Protecting your portfolio can be prudent with record markets
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.
Comparing protected portfolios
We run this analysis from the start of 2017 with the same protection strategy used last month.
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.
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