Downside protection at a reasonable cost over time

Matt Buchanan

Livewire Markets

If there is one thing investors can be certain about right now it's how uncertain everything is. Who, for example, knows the answers to any of the following questions: Will inflation spin commodities into another supercycle? Will the Fed really go as hike-happy as people variously suspect, fear, or demand? Is Putin's misadventure in Ukraine a short-term or long-term risk for European energy security, and does it really sound the death knell for globalisation? Will Anthony Albanese actually know the cash rate by the time you read this?

Nobody knows. 

But one thing we do know is that in the land of the uncertain, the risk mitigator is, if not a king exactly, then certainly a friend of the family.

And in this video, Stephen Coltman, portfolio manager at abrdn, outlines why. He explains how to hedge to bring in returns while risk and growth assets like equities are being tossed about like leaves, and how to time your re-investment when those equities hit distressed levels.

He also explains how the principle of "convexity" allows you to defend against calmer markets. For all the detail and more, please click the play button below.


This transcript has been edited for length and clarity

Could you explain your Global Risk Mitigation strategy and what makes it unique?

Well, it's a highly uncertain market environment we face at the moment. Investors worried about inflation or needing to generate returns over the long term, need to stay allocated to risk assets, growth assets like equities, for example. 

And what we're trying to do with GRM is that, in what could be a very bumpy road, we're helping to smooth some of those bumps, reduce your drawdowns, allow you to maintain that exposure to those risky return-generating assets, but not get too stressed about experiencing catastrophic drawdowns when you can get some of this extreme volatility. 

So by combining a strategy like GRM that has a negative correlation to your risk assets, what you find, even if markets are moving higher over the long term, if there's volatility along the way, it really improves your returns by, when equities are falling, your hedge is generating, your risk mitigation strategy is generating profits, and you can reinvest that into equities when they become distressed.

And conversely, when equities are rising strongly, by rebalancing your portfolio and topping up your hedge, you're then protecting some of those gains. 

So by doing that rebalancing through time, if markets are volatile, even if they ultimately move higher, it really improves your total portfolio returns because you're buying equities on the dips, and you're protecting them on the strong rallies. 

And so we think GRM, alongside equities in a portfolio in this more volatile environment, makes a lot of sense. Improving your long-term compound returns and reducing your drawdowns so the periods of stress that you experienced, they're significantly mitigated by the addition of this strategy. 

How does the strategy perform when equity markets rally?

When equity markets are going up, you should expect a modest negative return from the strategy. How the market goes up is important. So if it goes up in a very quiet, steady fashion, that's the most difficult environment for a hedging strategy.

If it goes up, but there's significant volatility along the way, then that can perform well because you have these opportunities to monetize some of that volatility.

You look at the year 2020, for example, equities finished that year strongly positive, but the GRM strategy had very positive performance over that period but it generated as returns in Q1 when equities were losing a lot of money and they gave back some of that performance through the remainder of the year but kept a substantial portion of it. 

So overall, quiet markets are difficult for the hedging strategies and so quiet, upward trend is the most difficult. But if markets go up with some volatility along the way, then that is a scenario that also works.

On a standalone basis, the best scenario is obviously a huge crash, but in a balanced portfolio, the average investor should want things to be going up, but smoothing that journey with some hedging on top.

In a time of continuing uncertainty, is this where the GRM strategy performs best?

Yes, in a time of real uncertainty, we think it's really additive to have a strategy that offers you some downside protection at a reasonable cost over time. So clearly the range of possible outcomes from here for markets is very wide.

There are large number of risks that people can see in terms of inflation, geopolitical risks, central banks tightening all sorts of reasons to be concerned.

But at the same time, a lot of investors who want some long term return, some maintain their purchasing power through time. In the long term, you need exposure to growth assets. 

So a combination of equities and growth assets that can perform well over the long term but with some downside protection, I think makes a lot of sense. And how you get that downside protection GRM is designed to provide that in a way that is efficient and lower cost so it doesn't allow you to hold it through the good times and the bad times. 

How does this strategy differ from a long-short strategy?

I think we've made it as user-friendly as possible. So it has a very explicit objective.

It's a very clear return profile. So we run it on the basis that when you run a stress test on global equities, the strategy would be expected to generate return of 6% or more as a flaw. 

That's the kind of level of hedging that we maintain in the portfolio. And it's very explicitly focused on that downside risk. It's not trying to identify specific stocks that'll be impacted, it's not trying to make specific calls around timing or sectors.

It's really a diversified hedging strategy against a broader move for lower global equities. The scenario that causes the most problem for our investors. 

Having this very clear mandate and very specific objective and this predictable behaviour, it makes it easier for investors to incorporate into their own portfolio when they understand their total equity risk and they can size it accordingly, depending on how much risk production they want. And it can size it up or down, understanding very clearly how it's going to behave.

And that should make the point as well, that it has daily liquidity so that at any point in the course of the market cycle, if there's a point where people want to rebalance, it's very easy to do that. 

Could you explain ‘convexity’ and how it allows you to defend against calmer market?

What that means is that if you consider a put option where you pay a fixed premium and then you generate gains if the market declines below your strike price. So on the downside, when markets are falling, you have uncapped gains but when the market is rallying against you, then your losses are capped out at the premium you paid.  So you can't lose more than the premium you paid for that option.

That means you have limited losses when the market moves against you when the market's rallying, but you participate fully when the market's declining and here you can have large gains. It's that difference in the risk of losses versus your potential gains is what we mean by convexity.

The GRM strategy in a market that is rallying would be expected to have a modest level of losses in that scenario, but if the market starts falling and if it falls significantly, you have a significantly greater scope for gains in that situation. So in a market stress scenario, it tends to make large gains quickly, but when the market's rising, it tends to have slow losses over time. 

How is leverage used to help investors manage downside risk in a cost-effective manner?

The GRM strategy is used by institutions as an overlay, but then for someone who wants to access the strategy in a fund vehicle, we apply some leverage. And that means that they need to put less dollars against it or fewer dollars against it in order to get the same level of protection. 

So if you need to fund your allocation, if you're hedging from somewhere in your portfolio, you want to make that allocation as small as possible to maintain as much exposure to your return generating assets.

That leverage just means it becomes more capital efficient that investors need to put a smaller amount in to get the same benefit in terms of broader protection for that portfolio.

Managed Fund
Aberdeen Standard Global Risk Mitigation
Alternative Assets
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Matt Buchanan
Content Director
Livewire Markets

Matt Buchanan is a former Head of Content at Livewire Markets. Matt is an avid investor and a big fan of the Livewire community, which he first joined in 2017.

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