In an environment of heightened market uncertainty and volatility, investors need to consider the portfolio guardrails they have in place to help withstand market disruptions.
Even the most prescient investor would have been hard-pressed to predict the path of markets since the start of the pandemic. Recent simultaneous drawdowns in equity and fixed income markets have been all the more surprising because they followed a decade marked by unusually low volatility and remarkably consistent positive returns. We believe that the “Great Moderation” period is clearly over, with central banks less likely to backstop markets as they fight inflation and look to reduce their balance sheets. The “new normal” higher-volatility environment should still provide opportunities for equity investors, but it will also likely feature deeper drawdowns and shallower (less V-shaped) recoveries. Importantly, actively managing the risk of the current environment will require proven downside protection strategies.
Investors should consider downside protection strategies not only during uncertain markets, marked by heightened volatility, but also during all other market cycles. Large drawdowns happen frequently and unexpectedly and can take time to recover from (see Figure 1). Downside protection, we believe, is an effective tool both from an offensive and defensive perspective — one that investors should consider for their portfolios across all market cycles.
Figure 1: Evolution of the Drawdown
S&P 500 Price Return Index, September 1929–September 2022
Downside protection is usually seen as a purely defensive positioning — protecting against losses and preserving capital. But it should also be seen as an offensive approach: if investors can limit losses during a significant market drawdown (preserving “dry powder”), they can then re-allocate that capital toward riskier assets after the drawdown, benefiting from rising return premiums. Downside protection’s defensive perception has discouraged some institutions from using these strategies, but there are effective approaches that enable investors to stay protected and capture the growth potential of equity investments. Two are detailed below, and we recommend a structured approach to considering, discounting, and eventually choosing between approaches.
It is important to maintain a long-term perspective on defensive strategies because, for example, market performance since the Global Financial Crisis (GFC) has been consistently positive. One way to gain this perspective is to use the long-term characteristics of an 80:60 defensive equity strategy and proxy its long-term performance against the historical returns of the Dow Jones Industrial Average (DJIA). The 80:60 concept — trying to capture 80% of the market upside and to participate in only 60% of the market downside — has been largely realized in the long-term performance of leading defensive equity strategies.
A review of the performance of the 80:60 concept going back to 1900, by decade, shows that in all but three of the past twelve decades, investing in an 80:60 strategy would have delivered outperformance over the DJIA Index. Furthermore, the level of outperformance has generally been greater in more volatile environments (such as the one we are experiencing).
Figure 2: Excess Returns of an 80:60 Strategy versus the DJIA, by Decade
This is not surprising, as previous research has shown that, over the long term, strategies with lower volatility objectives have superior returns — generally because investors’ behavioral bias toward taking on the riskiest assets drives high volatility (while suppressing long-term returns).
In an up-market cycle, investors get overly optimistic and take on excessive risk, driving up asset valuation in the process. Excessive valuation eventually becomes unsustainable, leading to a correction and downward pressure on asset pricing. In a down-market cycle, the pendulum swings to the opposite side, leading to excessive pessimism on asset pricing and driving down asset valuation (but setting the stage for eventual price recovery).
Presently, as investors face the prospect of shrinking central bank balance sheets and restrictive monetary tightening to combat inflation, we believe they should actively consider how defensive strategies fit into their asset allocation.
Another downside protection approach involves choosing an appropriate risk level (or target) and then switching between different levels of risky and non-risky assets (e.g., cash) to maintain the target risk level. In a Dynamic Asset Allocation (DAA) process, the allocation between risky and non-risky assets is systematic, based on a forecast of volatility relative to a target level. A DAA process’s complexity comes not from new asset classes but from the trading required to adjust the portfolio to the risk target.
The cost of entering a volatility targeting strategy should be relatively invariant to market conditions. That said, however, such strategies cannot always anticipate extreme market movements, which might cause portfolio volatility to “spike” on the open — e.g., when the value on the open of trading changes sharply from the level overnight, effectively defeating the volatility forecast. This can be a problem during fast falling markets, and will also cause volatility targeting strategies to generally lag the market in steep rallies, as the allocation to cash takes time to be reduced. Sharp V-shaped recoveries have negatively affected the performance of volatility targeting strategies, just as has been experienced with defensive equity strategies.
Investors for whom managing risk is a greater focus than achieving return would benefit from a volatility targeting approach. For example, insurance companies often favor this approach because they can be constrained by risk budgets. This approach would also benefit investors who may be able to tolerate a degree of variability in their returns but not a large drawdown. Trustees and sponsors of defined benefit plans can find themselves in such a position: They need growth assets to bridge funding gaps, but with liabilities on the horizon they cannot afford to bear the brunt of market volatility while their funding ratios are under scrutiny. A volatility targeting overlay on their portfolio can offer a cost-effective way of managing risk.
Each of these downside protection approaches has its own unique implementation implications for portfolios. For an optimal fit, investors need to be clear about their risk and return priorities when choosing one method over another.
What is clear, however, is that in an environment of heightened market uncertainty and volatility, investors need to consider the portfolio guardrails they have in place to help withstand market disruptions, in order to achieve their long-term investment objectives.
The information provided does not constitute investment advice as such term is defined under the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any investment. It does not take into account any investor’s or potential investor’s particular investment objectives, strategies, tax status, risk appetite or investment horizon. If you require investment advice you should consult your tax and financial or other professional advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
The views expressed in this material are the views of State Street Global Advisors through December 1, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
Investing involves risk including the risk of loss of principal.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Investing in foreign domiciled securities may involve risk of capital loss from unfavourable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
© 2022 State Street Corporation. All Rights Reserved.
Exp. Date: 11/30/2023