Should You Buy Downside Protection?

At the time of writing, equity markets seemed to have stabilized a bit today following a rough start to 2022. It isn’t surprising that markets have been soft to start the year given current market valuations following a nearly unprecedented run-up in stock prices. That said, are we looking at a brief pause in the upward trajectory of stocks or perhaps something more sinister that was witnessed twice during the ’00s and many times before? A reasonable question for investors is whether they should “insure” against downside risk in equity markets. However, current option prices suggest that such insurance strategies are quite expensive, especially relative to history. Why? One of the factors influencing the pricing of insurance is the plethora of macro events such as interest rates, economic growth, Covid-19, geopolitical risk (Russia/China), etc.

If buying traditional equity market insurance is too expensive, there is another way to protect your flank that might just minimize risk on a couple of fronts – liquidity and interest rates – if not the equity markets themselves. I am referring to the use of a cash flow matching strategy (CDI) that would be used in lieu of a traditional fixed income total return approach. If US rates continue to rise, not only will they likely destabilize equity markets, but total return-oriented fixed income portfolios will likely produce negative returns for the foreseeable future. We’d suggest using bonds for their cash flows carefully matched against the plan’s specific liabilities that will eliminate interest rate risk, as we will be matching future values that are not interest-rate sensitive, while dramatically improving the plan’s liquidity profile.

So where does the downside risk for stocks come in? Well, if we deconstruct the current approach to asset allocation that uses all the assets focused on a return on asset assumption (ROA) to one that uses a bifurcated approach separating liquidity (beta) and growth (alpha) assets we can provide a unique form of downside protection at a minimal cost. The beta assets are the cash flow matching bonds carefully allocated to maximize the cash flows (principal, income, and reinvested income) to meet benefits and expenses, while the alpha assets are the plan’s growth assets that will eventually meet future liabilities. In this construct, the alpha assets can grow unencumbered as they are no longer a source of liquidity. We’ve now bought time for these assets to recover should markets get hit. Furthermore, the reinvestment of dividend income is critical to the long-term growth of equities. One study, in particular, suggests that 48% of the return of the S&P 500 over rolling 10-year periods is attributable to the reinvestment of dividends. Extending that analysis to rolling 20-year periods finds an incredible 60% of the total return comes from dividends reinvested.

With the Ryan ALM approach, plan sponsors won’t need or be tempted to take dividend income to use for benefit payments. It isn’t necessary now that the CDI portfolio is responsible for funding the promised benefits and expenses. Traditional downside risk protection can be complicated and expensive. Adopting our approach is just common sense.

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