How to allocate to equities, which offer high potential returns but where investors are always ‘skating on thin ice,’ with the ever-present
risk of a bear market or crash? One answer is to remain fully invested for the long term and to ride out market lows. This has generally been good advice in the past as steep bear markets have often been followed by a sharp bounce back. However, investors may not be able to tolerate these drawdowns and, as the disclaimer on every piece of investment marketing literature states, past performance isn’t necessarily a guide to future returns.
Human psychology also exerts a powerful influence on investment decision-making. It’s well known that investors focus more attention on losses than the weight given to equivalent gains (called ‘loss aversion bias’ in behavioral psychology). When gains which have been slowly accumulated over several years are wiped out in a few weeks the pain is amplified, making it hard for investors to maintain a detached approach and stay invested.
An alternative response to the question above is to consider a strategy which aims to systematically control equity downside risk. Defensive equity strategies aim to provide high upside potential combined with smoother investment performance and lower drawdowns which can help investors to mitigate timing risks and stay invested through periods of heightened volatility to participate in subsequent market rallies. In other words, investors should aim to skate on ‘thick ice.’ There are many different approaches to designing a defensive equity strategy but we can categorize them into two buckets by their degree of predictability: lower precision, indirect strategies which depend on a repeat of historical patterns or correlations (e.g., minimum volatility equity portfolios, momentum strategies, ‘just in time’ hedging, cross asset hedging, etc.) or higher precision strategies which directly hedge downside exposure (e.g., optionbased approaches, dynamic exposure management strategies, etc.).
Lower precision strategies have not offered consistently effective defensiveness in the past, with many strategies failing to significantly reduce drawdowns during the 2020 COVID crisis, for example, when historical patterns of stock Betas and crosscorrelations changed rapidly. Many lower precision strategies have other appealing investment characteristics but in our view are not appropriate when robust downside risk mitigation is required at all times.
For the purpose of this paper we focus on higher precision strategies, in particular equity option defensive strategies which we believe provide highly reliable drawdown control and minimize the path dependency associated with portfolio insurance approaches. Our aim is to identify strategies which avoid the additional costs and pitfalls of very simple option strategies without introducing unnecessary complexity.
To aid in the identification of viable option-based defensive strategies, we set out below our criteria for success:
- Predictable: A defensive equity strategy should provide reliable downside risk control at all times and be simple and transparent
- Systematic: A rule-based strategy which doesn’t rely on judgement to deliver consistent risk management
- Efficient: A strategy which optimizes risk-adjusted returns and controls costs to deliver long term value from downside risk management
The performance reference point for a defensive equity strategy is a simple portfolio which is allocated between an equity index and cash to target a similar level of risk. A successful defensive equity strategy should aim to deliver more upside and/or lower drawdowns than this reference portfolio for the same level of risk.
In the rest of this paper we investigate defensive equity strategies and attempt to provide a better understanding of some of the factors which drive cost and efficiency and, finally, identify optimal approaches that satisfy the criteria listed above.
Here you'll find the complete report 'skating on thick ice - designing an optimized defensive equity strategy' from UBS Asset Management.