Financial Advisors

An Advisor’s Field Guide to Downside Protection

Stock market volatility and uncertainty represent major risks for advisors and their clients by testing investors’ resolve and their ability to stay the course to capture the effects of long-term compounding. That is why there has been a serious search for downside protection strategies that can be added to investment portfolios. This has increasingly become a major component of portfolio construction decisions for advisors and RIAs.

That is why it is very timely that a major research study – “An Advisor’s Guide to Downside Protection” - has just been published to review the dominant strategies now in use, as well as offer suggestions and advice on how to analyze and implement these defensive strategies. To better understand this research, we talked with the study creator and Institute member Jon Robinson, CEO and Co-Founder of Blueprint Investment Partners. In addition to investment management services, the Greensboro, NC based firm provides its advisor clients with practice management solutions, including tools and coaching to help advisors implement an optimal business model/strategy to compete in our industry’s new operating environment. We were interested in exploring their research methodology and perspective on how advisors can best manage downside risk and improve client outcomes.

Hortz: What was your goal and motivation for your research on downside protection strategies? What were the key questions that you wanted your research to answer?

Robinson: Ultimately, it was our conversations with financial advisors that fueled the creation of “An Advisor’s Guide to Downside Protection.” We kept hearing – and we still hear it – about the challenges they face in selecting the “right” approach to downside protection. This challenge has been significantly more difficult in environments like the last 12 years when there has been a temptation to ignore downside risk in favor of capturing the seemingly endless supply of upside.

Like any insurance policy, a downside protection strategy is one of those things advisors’ clients may not need…until they do. The whole point is to have the strategy in place before the unexpected happens, before the potentially catastrophic event occurs.

Our goal was to provide advisors with a practical field guide for considering how to manage downside risk in their client portfolios. And we wanted to explore the topic holistically, so our analysis centered on four critical questions:

  1. Is the approach accessible to the average investor and their advisor?
  2. How well does a particular approach diversify the traditional 60/40 portfolio to provide downside protection?
  3. In addition to providing downside protection, how well does the instrument perform on a standalone basis?
  4. How does each instrument influence investor behavior?

Hortz: How did you determine the 11 downside protection strategies that you chose to analyze for your study?

Robinson: Our first consideration was practical in nature. If the approach to downside protection was difficult for the advisor and their clients to invest in, then we removed it from consideration. This included non-exchange traded products, investments with high minimums, and illiquid securities. By excluding instruments with low accessibility, we further narrowed our universe requiring analysis to three macro categories and the following individual instruments:

  • Traditional diversification
    • Real estate investment trust (REIT) index
    • Value index
    • S. 10-year Treasury bond
    • Investment-grade corporate bond index
  • Hedge strategies
    • CBOE Volatility Index (VIX)
    • Gold
    • Inverse (short) S&P 500
  • Tactical and alternative strategies
    • S&P 500 short-term trend strategy
    • Liquid alternatives index
    • Long/short index
    • Managed futures index

Hortz: Can you explain the methodology you used in your analysis of each strategy?

Robinson: We wanted our analysis to objectively illustrate the pros and cons of various approaches to downside protection, rather than to proclaim some absolute truth. Like most things, this is not a one-size-fits-all solution.

To accomplish this, we looked at each of the 11 strategies through two lenses.

First, we tested the effects of incorporating each instrument as a 20% allocation in a traditional portfolio. We used a standard 60/40 portfolio of stocks and bonds as our baseline because we believe it to be a fair point of comparison for goals-based advisors. This allowed us to assess how incorporating each instrument as a 20% allocation impacted a portfolio during the four largest market declines since 2000, as well as over the full market cycle from 2000 to 2020.

Second, we considered each strategy as a standalone investment. This allowed us to prescribe a “behavior score” by combining traditional quantitative risk/return metrics with qualitative measures that can be strong indicators of whether, and for how long, an investor will stick with an investment. This standard focuses on practicality and investor behavior.

Hortz: Can you further discuss your “behavioral score?” How did you develop the scoring metrics and how should advisors employ these scores in their analysis of these strategies?

Robinson: While traditional investment evaluation often stops after the quantitative analysis of risk/return metrics, we think this is short-sighted because it misses a key consideration: How is an advisor’s client going to feel about the investment’s behavior in both up and down markets? Practically speaking, if an advisor must continually explain why a certain investment consistently generates losses, even if it quantitatively benefits the overall portfolio, the optics become highly difficult to defend to clients.

To objectively evaluate this, we prescribed a score ranging from 3 to 11 to each instrument based on their rating in three areas:

  1. Maximum drawdown – This risk/return metric captures the absolute pain an investor feels when the instrument declines in value.
  2. Maximum underperformance compared to a traditional 60/40 portfolio – This captures the relative pain an investor feels when they eyeball their investment versus a common benchmark.
  3. Transparency – This refers to access, visibility to the rules that drive the strategy, and the ability to see the underlying portfolio holdings (all characteristics that help an advisor explain the approach to clients and verify that a strategy is being managed as expected).

We would not recommend that an advisor only consider the instrument’s behavioral score when evaluating which method of downside protection is appropriate for their client portfolios. We simply think it is an important – yet too-often overlooked – input for making challenging decisions about how to manage downside risk.

The goal is to keep clients on a straighter path toward the long-term goals they have agreed upon with their advisor, right? Both parties succeed when the portfolio is created in a way that the client can stay anchored to during various market environments. Let’s say a particular client is incredibly uncomfortable with substantial deviation from traditional benchmarks. Then, the behavioral score can help an advisor identify that instruments like the VIX or an inverse S&P 500 strategy may not be suitable for this client since each scored very poorly for drawdown and underperformance (non-qualitative investment considerations the client feels strongly about).

Hortz: What did your research determine as to the best downside protection strategies to employ?

Robinson: A theme we saw throughout our analysis – and this should come as no surprise – was that there is no free lunch in investing. Advisors face a real challenge in selecting the best instrument for downside protection because sometimes solving for one problem creates less than ideal conditions elsewhere.

For example, if solving for drawdown improvement and “crisis alpha,” then the VIX could be an obvious choice. However, both the behavioral and quantitative pain from holding the VIX and seeing it drag on performance over nearly every other environment can be too great for many investors.

As another example, while U.S. 10-year Treasuries performed mostly in a favorable fashion in our study, a limitation with our analysis is that our sample period of 2000 to 2020 was marked only by falling interest rates. It stands to reason that, should the interest rate environment in the U.S. materially shift, Treasuries might prove to be less additive to a traditional portfolio than in the past. 

Therefore, while some clear distinctions emerged among the instruments, we stopped short of proclaiming any ‘absolutes’ because each advisor may weigh the factors used in our analysis differently than we do in the Guide. Or they may not value these factors at all.

Hortz: What does success for advisors and clients look like in integrating your research into their investment process?

Robinson: There is a symbiotic association between advisor and client success.

For advisors, success involves retaining clients by being relentlessly focused on financial plans. This has two parts: first, it is developing the roadmap that helps a client achieve their goal; next, it is guiding the client to stay anchored to the plan even in times of euphoria, fear, volatility, change, and every other cycle the market will go through at some point.

For clients, success means sticking to the plan up until its intended, pre-determined end date – with an exception for when goals change, of course.

Building a portfolio that is quantitatively sound and also behaviorally friendly is a foundational element. But it first involves getting clear about what variables advisors and their clients value the most.

An advisor may have clients who cannot stomach substantial divergence from traditional benchmarks. For these individuals, it may be appropriate to select diversifiers that are more correlated to equities but also can preserve capital – trend strategies and managed futures come to mind based on the data outlined in the Guide.

On the other hand, if material outperformance during bear markets is important, it is imperative to know and communicate ahead of time that there is a high probability of performance drag on the portfolio by adding instruments like the VIX or an inverse S&P strategy.

With so many options bombarding advisors, we consider our Guide a great success anytime an advisor tells us it provided them with some order and clarity.

The Institute for Innovation Development is an educational and business development catalyst for growth-oriented financial advisors and financial services firms determined to lead their businesses in an operating environment of accelerating business and cultural change. We position our members with the necessary ongoing innovation resources and best practices to drive and facilitate their next-generation growth, differentiation, and unique client/community engagement strategies. The institute was launched with the support and foresight of our founding sponsors - NASDAQ, Ultimus Fund Solutions, Pershing, Fidelity, Voya Financial, and Charter Financial Publishing (publisher of Financial Advisor and Private Wealth magazines).

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Bill Hortz

Bill Hortz is an independent business consultant and Founder/Dean of the Institute for Innovation Development- a financial services business innovation platform and network. With over 30 years of experience in the financial services industry including expertise in sales/marketing/branding of asset management firms, as well as, creatively restructuring and developing internal/external sales and strategic account departments for 5 major financial firms, including OppenheimerFunds, Neuberger&Berman and Templeton Funds Distributors. His wide ranging experiences have led Bill to a strong belief, passion and advocation for strategic thinking, innovation creation and strategic account management as the nexus of business skills needed to address a business environment challenged by an accelerating rate of change.

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