Investors often say, “I want the upside of equities but not the meltdowns.” So let’s talk about a concept that has gained currency lately—upside/downside capture. It explains how downside protection can actually drive outperformance.

With traditional safe-haven assets paying skimpy (even negative) yields, many investors realize that they may have to move up the risk curve to meet their long-term needs, including adding exposure to the higher upside potential of equities.

That’s a troubling proposition for a large and growing legion of investors. Whether they are an individual in or saving for retirement, a pension plan facing funding gaps or an insurance company dealing with stiffer capital requirements and asset/liability-matching challenges, these investors increasingly cannot bear the prospect of losing money, let alone wild market swings. They need their capital to go the distance—and with as little stomach churning as possible.

Get the Math to Work for You

Upside/downside capture offers an answer to this investor quandary. The term is a relatively recent entry to the investing world’s lexicon. It works on the same math that explains the superiority of the smoother ride in driving better long-term portfolio outcomes and the paradoxical tendency of less volatile investments to outperform the market over long horizons.

In a recent post, we showed the importance of the unglamorous efforts to avoid losses (a strong defense) in building long-term investor wealth. Simply put, an investment that loses less in market downturns has less ground to regain when the market recovers—and is better positioned to compound off of that higher base in subsequent rallies.

Upside/downside is another way of measuring this phenomenon. As with those other gain-by-not-losing cases, its workings can seem counterintuitive. Imagine a hypothetical global stock portfolio with a 90%/70% upside/downside capture ratio—meaning that it captured 90% of every market rally and fell only 70% as much as the market during every sell-off. What would the long-term returns of such a portfolio look like?

You’d be forgiven for thinking that it underperformed. But, as the display below vividly illustrates, this smoother-ride portfolio amassed a capital balance of nearly US$13,000 over the period examined—or more than 2.5 times the size of the MSCI World Index’s. And it did so with significantly lower volatility.

What’s the Catch?

In our view, achieving a 90%/70% upside/downside spread comes as close to investing nirvana as one can find: getting downside protection and still beating the market over the long term.

But here’s the rub: this performance potential doesn’t come for free. To get the full benefits of this approach, investors must accept that this strategy’s performance will, by definition, veer significantly from that of the market. Indeed, the tracking error of the hypothetical upside/downside capture portfolio was an annualized 3.1% over the period examined. That’s easy to overlook when the portfolio is outperforming in a crumbling market; the true test comes when it’s trailing in a roaring market rally. Investors must keep their eye on the long-term prize.

And, here’s another reality: striking the right 90%/70% upside/downside balance takes skill. That’s why we believe that dynamically focusing on the business models and fundamental traits of high-quality, less volatile companies (e.g., high and sustainable cash flows and healthy balance sheets)—while remaining vigilant on valuation—is the way to building a winning upside/downside capture portfolio.

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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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