1) Watching your nest-egg disappear is painful and for a good reason – as the magnitude of your drawdown increases, the size of the recovery and time required to generate the return to break even increases as well, hurting your ability to compound your capital.
2) Contrary to popular belief, capturing 100% of the upside movements of the market is actually less important than properly protecting your downside. It’s time to start taking downside protection seriously.
3) Typical methods to achieve proper degrees of downside protection are either often inefficient or losing some of their theoretical backing in this market environment. An actively managed portfolio of alts may offer you a refuge from the storm.
The first rule of an investment is don’t lose money. And the second rule of an investment is don’t forget the first rule.
A common theme in investing is the importance of downside protection. Psychologically it makes sense – losing money is always painful. However, since markets have historically tended to recover from drawdowns over time, many investors wonder whether this protection really helps their long-run returns. It turns out it does and here’s why.
Protecting against the downside is actually more important than being exposed to 100% of the market’s upside. Let’s use the performance of two investors to drive this point home. The first investor has a standard 60/40 portfolio – exposed to the whims and all of the volatility of markets. On the other hand, the second investor decreases the magnitude of their 60/40 portfolio’s drawdowns by 50%, while only capturing 60% of the portfolio’s upside. The end result? Investor 2 performs substantially better despite capturing a smaller percentage of the upside!
It often takes a long time to recover from drawdowns, hurting your ability to compound capital in an efficient manner. This is further exacerbated by the fact that as the magnitude of the loss increases, the return you need in order to get back to breakeven increases:
Take the infamous tech-focused ETF, ARKK, as an example. With the fund down (80)% from its peak over the last year, it needs a 400% return just to get back to breakeven!
One of the most common methods for downside protection is a concept known as tail hedging. This strategy typically consists of investors buying index put options well below the current market price. Think of put options as an insurance-like product that provide a “floor” for your investment when the market goes down because they give you the right to sell the index at a specific price, regardless of how far it falls.
As an example, imagine you are invested in an index worth $100 today. You decide that at the most you are willing to lose 30% on this investment and want protection in place in case it falls below $70. You can achieve this by buying a put option with a “strike price” of $70. This put option will cost you some amount of money upfront (the “premium”), but allows you to sell the index at $70 in the future even if it falls below $70, whether it falls $50 or even $0. In the scenario where it falls to $50, instead of losing half your investment, you only lose the 30% you were willing to risk. If the index never falls below $70, your only cost is the premium you paid for the option.
Because markets tend to go up over time, these tail-risk strategies almost always lose money. But in situations like the pandemic-induced crash of 2020 they offer high asymmetry, generating positive returns while the market was down double digits:
However, like most properly-run insurance products, profits are often immense for the insurer rather than the insuree. This is because many of these options expire worthless, meaning the seller of the option (the insurer) collects the premiums and never has to make any payouts. In other words, expected returns for the majority of tail-hedging products are negative over the long run. Therefore, a static asset allocation to these strategies acts as a drag on overall portfolio returns.
Another way for investors to seek downside protection is through proper diversification across asset classes. The general thought here is that through allocations to assets that have low or no correlation, you can cushion your portfolio against high-magnitude drawdowns since the portfolio constituents should not move in tandem. A common mechanism to achieve this goal is with the classic 60/40 portfolio. However, this only exposes investors to one sliver of the entire investable universe (equities and fixed income), and one of the fundamental premises for the portfolio, i.e. low or negative correlation, is no longer holding true this year.
At Equi, our funds are designed to be resilient in times of market stress, seeking to preserve investors’ capital in down markets so that they compound from a higher starting value once markets turn around. But how are we able to achieve this? First, Equi’s models track certain indicators and market statistics, ranging from changes in correlations across asset classes to how other investors are exposed to market moves based on their option positioning. Monitoring and acting upon signals like these allows our asset management team to proactively identify risks to the portfolio and hedge against them during periods of market turmoil or during regime changes such as the one seen in 2022.
Our funds are also managed dynamically, meaning we aren’t just maintaining a static hedge at all times, which can act as a drag on returns. Rather, Equi maintains higher degrees of protection during periods of market stress and reduces that protection during periods of stability. This active and discretionary process seeks to avoid the erosion of returns that comes with the cost of downside protection while still protecting in times of higher risk. This is also reflected in our underlying position management, where we are constantly screening for new positions, monitoring our underlying managers, and opportunistically rebalancing based on the market environment.
Our portfolio consists of a series of investments in alternative assets, comprising over 15 different return drivers, with little to no correlation with the day-to-day movements of the equity markets. Not only do we seek to dynamically protect against the downside, but we also target strategies with upside convexity, meaning we expect them to have more upside potential in favorable market conditions than their downside risk in unfavorable conditions. Our CIO, Itay Vinik, provides the following example:
“Our Scandinavian bond manager trades the spread between Swedish mortgage and government bonds, which is essentially the difference in yield demand by investors to hold these bonds. The country’s mortgage market has largely avoided turmoil over the course of its history; even in 2008 and 2009, the default rate was less than 1%, and the requirements to get a mortgage are pretty hefty. As a result, these mortgage bonds are placed on a similar pedestal to government bonds. Despite this, there is a difference in the yields demanded for mortgage bonds compared with the government bonds, providing a “risk premium” that can be harvested by investors for positive returns. This year, we’ve seen the spread between the two bonds go to its highest since 2008-2009, providing significant upside potential in the strategy. If the markets remain flat and the spread remains where it is, the carry alone in the position should yield north of 20% next year. Alternatively, if spreads were to return to 2019 levels, it would produce a return of nearly 40%.”
At Equi, we seek to build our portfolios around multiple strategies with similar potential upside dynamics in order to be well-positioned to capitalize in periods of risk-asset recoveries, continued market turmoil, or sideways price-action and volatile market movements.
Unlike the 60/40, where it may take years to get back to baseline after this year’s worst start in nearly a century, Equi’s funds are designed to be a core component of investors’ portfolios, and are core holdings of our founders’ for that reason. Putting these principles into action, Equi’s performance continues to exceed the market’s:
Don’t watch your nest-egg disappear in front of your eyes – consider making Equi a core part of your portfolio today.
Disclosure: Towards Equilibrium, LLC (Equi) and Equilibrium Ventures, LLC (EquiV) communications are intended solely for informational purposes. They should not be construed as investment, legal, tax, or trading advice and they are not meant to be a solicitation or recommendation to buy, sell, or hold any securities including funds mentioned. Any such offer or solicitation can only be made by means of the delivery of a Confidential Private Placement Memorandum ti qualified eligible investors.
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Past performance is not indicative of future results and an investment in an investment fund involves the risk of loss. The investment fund is speculative and involves a high degree of risk.
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The portfolio composition discussed herein is accurate only on the date set forth herein. The portfolio composition will change, and you should not expect the same or similar portfolio composition to be maintained at any time in the future.
Asset allocation does not guarantee a proﬁt or protection from losses in a declining market. Investments, when sold, may be worth more or less than the original purchase price.
S&P 500 performance obtained from Bloomberg. References to S&P 500 are included for illustrative purposes only. It is not expected that funds will make investments in S&P 500 companies. Funds are expected to invest with a strategy that is different from a strategy of making equity investments across an index. Accordingly, investors should not expect that an investment would provide exposure that is similar to an index investment in S&P 500 companies or any other specific benchmark.
Back-tested performance for the Equi Funds is hypothetical and does not represent actual fund performance. You should not make investment decisions based on back-tested performance alone. These hypothetical returns do not reflect actual trading and therefore do not account for actual financial risks, economic conditions, taxes, fees or expenses. These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these estimates do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. More information on the backtest methodology is available here.
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