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Market Downturn? What’s Your Price for Protection?

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Market Downturn? What's Your Price for Protection?

With markets hitting new highs and headlines warning of doom from all corners of the world, investors are rightfully worried about the severity of the next downturn. 

And the fear is justified given that the largest drawdowns have also been the most recent.

The severe downturns experienced over the past two decades have also hit almost all asset classes with the same level of force. 

The old standby of diversifying to protect one’s assets has lost some of its legitimacy as a result of the increasing correlations and rapid declines in prices that many investors have experienced.  Additionally, the more severe the downturn, the longer it takes for the market to recover to its pre-downturn levels.  These experiences have created flightiness within the markets and an increasing desire to find a comforting solution to protect against the next rout. 

However, the experience of late has been anything other than comforting.  It is completely understandable to fear the next great downturn, but too often that fear can lead to further wealth destruction in client portfolios. Clients fail to fully participate in rising markets, preventing a recovery of assets lost in the last downturn.  This may not be as apparent as an absolute loss, which may lead people to keep their statements closed, but the impacts can be much more destructive.  The worst outcome is for a client to invest in ‘protection’ strategies, only to find that the protection offered comes with little ability to recoup losses, leaving a client ill prepared for retirement.

There are many strategies that aim to protect wealth, attracting capital by feeding on the market’s fears, yet these strategies have resulted in this same missed opportunity in rising markets, leading to poor full-cycle outcomes for clients.  Three of the most prevalent of these strategies are 1) tactical management, 2) hedge funds, and 3) option based protection strategies.  Each looks to protect in down markets either by repositioning holdings, attempting to short a portion of the market, or buying derivatives.  Each has shown some success in down markets, but none appear to demonstrate their value throughout the cycle.  Each has materially underperformed in rising markets, suggesting the total cost of protection to be very high.

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John Rekenthaler of Morningstar recently wrote an article concerning the tactical category’s poor performance over the last three and five years.  From his data, tactical managers that trade frequently by following momentum signals typically underperform by 3.5% per year versus the representative Morningstar benchmark.  Given a seven-year bull market and using the historical returns provided in the article, during the next bear market, the tactical manager would need to suffer a drawdown less than one third that of the benchmark’s to simply break even!  Historically, the majority of tactical managers do not support that, which suggests clients are overpaying for this protection.

Another wealth protection strategy is the hedge fund, where many investors have been willing to place large sums of capital in their quest to find protection.  However, the results suggest an even higher cost to the client.  One popular method that has done a respectable job of replicating the Hedge Fund Index is the Goldman Sachs Absolute Return Fund (GJRTX).  The fund’s historical return underperformed the past five-year period by 4.5% per annum.  And with its drawdown in the latter half of 2008 — about half that of the respective market benchmark — the cost of underperformance during the rising market environment may not have been viewed as money well spent.

Lastly, the use of option strategies has been advertised as a method not only to produce protection but also to gain an additional source of income.  Though income yields are above the market’s performance, the overall return has lagged the market by over 6% per annum over the past five years.  Unfortunately,  despite the protection put in place, the strategies still exhibited about 80% of the drawdown on their benchmarks.  Not the best protection for the high cost.

The examples discussed above should not necessarily elicit hopelessness and despair.  There are always opportunities to evolve an effort — to lessen the impact of downturns without sacrificing the benefits of upturns.  The point to be made is that looking at drawdowns in isolation may not result in the most desirable outcome: a more secure retirement.

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