Downside Protection

Quiz!

Which strategy offers the best downside protection?

1. Defined Outcome Strategy
2. Derivative Income
3. Options Trading, Equity Hedged Strategy
4. Stocks + T-Bills
5. Buffered ETFs

The Failure of Investment Products with Downside Protection

If you are approaching retirement, you may be especially interested in limiting the downside of your investments. There are various strategies that fall into 3 Morningstar categories: Derivative Income, Defined Outcome, and Options Trading – Equity Hedged. Another common name you may have heard is buffered ETFs. What they have in common is a structure that limits the downside in exchange for giving up some upside.

Sounds great, right? The following article compares them to a simpler combination of Stocks and T-Bills (very short duration government bonds): https://www.aqr.com/Insights/Perspectives/Rebuffed-A-Closer-Look-at-Options-Based-Strategies. It turns out that the sophisticated strategies do worse than the simple stock / bond combo, not only in terms of returns, but even in terms of downside protection. There is a follow-up article with more details, especially for the skeptics: https://www.aqr.com/Insights/Perspectives/Buffer-Madness.

Why do these well-designed sophisticated strategies do worse than the simplest asset allocation? They are a form of insurance, with multiple costs. The costs reflect the big desire of people for protection, negating more than the entire benefit.

Is there an even better solution? Yes, a focus on diversified stocks. The cash / bond component introduces inflation risk – one of the toughest risks in retirement. The ultimate solution is reaching the point of low spending/investments (requires advance planning), eliminating the need for substantial cash or bonds. How? Say you withdraw 3% per year from your investments, and they declined by a dramatic 50% for a year, the cost is an extra 3% (6% total). Diversified stock portfolios enjoy growth that can make up for the penalty of withdrawals in down times. Such a strategy requires great discipline at all points in the cycle – otherwise, the entire plan can get derailed.

Quiz Answer:

Which strategy offers the best downside protection?

1. Defined Outcome Strategy
2. Derivative Income
3. Options Trading, Equity Hedged Strategy
4. Stocks + T-Bills [The Correct Answer]
5. Buffered ETFs

Explanation: Stocks + T-Bills avoid the insurance-type costs of the other strategies. The article demonstrates the benefit based on a historic analysis.