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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).


These episodes, which reflect drawdowns of -10% or worse, are therefore relevant for assessing RMI strategies whose drawdown threshold metric, D, is -10%.  Let us first examine an RMI strategy that provides 50% downside protection against a decline threshold of -10%, that is, one whose D and p metrics are -10% and 50%, respectively.  Such a strategy succeeds in modestly reducing the decline on the initial investment, from -21% to -15.5% (i.e., by half the excess decline beyond -10%), net of the cost of the strategy.  Thus, the subsequent 25-month bull market run need be only +57% cumulatively instead of +68% to achieve the “breakeven” value that would have been attained in the absence of the strategy.

Surprising Results

What does the above result mean in terms of the annual tolerable cost, CT?  The annualized equivalent of the +68% 25-month return is +28.3%, while the annualized version of the +57% 25-month return is +24.2%.  The difference is 410 basis points.  So, here is the result:  If history is a guide, an RMI strategy whose downside protection reduces only large declines in the equity markets (i.e., those worse than -10%), and reduces them only modestly (specifically, by half their excess beyond -10%), adds measurable value as long as its cost (i.e., its performance drag during bull markets) does not exceed 410 basis points per year.  In other words:

CT(-10%, 50%) = 410 bps

For another example, an RMI strategy whose downside protection reduces declines worse than -10% by three-quarters of their excess beyond -10% adds measurable value as long as its cost (i.e., its performance drag during bull markets) does not exceed 600 basis points per year.  That is, CT(-10%, 75%) = 600 bps.  Similarly, we find that CT(-10%, 25%) = 210 bps.

In the table below, we show the results for drawdown thresholds of -5% and -15%, in addition to the -10% threshold already discussed.

Source: Giralda Advisors analysis of Bloomberg daily return data

If you are like us, you are probably surprised at first observation that these tolerable costs are as high as they are.  The reason RMI can support such high tolerable costs is because of the power of return asymmetry, discussed in our prior article, “Alpha Generation through Risk-Managed Investing.”

We should point out the tolerable cost estimates, CT, derived through this analysis are conservative, as explained in our whitepaper.  We should also point out that, from a total portfolio perspective, there is an important dimension of value that we have not yet explicitly considered.  Our derivation of CT has concentrated solely on cumulative return. But RMI strategies, by virtue of their risk-dampening properties, can also mitigate portfolio risk and thereby elevate the efficient frontier.  We will explore this additional dimension in a subsequent installment.

This article was written by the team at Giralda Advisors, a participant in the ETF Strategist Channel

This material is for informational purposes only.  Nothing in this material is intended to constitute legal, tax, or investment advice.  Investing involves risk including potential loss of principal. 

Giralda Advisors, located in New York City, is an asset management firm that focuses on providing risk-managed exposure to the equity markets with a goal of limiting asset depreciation during both protracted and catastrophic market downturns while allowing substantial asset appreciation in up-trending markets.  The Giralda Advisors team welcomes your inquiries. Call (212) 235-6801 or visit