Home / Defensive assets / Advice clients have a breaking point; downside protection can keep them from it

Protecting the underside of portfolios, and even thriving through moments of market distress, can keep more fretful clients out of the danger zone. A new generation of products are designed to do just that, and without sacrificing the lion's share of outsized returns when markets run hot.

The phrase ‘uncertain times’ is a tired old trope, but a well-worn one in investment circles for a reason: markets have a habit of going up and down, and volatility never really goes away. For financial advisers, a big part of the job is being able to keep clients calm and steadfast in the wake of wild market swings that cause retirement savings portfolios to fluctuate dramatically.

Dampening those swings can help, but this practice typically involves locking in low returns via fixed income products like cash investments and bonds.

In the modern portfolio construction game, however, there are a raft of of products that harness the majority of market upside while capturing downside protection in myriad different ways. By employing them, providers believe, advisers have a better chance at keeping fretful clients out of the anxiety zone.

“We all know that some investors, if they lose 50 per cent or even 30 per cent… everyone has a breaking point and can run,” said Milford Asset Management portfolio manager William Curtayne at The Inside Network’s recent Investment Leaders Forum in Queenstown, New Zealand. “They get to that point where they just can’t take it anymore. They want out, and your job as advisers is normally to try and prevent that.”

Milford’s fund will “still do alright” in upside markets, he explained, but the downside market capture is “significantly better” than a fund that is simply trying to ascend when markets are going up.

“If you can soften the extent of a drawdown, it may just make taking the pain on those sell-offs a little bit easier, and if you can stock pick hard along the way – because we’re an equity portfolio – you can still keep your total return up above the market index over time.”

The reason funds with these defensive elements are important, Curtayne said, is because inflationary cycles will continue, which will lead to a constant boom-bust economic profile. “We’ll see the cycle rinse and repeat a bit, and that creates really good opportunities for active managers like ourselves and others,” he said. “But it also just means that sometimes you’ve got to think out of the box in some of your asset classes.”

Andrew Lakeman, co-founder of Atlantic House, took a similar line; volatility (both realised and implied) is going nowhere, he said, and markets will continue to go up and down, so it doesn’t make sense for those that steward capital to only try to make money out of upside markets.

Atlantic House’s Defined Returns Fund aims to deliver predictable, long-term annualised returns of around seven to 8 per cent in “all but the bleakest market conditions” by actually owning volatility as an investment factor.

“The big takeaway is that you can actually own volatility as an asset class,” Lakeman said on the panel. “You can isolate it and just be long volatility.”

The fund’s defensive strategy has two planks, he explained – “uncorrelated returns in normal markets and big returns in down markets”. The fund might not shoot the lights out in red hot markets, he said, but when those markets lag, or crash, it should excel. The added benefit then, he added, is that investors make money, and have capital to spare, when others don’t and when assets are cheap to buy.

“If your portfolio is stuffed with things that rely on the world being quite good – and I hope it is – in the event of something that comes out of nowhere… you want to redeploy money into beaten-up assets so you need something that’s gone up.”