Preparing your portfolio for a sharp equity market sell-off

The current equity bull market and phase of economic growth are both extended by historical standards. A  growing number of long-term investors believe a correction is looming that will last longer, and cut deeper, than that experienced late last year. Directional calls on markets are of course fraught with risk, but for those investors worried about the vulnerability of stock markets, there are strategies available that can limit volatility.

In Q4 2018 the equity market sold-off abruptly. Peak-to-trough, the S&P 500 fell by almost 20% between October 2018 and January 2019. The market subsequently recovered into the summer of 2019. However, the same causes of last year’s sell off remain active. Trade war fears have recently re-escalated and the dispute’s impact upon growth is becoming more evident. The market has been underwhelmed by the Federal Reserve’s tone even as it has cut rates, and the 10-year Treasury yield has recently fallen through 1.5%.

Duration of current market rally versus previous bull markets (and corrections)

Source: Bloomberg, Schroders, as of Aug 30, 2019. Based on S&P Gross Total Return Index. Bull market defined as rise of 50% or more over a period lasting more than 6 months, bear market defined as fall of 20% or more that lasted at least 3 months. Past performance is no guarantee of future results. Actual results will vary from above.

Indeed, institutional investor concerns over slowing economic growth and destabilising political and world events have been rising steadily for some time. Despite these fears, equity exposure continues to dominate institutional investor portfolios. We believe risk control measures warrant consideration, but that investors may be overlooking the full range of tools available to them.

How can investors limit the negative effects of volatility?

There are numerous strategies available to reduce equity risk. Broadly, we break these down into “beta reduction” and “tail risk” management strategies.

Beta reduction, where an investor seeks to reduce portfolio sensitivity to equity market movements, might involve one of the following approaches:

• Holding assets that have historically realized lower volatility than broader equities (i.e. minimum or low volatility equity strategies)
• Dynamically allocate across a broad range of asset classes to improve risk-adjusted returns (versus a periodically rebalanced, static asset allocation)
• Allocating to assets whose return drivers - or premia - differ from those of equities

These strategies may have proven effective in “conventional markets”, by which we mean markets in which volatility is close to its longer-term average. However, the efficacy of these approaches during times of pronounced market stress – where correlations can increase dramatically – can be lower than anticipated. For example, min vol equities delivered mediocre downside protection through 2008, experiencing losses not far off the broader equity market during the downturn.

Tail risk refers to market scenarios which are statistically unlikely but can be material in terms of their negative impact on total portfolio returns.

A focus on insulating a portfolio from tail risk comes with its own challenges. For example, an increased allocation to cash-like instruments (or short-duration fixed income) can significantly reduce tail risk. Another common approach is increasing a portfolio’s allocation to long duration Treasuries - a tail risk management strategy which relies upon their historically negative correlation to equities, especially during large market sell-offs.

However, in both of these scenarios, the investor’s opportunity cost in the event that equity markets remain stable or rise, might discourage increasing their allocation to cash or lower-yielding fixed income.

A primer on equity protection strategies

Many investors, such as pension plans, require a reasonably high level of equity exposure for long-term funding growth. These types of investors can also have low tolerance for the large, short-term market losses that an equity-heavy asset allocation can bring. For these types of investors, “equity protection” strategies can offer an attractive balance between the desire to maximize total returns and effectively control tail risk. Equity protection can take numerous forms depending on a client’s preferences.

The most desirable structures are those that deliver the greatest degree of reliability in a cost effective manner, and are aligned explicitly to an investor’s specific risk and return objectives.  We outline two option-based approaches that can be employed to mitigate equity market tail risk below.

“Static” equity protection

Options can be used to limit a portfolio’s exposure to equity market losses to a pre-specified level while keeping existing equity holdings intact. A “static” equity protection strategy seeks to preserve the value of the equity portfolio over a specific time horizon. Typically, equity options are purchased at the outset and held through until expiration to deliver protection for a fixed term. Such a strategy might be implemented due to a shorter-term, tactically bearish view on the equity market (alternatively, in the case of a pension plan, the view might be based on their next actuarial valuation date).

By way of example, a static equity protection strategy might protect the portfolio from a sharp market sell-off through the purchase of put options. The cost of buying the put options could also be offset or reduced by selling call options (a so-called “option collar”). Selling the call options therefore finances the downside protection - offered by the puts - but can reduce potential upside participation if equities were to rally strongly. The table below illustrates the potential trade-off between downside and upside participation based upon how the static option collar strategy is structured.