Downside protection isn’t a free lunch!

August 27, 2014 Categories: Investment Strategy

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Nothing in life comes for free (well, except things like oxygen and the Metro). But my point is that most things that look too good to be true usually are, and there is often a downside to every upside – and vice versa.

The same is to be said for put protection strategies. Option strategies have gained prominence in investor toolkits given their ability to improve risk return outcomes relative to traditional long only strategies on their own. However there is rarely a free lunch, particularly when trying to hedge against market falls. While combining the S&P 500 Index with protection below 90% of the starting market value would have beaten the S&P 500 Index in isolation by a whopping 23.8% in 2008, in most years adding protection would have underperformed a simple holding of equity in isolation.

Indeed, despite the last 14 years having witnessed more than its fair share of significant market falls, you would still have been better off holding naked equity exposure over the period as a whole. Protection might have helped you sleep better over the period, but it would not have made better off.

Figure 1: Performance of £100 invested in S&P 500 (TR) with 90% put vs. S&P 500 (TR) in isolation
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Source: Bloomberg as at 31.12.2013

Note: “TR” refers to the Total Return Index

It is unsurprising that the portfolio with protection underperforms under normal market conditions. If you buy insurance to protect against risk, by definition you are passing it on to someone else. Under such circumstances you cannot expect to earn the reward for bearing that risk. That would be the same as “having your cake and eating it”!

So what can we conclude? Firstly, that successful timing of the market for protection can lead to significant profits; just look at 2008 as an example. But secondly, for the profits from downside protection to be preserved, protection needs to be used in a more tactical way to complement your current portfolio positioning.

 

David Vickers – Senior Portfolio Manager

David Vickers

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