Investors who bought put options to protect their portfolios were able to mitigate the swift stock market losses witnessed in March 2020. However, portfolio protection through the use of options strategies can prove to be very expensive insurance when seeking uninterrupted, long-term protection, rather than just during times when markets “appear to be especially risky.”

In an analysis by AQR Capital Management, “Portfolio Protection? It’s a Long (Term) Story…,”¹ it was found that option strategies, while they gained big during months like March, are most likely to lose all or most of the capital—perhaps multiple times over—during the good times.

The authors argue that investors are better off focusing on bad outcomes that unfold over longer time periods since these types of losses tend to be most harmful to long-term plans. Indeed, longer lasting declines may not only be deeper, but they also represent a longer period of lost positive returns, which is highly detrimental to wealth accumulation.

Three Long-Term Protection Strategies

The aforementioned analysis suggests three risk-mitigation strategies that may be more effective than options-based hedging over the longer term:

1. Invest in defensive equities within the portfolio’s equity allocation. AQR contends that defensive stocks have historically generated returns in line with broader equity market returns, but at less risk. Of course, such stocks will fall just as steeply as the rest of the market during a meltdown like March 2020; however, over the longer term, a defensive equity orientation has tended to outperform during down-market cycles.

2. Risk parity may protect investors by reducing their exposure to equity and by increasing their exposure to other sources of returns. This smaller equity exposure and greater diversification has the potential to outperform in down markets.

3. Invest in alternatives. Especially effective are strategies that have limited correlation to equity markets, such as a long/short strategy applied across multiple liquid asset classes and a trend-following approach that goes long or short different asset classes depending on their trailing performance.

AQR maintains that investors shouldn’t limit themselves to one approach. Rather, they should consider a combination of strategies to achieve their portfolio protection objectives.

For advisors who want a more in-depth understanding of these ideas, we encourage you to read the full analysis.

Source:

1. https://www.aqr.com/Insights/Research/Alternative-Thinking/Portfolio-Protection-Its-a-Long-Term-Story

See referenced disclosure (2) at https://blog-dev.americanportfolios.com/disclosures/