘better day’. Think of the BMW in the garage for a year or longer While the cash does offer some protection, the opportunity cost of withdrawing and not staying invested is often very high. You also lose out on many short-term opportunities with high rewards.
At Kristal, we have been telling all our clients to protect their upside by protecting their downside. Not because we think that the current bull-ish market is a bubble, but because bubble or not protecting one’s blindside is the prudent thing to do. For the longest while, our analysts have been customizing equity-linked option notes (ELONs) which allow investors to hedge their bets in emerging markets, or by gaining exposure to sectors that have been thriving and are expected to do well through this pandemic. These are strategies that are slightly difficult to implement, and hence it is advised to use advisory help before adding them to your portfolio.
You can always write to us at firstname.lastname@example.org to know more about customized options that would fit your portfolio. The markets are volatile, yes, but by investing right you can turn the uncertainty into opportunity. The bulls would be proud
This article does not constitute legal advice.
The opinions expressed in the column above represent the author’s own.
Article syndicated with permission from https://kristal.ai/blog/downside-protection/
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