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Should Investors Buy Downside Protection to Hedge Against an Equity Market Drop?

Wade O’Brien

Wade O’Brien

Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.

We don’t think so. Investors with diversified portfolios already have some cushion if equities sell off given holdings like fixed income, hedge funds, and other diversifying assets. Further, trying to time the market by buying derivatives or substantially reducing equity exposure is rife with behavioral risks that could see investors ceasing to purchase protection just when it might eventually pay off or failing to re-enter the market when valuations are bottoming.

Investors could be forgiven for thinking this equity rally is a bit long in the tooth. A post-election bounce has taken the trailing 12-month return (through March 31) of the S&P 500 to 17.2%, and the market has not suffered a bear-sized correction (defined as a fall bordering on 20% or more) since 2011. Earnings have been weak and multiples certainly have expanded—US equities are nearing very overvalued territory, with our normalized composite price-earnings (P/E) ratio in the 89th percentile of observed valuations. To reduce the risk of a sudden or perhaps more gradual deflation of risk assets, some investors have explored derivatives strategies such as buying puts or have asked if they should simply move to cash and wait for more reasonably priced opportunities.

We don’t recommend this for several reasons. First, getting the timing right is very difficult. Valuations are a notoriously poor signal for near-term stock market returns; there is little relationship between either short-term or normalized P/Es and subsequent one-year returns. Cycles are difficult to identify ex ante and knowing when and by how much the market last corrected does not itself provide any insight into when the next correction is coming. The historical record suggests market volatility is not evenly distributed and in fact often occurs in short spurts (e.g., all of the trailing 12-month returns between June 2008 and August 2009 were -10% or worse).

Since the frequency of short, severe equity market declines is low, the deck is stacked against investors trying to time their exits. Since 1969, the S&P 500 has only experienced -10% or worse returns over trailing three-month periods around 7% of the time. More importantly, exiting the market and parking funds in cash can result in significant foregone performance. Our data show that sitting out just the best 30 trading days since 1980 would have lowered an investor’s return in US equities by around 500 bps per annum!

Second, the costs of buying protection while staying invested can also be a significant drag on overall performance. The cost of 12-month 15% out-of-the-money options on the S&P 500 has declined over the past year and is now around 200 bps—a seemingly small price to pay given strong recent returns. But this misses the point. The odds that the S&P 500 will return -17% (the point at which the investor buying the 15% out-of-the-money option would break even considering the 2% fee) over the next 12 months are very low. Historically this happens around 6% of the time and, in fact, has not occurred since the depths of the financial crisis.

The last time we fielded so many questions about the value of buying puts was the summer of 2014, when investors were also skittish following the market’s strong recent performance. Our advice hasn’t changed since a similar CA Answers at the time, and we suspect anyone who did buy options would rather have had the market’s 28% cumulative return since that time than the peace of mind that options might have offered during the market’s minor wobbles in late 2015 and early 2016.

This is not to say that investors in US equities should not be cognizant that risks are rising in conjunction with equity prices. Rather, it is to say that we believe maintaining a diversified portfolio is a better way to dampen portfolio volatility. True, bond valuations look stretched, and instruments like US Treasuries may not offer the same ballast they have in the past if correlations become positive between stocks and bonds. Should volatility tick up, strategies like long/short hedge funds and trend following may be better protectors of capital. Even if it does not, an environment of low yields and low economic growth may mean private equity strategies like royalties, life settlements, and leasing will outperform. These strategies are a better use of capital than buying downside protection.

Wade O’Brien is a Managing Director on Cambridge Associates’ Global Investment Research team.

Originally published on April 11, 2017

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