Equity Protection – is now the right time?

by and | Nov 14, 2018 | Derivatives, TalkingPoint

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Recent bouts of volatility have made headlines and questions are being asked of one of the longest equity bull markets in history. However, strategies to protect against declines in the equity market have been steadily getting cheaper and are now at multi year lows…

For example, to contractually protect a portfolio of US stocks against market falls of up to 25% over a three year horizon is about 3.6% of the investment paid up front, or 1.2% p.a. An alternative strategy could be to pay zero premium for the same protection and instead agree to sacrifice returns above 26% over the same three year horizon. Both of these strategies may be especially attractive to asset owners looking to lock in current equity market levels, and to take advantage of relatively attractive pricing in the markets for put and call options on major stock indices. In particular, frozen pension plans may not need the market to rise 26% or more in order to meet their funding objectives.

Protecting against equity market falls

Put and call options can be used to participate in equity returns, while protecting you from certain negative outcomes, in a predefined way. Many investors are familiar with these kinds of options, but assume that they don’t make sense for their situation; one common objection is that they’re too expensive or provide too much of a drag on returns. This concern didn’t appear out of thin air as certain protection strategies can be prohibitively expensive in certain market conditions.

However, in the last year market conditions have made a well-designed equity protection portfolio relatively more attractive. As an example, consider a combination of put options designed to protect an S&P 500 portfolio from price decreases of between 5% and 25% over three years. The put options will rise in value when the equity market falls, such that the capital value of the total portfolio is protected down to a fall of 25% in equity markets at the maturity of the options (in three years). After a 25% price decrease, downside participation of the total portfolio would resume. Such a strategy would contractually outperform the S&P500 if the market falls by more than 5% over three years.

For the six year period from November 2010 through November 2016, this strategy would have required an upfront premium averaging between 4.5% and 5% of the portfolio, which would have been a drag on subsequent returns. However, over the past two years, the cost of such a strategy has fallen to only 3.6%, or 1.2% p.a. This is not far from the cost that many asset owners pay for active management, which many hope will provide a degree of downside protection. This cost may now be more palatable as many are concerned about giving up strong returns earned in 2017. Many investors do not wish to pay premium to purchase protection, but are willing to give up potential future upside that they may not need. Pricing is also relatively attractive for these “zero premium” strategies.

This pricing is measured by the amount of upside that must be forgone to receive a fixed amount of protection without a premium being paid. Today, an investor will need to give up price returns over three years beyond 26% (or 32% including dividends) to receive protection for the first 25% of an equity market fall. Since 2010, there have been periods when an investor would have had to give up returns above 12% to get the same level of protection.

1 Based on market conditions as at 31 October.  Strategy shown is a bought put option, 3 year term, notional 100% of underlying equity investment, strike 95%, combined with a sold put option, 3 year term, notional 133% of underlying equity investment, strike 75%.  For zero premium, this strategy is combined with a sold call option, 3 year term, notional 100% of underlying equity investment, strike X%, where X% is that required to given zero total net premium.

For some plan sponsors, a +26% total return on equity markets over three years would already give them all the excess return they need – the prospect of “giving up” additional return on top of that seems like a small price to pay for protection from the first 25% of losses.

In summary, with a simple, transparent strategy it is possible to provide meaningful equity market protection without removing equity exposure entirely.  Such strategies are not too good to be true. Paying a premium for protection will be a drag on returns if markets do not fall, and similarly, forgoing potential upside will cause underperformance if equity markets rise significantly.  However, many investors may be surprised at the current costs of downside protection and may consider this a worthwhile trade off.

About the Authors

James Walton is an Investment Director in River and Mercantile Solutions’ Boston office. James works with clients on financial risk management, develops investment strategies and derivative solutions. He also leads the due diligence of annuity providers and is a member of the US Investment Committee.

Email: james.walton@riverandmercantile.com
Phone: 781-373-6957

Joe Anzalone is a Director and Consulting Actuary in River and Mercantile Solutions’ New York City office. Joe helps his clients with many aspects of their defined benefit pension plans, including design, compliance, financial risk management, and administration.

Email: joseph.anzalone@riverandmercantile.com
Phone: 862-703-1185

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