Portfolio Protection? It’s a Long (Term) Story…

Abstract

Investors have a natural urge to protect their portfolios from sudden crashes. The authors argue that investors should instead focus on bad outcomes that unfold over longer periods because those tend to be more detrimental to the long-term goal of wealth accumulation. The authors show that options-based hedging can be effective over shorter periods but tends to weaken over time. Worse still, returns tend to be very punitive during prolonged bull markets. In contrast, risk-mitigating and diversifying strategies such as defensive equities, risk parity, alternative risk premiums, and trend-following have more consistently added value in the longer-lasting market drawdowns that matter most to investors—and, unlike puts, can profit in up as well as down markets. This latter point suggests a crucial advantage for these strategies: that unlike options-based hedging, it is never too late to consider diversifying into them.

TOPICS: Portfolio construction, tail risks, options

Key Findings

• ▪ When it comes to drawdowns, many investors focus on depth, but length matters, too. Empirically, strategies that protect against longer-lasting tail events are more helpful to long-term wealth creation than strategies that protect against shorter-lived ones.

• ▪ Options-based hedging strategies have been highly effective at delivering value over short-term bad outcomes for traditional portfolios, but their efficacy wanes at longer horizons—eventually underperforming 60/40 even in bad outcomes for 60/40.

• ▪ In contrast, the authors present a range of alternative diversifying strategies that can provide more consistent and higher relative returns during longer-term bad outcomes, thus potentially benefitting investors when they need it the most.