For a long time, investors had gotten accustomed to the low volatility, high level of returns that 2017 brought. I think 2018 helped people to learn or remember that volatility exists and is a very real thing.
This year has been driven by really strong performance with, honestly, deteriorating fundamentals in certain parts of the market. So I think that many investors are starting to think, Well, maybe I should start to incorporate some degree of downside protection into my portfolio in order to help protect against the possible future downdraft.
We think there are three different strategies you can employ in your portfolio to incorporate varying degrees of downside protection.
The first that we’d recommend is, look beyond the US. If you look at international developed equities, they’re actually trading at pretty meaningful discounts to the 20-year average. Price isn’t everything, though: it’s really important to discern between lowly priced securities and lowly valued securities.
So we think that focusing on fundamentals, identifying companies that have a nice balance of quality, stability and price, can help investors to deliver better risk-adjusted returns over time. To add in another layer to that, if you can identify companies that have a better up-market capture than they do down-market capture, the path of your returns from point A to point B should be better over the longer term. In fact, we found that if you can construct a portfolio that captures 90% of the market’s upside and 70% of the market’s downside, you’ve actually doubled your annualized return versus international developed equities over a 20-year period.
For those investors who have a greater need for downside protection—more aggressive downside protection—we’d recommend flexible equity hedge strategies, or you could think of those as long/short strategies. So these strategies typically will combine long exposure and short exposure to manage their overall exposure to the equity market.
So as market conditions become more challenging and markets get more volatile, those strategies to have the ability to either increase short exposure, to reduce their exposure to the market, or in really difficult environments, some may look to reduce overall exposure by raising cash and acting defensively that way. Over time, these strategies have been able to deliver shallower drawdowns for investors. And what’s also important is quicker recoveries from those drawdowns.
Some investors might look to reduce some of their equity exposure and replace that with high-yield bonds. So, historically, high yield has offered similar returns to traditional equities, while also offering a better volatility profile than equities over time. So some investors may look to take some of their gains after a very strong performance in the equity market and potentially shift that over into fixed income, particularly through higher-yielding securities.
So there are several strategies that investors can employ to help them better navigate uncertain environments ahead. The key thing here is to focus on the path of your returns that will give you a better risk-adjusted performance over the longer term.