08/13/2015

INVESTORS NEED FAITH ALONG WITH THEIR DOWNSIDE PROTECTION

The unpredictable nature of the market can be terrifying. Any hint of volatility sends skittish investors in search of skilled managers to guide them through pending storms. But even when armed with a sound strategy, investors are vulnerable to fear of potential loss and could jump ship if doubt begins to seep in. That means managers must do more than just identify the right game plan. They must also consider investors’ confidence level in a strategy, and their willingness to ride it through the turmoil, to stop an exodus from the market.

We know from behavioral finance studies that investors feel the sting of loss more acutely than the thrill of gain. Recent reports indicate that the threatened loss of assets drove investors to squirrel away more money in cash allocations to protect from a downswing. Cash levels have increased to their highest point since the 2008 crisis at 5.5 percent of portfolios, according to the Bank of America Merrill Lynch Fund Manager Survey for July. That spike in risk aversion came amid weakening economic confidence in China, worries over Greek debt, and frustration over a low-interest-rate environment.

It’s never clear when an equity market fall might occur, or how long or severe it will be. But there is a range of strategies that may mitigate the damage when it does strike. The question is, which strategies are best equipped to not only provide that downturn protection, but to capture the faith of investors needed to keep them on board?

Over the last decade, an abundance of alternative strategies have emerged to help weather the downside of the market, seeking to maintain equity exposure while protecting against major losses. With a look at a few of the better known strategies, we can review the various approaches to downside protection as well as determine through the lens of behavioral finance how investors perceive that protection:

 

Low Volatility

Low volatility strategies generally purchase a subset of an index, such as the S&P 500, with the least amount of recent historical volatility. In essence, the beta is generally lower than one, meaning both upside and downside moves should be further minimized due to a lower beta/volatility. There is some complexity to that assumption, as lower volatility stocks tend to have higher dividends and cluster within certain industries. That could result in disparities in terms of shorter-term performance or what may occur in a downturn.

We believe the degree of confidence instilled by low volatility strategies may be limited by the inability to actually quantify protection. For example, if the market is down 30 percent, how does one determine how much a given low volatility strategy will decline? The lack of any concrete identifiable levels of protection could undermine the willingness of investors to stick out the storm.

 

Tactical

Proper market timing can eliminate downside risk by “jumping out of the way” in time. These tactical strategies depend on getting the timing right, and because managers lack crystal balls, it is not uncommon for tactical funds to have successful runs of “predicting” the market, followed by unsuccessful ones. These strategies are the antithesis of the “buy and hold” approach that has consistently driven market thinking for decades. Luminaries such as Vanguard Group founder John Bogle have warned against basing long-term investments on the minute-by-minute market reactions sometimes employed with this strategy. It’s important to note that it is possible for market timing strategies to result in precisely the opposite outcome they seek—having to buy at the top and sell at the bottom.

The degree of confidence instilled by tactical strategies is limited by that lack of a crystal ball, as investors question whether the manager will make the right call from cycle to cycle. Relying on tactical strategies has the potential to introduce two unpleasant outcomes: wild underperformance with the wrong conservative call and failure to deliver enough protection with the wrong aggressive call.
Equity Hedge Fund
The objective of the equity hedge fund strategy is to maintain a relatively neutral exposure to the market while capturing alpha by going long on some securities and short on others. Some strategies are true market neutral, while many have a long tilt of at least 30 percent. In essence, these funds offer lower beta exposure to the market with an alpha kicker on performance.

For most fund varieties in this sector, the offsetting long and short positions reduces risk to the point where it becomes difficult to capture much reward. Investors are therefore well protected on the downside, but may enjoy minimal capture on the upside (for an example, see HFRX data for market neutral managers).

The degree of confidence instilled by market neutral strategies is relatively strong from a protection perspective, but will often raise concerns regarding a lack of expected performance in up markets (as indicated by the HFRX data). Certain fund types in this space will dial up exposure, for example, by maintaining a heavier long tilt to address the performance concern. That move, however, introduces a lower degree of confidence for downside protection.

 

Defined Outcome

Defined outcome investing is an options driven strategy whereby levels of market participation are preset. Therefore, the targeted downside level is known as well as the upside potential. In a market downturn, the downside protection level achieved through option contracts should mitigate negative exposure.

The degree of confidence in these products is high as the protection levels are preset and generally spelled out ahead of time. As a result, in a market decline, the investor should have a good indication of the potential loss. Based on the risk the investor takes on, an associated reward level is available. As a result, the risk/reward exposure is very clear.

 

It’s never clear when a market downturn will occur; there’s only the certainty that it will. The onus is on the financial services community to provide both the advice and the products to balance long-term investor risk and reward, and steer investors through adverse market events. But managers need to go a step further, ensuring that investors are also confident in that downside protection to minimize untimely exits from strategies. Confidence is as important as actual performance in determining an investor’s success in surviving a storm. Not all strategies perform the same, and not all protection is experienced equally.

A version of this post appeared in WealthManagement.com