Thinking about portfolio protection

Downside risk protection is one of the more interesting things to think about in investing. After all, if you ask me, “should I own US stocks or international stocks?” my answer will be “yes.” We can quibble or even fight about what proportion of your equities should be large cap, small cap, growth, value, etc., but those are all ultimately battles around the margin. The fact is, owning equities is the best way to participate in the profits of publicly traded companies, so if you want to participate, you should own them.

So, if investing in global capitalism has a positive expected return, why would you worry about downside risk at all? The answer isn’t war on the Korean peninsula, or Chinese industrial espionage, or the first of what I can only assume will be many US government shutdowns in the coming years. The reason is (almost) entirely behavioral: if you, personally, are going to make decisions you know to be bad when your portfolio tanks, then one way to avoid making those bad decisions is to put in place protections that will keep your portfolio from tanking.

Faithful readers know about my unfortunate literal tendency, and it’s remarkably difficult to find any concrete descriptions of how a person might implement a strategy to protection their portfolio from downside risk. So, I thought I’d take a swing at it.

Options

It’s easy to find people online who are happy to sell you options trading strategies with a positive expected return. I do not believe those people and don’t think you should either. But options really do exist, and you really can use them to provide portfolio protection — as long as you’re willing to pay for it.

To see how this would work, let’s use the example of SPY, the S&P 500 SPDR and the most heavily-traded ETF in the world every single day. SPY is currently at $280.41 and, in 2017, paid $4.79 in dividends, which we can use as a baseline (under most — but not all! — market conditions dividends are stable or rising). Assume a portfolio of 100 shares of SPY, which paid $479 in 2017 dividends.

According to Nasdaq’s information at the time of writing, you could buy 100 option contracts giving you the right to sell SPY for $280 per share at any time before April 20, 2018, for $543. That would give you downside protection should the price of SPY fall by more than $0.41. Of course, it would also mean giving up $543 of your $479 in 2017 dividends. If the price of 3-month options remained constant quarter-to-quarter (more on that in a moment), you’d end up paying $2,172 in annual options premia, turning a modestly positive 1.71% yield into a negative 6.04% yield.

If you were able to do that, would it be worth doing? Well, that depends. How bad a decision do you think you’ll make if the markets tank? If your portfolio loses half its value, will you sell everything and never touch stocks again? In that case, giving up 7.75% in annual returns might be cheap.

Of course, this exercise has insisted on complete downside protection using at-the-money puts covering an entire portfolio. Naturally, there are other strategies you could use to provide partial downside protection.

Since options are cheaper the further out of the money the strike price falls, you could buy out-of-the-money put options, for example corresponding to your portfolio’s dividend payout. In the case of SPY, $118 (roughly a quarter of the $479 2017 dividend) would buy you 100 put options with a $252 strike price, roughly 10% lower than SPY’s last closing price. You would sacrifice a 1.71% dividend yield for protection from any fall in the price of SPY of more than 10%, while fully participating in any price rise. This is, incidentally, essentially how variable indexed annuities work, although they cap upside participation as well as downside risk.

One problem with such a strategy is that options prices are not constant quarter-to-quarter, so the same amount of protection could cost more when your contracts expire and you need to replace them. One solution would be to buy longer-dated puts.

Rather than paying $543 for an April at-the-money put contract, then in April replacing it with a July at-the-money contract, then replacing that in July with an October contract, and finally replacing that with a January contract, you could buy a January at-the-money put today for $1,402. It may take a moment to realize why the January contract doesn’t cost four times (or more) the April contract: the strike price of the January put doesn’t reset each quarter, and since SPY has a positive expected return, the option is priced on the (reasonable) assumption that it will be very far out of the money by the time it expires. In other words, if you want to reset your option’s strike price each quarter, you have to pay up.

Incidentally, for the $2,172 you’d pay for four equally-priced quarterly put options you could buy a January, 2019, SPY put with a strike price of $295, locking in a 5% price increase (but you shouldn’t).

Put strategy funds

Instead of getting involved in options trading yourself, you could pay somebody to do it for you. For example, Cambria Funds offers what they call a “tail risk” ETF, ticker symbol TAIL [full disclosure: I own two (yes, two) shares of TAIL in my Robinhood account]. Their strategy is slightly different from the ones I described above, since the fund uses bonds instead of equities to generate income that they then use to buy out-of-the-money puts. You can see their actual holdings here, they only have 13 positions so it’s pretty easy to understand the strategy, although for reasons I don’t entirely understand the ETF also pays a small dividend.

One thing to keep in mind is that since TAIL holds 95.5% of its value in Treasuries, you would want to use it to replace bonds in your portfolio, since it’s basically an intermediate-term Treasury fund with a small allocation to put options.

Sell part

The single easiest thing you can do to protect yourself from a fall in asset prices is to simply sell now, before the fall. If your equities have doubled or tripled since the depths of the financial crisis, there’s no rule that says you have to hold onto them forever. If holding some cash, or short-term treasuries, or inflation-protected securities, is going to make you more psychologically resilient against the inevitable crash, just hold some cash!

In tax-sheltered accounts that may be as easy as pushing a button, although for assets in taxable accounts be sure to consult with a fiduciary financial advisor or tax professional to understand the tax implications of selling appreciated assets. If you are still making contributions to IRA’s or workplace retirement accounts, you can also adjust how your ongoing contributions are allocated in order to build up a defensive position.

The problem of asset location

That last point raises an issue that I’ve only begun to struggle with, the problem of asset location, which arises because different investment vehicles have different rules about contribution limits and contribution timing.

For example, since funds in IRA’s compound tax-free, you’d ideally like them to be fully invested in assets with the highest expected returns. But since there are annual contribution limits, you’d also like to keep some of the value of the account in safe assets, or assets that are uncorrelated with the account’s most volatile investments. Once solution, counter-intuitively, could be to hold each year’s contribution in a high-yield taxable account (I like Consumers Credit Union’s Free Rewards Checking) and delay contributions until as late in the year as possible, in order to determine whether each additional contribution should be added to the high-risk or low-risk portion of a portfolio. Contribution limits are so low to such accounts that delays are unlikely to have much effect one way or the other in the accounts of high-net-worth individuals, however.

Likewise, workplace retirement plans that are funded through paycheck withholding require you to specify how your biweekly or monthly contribution is to be allocated. Whether or not you can accelerate contributions in response to events in the market depends on your payroll department and the time of year, and in any case you’re subject to annual caps on elective employee contributions, meaning for some people there may be strategic value in holding less-volatile assets even within an account that internally compounds tax-free.