In our last piece (Balancing Risk Management and Growth Potential in Equity Investment), we explored how volatility represents a threat to many of today’s investors as they expand equity allocations with the hope that growth can offset an ongoing low-rate environment. We also introduced structured outcome strategies, focusing on buffered strategies that seek to protect investors on the first losses of an underlying equity index or product, providing an option for those investors concerned about equity downside in their portfolios.
Now let’s shift our focus to the upside participation of these buffered strategies. Even for the most conservative investors, equities have been the historical go-to asset class for growth in portfolios. And while managing downside volatility is an important factor in creating a smoother investing experience, capturing as much of those outsized positive return years, or “good†volatility, in equity markets has a significant impact on long-term performance.
This can be seen in the chart below, where we consider the growth of $10,000 invested in the S&P 500 Index since 1988 and then check the impact of removing the 5 best performing years.
And therein lies the challenge for buffered strategies. We often remind investors that there is no “free lunch†when implementing risk management tools. Mitigating downside volatility often requires sacrificing upside participation. But when is that trade-off potentially detrimental to a portfolio’s longterm performance? In other words, how much “good volatility†should an investor forego to avoid “bad volatility�
For illustrative and discussion purposes only. Source: Bloomberg, as of 9/30/2020. Rolling returns shown in the chart represent 1-year returns measured on a monthly basis for the previous 1-year period, with the first return measured 01/31/1989. The lines in the chart represent the total number of occurrences for a given return percentage over the full date range noted. Index performance shown is for the S&P 500 Total Return Index and does not represent TrueShares fund performance. It is not possible to invest directly in an index. Values in the chart are rounded to the nearest whole percent. Performance data quoted above represents past performance and does not guarantee future results.
So the takeaway for investors in the S&P 500 Index over the period shown is that when the market was up they would have expected to return around 17% on average.
For illustrative and discussion purposes only. Does not represent the performance of any TrueShares ETF. It is not possible to invest directly in an index. Performance shown is hypothetical, does not take into account any fees or taxes, and is based on assumptions as noted. The returns streams used in this analysis are hypothetical and are not tied to, or meant to represent, any index or security. They are intended to solely represent a mathematical exercise. IMPORTANT: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
For illustrative and discussion purposes only. Source: Bloomberg, as of 9/30/2020. Rolling returns shown in the chart represent 1-year returns measured on a monthly basis for the previous 1-year period, with the first return measured 01/31/1989. The lines in the chart represent the total number of occurrences for a given return percentage over the full date range noted. Index performance shown is for the S&P 500 Total Return Index and does not represent TrueShares fund performance. It is not possible to invest directly in an index. Values in the chart are rounded to the nearest whole percent. Performance data quoted above represents past performance and does not guarantee future results.
As we can see in the table, below-average positive return periods occurred roughly 57% of the time. In those periods, the average return was significantly lower (+10.1%) than the average for all positive markets (+17.0%). Conversely, when the markets outperformed the positive-market average (43% of the time), returns were up on average over 26%, a substantial increase over the positive market average.
Conclusion
At TrueShares, it’s no surprise that we consider uncapped strategies as the way to go if you believe, as we do, in the impact outsized positive equity market performance years have on long-term portfolio results. We think that the potential relative performance benefits of uncapped strategies in those types of market environments should outweigh any relative underperformance in lower return years. Big picture, we do believe in the power of equities as a primary growth driver for many portfolios and employing a risk managed approach to equity investing will likely be attractive to a sizable group of investors.
With that as a backdrop, if you’re considering buffered equity ETFs, it’s important to explore the various upside capture mechanisms in the marketplace and not solely the buffer levels. This is paramount to developing an effective plan with your advisor that reflects your personalized needs and accounts for longterm capital market expectations.
