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Protection as part of the Asset Allocation process

April 2021

This month we continue our look at more direct portfolio protection using options. Implementing protection should not be a decision made in isolation. Instead it is prudent to think about protection in context of broader asset allocation considerations.

Protection allows for an increased equity allocation

Implementing a well-designed protection strategy while simultaneously moving to overweight equity can outperform the standard equal-weighted allocation. In a similar way, protecting an existing allocation to equities can be more effective at changing equity exposure than selling. This is due to the combination of the extra equity exposure and the decay profile of the strategy. Consider the performance of increasing an equity allocation by 20% while protecting half of the increased equity notional; this might represent a 50/50 portfolio moving to 60/40. Figure 1 shows the outperformance of this strategy over the unchanged equity allocation after 6-months. This scenario analysis shows the combined strategy outperforms the equal-weighted case if the S&P 500 falls less than 15%, or rises by less than 17%. Over the past 20 years, the index has traded within this range over 6-months in 71.1% of cases. Peak outperformance is ~75 bps.

Different strategies produce vastly different outcomes (Figure 2), highlighting the importance of strategy design. Table 1 shows the corresponding performance metrics. Well-designed strategies can provide attractive returns with substantial reductions in volatility and drawdowns.

A well-designed strategy is not always about the return it generates. Metrics of risk such as volatility and maximum drawdowns are also important. Understanding how a strategy performs on a risk-adjusted basis is vital to ensure portfolio and strategy goals are achieved.

To illustrate the contribution of the overweight equity alongside the protection strategy, we deconstruct an example strategy during 2020 into two constituent components: protection P&L and equity P&L. In Figure 3 these are given by the two shaded lines, while the combined strategy is in dark blue.

This approach is effective in both market regimes we saw in 2020. During the sell-off, the protection paid off, mitigating drawdowns. As the market recovered, the overweight equity allocation contributed enough exposure to equities to take advantage of the subsequent rally. Both components contribute to the better performance of the strategy compared to the equal-weighted case. While these results highlight the efficacy of using protection as an asset allocation tool, they understate total performance because active management of the protection is not considered. Next month we will discuss how active management can help crystalise gains and provide superior outcomes.

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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