July 28th, 2014 | by Gregg S. Fisher, CFA, "Invest with Reason"
The Price of Downside Protection
Volatility is back in the markets. On July 17, following the Malaysia Airlines disaster in Ukraine and the Israeli land invasion of the Gaza Strip, the Volatility Index (VIX) of implied S&P 500 Index volatility surged 32.2% in one day, to 14.54. This and the long bull market the US has experienced since 2009 have caused many investors to regain interest in forms of downside protection for their stock portfolios. In this column, I’ll discuss three downside protection strategies for nervous investors –options, variable annuities and asset allocation—but before that, for context, let’s review some recent market history.
By almost any yardstick, the market has been relatively stable recently. We are approaching three years now without a correction of 10% or more in the S&P 500 Index, which historically has dropped by 10% or more about once a year. VIX, the “fear index”, was recently at a seven-year low (see VIX and S&P movements from 2011 in the exhibit below). If stocks finish 2014 with gains, it will be the sixth consecutive calendar year of increases for the S&P 500. From March 1, 2009 to June 30, 2014, stocks returned 199%, or 22.8% annualized. It’s been a good ride.
Are we set for a pullback? I have no idea; we make no attempt to time markets or to divine the future at Gerstein Fisher. But investors should prepare for a correction and avoid making fear-based decisions in the event of one. Keep in mind that market corrections are a normal and even healthy aspect of embracing risky assets such as stocks—without them, investors would not collect the risk premium they offer.
The Cost of Puts and Guarantees
Now let’s examine some downside protection strategies, starting with the purchase of put options to hedge the downside risk of your stock portfolio. That cost has crept up in recent days with market volatility (the cost of insurance usually rises when everyone wants it), but by historical standards the current cost of buying puts is still quite modest.
For example, let’s say you have a $1 million portfolio of stocks. We’ll use the exchange-traded fund SPY, which tracks the S&P 500 Index, as a proxy for the stock holdings. If you’re particularly anxious and would like to hedge the risk of the portfolio dropping by more than 10% in six months, you could purchase out-of-the-money put options (January 2015 expiration) on SPY, which would cost $13,750 (on July 21, 2014), or 1.38% of the portfolio value. Or let’s say your goal is more along the lines of catastrophic protection—say, to protect against 25% or 50% market declines in 12 months. To purchase enough out-of-the money put options on SPY to hedge against a 25% decline in one year, you’d pay about $13,133, or 1.313% of the portfolio value; for protection against a 50% decline, you’d fork over just $1,900, or 0.19%.
As a general rule, the worst time to buy an option is when you want to buy an option. What I mean by this is that when volatility is high in the market and investors are nervous, they tend to go shopping for insurance at the same time. I have published a behavioral finance article with my research partner Phil Maymin on how investors react to recent market volatility (see Preventing Emotional Investing: An Added Value of an Investment Advisor). Interestingly, our research demonstrates that VIX, which measures “implied volatility”, is actually a more accurate measure of trailing, realized 30-day volatility than of forward 30-day volatility (see Exhibit 2). In other words VIX is excellent at telling you what has already happened in the markets.
But returning to the option strategy, let’s consider some of the problems with this strategy even when the cost appears reasonable. Remember that you’re purchasing downside protection for only a limited time period. You could roll over the put contract, but this tactic is expensive and will depress your equity portfolio’s long-term returns. If you are saving and investing long-term for retirement, it seems counterproductive to purchase puts to protect against potential short-term losses, given the costs of doing so.
Let’s look next at the variable annuity approach to acquiring downside protection. Say you’re nearing retirement. You know that, long-term, stocks are generally a very good investment that will maintain or increase your purchasing power in retirement. But the memory of two market crashes in the past 14 years is etched into your brain. As a way of hedging your bets, you could sell your equities and with the proceeds purchase a variable annuity that offers a level of guaranteed income in retirement (we’ll assume the insurance company stays solvent), along with the potential market upside in the form of an aggressive allocation to equities. The issue, as with using options to minimize potential losses, is that you’re surrendering much of the potential market upside since annuity contract fees can cost at least 2-3%.
Revisiting your Portfolio’s Allocations
The third approach to downside protection is to modify your asset allocation. Each client situation is unique, but generally speaking we prefer to implement an investment allocation with careful attention paid to risk instead of the relatively expensive and complex instruments of options or annuities. To be clear, I am speaking of shifting allocations in the portfolio to match long- term objectives, not because you fear the market may shed 10% or 20% in the coming weeks (to repeat, we do not believe in market timing). For example, by increasing your fixed income allocation and reducing exposure to equities and other risky assets, you are narrowing the range of expected returns and cutting volatility. But this peace of mind also comes at a price.
Let’s say you’re considering switching from a portfolio with 60% invested in equities and the remainder in bonds to one with a 40% equity allocation. Using the S&P 500 Index to represent stocks and 5-year Treasuries as a proxy for bonds, we back-tested both portfolios from January 1926 to June 2014 and rebalanced quarterly. Result: the more conservative 40/60 portfolio was nearly 30% less volatile, but returned 7.78% annualized vs. 8.75% for the 60/40 blend. That 0.97% per year gap adds up when you’re compounding wealth over time. For instance, assuming the historical results we just cited, after 20 years a $1 million account invested in the more aggressive portfolio would multiply to $5.35 million, compared to $4.47 million for the 40/60. In other words, the short-term cost of switching to a more conservative allocation may seem minor compared to buying puts or annuities, but there is in fact a steep price in the form of the opportunity cost of a lower expected long-term return as a result of cutting exposure to risky assets.
In closing, I would encourage investors to focus on some basic principles. Ensure that your portfolio allocations are appropriate for your needs and risk tolerance and that cash reserves (at least 6-12 months’ worth) are adequate for any emergencies that might arise. Don’t neglect to rebalance portfolios back to strategic asset allocations (you can look at rebalancing as another form of risk management). It is far better during relatively calm times to think through whether your portfolio allocations are appropriate for your long-term goals than to wait for turbulent times when the VIX is headed for the sky.
Three forms of market downside protection— put options, variable annuities with a guarantee, and asset reallocation—each have their place, but investors should understand that all usually come with the price of reduced expected portfolio returns. By all means, however, when markets are relatively placid and minds are cool, take the opportunity to assess whether your portfolio allocations are appropriate for your objectives and your time horizon. Don’t wait until markets are in a mode of panic.