• February 23, 2024

An Advisor’s Guide to Downside Protection

IIt has been 12 years since the last sustained market decline, a reality that inspires complacency.

After spending many years in the investment world, I sometimes want to hit my arms and scream: “We have to wake people!” … but the living, breathing and human person in me also empathizes with advisors. caught in a difficult situation.

Are you holding on to positions designed to protect against the possible market decline, even though many of these instruments detracted somewhat from performance during this sustained upward trend in stock prices (and we all know how quickly many clients will point this out)?

In our view, when considering how to avoid potentially catastrophic market declines, the right question for consultants is: “Will adding downside protection to my portfolios improve long-term benefits for my clients?”

The “why” of this question is relatively straightforward, but the “how” is where things can get complicated.

Now available: A Guide for Consultants

To help answer the “how”, Blueprint today publishes “Advisor’s Guide to Protecting Against Downside Risks. “We set out to create a guide for financial advisors instead of a highly technical specification document. As such we have:

  • Evaluate a mix of 11 traditional, hedging and tactical / alternative strategies commonly used as an “insurance policy” to protect a portfolio during a market downturn
  • Take into account the practical elements that advisors will face, including implementation, product / strategy availability, and investor behavior

Our analysis focuses on four critical questions:

  1. Is the approach accessible to the average investor and their advisor?
  2. How well does a particular approach diversify the traditional 60/40 portfolio to provide downside protection?
  3. In addition to protecting against downward movements, how well does the instrument work in standalone mode?
  4. How does each instrument influence investor behavior?

In order to answer these questions objectively, we apply a methodology that analyzes each instrument of downward protection by two lenses.

The first lens: the instrument as a 20% allocation in a traditional portfolio

We have simulated the effects of adding any downside protection tool to an otherwise standard 60/40 portfolio that we believe provides a fair foundation for goal-oriented advisors. This allows us to assess how each instrument impacted the traditional portfolio during the four largest market declines since 2000, as well as throughout the market cycle from 2000 to 2020.

Here is a selection of the results from the guide:

  • Nine of the eleven instruments received capital during all four market declines
  • The Value Index was unable to obtain capital versus a traditional portfolio in all four crisis periods, and Real Estate Investment Trusts (REITs) only received capital in one
  • The CBOE Volatility Index (VIX) was the only instrument that performed positively during all four market declines, but it was also the only instrument that pulled composite returns negative across the sample
  • The short-term trending strategy S&P 500, REITs and Gold offered the best average annual growth rate since 2000

The second lens: the instrument as an independent investment strategy

We mandate a “behavioral score” for each instrument by combining traditional quantitative risk / reward metrics with qualitative metrics, which can be powerful indicators of whether and how long an investor will hold on to an investment.

While traditional asset valuation often ends after a quantitative analysis of the risk / reward metrics, we find this short-sighted as it overlooks one important consideration: How will your client feel about the investment’s behavior in both up and down markets? In practice, it is difficult for clients to defend optics when they have to constantly explain why a particular investment is consistently losing money, even if it is quantitatively beneficial to the overall portfolio.

Here is a selection of the in the leader::

  • The short-term trending strategy S&P 500 and the investment grade index for corporate bonds were the most behavior-friendly instruments
  • Liquid alts and government bonds ended up in the middle
  • One group of instruments was in a non-behavioral area: long / short and managed futures (lack of transparency affected their rating) as well as gold, REITs, Value, VIX and the inverse S&P strategy (due down) too their underperformance and / or drawdown)

The role of consultant preferences and values

Several results highlight the major challenges consultants face in trying to select the “right” strategy or asset to protect against downside risk. For example, if you are looking for drawdown enhancements and “Crisis Alpha” an instrument might be an obvious choice. However, it can be too big for many investors to hold this position and see it affect performance in almost any other setting.

Any consultant can clearly weigh the factors used in our analysis or not evaluate these factors at all.

Rather than proclaiming an absolute truth, our intention with the guide is to objectively present the pros and cons that will emerge from our analysis. We hope the results can serve as a framework for determining how to use processes to manage downside risk in your portfolios.

We would be happy to answer your questions about the data or how to use the manual. Just Write us a message so we can continue discussing.

Blueprint Investment Partners is a registered investment advisor under the Investment Advisers Act of 1940. Registration as an investment advisor does not imply any qualification or training. A consultant’s oral and written communications provide you with information about which you would like to hire or retain a consultant. For more information, please visit Adviserinfo.sec.gov and search for our company name.

The views and opinions expressed are those of the author and do not necessarily reflect those of Nasdaq, Inc.

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Jack

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