In A Crash, Cash Is No Longer King

(MoneyManagement) A well-designed crash protection strategy makes sense for many families. The crash protection in their portfolios are like little sleeping securities, for the most part. They are always there, and in a good year you hardly notice their impact on returns. However, they are ever-vigilant, and wake during times of crisis to aggressively protect capital – precisely when you need them most. These little sleeping securities allow the portfolio to remain fully invested in the pursuit of equity returns, all the while adding a significant element of capital protection to the portfolio.

Wealthy families should be especially concerned with capital protection. After a typical 40 years spent working and accumulating wealth, the switch to affluence introduces unique risks that simply don’t exist when we are working.

With all our financial capital working for the family and with less flexibility to re-enter the workforce should we experience a financial misstep, it’s no surprise that protection of our financial nest egg becomes a far higher priority in retirement. 

For many, this means an increased portfolio allocation to cash to minimize harm and reduce downside risk. And this approach is prudent and perfectly sensible.

Cash is the lowest risk asset out there – but it’s also the lowest returning. Consider the current annual interest rate on term deposits of around 2.5 per cent. Bank interest is even lower. Once inflation has staked its claim, this capital is earning less than one per cent in real terms, which is often significantly less than the rate at which most families draw down on their capital.

If we’re spending more than we’re earning in returns, the issue of capital erosion becomes increasing relevant – especially as a single "career" now stretches to 30 years or more. The magical power of compounding, which worked so well when retirees were employed and saving, begins working its ‘magic’ in reverse.

With yields so low, we believe investors need to turn over a few more rocks to find a better solution. One alternative way of doing so is including crash protection in portfolios.

Crash protection is a fundamentally different way of reducing risk in an equity portfolio, as opposed to increasing exposures to cash. Because the premium paid to secure crash protection is a fixed outlay, it allows the rest of the portfolio to remain fully invested in the pursuit of equity returns. Depending on market conditions, this can have a meaningful impact on long-term investment outcomes.

Similar to a payment for house insurance, crash protection is bought for a certain period (e.g. 12 months) and is attached to a certain notional value. Also, similar to insurance, the premium is significantly cheaper if the investor wears the first few percentages of declines, in the same way that house insurance is less expensive if we opt for a larger excess.

The analogy with insurance doesn’t end there. When we are working, raising families and building a nest egg, the primary source of capital that we rely on is ourselves. Because so much depends on our ability to work, many of us take out income protection insurance as a means of safeguarding our human capital. So, in affluence, doesn’t it also make sense to take out some form of protection on our financial capital, which at that stage of life is critical to funding our lifestyle?

For example, our own fund’s crash protection is currently costing an annual premium of 1.4 per cent. While this is not an insignificant amount, the protective strategy we designed is intended to limit losses to 50 – 60 per cent of the market’s fall when in correction. So, in crisis periods, or a move of greater than 10 per cent down, our protection is designed to remove nearly half of our risk for all further declines. To deliver a similar protective characteristic through cash (and assuming no stock outperformance), the portfolio would need to have a 40 – 50 per cent allocation to cash.

The return characteristics of a portfolio with 100 per cent in equities, less 1.4 per cent for crash protection, are quite different to a portfolio with 50 per cent in equities and 50 per cent in cash (assuming equity markets annualize at 10 per cent return).

Clearly, both approaches are defensive, but their suitability depends on what problem we’re solving. The portfolio with 50 per cent cash will outperform in shallower market declines (so less than -10 per cent, when our protection is designed to engage), although we have other mechanisms in our portfolio to protect capital for these smaller moves.

We would also argue that in order to deliver equity returns, investors need to assume some element of market volatility. A 100 per cent capital protected strategy can only hope to deliver a cash return at best, and if it promises greater than this then be assured there are other unconsidered risks that are being assumed to deliver such a profile.

The other major advantage of our own crash protection is that it’s always on. We don’t try to time when protection is or isn’t required, meaning the portfolio has crash protection for unforeseeable ‘bumps in the night’, such as the September 2001 terrorist attacks or surprise election results like Brexit or Trump. We also consider slower burn declines, where it may take many months for damage to be wrought.

This is a key advantage of the approach – crash protection is ready and in place well before the event ever crystallizes, so by the time the event is on the news and before the market even opens, our little sleeping securities are wide awake and ready to defend.

This is a critical point – it means we never need to sell a single security to reduce the risk in the portfolio. Markets react instantly to these types of news events, far quicker than anyone could ‘pull the trigger’ to sell shares (and at what price!). This has implications for tax realizations as much as for portfolio turnover.

The other key advantage of crash protection is the concept of ‘convexity’. As the market begins to get closer to targeted protection levels, the hedge securities begin increasing at a non-linear rate. In other words, for every one per cent decline, they may appreciate by two per cent. For the next one per cent decline, they may appreciate by a further three per cent.

The worse the decline is, the more aggressively these securities increase in value. This is a very different profile to holding cash, which by its nature can only ever protect capital in a linear relationship. 

Crash protection isn’t something that can be bought as a band-aid for every portfolio. It needs to be tailored to the underlying portfolio exposures, and match the risks that are present in the portfolio. Poorly designed strategies can also be more expensive and, if incorrectly positioned, can disappoint in their protective abilities.

Similar to a well-managed equity portfolio, crash protection needs to be actively managed in order to maximise its effectiveness, and you need to know when to monetise portions of the protective overlay and reposition the hedge for a changing market environment.

Crash protection isn’t for everyone. Indeed, we would argue that in a systematic form, such as we use in our fund, it isn’t required for younger investors, who have enough time to ride through market storms and average down their acquisition costs along the way. 

For wealthy families, however, this math is completely reversed. Time is long, capital is more critical, and there is far less flexibility to return to work if there is a financial misstep. In a low interest rate environment, the defensive qualities of crash protection permit a portfolio to be more fully invested, harvesting steady income streams and accessing equity rates of return, thus reducing the risk of capital erosion and critical failure.

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