Reducing the risk of loss? Focus on two strategies

If you want to reduce the risks in an investment portfolio, you can take the traditional route: This involves selling shares and investing in lower-risk investments such as bonds. We call this strategy "Reduce" below. But there is another way: here the equity allocation in the portfolio remains the same, but it is hedged with put options. We call this strategy "Protect".

A revealing look into the past

The following section uses a historical analysis to show how the two hedging strategies have performed since 2006. The performance of the two strategies was measured at the end of each quarter. The following premises form the starting point:

• For the sake of simplicity, we consider a mixed portfolio with 45% equities (S&P 500 Index (TR) in USD) and 55% government bonds (ICE BofA US Treasury Index (TR) in USD). 
• In the "Reduce" variant, the equity allocation is reduced by 10 percentage points and the bond allocation is increased by the same amount.
• The "Protect" variant consists of the quarterly purchase of a put option on the S&P 500 index with a strike price of 90% for the entire equity quota of 45%. This variant takes into account the costs in the form of the option premium and the amount paid out when the option fulfils its protective effect.

The following chart shows a performance comparison of the two strategies over the periods from June 2006 to the end of 2016 and from the beginning of 2017 to June 2024.

The findings: Both strategies achieved a negative relative performance in the period analysed. This is not surprising, as both strategies reduce the portfolio risk and a lower risk is associated with a relatively lower performance in the long term. The different performance of the two strategies in the first (2006-2016) and second period (2017-2024) is also striking. While the risk reduction with "Reduce" yielded better returns than with "Protect" in the first period, it was the other way round in the second period. Why is that?

1. Stock market volatility: The chart also shows the option premiums to hedge 100% shares for one quarter with a 90% put (right-hand scale). The amount of the premium depends on the stock market volatility, which was particularly high during the financial crisis of 2008 or the Covid crisis of 2020, for example. In the first period, the premiums were higher at an average of 1.24% (based on 100% shares) than in the second period at 1.14%. As a result, the costs for the "Protect" strategy were slightly higher in the first period than in the second.
2. Correlation: The better performance of the "Protect" strategy in the second period is also due to the change in the correlation between equities and bonds. This was -0.6 from 2006 to 2016 (with quarterly data). At that time, bonds offered effective diversification compared to equities. Since 2017, the correlation between equities and bonds has been 0, meaning that falling share prices could no longer be offset to the same extent by gains on bonds. This increased the attractiveness of the "Protect" strategy compared to "Reduce".
3. Change in the interest rate level: Interest rates fell significantly in the first period and rose again in the second. For example, the 10-year yield on US government bonds was 5.14% at the end of June 2006 and fell to 2.44% by the end of 2016. It then rose again to 4.40% by June 2024. This meant a better average performance of US government bonds in the first period (4.26% p.a.) compared to the second (0.65% p.a.), which made the "Reduce" strategy with the shift from equities to bonds relatively more attractive from 2006 to 2016.

How do the strategies protect in the crisis?

We have chosen the reduction in the equity allocation so that the two strategies "Reduce" and "Protect" are roughly equally risky. In addition to the volatility of the returns, we have also taken into account the maximum loss, which should be lower with the "Protect" strategy than with the "Reduce" strategy. This is because while the "Reduce" strategy reduces the frequency of small losses, the "Protect" strategy primarily minimises large losses (tail risk events). The following table shows the return and risk figures of a mixed portfolio with and without hedging during the financial and Covid crisis. In each case, the quarter with the highest losses during the two crises was selected.

Conclusion

The decision to "Reduce" or "Protect" depends on the respective expectations and preferences of the investors. In principle, it can be said that,

"Reduce" is more advantageous for those who

• expect high volatility (=high hedging costs) in the future, but no tail risk events,
• assume a high protective effect of bonds and falling interest rates in the future
• also want to suffer smaller losses less frequently,
• do not regard participation in positive equity markets as a top priority,
• do not wish to use derivatives.

"Protect" is more advantageous for those who

• expect low equity market volatility (= low hedging costs) but more frequent tail risk events in the future,
• assume that the protective effect of bonds will be reduced and interest rates will be rising in future,
• want to continue to participate fully in positive equity markets (after deduction of the option premium),
• like to protect themselves against very high equity losses (tail risk events), but who can continue to bear smaller losses themselves,
• have the willingness to use derivatives.

Note: The "Protect" hedging strategy is a simple example. The hedging strategy with put options can be further optimised, e.g. by selecting more suitable maturities and staggering the option purchases so that several options with different maturities are activated. In practice, it is also possible to hedge other equity markets (e.g. Swiss Market Index, Euro STOXX 50 or Nikkei 225).