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At a glance

With markets close to record highs, lockdowns back on the agenda, and vaccine rollouts still in progress, some investors may be looking to increase portfolio protection by adding high-quality bonds and reverting to cash. But using bonds alone as a hedge for falling equity markets is more costly and potentially less effective than in the past, due to low yields. Meanwhile interest rates on cash are close to, or below, zero. We think investors looking for protection should instead consider a diversified set of hedging strategies.

Recommended ways to diversify

Last year’s record-breaking fall was followed by a record-breaking rebound, highlighting why it is important to stay invested. But now investors are more worried about bubbles, and renewed market drawdowns, which could be triggered by the combination of delayed vaccine availability, further restrictions on mobility through 2021, and monetary policy being tapered in light of inflation increases.

First, to manage these risks, diversify across regions and asset classes. A 60% stock, 40% bond portfolio would have experienced an average of 19.9% peak-to-trough drawdown in the past seven bear markets, versus a 34.5% drawdown for an all-equity portfolio. However, given low starting yields, the ability of high-quality bonds to provide significant positive returns in the event of equity market declines is currently limited. Even worse, real yields on high-quality bonds are likely to be negative for the foreseeable future. As a result, some investors are resorting to cash in order to protect against a fall, although this can also be a detrimental strategy due to interest rates being lower than inflation, which erodes purchasing power over the longer term being.

So aside from cash and bonds, we recommend other ways to diversify for risk-averse investors looking to protect their portfolios or enter the market:

Gold

With falling real rates reducing the opportunity cost of holding non-interest-bearing assets, gold became a top-performing major asset in 2020. Given political risks have diminished, it has fallen since, but with real interest rates still low, gold can offer some diversification properties as a hedge with benefits, although investors should not expect substantial upside unless our downside market scenario occurs.

Active management (dynamic asset allocation, hedge funds)

One way of insulating portfolios against downside is by including exposure to hedge funds with a strong record of downside risk management. Investors can also reassess their approach to portfolio risk management, relying more on dynamic asset allocation strategies rather than equity-bond diversification to navigate periods of elevated volatility.

Options structures

Option strategies, for those able to implement them, can allow investors to stay invested – and participate in any asset price rises – while protecting against the downside. The simplest way to protect is via a put option, which gives the holder the right, but not the obligation to sell an asset at a specific date for a specific price (i.e. strike price).

Equity replacement strategies (structured solutions)

Investors who want to retain upside exposure but reduce downside exposure could consider replacing equity exposure with strategies that provide asymmetric return profiles, e.g., structured investments with a degree of capital protection.

A vital part of protecting against the downside includes not having to sell out of the market at the wrong time due to a cash shortfall. As a result, we recommend investors adopt a financial plan. Our Liquidity. Longevity. Legacy. (3L)* framework starts with a Liquidity strategy to ensure sufficient resources to meet cash flow needs for the next three to five years. Because well-diversified portfolios have historically experienced a full recovery from most previous bear markets in this timeframe, this allows investors to confidently invest the rest of their capital for growth, either for retirement spending (i.e., the Longevity strategy) or for inheritance and philanthropy (i.e., the Legacy strategy). Setting aside resources for spending needs provides an ample buffer to help ensure that investors aren't compelled to sell assets at the wrong time—a comfort that's particularly helpful during periods of market panic. Investors whom we advised to structure a strong Liquidity strategy—which includes cash and short-term bonds—had no reason to sell out of the market during the recent sell-off, and could even take advantage of opportunities as they arose. Given that interest rates are historically low, the arithmetic favors using borrowing strategies—which can also help investors avoid cash shortfalls—as a complement to the asset-based component of the Liquidity strategy.

Key investment takeaways:

  • Stocks are near record highs, though there are still a number of uncertainties.
  • Setting aside resources for spending needs provides a vital buffer against short-term uncertainty, and allows long-term capital to be invested for growth.
  • Global diversification remains paramount. Risk-averse investors have several options beyond just high-quality bonds. We advise adding exposure to alternative diversifiers to protect against the downside.

*Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

Structured solutions

Investing in structured investments involves significant risks. For a detailed discussion of the risks involved in investing in any particular structured investment, you must read the relevant offering materials for that investment. Structured investments are unsecured obligations of a particular issuer with returns linked to the performance of an underlying asset. Depending on the terms of the investment, investors could lose all or a substantial portion of their investment based on the performance of the underlying asset. Investors could also lose their entire investment if the issuer becomes insolvent. ÃÛ¶¹ÊÓƵ Financial Services Inc. does not guarantee in any way the obligations or the financial condition of any issuer or the accuracy of any financial information provided by any issuer. Structured investments are not traditional investments and investing in a structured investment is not equivalent to investing directly in the underlying asset. Structured investments may have limited or no liquidity, and investors should be prepared to hold their investment to maturity. The return of structured investments may be limited by a maximum gain, participation rate or other feature. Structured investments may include call features and, if a structured investment is called early, investors would not earn any further return and may not be able to reinvest in similar investments with similar terms. Structured investments include costs and fees which are generally embedded in the price of the investment. The tax treatment of a structured investment may be complex and may differ from a direct investment in the underlying asset. ÃÛ¶¹ÊÓƵ Financial Services Inc. and its employees do not provide tax advice. Investors should consult their own tax advisor about their own tax situation before investing in any securities.

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