From Gerd Kommer and Maximilian Bartosch
The global stock market has lost 13% since the last peak on January 4th of this year (2022) (MSCI World Index in euros, as of July 1st, 2022). In view of the inflation rates and interest rates that have been rising for around eight months, as well as the Russia-Ukraine war, which will probably last even longer, the opinion has become established in the media and on the internet that “the risks of an imminent stock market crash are currently particularly high”.
Against this background, a well-known investment zombie is now climbing out of its grave - as always happens when the stock market has been significantly downwards for a long time: the "downside hedging zombie" (hedging = protection). It represents the belief that, using certain financial products or investment techniques, it is systematically possible to reduce the drawdown risk (price loss risk) of a stock portfolio without having to make a corresponding sacrifice in the sense of a lower long-term return or lower risk-weighted return. In the marketing material for such hedging strategies or investment products, this is called “taking advantage of the upswings of the stock market and avoiding the downturns”. Financial journalists, bloggers and “finfluencers” also often publish stories about individual cases in which such hedging or “portfolio insurance” approaches have worked. Behind this lies the old investor dream of “same return with less risk” – the supposed holy grail of investing.
In this blog post we want to show that this is not far off. On closer inspection, the holy grail of investing turns out to be largely “defective goods” that people would like to return after a long period of use. In the medium and long term, more than half of those who believe in the promise of downside hedging (“DH”) will be worse off than those who do not. The minority who benefit from DH in a (usually short) time window probably do so out of sheer luck, i.e. coincidence. However, luck cannot be repeated systematically in the following time window and, on average, DH reduces the realized return.
Which downside hedging or downside protection products and strategies exist?
The world of DH or financial products is a big, colorful zoo. With regard to stocks, the following are among the most important: put options (sell rights), put warrants, short certificates, short ETFs (also called inverse ETFs), numerous financial products with built-in capital guarantees (e.g. Riester funds and other "guarantee funds" [1] or guarantee certificates), derivatives on volatility [2] or – for institutional investors – absolute return hedge funds and “tail risk” hedge funds. (Basically the raison d’être exists all Hedge fund strategies – hence the name Hedgefunds – to limit downside risks to a greater or lesser extent. If you consider how catastrophically the hedge fund sector as a whole has performed over the past 15 years, this also points to the slim chances of achieving correctly measured long-term success with systematic downside hedging.
There are also many mutual funds (investment funds) that are not explicitly DH financial products, but ultimately present themselves as such in their marketing. An example of this is Dirk Müller's investment fund (“Dirk Müller Premium Shares”, WKN A111ZF). The main reason for his anemic long-term returns is a special DH strategy that he has been practicing for seven years in preparation for “the greatest economic crisis of all time” (subtitle of his last book).
DH can also be operated in do-it-yourself mode or by an asset manager, for example through the use of stop loss orders, [3] through short selling (short selling) of either individual securities, [4] by short selling conventional ETFs or so-called index futures (stock packages defined by indices) or by purchasing “inverse ETFs”.
The most common DH strategy is the well-known one Market Timing without using special hedging products – attempting to time stock market downturns and upswings. A less grandiose synonym for market timing is “in-out.” In-out is just as common among do-it-yourself investors as it is among asset managers and fund managers. In the fund sector, this is called “asset-managing funds”, “multi-asset funds” or – less glamorously – “Mixed funds”.
Traditional stock picking is also used for DH purposes. The stock picker believes he can shift into “defensive stocks” or cash in time for a market downturn.
A distinction to be made from DH is cross-asset class diversification, i.e. combining stocks with, for example, high quality bonds with a relatively short remaining term within a portfolio in order to reduce the volatility and drawdown risk of the portfolio. However, here – unlike DH – there is no wish that one could systematically reduce risk without having to sacrifice returns.
Below we look at the advantages and disadvantages of DH. We send ahead – attention Spoiler alert – that the disadvantages outweigh the disadvantages.
Difficulties in implementing downside hedging
For those investing on their own, disadvantage #1 is that DH produces a lot of work and/or additional costs. Private investors who have not already tried DH themselves are likely to underestimate this effort and additional costs. Implementing a DH strategy correctly requires ongoing close monitoring of the investment and ongoing active intervention and action - i.e. work.
In addition, there is something that is often overlooked operational risk the implementation of a DH strategy. [5]
Two examples: Using stop loss orders is more demanding and labor-intensive than anyone who only knows the dictionary definition of stop loss orders imagines. It starts with the fact that this type of order does not work in practice as reliably as it says in the textbook, especially in the case of very violent downward market movements.
With short ETFs you are faced with the complex problem of Path dependency the hedging effect of these products. Path dependence means that a short ETF requires daily (!) reevaluation by the investor. (Some users of short ETFs may not initially realize this until they have learned the hard way.)
To the extent that the high amount of work required by DH and the operational implementation risk are outsourced to a bank, an asset manager or a fund manager, the associated considerable effort will manifest itself in high ongoing fees. These will be two to five times the cost of a delegated index investment on a buy-and-hold basis.
The performance record of downside hedging
This brings us to DH's problem number 2: its poor performance record in the long term. In the studies mentioned at the end of this blog post, this balance is quantified for a variety of different DH strategies and time periods - in two studies even for periods of around 100 years (Dimson et al. 2007, AQR 2018). [6]
Ultimately, the main reason for the disappointing figures is always the same basic fact: in the long term, the lost profits caused by DH - the Opportunity cost – higher than the benefit achieved, the cushioning of price losses.
This in turn has three interrelated causes: First, the global stock market is moving upwards in the long term. This structural upward movement is overshadowed by high short-term, severe volatility, making it extremely difficult to identify at any given moment whether there is a longer upswing or a short to medium-term downswing at that moment. Operating DH during one of the longer upswings will limit the investor's participation in that upswing. This has to do with the costs caused by DH and/or with the fact that DH very rarely works precisely enough for the “DH handbrake” not to be applied at least temporarily in the upswing phase, when unbraked forward driving would actually be the order of the day.
An example: A fund manager who invests in individual stocks (stock picking) believes that the probability of a sharp decline in the stock market in the next few months is high. That's why he buys put options [7] on the ten largest individual stocks in his stock portfolio. The options have a term of six months; the price of these options depends on the structure of the puts. The stronger their downward hedging effect, the more expensive they are. Now, if we assume that over the six months in question the stocks in the portfolio produce a positive return of, say, a moderate two percent, the net return on a portfolio basis will be that two percent minus the cost of the options expiring in vain.
Second, despite our gut feeling to the contrary, strong sustained drawdowns are too rare to make the cost of hedging worthwhile in the long run given the current cost of hedging. The argument can also be turned around: On average, insurance is simply too expensive relative to the level of protection it offers.
Third, the stock market is like that information efficient, [8] that, according to everything we know from 60 years of empirical capital market research, it is not possible to predict the beginning of sustained up phases or down phases reliably enough to be able to beat a more cost-effective corresponding buy-and-hold strategy. In particular, releasing the handbrake in a timely manner usually fails.
Anyone who tries to limit the losses in their stock portfolio in a downward movement by simply switching to cash usually fails not because they cannot exit before reaching the low point, but rather because they miss the timely re-entry in the subsequent upward movement. Missing out happens because investors consider the upward movement in real time to be just a “false interim high” and fear a further or repeated strong downward movement.
Nevertheless, probably 95% of the financial industry and 95% of the financial media and investment bloggers claim that DH works for them, directly and indirectly, day in and day out. It's easy to explain why they do this: As a financial services provider, you can earn far more with active investing, including DH, than with rational, forecast-free buy-and-hold.
And in the financial media and the bloggersphere, storytelling and clickbait à la “Wall Street sell-off is gaining momentum” [9] or “How investors protect their portfolio” simply have more circulation than publications about scientifically oriented investing like the one you are currently reading.
In addition, most private investors simply want to believe the fairy tale of returns with limited risk because it corresponds to their own intuition and the all-too-human desire to “get rich with limited risk.”
Scientific studies on downside hedging
Ultimately, when making a final judgment on DH – as is recommended for assessing all investment strategies – we should rely on science. In science the situation is seen as follows:
Really convincing evidence for the functioning of DH is lacking. Working would mean that DH reliably and sufficiently significantly outperforms a comparable buy-and-hold strategy in terms of costs over a long-term period or generates a significantly better risk-adjusted return (e.g. Sharpe ratio). We have mentioned the reasons for the lack of such DH success evidence above.
However, one could fill an entire library with evidence of the failure of DH. We list 20 of these studies at the end of this blog post.
But one must not and should not limit oneself to studies that specifically deal with DH. Ultimately, almost every one of the thousands of scientific studies on the failure of active investing that have been published since around 1960 is also a study on the failure of DH. Reason: Practically all active investors, be they the managers of one normal mutual funds, the managers of one Hedge funds or do-it-yourself private investors, operate at least one of the above-mentioned DH forms.
Are there situations in which downside hedging can help?
We have now shown what the disadvantages of DH are, namely the high amount of work involved and its statistically unattractive performance record.
But aren't there still constellations in which DH is beneficial?
In the specialist literature it is pointed out – mostly “for the sake of good order” – that DH is used to reduce the drawdown risk or, in general, the risk of loss in a portfolio short term can limit. That's true and it's true not only in the short term, but also in the long term. That still doesn't mean much.
A globally diversified 100% equity portfolio has a maximum drawdown risk based on data from the last 120 years [10] of around 55%. If you don't want to bear this risk, you can actually mitigate it with one of the DH products or techniques mentioned here. [11]
Doesn't that show that DH does have some use? No.
First, when we think about it, investing is almost never about just short-term results. Short-term results may dominate our moment-based perception and emotions, but are rather meaningless in the numerical reality. This applies even to a day trader. They are rather meaningless because investing and wealth creation is a marathon, not a 100-meter sprint. We and the media often foolishly interpret this marathon as a race consisting of 420 individual 100-meter sprints, but that does not change the underlying reality: the investment horizon of most private households corresponds to their remaining life expectancy and not just the next 12 months.
Secondly, those who do not want to bear a 55% drawdown risk in their portfolio could reduce this risk by adding a risk-free investment in the form of a high-quality bond ETF [12] reduce as much as you like – at modest costs, with noticeably reduced complexity and with greater reliability. But of course also by giving up a corresponding part of the share upside.
Thirdly, even when looked at favorably, DH often does not succeed even in the purely short-term perspective as stated on the “packaging description” of the hedging product or hedging strategy.
Conclusion
Downside hedging is a promise the financial industry has repeatedly broken for at least 40 years to significantly mitigate the risk of stocks without giving up significant return opportunities. It's time we stopped falling for this chimera.
The stock asset class has higher long-term returns than all other asset classes, higher than real estate, than bonds, than gold, than raw materials and probably also than cryptocurrencies. Anyone who wants to take full advantage of these high long-term returns must also bear the associated drawdown risk undiminished.
Compared to downside hedging, reducing equity risk is easier, more reliable and more profitable with traditional diversification across asset classes, in particular by adding short-term high-quality bonds. In the long run, an investor is very likely to achieve a more attractive return-risk combination this way than through DH. At least that's how it has been for the last 100 years: "We find using nearly a century of data that diversification is probably (still) investors' best bet" (AQR 2018).
Endnotes
[1] For guarantee funds with a limited term, there is a minimum repayment amount at the end of the term; for guarantee funds without a limited term, there is a minimum repayment amount on periodically recurring deadlines.
[2] Volatility derivatives: Such investment products increase in value when volatility (price fluctuations) in the stock market increases, e.g. B. Certificates on the S&P 500 VIX volatility index. A sharp market decline typically brings with it an increase in volatility.
[3] With a stop loss order, you can instruct a bank to automatically sell an investment as soon as the price has fallen below the price limit specified by the investor. Stop loss orders are divided into conventional stop loss orders, trailing stop loss orders and stop loss limit orders.
[4] With short sales, the short seller profits from falling prices (prices) of the short-sold investment.
[5] Operational risk is the risk of damage in the practical Implementation (implementation) of an investment strategy. Operational risk has nothing to do with investment risk, e.g. B. in the form of market fluctuations. Anyone who invests on their own bears investment risk and operational risk. Anyone who delegates investing to a third party usually only bears investment risk.
[6] Since there are, in principle, as many variants of the concrete implementation of DH as there are investors in DH, we think it is unhelpful for the purposes of this blog post to give concrete numbers. Most of the numerical examples would have in common that they would lead to a lower return than a comparable buy-and-hold investment, provided the period evaluated exceeds five to seven years. For shorter periods of time the statements are less clear. If you want to check this yourself using a simple example, you can simply enter the absolute return and, if necessary, the Sharpe ratio of a simple guarantee certificate with e.g. B. Compare 90% capital protection (maximum downside 10%) with a corresponding ETF without downside protection.
[7] A put option is the right to sell a security to the issuer of the option during a specific period of time or at a specific point in time at a specified price (strike price). The option becomes a profitable transaction for the option holder if the market price of the security falls sufficiently far below the strike price and - this is important - the investor then exercises the option or is allowed to exercise it at all (some options may only be exercised by the holder at the end of the term). If it is not exercised, the option expires and becomes a loss-making transaction for the holder.
[9] “Sell-off” in such headlines or statements is always a lie because it cannot happen, no matter what financial market it is. See here.
[10] Maximum Drawdown: The maximum cumulative (“accrued”) (book) loss during a given historical period.
[11] Contrary to what many believe, the 1929 crash is no exception to this. The maximum drawdown at that time is regularly overstated incorrectly in the financial media - see here.
[12] High quality bond ETFs: For relatively small portfolios, a daily cash balance would also be acceptable as long as the risk-free investment does not exceed 100,000 euros, the amount per bank-customer combination effectively guaranteed by the state as part of the statutory deposit insurance.
literature
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