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Protection needs active management

May 2021

Last month we looked at why a direct portfolio protection strategy should be viewed in context of broader asset allocation considerations. This month we look past the initial implementation of the protection strategy to the ongoing management. The main risk with protection overlays is that gains made during sell-offs are lost as the market rebounds. Active management of the strategy through monetisation locks in some profits, allowing for gains to be crystalised while still maintaining protection.

Developing an active management framework

There are two salient risks with options-based protection. As markets sell-off, the protection strategy will make money through the mark-to-market of the position. Without active management, these gains are lost if the market rebounds. The sharp rebound following the March 2020 sell-off reminded market participants that these gains can evaporate as quickly as they were generated. Additionally, some protection strategies involve capping upside exposure to cheapen the strategy. If upside is capped, this will reduce gains in market rallies if the protection is left untouched. These two issues show that a “set-and-forget” mindset is suboptimal when implementing protection strategies.

Actively managing the strategy can help mitigate both these risks. Motivated by the portfolio goals, it is useful to agree upfront on the monetisation strategy. This might include a review trigger based on a fixed index level (Figure 1) or monetising based on a certain dollar profit amount to realise. At any point in time and at any spot level, there are three choices available (Figure 2); our quantitative tools help optimise this decision.

An important point with active management is that it releases cash when you need it. During sharp sell-offs, monetisation will provide cash when other parts of the portfolio are drawing down. This is useful in providing liquidity or generating alpha in a falling market.

Restriking protection

Active management via restriking protection is an effective way to monetise positions while keeping the portfolio protected. When markets sell off, the protection gains in value. Restriking involves selling this valuable position and buying new protection at the prevailing market level. The cash generated from selling the profitable protection will generally be over and above the cost of the new protection, leaving a realised cash profit.

To illustrate the effectiveness of active management via restriking, we run a back-test comparing the same protection strategy with and without active management. In line with our analysis last month, we consider overweight equity with downside protection. The pre-agreed rule is to monetise and restrike the strategy when the delta of the strategy exceeds a trigger level. Figure 3 shows the results.

The above analysis shows that gains made by the protection during the December 2018 and March 2020 drawdowns were monetised, captured, and reinvested. The choice of monetisation trigger should be high enough to capture significant drawdown events, but low enough to not trigger too many times as markets move around. Restriking too often can be an issue if you pay a much higher premium to restrike than you did for the original trade.

These results highlight the importance of active management of protection strategies, and therefore the pitfalls of a ‘set-and-forget’ mindset. Next month we will combine protection as an asset allocation tool with active management to highlight the effectiveness of these two factors when thinking about protection strategies.

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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