Risk Management in Times of Uncertainty
US economic resilience, a pause in the Federal Reserve’s rate hiking cycle, and enthusiasm for Artificial Intelligence have fueled double-digit returns in the S&P 500 year to date. This strong market recovery is a welcome relief for investors who suffered through a historic drawdown in both stocks and bonds last year. Now, as we move into 2H 2023, the question is whether this impressive market rally is sustainable. Given the murky economic backdrop, many investors are concerned that there is little room for the market to move higher and prefer to hold cash and other safe assets. Meanwhile, other investors are loading up on risk assets in response to such strong positive momentum. So, should investors be buying or selling equities? Unfortunately, no one has a crystal ball and can answer this question with absolute certainty, especially in the current environment with such a wide range of outcomes.
Given the inherent uncertainty involved in investing, research has shown that attempting to “time” the market has a negative impact on long-term returns. Staying invested and keeping asset allocation consistent are crucial components in achieving financial goals over the long run. Missing out on some of the best days in the equity market because money is sitting on the sidelines is severely detrimental to long-term returns. In fact, the tremendous power of exponential growth through compounding can be seen in research from Putnam Investments who found that if you were to have invested $10,000 in the S&P 500 on 12/31/2007 and remained fully invested, you would have earned $35,461 by 12/31/2022. In contrast, someone who invested $10,000, but missed out on the 10 best days of the market, would have earned only $16,246 (see chart).
Source: Putnam Investments
But not all investors have long-term time horizons. In the short run the stock market can be extremely volatile. Over the past 74 years, there have been 14 bear markets, lasting an average of 13 months, with declines averaging -25.3% before markets recovered. These drawdowns can have a strongly negative impact on immediate financial goals and needs. Large losses also require even larger gains to get back to even and many investors (especially those near or in retirement) don't have time to wait to recover from a large drop in portfolio value. For many of our clients, capital preservation through prudent risk management is paramount.
Staying invested in volatile equities is important in achieving long-term goals, but at the same time, risk management and volatility reduction are important in achieving short-term goals. Given the current uncertain environment, Accuvest believes that hedging equity exposure can best satisfy these two investing principles. Our hedging strategy allows us to avoid the pitfalls that come from trying to time the market while still retaining capital appreciation potential. We can maintain equity exposure in our portfolios with confidence knowing that downside risk and volatility are reduced.
Our Hedging Strategy Explained
Our hedging strategy makes use of Defined Outcome Buffer ETFs. Buffer ETFs are innovative exchange-traded funds that track the performance of an underlying index such as the S&P 500 but provide investors with a predetermined level of downside protection (a “buffer”). Many buffer ETFs in our portfolios have 15% downside protection. This means that if, at the end of the outcome period (usually one year), the market is down 15%, the fund will be down 0% (flat). If the market is down 16%, the fund will only be down 1%. If the market is down 17%, the fund will only be down 2%. And so on.
Downside protection can be implemented in portfolios in other ways, such as the use of puts or by moving to cash. But the beauty of hedged ETFs is that they retain upside potential. If the underlying index performs well over the course of the outcome period, the funds will appreciate up to a predetermined level (the “cap”). Currently, buffer ETFs are offering excellent upside – many have a cap above the 20% level. To illustrate the concept of a “cap”, a fund that offers a 20% cap can be used as an example. If the market is up 20% at the end of the outcome period, the fund will also be up 20%. If the market is up 21%, the fund will only be up 20%. If the market is up 22%, the fund will only be up 20%. And so on.
Buffer ETFs are built using three “layers” of options contracts. The first layer involves buying a deep-in-the-money call option on the reference asset (the stock market index). The second layer is a put spread. Together the long call and put spread deliver exposure to the underlying investment with a downside buffer. Finally, the third layer consists of selling a call. The call is sold as far out of the money as possible, while still generating enough premium to cover the cost of the buffer (layer 1 and 2). The sale of this call is what creates the upside cap.
To summarize, by accepting a limit on growth potential in the form of an upside cap, these ETFs create a built-in buffer against loss over a defined outcome period, usually one year, after which the ETF resets its exposure and buffer zone. The “payoff profile” of these ETFs is depicted in the graphic below:
Source: Innovator ETFs
Historically, these types of defined outcome vehicles have only been available through certain bank and insurance products, often in the form of structured notes. These legacy products are opaque, illiquid, and come with punishingly high fees. They are also subject to the underlying credit risk of the issuer. In contrast, Buffer ETFs are daily liquid, transparent, tax-efficient, cost-efficient, and are not subject to counterparty risk. Accuvest believes that these vehicles are very attractive given the uncertain market and economic environment. We have the upside potential needed to achieve our clients’ long-term goals but are managing risk in the short term by protecting on the downside.
Disclosures: This information was produced by, and the opinions expressed are those of Accuvest as of the date of writing and are subject to change. Any research is based on Accuvest’s proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however, Accuvest does not make any representation of their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Accuvest, and do not represent all of the securities purchased, sold, or recommended for client accounts.
The reader should not assume that any investments in sectors and markets identified or described were or will be profitable. Investing entails risks, including possible loss of principal. The use of tools cannot guarantee performance. The charts depicted within this presentation are for illustrative purposes only and are not indicative of future performance. Past performance is no guarantee of future results. Actual results may vary based on an investor’s investment objectives and portfolio holdings. Investors may need to seek guidance from their legal and/or tax advisor before investing. The information provided may contain projections or other forward-looking statements regarding future events, targets, or expectations, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved and may be significantly different from that shown here. The information presented, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.