Why Downside Protection Is So Important

By the end of 2019, equity markets finished off an incredible decade with returns well above historical averages, and volatility well below them. Investors that had any kind of diversification or hedging in their portfolios were likely frustrated about lagging long-only U.S. equities and may have gone either full beta or deployed ‘hedging strategies’ that had been performing well relative to the broader market (likely due to their higher beta). Now with the sharp decline that markets have experienced since February 19th, investors have perhaps been reminded why protecting capital on the downside is still so important.

As you can see in the below chart, rolling one-year up periods occur much more frequently than rolling down periods (approximately 76% of the time). As expected, hedged equity strategies tend to trail in those up periods and that can lead investors to think they are missing out. However, what is often forgotten, especially during periods of strong equity performance, is that hedged equity still outperforms the broader market over time―not because of the amount of upside these strategies deliver, but rather the protection they provide during periods of market stress which is beneficial, due to the effect of compounding.

Past performance is not indicative of future results. Source: Morningstar and Eurekahedge. Long/Short Equity is represented by Eurekahedge. Data from 01/01/00-12/31/19. Return periods are determined based on the rolling 12-month returns of the S&P 500 Index. Returns during periods represent average rolling 12-month returns for each investment. Long-only equities are represented by the S&P 500 Index.

This year has provided the perfect example of why downside protection is so important. Through March 23rd, the S&P 500 Index was down 30.43%. To recover these losses by year end, the market would need to be up 43.74%. While this is certainly possible, it is a large hole to dig out from. Contrast that to the Morningstar Long/Short Equity Category which was down 19.04% through March 23rd. The return needed to recuperate from that loss would be 23.52%. While the difference in return between the market and the Long/Short Equity category is only 11.39%, the difference in recovery needed is 20.22%. As these numbers increase and the disparity widens, the difference needed to recover will grow significantly. It is easy to forget about downside protection when things are so good and easy for so long, but current markets have provided a stark reminder of its importance.

While it is likely that your portfolio could have benefited from exposure to true hedging strategies the last few weeks, it is important to remember that these are not the types of strategies that you should own only when you think the market is due for a correction―nor should you be transitioning out of them once that correction occurs. While the recent market decline may provide an opportunity for buying something on sale, there is little certainty as to what the path leading out of this environment may be. Just because we have experienced this one drawdown does not mean we won’t experience others in the coming months and years. And unless you can get your market timing perfect every time during the inevitable ups and downs, a strategy that can consistently provide exposure to the upside while limiting the downside will likely prove much more effective over time.

So how do you approach this type of allocation in client portfolios?

Given the magnitude of this correction, it’s probably fair to assume that markets will finish higher from this point through the end of the year and hopefully deliver positive returns over the next three- and five-year periods. Therefore, if you are not already allocated to the space, it may not make the most sense to fund a hedged equity position out of your long-only equities (unless you think there is more downside to come and you are seeking an effective means of lowering your portfolio beta, in which case Long/Short Equity is a compelling solution for that). Rather, a more attractive way to implement this type of strategy at this moment may be to fund the position from bonds. While that may seem like an unorthodox approach, recent volatility and illiquidity concerns have wreaked havoc in fixed income markets. While these issues will likely be resolved at some point in the next couple of months, at a minimum it is generally accepted that long-term expected returns from fixed income are likely to be very muted as the chart below highlights.

Past performance is not indicative of future results. U.S. Aggregate Bond Index is represented by the Bloomberg Barclays US Aggregate Bond Index. Source: Bloomberg Calculations/361 Capital. Data from 02/01/78-02/29/20.

As is probably expected from some of the data discussed above, Long/Short Equity has historically delivered returns in line with equity indices, but at a much lower level of risk. However, what is often surprising to most investors is that Long/Short Equity volatility is also roughly the same as some fixed income markets, notably high-yield and international investment grade debt. While it may be slightly more volatile than investment grade bonds, it has historically provided a much higher return. If you want to take advantage of the current sell-off, but don’t want to significantly increase the overall risk of your portfolio by moving from fixed income into long-only equities, re-allocating some of your fixed income into a Long/Short Equity strategy, that provides similar volatility with much higher go forward expected returns, may be an idea worth considering.

Source: Morningstar. Data from 01/01/94-12/31/19. Past performance is not indicative of future results.

We understand that the current drawdown has been very aggressive and painful. Hopefully you have already benefited through the implementation of hedging strategies. If so, we would advocate that you maintain those allocations, as history shows they are likely to outperform equities over time while also helping to dampen future unexpected volatility. If you do not yet have hedging strategies in place in your client portfolios, know that it is not too late. Use this moment to adjust your exposures (potentially by allocating from some of your fixed income exposures) to participate in the coming recovery while effectively managing risk and keeping your clients invested.

361 Capital has been a leader in the alternatives space for nearly two decades and we have a great deal of experience in evaluating hedged equity strategies, please don’t hesitate to reach out to us if you have questions about the space that we can help with.

 

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