Downside protection strategies for a bear market

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With high correlations across traditional asset classes and geopolitical and economic risks steepening, navigating market turbulence and protecting your portfolio from downside threats requires innovation and a careful approach.

  • Diversification becomes harder when inter-asset class correlations are high
  • Downside hedges can be costly
  • Using a volatility trigger can be effective in limiting bear market losses

For many investors, professional or not, one of the first pieces of advice was always “don’t put all your eggs in one basket”. In other words, diversify your portfolios across multiple asset classes so that if one type of asset does badly, you still have all the others to help your portfolio get to where it needs to be by the time you need it.

But how do we do that in this market?

Correlations between asset classes are at an all-time high, and look likely to remain so for some time yet. I believe one key reason for this is that until recently, financial markets were still riding the highs coming off the recovery from the global financial crisis and we have seen significant changes in return, risk and correlation profiles across asset classes.

The efficient frontier looks like a mirror image of itself, where asset classes on the high side of the risk spectrum have literally swapped places with lower risk ones. There is no clearer example of this than the US yield curve’s inversion, which in effect proclaimed that the market requires a higher return on a short-term investment than on a longer-term one – in short, it signalled market turbulence in the near term.

Concentrated holdings have outperformed diversified ones

For some investors, the hard pill to swallow has been that diversification has not brought rewards over the last 10 years; in fact, it has been more of a penalty on portfolio returns. In contrast, having concentrated holdings in developed markets, in broad market indices or in exchange traded funds has been the winning strategy.[1] Don’t get me wrong, diversification is key to building an effective, robust portfolio optimised to achieve long-term goals, but in the last 10 years of relatively low volatility, the reward for diversification has not been as pronounced.

Now volatility is back, and diversification is harder than ever to find. Putting our eggs in multiple baskets does not work if all the baskets are glued together.

So, how do we protect our portfolio against downside risk? This is where systematic downside protection approaches such as rolling put strategies come into focus. How we apply them can make the difference between really protecting our portfolio through turbulent markets and protection just being a drag on performance.

For example, if we look at an investment in US equity over the last 20 years, a dollar invested at the beginning of this period and held right through and past the financial crisis has returned 4.30% a year, on average.1

Timing is crucial

Theoretically, if we applied a put option strategy that hedges 15% of downside movements in the market, it would result in an additional loss of 2.43% to cover the cost of the put strategy. This means that even after capping the nearly 50% loss of the 2008 financial crisis to 15%, leaving the portfolio unhedged would actually have been better than applying this simple downside put strategy.

How do we improve on this? The answer is simple – but hard to implement. Timing the put strategy so that it kicks in when needed would give us the most efficient protection. However, timing this correctly is crucial.

A far more effective way of applying the put strategy is to use the volatility index (VIX) to provide a better alert on market turbulence. This can act as a trigger so that when volatility rises to a pre-determined level, our put strategy can kick in and deliver the required protection.

Conclusion

We believe diversification remains essential when building a portfolio, but the crucial questions are, “what part of our portfolio do we want diversified, and how to we do that effectively?”

In current markets, the asset class baskets are attached to one another when it comes to performance and the speed bumps of various types of risk are numerous and difficult to predict.

Structured downside protection strategies that are designed to kick in efficiently in times of turbulence, much like shock absorbers laid under the asset class baskets, can help prevent unwanted cracks appearing in your portfolio.


[1] The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.


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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

Paul Sandhu

Head of Multi-Assets Quant Solutions (MAQS) & Client Advisory, Asia Pacific

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