KEY POINTS:
Two weeks ago we took a look at how well traditional strategies of protecting a portfolio from decline - whereby, for example, if a portfolio falls by say 10 per cent it is automatically sold - or locking in a profit actually worked in practice.
We found that over the very long term the strategy did not add value as returns were less than buy and hold, even before transaction fees.
This week we return to the work of Dimson, Marsh and Staunton, professors at the London Business School who in the ABN Amro sponsored 2007 version of the Global Investment Returns Yearbook calculate how well a protection strategy using derivatives would have performed over the last 107 years since 1900.
Guaranteed or structured products, as they are also known, are becoming popular with institutional and retail investors but the cynic might worry that they sound too good to be true sharemarket returns without the risk. Is this possible when we know that return and risk generally travel together?
Stop/loss and profit-lock-in are simplistic strategies which are implemented after the event. The alternative and the process upon which many guaranteed or structured products are based is to enter into a transaction before disaster strikes - ie, to insure the portfolio against those adversities.
According to the professors this is typically achieved by using the derivative market to purchase a costless collar. In this transaction the investor buys the right to protect a portfolio from declines beyond certain levels. This right is financed by selling the high returns which might occur if the market rises sharply.
According to DMS, in a costless collar the protective "put" is paid for by selling the high returns that might occur if markets boom while retaining the returns that are towards the middle of the distribution. Now while these alternatives sound better than buy and hold we need to know the extent of the upside forgiven - ie, the cost of the costless collar.
DMS model the performance of a costless collar set at various levels of protection. The results are detailed in the table.
What the professors' analysis shows is that the cost of protecting the portfolio from a decline of greater than 5 per cent, for example, brings down the total return over the 2006 period from 9.77 per cent for buy and hold to 6.2 per cent a year, back around the level of performance averaged by Government bonds.
DMS thus conclude that it is relatively expensive to engineer a protected portfolio. The fees embedded by the intermediary creating the structured product are much larger than the fees normally charged for managing an index fund.
The main reasons that returns from a protected portfolio are so poor (protection from anything greater than a 1 per cent decline annually reduces average returns from 9.77 per cent a year to just 0.4 per cent a year) is that it is very expensive to buy protection against severe financial setbacks.
Nobody likes a Black Monday and no one knows when it's going to happen so the price to buy protection from it is prohibitive, more expensive, in fact, in terms of derivative prices than is even implied by actual volatility.
It looks very much the case that people who buy guaranteed products embrace the idea of protection without realising the cost. This isn't altogether surprising because investment statements generally don't help. The stockmarket has a long history of overpricing flavours of the month and with shares having done so well in the last few years everyone likes the idea of locking in their profits while still staying in the race. Too bad it doesn't work.
So what does work? Surprise, surprise - DMS nominate the tried and true, easy to understand, and low-cost concept of diversification - spreading your funds over risky (stocks) and non-risky assets (bonds).
DMS note that the correlation of shares and bonds which was positive through much of the 80s and 90s has now turned negative. Thus there is today renewed scope to reduce risk by diversifying across the asset classes.
DMS found that for any given level of risk from a protected portfolio returns are higher for the same level of risk from a portfolio split between shares and low-risk bonds. If you are worried that the stockmarket is expensive and likely to crash DMS advise that you should forget the protected strategies and simply shift some of your share portfolio into low-risk Government bonds.
* Brent Sheather is a Whakatane-based investment adviser
