The Tolerable Cost of Risk-Managed Investing

In our immediately preceding article in this ETF Strategist series on Risk-Managed Investing (RMI) — the attempt to embed downside risk management directly into equity investments — we promised to answer the question: “How much market upside should you be willing to give up to achieve a given level of downside risk mitigation?”

All approaches to RMI (we’ll examine a few of these approaches in detail in future articles as well as provide an overall marketplace review) have a cost of some sort.  This cost typically presents itself as a drag on performance during periods when, in retrospect, downside protection isn’t needed. We sought to develop an objective way of measuring how high this cost could be before it exhausts the benefits of RMI, which we have outlined in our preceding articles.

“Deductibles” and “Co-Pays”

To provide the appropriate context for calibrating the tolerable cost, we first need to express the benefit — the nature and degree of the downside risk mitigation — that a particular RMI strategy delivers, and to do so in a manner flexible enough to accommodate the majority of RMI solutions in the marketplace.

The framework we have found most useful in this regard is borrowed from the field of medical insurance, wherein protection is described in terms of a “deductible” amount and an insurer “co-pay” percentage.

Following this convention, the downside equity risk management offered by any particular RMI strategy can be characterized by the depth of equity market decline that triggers the protection, and the portion of subsequent market decline that the RMI strategy protects the investor from.

The former is the equivalent of the deductible, call it “D”; the latter is the equivalent of the co-pay percentage, call it “p.”

For example, a hypothetical RMI strategy that offers exposure to the S&P 500 Index plus a continuously rolling 10% out-of-the-money put sized to cover half of that exposure has D = -10% and p = 50%. We have found that this simple framework can accommodate most any RMI offering an investor may wish to consider.

Tolerable Cost = Benefit

In addition to D and p, the third metric of importance when evaluating an RMI strategy is its cost, C. Let’s be more precise in how we define our three RMI metrics:

  • D: Denotes the point, in drawdown terms, at which downside protection is provided (i.e., how deep a peak-to-trough equity market drawdown does the strategy respond to?)
  • p: Denotes the degree to which protection is provided, net of the cost of the strategy (i.e., what percentage of damage is mitigated?)
  • C: Denotes the cost of the RMI strategy in terms of loss of upside potential (i.e., what is the performance drag during periods when protection isn’t needed?)

Now, the economic value of protection is a function of the first two metrics, i.e.:

EV = f(D,p).

The cost of the RMI strategy can be considered “tolerable” if:

C < f(D,p).

Equivalently, we can denote the threshold tolerable cost as CT, and note that:

CT(D,p) = f(D,p).

We have derived an empirical estimate of this critical function CT, using the long history of the S&P 500 Index.  The details of this derivation are beyond the scope of this short article but are available for review in our peer-reviewed whitepaper “Quantifying the Value of Downside Protection” (Journal of Financial Planning, January 2016).  We are pleased to share the key results here.

A Simple Model

Over the 78-year history of the S&P 500 Total Return Stock Index that we reviewed, there were 29 separate, non-overlapping episodes of market declines that were each worse than -10%.  Note that this equates to a frequency of once every 2.7 years (32 months), on average. The average decline during those peak-to-trough periods was approximately -21%, and the average length of those periods was about seven months. Representatively, the subsequent trough-to-peak upswing was roughly +68% cumulatively and lasted about 25 months (i.e., before the next -10%-or-worse downswing began).