How to tell if your portfolio protection strategy is underperforming

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By Michael Armitage | 16 January 2017

Investors often become dazzled by long periods of robust returns only to be blinded by sudden downturns.

While some investors have decades to ride out volatility and heavy capital losses, retirees are not among them. They need to pay greater attention to these risks while still attempting to maximise returns.

They face a number of options–and they all have a cost. There’s “no free lunch” when it comes to investing.

However, measuring the true performance of strategies which place a greater emphasis on risk management is still sorely lacking and often misleading.

The shortcoming of popular benchmarks

Typical benchmarks don’t incorporate the risks faced by retirees (or investors with relatively short-term time horizons).

For example, most share investors rank their short-term returns against major indices such as the S&P/ASX 200 or the S&P 500. Their longer term expectations are also typically based on annualised returns which smooth out the impact of volatility and protracted downturns.

This is a deadly approach for retirees.

For example, the average total annualised standard deviation of the S&P/ASX 200 over the decade ended November 2016 was 14.31%. This shows just how far actual returns swung from the average total annualised return of 4.46% over the same period. The maximum drawdown as measured from the peak to valley of the S&P/ASX200 during the global financial crisis (GFC) period of 2007 to 2009 was -50.6%.

This volatility has a significantly larger impact on retirees or those near retirement, which is described by the sequence of return risk. As they are no longer making contributions and are drawing an income, they miss out on the benefits of compound interest as markets eventually rebound.

There are several strategies to manage this volatility, which provides a crucial benefit, although they all act as a drag on investment returns.

However, typical benchmarks portray this as blunt underperformance rather than a more efficient way to balance risk and return.

Better ways to measure risk and return

Retirees and those close to retirement are the least well placed to absorb the volatility and potential for capital losses which form an inherent part of most benchmarks.

They need strategies to reshape their personal risk-return profile and then more accurately measure them against better benchmarks. But measuring risk is less simple than measuring returns.

Investment returns are tangible and highly sought after. Risk comes in many different guises and is something to be handled with extreme caution (or even avoided).

There are several investment ratios which measure different aspects of risk–the Sharpe Ratio is one of the most well-known. It measures the average return received for incurring an additional unit of risk above the risk-free rate, using the standard deviation of past returns as a proxy for risk.

The S&P Managed Risk Indices, recently launched in collaboration with Milliman, are an example of an improved way to measure the performance of capital-protected products.

The following diagram compares risk-adjusted returns (the Sharpe Ratio) against maximum drawdown. A managed risk portfolio (which uses a two-step risk management overlay to control volatility to a set level and then applies a synthetic put position to further reduce the downside risk) significantly outperformed an unmanaged portfolio on this basis.

Figure 1: Historical sharpe ratio and maximum drawdown: Managed risk indices versus unmanaged portfolios

However, this outperformance is different than outperforming a typical index such as the S&P 500. This more nuanced measure isn’t a comparison against absolute investment returns, but of returns per unit of risk–a far better measure for retirees. The objective of an efficient capital-protected strategy should be maximising risk-adjusted return relative to minimising maximum portfolio loss. For retirees, minimisation of loss and volatility of returns is of paramount importance to meet their income needs throughout retirement.

Why risk management is needed across all market conditions

The GFC ushered in a very different set of market conditions. Central banks slashed interest rates to historic lows in many developed countries and began buying a range of assets with newly printed money under quantitative easing programs.

This propelled many asset classes to new highs and dampened overall market volatility (although punctuated by occasional extreme spikes as markets responded to the actions of central banks).

This has been challenging for many risk management strategies.

Under these market conditions, even low-cost, futures-based strategies have, in some cases, cut 3% to 5% from annualised short-term equity returns while option-based protection strategies have experienced even larger drags on performance.

Protection strategies relying on put options (which grant the buyer the right to sell the underlying index at a pre-determined price before a set maturity date) suffer from relatively high costs compared to dynamic futures hedging strategies. This is why put option-based strategies also typically rely on the fund manager’s discretionary trading or limit the amount of protection during certain periods.

The following table shows that a dynamic futures hedging strategy (in this case, the Milliman Managed Risk Strategy™ (MMRS) which uses futures contracts to manufacture long-dated put options) produced the best blend of risk and return compared to two option-based strategies.

Figure 2: Comparison of protection strategies (2007 – October 2016)

  ASX 200 Index ASX 200 + MMRS (12v) ASX 200 + 12m 100mny put purchase ASX 200 + 3m 95/85mny put spread
Annualised return 3.80% 2.90% 1.70% 2.00%
Standard deviation 18.30% 8.90% 8.90% 14.00%
Max daily drawdown 50.60% 22.00% 24.00% 40.40%


These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Milliman does not manage the underlying fund(s). Any index performance information is for illustrative purposes only, does not represent the performance of any actual investment or portfolio. It is not possible to invest directly in an index.

While all three strategies underperformed the S&P/ASX 200 on a pure annualised return basis, as we have seen, such headline comparisons are made against benchmarks which don’t take into account risk. With managed risk, volatility remains significantly lower and risk-adjusted returns are significantly higher–these are key attributes of major importance to retirees.

Investors may also now be at the cusp of a change in market conditions which will bring risk management back to the fore.

Bond markets were dramatically sold off towards the end of 2016 as market expectations for inflation and growth climbed after the election of Donald Trump as US president. The November surge in global yields has already resulted in the worst monthly loss in the Bloomberg Barclays Global Aggregate Total Return Index, which lost 4% in November, the deepest slump since the gauge’s inception in 1990.

Moving forward, the expectation of diversification benefits of bonds in a negative equity environment may be overly optimistic.

Meanwhile, the market is beginning to realise that central banks are preparing to tighten their quantitative easing (QE) taps ahead of switching them off.

Systematic strategies that offer a predictable and cost-effective way to manage risk more explicitly remain a sound way to counter complex and interrelated forces which are difficult to predict. The alternative is attempting to time markets, which is a strategy no better than rolling the dice.


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