You don’t have to be a football fan to appreciate this year’s Super Bowl victory by the Denver Broncos over the Carolina Panthers. Why? Because throughout the playoffs, Denver was an underdog and all of us admittedly enjoy watching teams nobody expects to win shock the world. Moreover, Peyton Manning became the oldest quarterback to ever win a Super Bowl in NFL history, which was another incredible feat in itself.
But in the end, Denver’s suffocating defense was its ultimate weapon, thereby providing a valuable lesson for financial advisors and the clients they serve: good defense is a winning formula.
Now that global equities are in correction mode, with some areas like emerging markets already in a bear market, protecting capital using defensive strategies can mean the difference between hitting investment goals or striking out. This is particularly true for clients who are already retired or nearing retirement. Let’s examine a few loss prevention strategies.
Short ETF Protection
Despite the bad rap they’ve received, ETFs that deliver opposite or short performance to stocks can be valuable tools.
For example, clients with a substantial part of their portfolio in stocks may want insurance protection against the potential of future losses, but selling out may cause headaches like an unwanted bill. What can they do?
ETFs like the Direxion Total Market Bear 1x Shares (TOTS) and ProShares Short S&P 500 (SH) could be used as an affordable hedge. Both funds are unleveraged and aim for 100% daily opposite exposure to U.S. stocks. That means if the total U.S. stock market or S&P 500 is down 2% on any given day, TOTS and SH should be up 2% or close to it.
Compared to more aggressive ETFs that use 200% (2x) or 300% (3x) daily leverage, unleveraged 1x ETFs could play a defensive role within the context of a diversified portfolio. On the other hand, leveraged ETFs are offensively focused with short-term capital gains — not necessarily hedging — as the main goal.
Hedging With Puts
One of the unsung advantages of ETFs over traditional mutual funds is financial flexiblity. And clients who own equity ETFs, unlike mutual fund investors, have the flexbility of hedging all or part of their portfolio with ETF put options. A customer with a 10,000-share position in the iShares Core S&P Small Cap ETF (IJR), for instance, can completely hedge that position by simply buying 100 put IJR contracts. Any losses in the share price of IJR are automatically offset by gains in the rising value of IJR put contracts. And those IJR put options can be sold for a profit before their expiration date, thus buffering the client’s portfolio against the adverse impact of declining IJR shares.
The timetable for protection with put options can be customized to suit the clients needs too. For customers who want temporary coverage, put options that expire in three months or less are the optimal choice. In other cases, clients seeking longer term protection can buy put options with longer expiration dates. Keep in mind the cost of protection with put options is more expensive when the length of coverage is extended. If the client still wants longer term protection, consider using 1x short ETFs in conjuniction with put options or insuring only a portion of the entire portfolio to limit the cost of hedging.
Finally, hedging a client’s portfolio with put options extends beyond the equity portion of a their portfolio. Holdings in bonds or commodities like gold can be hedged in the same exact manner.
Owning defensive equity sectors is another solid loss prevention strategy. Although this strategy won’t fully shield a client’s portfolio from the threat of market losses, it can still provide better relative performance versus the rest of the stock market.
A study by FactSet examined the top 10 and bottom 10 quarters since 1995, ranked by S&P Composite 1500 quarterly price returns. In the 10 worst performing quarters, defensive industry sectors like utilities (XLU), consumer staples (XLP), and health care (XLV) outperformed the S&P Composite 1500 by an impressive margin of 4.9%. In other words, while the broader stock market fell –14%, defensive industry sectors fell much less (–9.1%).
Analzying monthly price returns from February 1995 to January 2016, the S&P Composite 1500 enjoyed 155 months of gains while 97 months were losses. During the months with losses, defensive sectors beat the broader stock market around 80% (78 out of 97 months) of the time with an average return that was 2.1% higher.
Besides providing better historical performance during market downturns, defensive sectors also provide better returns when stock market volatility is rising. During months the CBOE Volatility Index (VIX) exceeded 50, defensive sectors lost just –3.9% in value compared to deeper losses of -6.9% for the S&P Composite 1500.
The key takeaway is that defensive sectors have historically provided better relative performance against the broader stock market during periods of falling prices and rising volatility.
Do not underestimate the importance of good defense. Why do you think the greatest investor of our era, Warren Buffett, chose Todd Combs as his eventual successor? It wasn’t because Combs is a great stock picker, but because of his risk management expertise with Florida’s comptroller and Progressive Insurance.
Avoiding the 10 worst days of stock market performance beat a buy-and-hold portfolio by more than double, according to a 17-year study conducted by Michael Gayed, CFA. He found that from 1993 to August 2010, the defensive portfolio netted $692,693, whereas the buy-and-hold netted just $324,330. This time period is noteworthy because it includes the 2000–02 and 2008–09 bear markets. (Missing the 10 best days sacrifices more than 50% of the buy-and-hold performance by ending at $156,354.)
The point of this data isn’t to prove that daytrading or timing the market works, but rather, investing with caution pays. While it’s impossible to know what will become the 10 best and worst days of market performance in the future, there is ample evidence that investing defensively works.
In summary, making money is important, but not any more so than loss prevention.