The View from the Hill - Perspectives on Markets and Strategies

When investors evaluate hedging or risk management strategies, they often focus on performance during an equity market decline and the benefit of reduced downside participation. Performance in market declines is undoubtedly critical in assessing the effectiveness of risk management, but it is only half the story. A further benefit comes when markets begin to recover; investments less exposed to a market decline are better positioned to participate in the eventual rebound. This is a subtle but critical point in assessing the rewards of risk management.

We illustrate this here with an example based on the mathematics of returns and by taking a look at real market environments surrounding the financial crisis and the COVID-19 pandemic. It turns out that investors who manage risk tend to have a performance advantage compared to those who stay fully invested for months or years after the market bottoms. This occurs in large part because these strategies allow investors to exit the decline with more assets. The extent of time advantage for lower-risk strategies depends on the speed of the market rebound. 

Risk-Managed Strategies Offer Strong Relative Performance in Declines and Steep Rebounds

To understand the longer-term benefits of lower risk strategies when investors experience bear markets, we can look at a stylized example based on different magnitudes of declines for an equity index fund (such as one invested in the S&P 500 Index) and for some index strategies that reduce downside equity risk during recent equity market environment.  For this stylized example, we consider a risk-managed strategy that has market exposure of 70% (beta of 0.7) to an equity index fund. This strategy could combine equities plus fixed income or an option-based hedging approach such as a buffer protection ETF or mutual fund.

Exhibit 1 shows this example of the relative performance of a reduced risk strategy compared to a fully invested position for an index fund declines of 30% and 40%. The assumption is that the risk reduction strategy would outperform during the decline by 10%.  This outperformance sets the stage for the risk-managed strategy to start the rebound period at a fund value 10% higher than the fully invested equity index fund. The table shows that this higher valuation after the decline leads the risk-managed strategy to outperform for a wide range of positive returns during the subsequent market rebound.

Exhibit 1: Comparison of Risk-Managed Vs. Fully Invested Index Fund Strategy for Different Ranges of Rebounds

(Based on Initial Fund Value of 100)

Source: Calculations based on hypothetical percentage declines and subsequent rebounds on a portfolio initially valued at 100. 

Note that the larger fund value after the decline for the Risk-Managed Strategy brings advantages to the investor at fund values well past the 100 breakeven point.  In the case of a 30% decline for the index fund (to a Fund Value of 70  for the Fully-Invested Strategy), the Risk-Managed Strategy has a higher fund value through a 70% Rebound Return.  It is only at an 80% or higher Rebound Return that the Fully-Invested Strategy results in higher fund values.  In the 40% decline example, a rebound move of as much as 90% still leads to a Fund Value for the Risk-Managed Strategy of 114.10 compared to slightly less 114.00 for the Fully-Invested Strategy.   

Examples of S&P 500 vs. Buffer Protection Strategies for Recent Equity Market Declines

The simplified example above is limited in that it ignores the path and duration of the equity market rebound, making it difficult to assess the length of time investor benefits from the outperformance of the risk-managed strategy. To examine these issues, we look at the return history of a risk management strategy index during two recent periods of significant declines in the equity market – the period around the Global Financial Crisis and the fallout from the onset of the global COVID-19 pandemic in early 2020. The index we use to illustrate the benefits of during the rebound period is the SPRO buffer protection strategy index (Cboe S&P 500 Buffer Protect Index Balanced Series (the “SPRO Index”)).  We compare SPRO’s returns to the performance of the S&P 500 Total Return index. 

Each series of the SPRO index is designed to track the returns of a hypothetical investment that, over a period of approximately 12-months, seeks to “buffer protect” against the first 10% of losses in the S&P 500 Index, providing participation up to a capped level.  More specifically, this index measures the returns of the S&P 500 index combined with a balanced portfolio of one-year term buffer protection strategies that are laddered to roll in each of the 12 calendar months of the year.    At each annual roll point, index puts are purchased based on a 10% downside move from the current S&P 500 Index level, and a call option is sold to cap on upside returns and generate sufficient premium to pay for the 10% downside protection.    

For the Global Financial Crisis period, we start the comparison at the end of June 2007. During the summer of 2007, the extended bear market began with several downside moves as  equities reacted  to losses associated with sub-prime mortgage security holdings. This decline accelerated in 2008, with the U.S. equity market bottoming in March 2009.  Exhibit 2 shows the relative performance from mid-2007 through 2013 of the S&P 500 Total Return Index (the “S&P 500 Index”) compared to the SPRO Index.

Exhibit 2: Cumulative Performance of S&P 500 versus SPRO Buffer Protection Strategy 

(June 29, 2007-December 31, 2013)

The SPRO Index buffer protection strategy showed reduced downside participation as the S&P 500 experienced over a 50% decline through early 2009.  This advantage allowed the SPRO index strategy to enter the extended rebound period with a more significant asset base and post higher performance than the S&P 500 Total Return index through early May 2013, four years after the U.S. equity market bottomed in early 2009. The SPRO index, with its buffer protection strategy in place, had significantly lower volatility relative to the S&P 500 index, between June 2007 and December 2013, with an annualized standard deviation of 17.5% compared to 24.0%.[1]   This represented approximately a 27% reduction in risk compared to the S&P 500 index, but it provided an investor a performance (and risk) advantage that lasted for years after the deep bear market episode (e.g., June 2007-March 2013). 

The COVID-19 Pandemic of 2020 provides another opportunity after an equity decline to examine the relative performance of the SPRO Index relative to the S&P 500.  In this case, the equity market fell 30% in March 2020 and proceeded to recover quickly over the next few months.  In Exhibit 3, we look at the relative performance of the SPRO Index relative to the S&P 500 for 2020. 

Exhibit 3: Cumulative Performance of S&P 500 versus SPRO Buffer Protection Strategies 

(December 31, 2019 – December 30, 2020)

In this case, the S&P 500 recovered and attained outperformance versus SPRO much more quickly than it did during the Global Financial Crisis.  In the first three months following the March 2020 selloff, the S&P 500 rebounded, but the SPRO index still outperformed.  Between June and October, the investments broadly tracked one another, although the S&P 500 index did have brief periods of outperformance.  Toward the end of the year, the S&P 500  moved sharply higher, leaving the SPRO Index behind.

A SPRO Index investor would have experienced a significantly smoother ride throughout the year.   The standard deviation of the SPRO index returns over this turbulent year was 22.4% compared to a high 34.3% for the S&P 500 index, well in excess of normal equity market volatility.[2]  While the S&P 500 index delivered a return 18.4% in the highly volatile market of 2020, it also incurred high risk.  The SPRO index’s buffer protect strategy afforded investors double-digit returns (12.3% with lower risk amidst a highly volatile market, an outcome that can appeal to investors with moderate to low-risk tolerances.

Risk-Management Rewards Across Market Regimes

The bottom line in this analysis is that risk management offers investors benefits beyond outperformance during an equity market decline, even for those with long-term investment horizons. The larger amount of assets going into the rebound can extend the period of outperformance from months to years, depending on the speed and magnitude of the recovery.  Given the history of U.S. equity markets, one can expect a significant market decline on average once every four to five years.  Some decades are quite friendly, such as the 1990-1999 and 2010-2019 periods, which had no significant bear markets. Other periods, like 1970-79, 1980-1989, and 2000-2009 have had deep bear markets that adversely impacted investors’ portfolios for years at a time. In some cases, fixed income allocations can provide sufficient risk control; however, the correlation of fixed income to equity returns may be unstable and can be positive during periods of rising nominal interest rates. 

Therefore, risk management with downside protection strategies such as those analyzed here can help investors weather market storms as well as thrive in the sunshine that comes after. What is key is that these investors enter the period of favorable market weather with more assets if they retained higher levels of assets during the market turbulence. Equity markets can have severe limitations on liquidity, especially during periods of sharp declines. This can lead markets to overreact on the downside and then rebound sharply as investor sentiment quickly changes. These ebbs and flows are difficult to time well with exit and entry strategies. A better approach may be to stay invested in equities but with some form of a downside risk control strategy. There are many choices available in terms of the range and duration of the buffer protection that can be customized to a market outlook or risk tolerance. Investors can benefit by targeting portfolio risk levels to at least 75% of full equity exposure, given the large swings in equity risk that can disrupt long-term investment strategies.