Wouldn't it be great to invest when the markets are racing, but protect your assets during financial crises?
Investments that offer a 'capital guarantee' (increasingly rare with interest rates so low), or a form of 'capital protection', do just that. I have handled products of this type for years. Result: I am their fierce enemy. And now I'll tell you why.
How protection works
The legal form of guaranteed products varies: from mutual funds to certificates, from unit-linked policies to structured bonds. But, in any case (without going into details, because we would soon slip into the technical going), I would say that there are essentially three ways to protect capital.
1- “Portfolio Insurance” and “Dynamic Asset Allocation” Strategies – Part of the capital is invested in "safe" instruments, such as money market funds and bonds that are deemed solid (a concept we could discuss for months), while the rest is invested in riskier and more profitable assets, such as shares, ETFs or equity funds . The proportion between the two types of investment varies over time according to formulaic rules. That is: algorithms. The amount of models that fall into this category is astonishing. They have arcane, glittering names: Option Based Portfolio Insurance (OBPI), Constant Proportion Portfolio Insurance (CPPI), Time Invariant Portfolio Protection (TIPP), Rolling Economic Drawdown-Controlled Optimal Portfolio Strategy (REDD-COPS), Drawdown-Controlled Optimal Portfolio Strategy (DCOPS) and so on. I got my hands dirty with these algorithms and I can tell you that at the end of the day they are all "pro-cyclical": that is, they tend to sell risky assets when they go down in value, and to buy them when they go up, based on signals produced by the model. Therefore they carry out more or less frequent transactions, with related trading costs which negatively affect performance.
2- Use of derivative instruments – One or more derivatives (for example a put option, in the more scholastic case) are inserted into the portfolio which offer protection in the event of loss of value of the investment. But the derivative has a cost, just like in the case of insurance, which obviously weighs on the performance of the strategy.
3- Reinsurance – The protections/guarantees are purchased by the offerer of the product from an external party, usually a reinsurer or an investment bank. In turn, these subjects end up using methodologies that fall into the previous cases, also enjoying a possible benefit of risk diversification: if I sell 1000 protections on 1000 different portfolios maybe they don't all crash together (even if history tells us says the risk is just that – more on that in a moment). Obviously, the cost of the insurance weighs negatively on the result of the investment.
Protect yourself or not?
In the following graph I show you the 10 possible performances in as many "possible worlds" of a ten-year investment in US shares (Dow Jones index), with two alternative strategies:
1- "bare" investment, i.e. without any protection or guarantee;
2- with protection (and not guarantee), limiting drawdowns thanks to a dynamic strategy mentioned above, called Rolling Economic Drawdown-Controlled Optimal Portfolio Strategy (REDD-COPS).
The performances in the 10.000 "possible worlds" are generated with a Monte Carlo simulation, sampling entire blocks of the history of the US Stock Exchange from 1899 to today: many market trajectories that actually occurred. This means that all the major crashes in financial history are included in the simulation, from that of 1929 to the Lehman Brothers crisis. So let's see the results, and more precisely their empirical probability distribution.
The graph is easy to interpret: if the protected strategy (the narrower bell) is used, negative results are much less probable, but so are positive ones; the "naked" strategy (larger bell) instead has a higher potential at the price of some more risk.
A quick look at some performance and risk metrics confirms it all: the protected strategy has an average annual performance that is half that of the "naked" portfolio, with risk measures reduced to about a third. In short, for once we are faced with a true cause-and-effect relationship: less risk, less return. Using different algorithms, or even just different parameterisations of the same algorithm, some numbers vary, but the substance does not change.
Risks of anti-risk products
In the real world of savers there are other factors to keep in mind when considering such an investment, which has specific risks, even if it was created to protect against these.
High costs - Whatever the methodology, the cost of protection is high. The formal guarantee of minimum return is very expensive. Quite obvious: over the past twenty-five years, during financial crashes, we have come to see over 90% of the stock and bond markets crash simultaneously2. Thus, those who provide collateral to asset managers, banks and insurers run the risk of having to pay their policyholders simultaneously. A huge risk: natural that they get paid the right amount. Then, often, those who offer these products know that "the capital guarantee" is a myth of the average saver and so they adjust the commission load by increasing it to levels that kill any possibility of obtaining returns above the minimum ...
Counterparty risk – Are you sure that whoever provides the warranty or crash protection will be able to fulfill the contract? In the event of serious episodes of systemic risk – such as the default of the Lehman Brothers bank – it cannot be taken for granted. It is possible that the guarantor will end up belly up. This is one of the most serious risks in the insurance sector: there are those who, years ago, sold life products with very high minimum guarantees and are having difficulty finding sufficiently profitable investments to allow them to pay for the promised guarantees.
Inflation risk – The guarantee/protection usually applies to nominal returns. Ergo, inflation is free to eat capital: a rather significant risk for long-term investments.
Mummification risk – Many of these strategies, when the "protection kicks in", remain nailed to low-risk, low-yield investments. Even if the stock markets then restart with a rally that reaches new highs (as regularly happens after a serious crisis): it is frustrating. There are protected investments that remained nailed to the defensive positions assumed in 2008, during the Lehman crisis, which lost the subsequent increase. A great classic, and exactly the opposite of what a sensible person would do.
Protection level – Read the documentation carefully to understand if it is a real guarantee (which has formal value), or a simple protection (which is an objective, but not binding). And then: what is the protected/guaranteed level? There are products that guarantee only a portion of the capital. Others have knock-out clauses: this means that below a certain level of loss, the protection disappears. In short, be careful what you do.
Time constraints and illiquidity – How long does the capital remain tied up before it can be released? Are there penalties? Often constraints and penalties are significant. Furthermore, structured notes and certificates can be difficult to sell on the secondary market.
Is it really worth it?
«Nothing is created, nothing is destroyed, everything is transformed» – Antoine-Laurent de Lavoisier. There is a balance in things, as Lavoisier's fundamental postulate and the law of conservation of mass remind us. And just as energy cannot be created or destroyed, investment performance is not magically generated, but derives from careful risk-taking. Thus, by eliminating a part of the risk, a portion of the return also goes away. There are no magic solutions – the only real free-lunch is portfolio diversification, which lowers risk without paying for expected performance.
Put it in your head: a protected/guaranteed investment does not have the level of security of a deposit account or current account, which has the parachute of the bank guarantee fund. Tattoo it on your arm: no investment is 100% safe (editor's note: not even keeping money on the current account, for that matter, or under the mattress).
So, is it really worth buying a product based on risky asset classes and then placing protection or a guarantee on top of it? Boh, it's a matter of opinion, of course. Each has its own unique situation. But, in principle, I see it as follows.
If an investor has a decent objective ability to bear risk (I stress: "objective", measured by a good profiling questionnaire), with a long time horizon, well, he faces a relatively low probability of obtaining negative returns - on this point I invite you to read this post. The history of the markets has abundantly demonstrated that they reward risk in the long run and, if this is the case, the protected investment is highly sub-optimal.
If, on the other hand, the ability to bear risk is objectively low, then perhaps it is better to focus on a truly low-risk investment. For example a savings account. That's why I'm not a big fan of these capital-protected products.
Based on my direct experience, protected or guaranteed investment is mainly for anxious people who don't really want to understand the markets and, therefore, don't want to consciously take on risks that they could often bear instead. So he prefers to delude himself into avoiding them, hiding behind these products. Which are risky anyway. And whose commission cost most often eats up the yield.
