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Protecting your portfolio can be prudent with record markets

June 2021

Over the past few months we have highlighted some key considerations when thinking about explicit options-based protection. Decisions on explicit protection should be made in conjunction with broader asset allocation decisions, and active management of the protection should be involved to manage the position optimally. These apply to both first- and second-order protection strategies. This month we will combine these factors in a broader portfolio context.

Building a protected portfolio

We will analyse a portfolio of equities and bonds and show how tweaks to the portfolio can affect performance. Specifically, we take a standard 60/40 portfolio, tilt it overweight equities, and add explicit protection (Figure 1). This will aim to show the incremental benefits of adding each piece of the overall protection framework to the entire portfolio. These improve portfolio outcomes both from a return and volatility angle. While this is an example construction process, this methodology can be extended or applied to any iteration of portfolio construction choices.

Figure 1

Comparing protected portfolios

We run this analysis from the start of 2017 with the same protection strategy used last month.

Figure 2

This chart highlights a few important points:

  • Shifting from the original portfolio to overweight equities increases returns over the period but also volatility and drawdowns
  • Protecting the overweight portfolio with no monetization introduces negative drag on the portfolio
  • Monetization allows for protection gains to be crystalised. This generates significant outperformance, particularly during the March 2020 selloff.

To quantify the above points, we now look at performance metrics:

The protected overweight increases the risk-adjusted returns of the portfolio, but results in lower absolute returns. Introducing active management of the protection has almost no effect on the risk-adjusted performance of the portfolio, but substantially increases absolute returns. These results highlight the importance of the entire end-to-end protection strategy design. We note that this period had a large drawdown which helped the performance of the protection strategies but the active protected overweight strategy would have outperformed the Balanced strategy by 0.35% p.a. even if we stop the test prior to the drawdown in 2020.

The Solutions Team

The Solutions team provides derivative overlay and risk management fiduciary services to Asset Owners and Managers in Australia. Our goal is to provide asset owners and managers with an experienced overlay advisory and execution service to improve portfolio outcomes and cost efficiency.

Important notice
Financial services provided by Challenger Investment Solutions Management Pty Ltd (ABN 63 130 035 353 AFSL 487354) (CIP Asset Management, CIPAM). The material in this document is general background information about Challenger’s Investment Solutions activities and is current at the date of this document. It is information given in summary form and does not purport to be complete. It is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any particular investor. These individual circumstances should be considered with professional advice when deciding if an investment is appropriate. Nothing in this document should be considered a solicitation, offer or invitation to buy, subscribe or sell any, or a recommendation of, financial products. All reasonable care has been taken to ensure that the facts stated and opinions given in this document are fair and accurate. To the maximum extent permitted by law, the recipient releases each member of the Challenger Limited group of companies, their directors, officers, employees, representatives and advisers from any liability (including, without limitation, in respect of direct, indirect or consequential loss or damage or loss or damage arising by negligence) arising in relation to any recipient relying on anything contained in or omitted from this document. Any forward looking statements included in this presentation involve subjective judgment and analysis and are subject to significant uncertainties, risks and contingencies, many of which are outside the control of, and are unknown to, Challenger. In particular, they speak only as of the date of these materials, and they are subject to significant regulatory, business, competitive and economic uncertainties and risks. Actual future events may vary materially from forward looking statements and assumptions on which those statements are based. Given these uncertainties, recipients are cautioned not to place undue reliance on such forward looking statements. Any past performance information provided in this presentation is not a reliable indication of future performance. This document is not audited.