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Portfolio Protection: Towards Better Investment Diversification?

November 3, 2011

(Reprinted from the December 2011 edition of the Bath Country Journal.)

by Kevin Kroskey, CFP, MBA

While well-disciplined diversification helps in the vast majority of markets, during the global financial crisis investors learned that diversification among many asset classes failed to provide expected benefits. During the fourth quarter of 2008, virtually all asset classes dropped in unison. More recently in August and September of 2011, as concerns spiked over European sovereign debt, the same phenomenon was observed. This leads to the question: Is there a better way to build a more diversified portfolio?

Portfolio Protection

Setting criteria to measure various strategies against is a reasonable place to start to answer this question. When considering portfolio protection strategies, first an investor would want minimal disruption to the overall portfolio as to not divert funds away from productive purposes. Second, costs must be reasonable for expected benefits. Third, the investment should be transparent and have sufficient liquidity. Finally, the investment needs sudden and substantial appreciation in severe market downturns without much give-back once the market rebounds. Now let’s discuss three protection strategies that have merit against these criteria.

Long-term U.S. Treasury Bonds haved spiked in price during times of distress. Treasury bonds are among the most liquid markets in the world and very transparent. In 2008 the Barclay’s Long Treasury Bond Index has been up more than 24% but then returned negative 13% in 2009. With interest rates being at such low levels, one has to also be concerned about just how much price appreciation could be left in these bonds and whether more give-back should also be expected. At some point when the Great Recession and its lingering effects exist only in memory,  the economy has recovered, and interest rates do increase, the inflation risks of owning these bonds can quickly materialize and severely punish bond prices.

Put options are among the purest form of portfolio protection. A put gives you the option to sell at a certain price at a specific point in the future. A common method to apply this to a portfolio would be to purchase a put on a broad-based market index like the S&P 500. If the S&P 500 declines in price, the put option appreciates. If the S&P 500 increases, the put option expires worthless. Thus put options inherently have no expected return.

The problem with using put options is that they are very expensive in today’s environment and completely divert funds away from investing in positive expected return asset classes. Further, a more actively managed strategy is required.  Since put options do expire, they must be sold to capture the rise in price, if this materializes, or repurchased to put the protection back in place. So called “Black Swan” funds can be owned that apply a put option strategy but add yet another layer of cost onto an already expensive proposition.

Volatility strategies such as those based on the VIX index, commonly called the "fear gauge" of the market, are a newer form of protection. The VIX index is derived from the value of S&P 500 options and is a forecast of expected market volatility over the next 30 days. Many investment products in the form of structured notes issued by global banks or exchange traded funds linked to the VIX have been developed over the last few years and generally utilize futures contracts on the VIX or S&P 500. These products have similar problems to using put options and added issues of a substantial roll cost from the use of futures contracts and of potentially assuming credit risk of the issuing bank.

More recently volatility products have been developed that dynamically allocate between short-term and medium-term futures contracts in a formulaic and transparent manner. This has the net effect of substantially reducing the roll cost but provides the sudden and substantial appreciation desired in a portfolio protection strategy. Though these strategies are very new, they performed as expected with one such dynamic index being up nearly 39% and 10% in August and September, respectively, at a time when the S&P 500 was down negative 5% and 7%, respectively. In October when the S&P 500 rebounded sharply to return nearly 11%, the dynamic index gave back about 17%. While this give-back is not ideal, given the size of the positive prior month returns, it is not unreasonable.

Variable annuities and guarantees available through various riders are generally unadvisable. Quite simply the liquidity restrictions, complexity of these products, and all-in costs make variable annuities currently not worth consideration when measured against expected benefits.

Implications for Investors

Market volatility and long run expected returns of stocks are one in the same.  If there were not volatility, there would not be an expectation of returns above less volatile fixed income investments. While disciplined diversification helps to manage volatility in the majority of markets, it has fallen short in the light of seemingly more frequent, global crises. Even government bonds need to be re-examined as the tried and true measure of portfolio protection in today’s low interest rate environment.

Portfolio protection is something to be considered by savvy investors, but expected benefits must be measured against expected costs. Careful consideration needs to be made to decide how much to potentially include in a portfolio and where these funds are to be diverted from within the portfolio. While some dynamic volatility strategies have shown to be promising, these strategies are young and need to be closely monitored. No strategy will prove to be a perfect hedge against all market declines.


Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists families with their overall wealth management, including retirement planning, tax planning and investment management needs. 

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