Equity markets – Don’t break the trampoline!

January 16, 2014 Categories: Investment Strategy

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Type ‘broken trampoline’ into Google and it will bring up hundreds of YouTube links showing people breaking various limbs while jumping on trampolines.

Our equity markets last year were like a trampoline bouncing us ever upwards – but what is the risk that we’re heading for a break?

In 2014 is a year for investing cautiously  Andrew Pease tells us that while equities are by no means cheap, they still have an upside – provided a few conditions are met.

As a multi-asset investor, I want to capture more of the upside than the downside risk in markets. In fact, mitigating the downside can be more valuable than capturing the upside. If an investment rises by 50%, then it only takes a 33% fall to take it back to the starting level. But if an investment falls by 50% it needs to rise by 100% to get back to the starting level. It’s really hard, in other words, to recover from big losses.

So why own protection? – Surely if we are heading into markets like the ones our strategists foresee in 2014 we should simply reduce our risk exposure? At particular points in the market cycle that would certainly be the most efficient way of protecting value. But we do not believe we are yet at the euphoric stage categorized by high valuations and over confidence.

Burnt by the recent memory of 2011, 2008 and perhaps even 2000-2001, investors are still rightly cautious, and some are still on the sidelines. As such the potential exists for further upside surprises. Markets rarely stop at the fair valuations we see today, rather they overshoot. As such it pays to “hedge your position” by protecting the downside, but also maintaining the equity allocation such that upside is not lost should markets continue to rally.

Now there is no such thing as a free lunch, and we all know that insurance premiums can be expensive. But just now it’s relatively cheap, because volatility – a key measure of risk that the cost of protection is based on – is at relatively low levels. We can reduce that cost further by selling protection and receiving a premium. The net effect is that we are partially, not fully, protected, against falls in equity markets. But some protection is better than none at all. And affordable partial protection is better than unaffordable full protection.

The cost of this strategy today is around 2% of your equity portfolio, which is a historic low for this strategy (see chart below).

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Source: Morgan Stanley Quantitative Derivative Strategies

If you have about 40% of your assets in equities (the current average allocation for UK pension funds is 40.6%)* , the cost is around 0.8% of your total fund. If equity markets pulled back by more than 10%, the protection strategy would save you up to 3.2% of the total fund, net of costs.

The 2% quoted is the cost of putting the protection strategy in place until the end of March, by which time we should know whether or not the improving business cycle has started to feed through to company earnings.

An additional benefit to protection is that it also helps remove behavioural bias from the investment process. We are not predicting a recession: just perhaps a short term pull back. Everyone thinks they will add back as and when markets fall. But as markets fall, investors tend to become reticent of catching a “falling knife”. Having sold protection you are obligated to buy the markets at a preset level, overcoming this behavioural bias.

That’s why I like equity protection strategies right now. I’m still bouncing on the trampoline, but I feel I’ve got all the right safety nets in place to prevent any broken limbs!

*Source: The Purple 2013, Pension Protection Fund

David Vickers – Senior Portfolio Manager

David Vickers 

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