Equity investors need more than market returns

The slow “grind down” in equities over the last two years has been testing investor’s nerves. It’s just not the new investors that’re questioning their thesis but even those long-term investors. While this characteristic of the market is not a bug but a feature, it still unsettles most investors, particularly, those heavy or overweight on equities in their portfolios. I’ve been asked if there’s a hedge that could protect against such situations but it’s not an easy solution but for one.

When we set up on investments, most of our goals usually tied to build a strategy that offers attractive returns but make it an all-weather portfolio, the goal must be tinkered a bit. These portfolios are designed to survive during the periods when those returns don’t arrive. The difficult part in investing isn’t about understanding how the returns are created but to have the financial capacity and psychological patience to stay invested when those returns don’t materialize.

Tail-risk is an event that could be an outlier, an extreme that falls beyond the standard or usual outcomes. Markets declines are of three types broadly: the ordinary corrections which measure up to 5-10% happening almost at regularity, the bear market phases where they could correct by 20-30% potentially extending for months and extreme correction involving sudden, severe sell-off that renders an ordinary portfolio protection ineffective.

A tail-risk hedge is designed primarily for the last type of market conditions, though its effectiveness depends on the actual design.For instance, if the more than half of the portfolio is mid- and small-caps, hedging against NIFTY mayn’t yield the best results. To protect against such instances, which are rare, like those of 2008, 2020, etc. one need to have the knowledge, the timing and the capacity. This is because many of these strategies could be expensive and complex while the probability of such event is rare. The complication, however, is that they don’t work when the fall is slow and prolonged.

The best real-world case: the Simplify Tail Risk Strategy ETF which was launched in Sept ’21 was designed to provide significant protection during severe market declines. The strategy was designed to benefit from sharp market dislocations but during ’22, the US S&P 500 experienced a substantial decline, but it was prolonged and never sharp. So, the risk pay-off never generated while the cost of hedge continued to accumulate, leading to its liquidation in Mar ’24.

Then there’s another aspect that could throw the best of the strategies to wind, the behavioral or temperament of the investors themselves. They could turn the villain in their own story. I’ve witnessed investors repeating the same mistake despite repeated experiences. It’s a pattern difficult to cull from. Loss aversion i.e., losses hurt more psychologically than their equivalent gains feel good. The same quantum or proportion of loss and gain don’t carry the equivalent reaction or satisfaction. And Myopic evaluation i.e., focusing too much on short-term results rather than the full investment horizon.

A real-world example is the California’s public pension fund, CalPERS. It has established a tail-risk hedge programming before ending it at end of Oct ’19. The unwinding of the positions continued till early 2020. The COVID-19 crash followed soon after the exit decision which otherwise could’ve yielded about a $1bn profits to the fund. No one can predict the future, but the fund abandoned the hedge siting the cost-benefit of this strategy. So, even the best of the strategy could fail, if abandoned before it has chance to work.

These general behavioral aspects go beyond the tail-risk hedge in investing. So, when designing a tail-hedge risk, one must expect it to lose money during the ordinary markets. It doesn’t mean that poor performance is tolerated but the assessment of the investment should be conducted against the job it was designed to perform.

As I mentioned earlier, the one easier way is to design a diversified portfolio. A high concentrated equity portfolio could add allocations of gold and debt to reduce the event risk, especially, when the markets go through a lull period or sideways for longer periods of time. Then the overall portfolio-level loss is relatively lower than the equity losses. This is probably a near-all-weather strategy which if designed well within the limits of the investor’s risk profile, timelines and goals could generate optimal risk adjusted returns.

While many have these designs in place when creating portfolios, the evaluation is the key for each ingredient. I remember my clients questioning the presence of gold in their portfolios in ’21 when the prices came off the mid-20 peaks. Some even questioned why the profits weren’t booked. It’s only by 2025; did they realize the importance of its position in the portfolio. It’s not a piece to gloat about the past achievements but to highlight how counterbalance in the portfolio is critical for better risk-adjusted returns.

Initially I mentioned that not just the design but the financial capacity and psychological wherewithal.

So, when designing a strategy check if it’s a credible mechanism for providing protection or returns expected of it? Can the financial costs, opportunity costs and potential underperformance be tolerable financially, to wait through those difficult periods? And are there rules for evaluation and changing the strategy in place than reacting to recent performance? These questions are related but aren’t interchangeable. Remember that the strategy is as good as its investors.

(The author is a partner with “Wealocity Analytics”, a SEBI registered Research Analyst firm and could be reached at [email protected])

ABOUT THE AUTHOR

K Naresh Kumar

K Naresh Kumar[email protected]