Various Ways to Prepare for the Bear – Risk Management Overview


The current US equity bull market started in March 2009 and is now the longest on record. Like the bulls of the past, this current one will end, maybe not just now, but eventually. What can one do? Fight the market and reduce, exit or go short equity? Without a clear catalyst this has historically been a recipe for underperformance. Staying in the markets and trusting that this time will be different, is not a good idea either.

Instead, we advocate thinking more about risk management. It’s good practice to put your defence in place during the good times and be prepared for the turbulent periods. In the past, the average bear market in the US wiped out more than 70% of the investment gains from the previous bull market. Avoiding these kinds of large drawdowns results in a better long-term performance, even if you give up some return during strong markets.

Methods to defend your portfolio range from simple stop-loss strategies, to classic option-based strategies, to systematic futures overlays where momentum-based signals indicate weak market conditions. Which one is best? Well, as so often in finance, it depends. There is no Holy Grail of risk management; each strategy has its pros and cons. But although there is no best risk management strategy per se, there probably is one that is best suited to achieve your particular goals. The first step in choosing a strategy is therefore to clarify these goals. Is it long-term outperformance? Is it drawdown reduction? Or do you simply aim to generate large profits to deploy after a drop in asset prices? Below we list a range of risk management strategies available.

Classic Diversification

Only two of the strategies we compared yielded a similar long-term return as an unhedged investment in the S&P 500. Simple static diversification between equities and treasuries is one of them. The historic performance is stunning. High returns with significantly lower risk than the S&P 500. Unfortunately, this superb return performance cannot continue into the future. The period from 1999 to 2017 saw 5-year treasury yields decline from 5% to less than 1% and resulted in treasuries yielding about the same risk premium as equities. Today, with 5-year treasury yields hovering around 2% there is little room for future bond price appreciation. In short, a great historic performance which is unlikely to continue. A similar argument holds for classic risk parity strategies since they typically hold a large proportion of low-risk bonds.

Stop-Loss strategy

While this strategy presents a clear rule when to exit the market, Stop-Loss strategies have the disadvantage that there is no obvious good rule when to re-enter the markets. As expected, the strategy had a positive impact during bad times, but in general we lose too much performance over those periods during which we were stopped out. And while the volatility is low compared to an unhedged investment, the drawdowns may not be reduced that significantly.

Protective Put Strategy

The advantage of this strategy is that we always stay fully invested with a defined floor. Another benefit is the “double protection” in crash scenarios because implied volatility increases when the underlying markets crash. The disadvantage is the high running cost. It is hard to keep paying premium during long up-markets. But if a fixed floor is needed, this is a good strategy.

Portfolio Insurance

This strategy dynamically moves capital from equity into cash when markets are moving down and then move capital back from cash into equity when markets are moving up again. In a nutshell, we replicate the protection we would get from a put option by dynamically allocating our capital between equity and cash. Note that the decision of when to move in and out of equities is based on the portfolio NAV and not on any market intelligence. The strategy has similarities with the put strategy, but portfolio insurance faces the risk of getting cash-locked. And the performance is terrible when you have long phases of high realized volatility.

Managed Futures

This is the only strategy in our analysis where market exposure is based on (quantitative) market intelligence. Systematic futures overlays use short signals from top-tier quantitative funds to indicate weak market conditions and reduce the market exposure based on those signals. While this strategy does not come with a fixed protection it will reduce drawdowns effectively. A price is paid for that protection with a fee for the use of the signal and a return reduction in up-markets caused by wrong sell signals.

Overall, we consider this strategy to be the most effective of those we have investigated. It offers efficient downside protection and the potential for long-term outperformance. Hence, our preferred strategy if you do not absolutely need a fixed floor. Both systematic and option based strategies can easily be tailored to your particular needs. If you like the characteristics of a systematic future strategy but you need a fixed floor, then a combination of an option and a systematic strategy might be the optimal solution for you.


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