Downside Protection

Downside Protection refers to a risk mitigation strategy involving the use of various techniques to safeguard investments from falling below a certain minimum threshold. Portfolio managers, traders, and investors often undertake measures to eliminate losses from investments that decline in value

It defines the extent to which a price fall is tolerable. Beyond this level, investors would end up incurring losses significant enough to make a dent in their investment. Thus, adopting strategies to protect assets from falling beyond this limit helps fund managers preserve investors’ capital and ensure that these assets provide consistent returns in the long run.

Downside protection is a systematic plan of mitigating the risk of an asset falling below a minimum threshold value to ensure that traders or investors do not incur losses due to such price fluctuations. It involves using various strategies, including stop-loss orders, diversification strategy, protective puts, covered call downside protection techniques, and hedging, to manage the potential downside risk in investments. 

For instance, recently introduced to the family of buffer Exchange Traded Funds (ETFs) is the Innovator Equity Defined Protection ETF. It is a kind of ETF with 100% downside protection, as claimed by Innovator Capital Management.

Although financial markets are full of ups and downs, and no one can be in a win-win position for long, there is always a tradeoff between the risk and return expectations that drive investment strategies of fund managers, traders, and investors. Thus, it is important that these market participants mitigate market risks. However, this should not be done at the cost of sacrificing the upside potential of their investments. Hence, downside protection plays a pivotal role in limiting the loss on investments while ensuring high returns in the long run.

Striking a balance between risk and return can help investors, fund managers, and traders manage market volatility and the general uncertainty surrounding financial markets. To this end, employing downside protection strategies is a wise decision. It enables them to confidently handle uncertainties in financial markets while safeguarding their funds.

These strategies can be customized to meet specific investment or trading needs. However, it must be noted that they involve certain costs. For example, if an investor wishes to use specific strategies (hedging, diversification, etc.), they will be required to bear transaction costs, make premium payments, buy assets, etc., depending on the methodology or financial instrument used to hedge the risks. Hence, ensuring that the benefits outweigh the costs is essential before committing to a strategy. 

Another aspect that investors, fund managers, and traders should pay attention to is the long-term success of their endeavors. Any strategy they employ should ideally support or promote long-term growth and capital preservation instead of short-term goal achievement. They should also beware of falling prey to behavioral biases when focusing on downside protection measures. 

The markets are unpredictable, and asset prices keep fluctuating, increasing the concerns of fund managers, investors, and traders about preventing possible losses. Due to this, downside protection techniques become important. Some well-known strategies and techniques have been discussed below. 

1. Diversification: A prominent strategy is to effectively spread the risk by investing in different kinds of assets belonging to distinct sectors, classes, and locations. Thus, the loss on one or some assets in the portfolio can be offset against the gains on other assets.
2. Hedging: Investors can hedge the risk involved in assets by investing in the underlying options or futures that can even post profits when the investment value drops.
3. Targeted Market Exposure: Fund managers can concentrate on the equities of market segments that are less exposed to market fluctuations.
4. Long-term Risk Management: Investors can opt for fixed-income securities for long-term risk mitigation and to diversify the investment portfolio.
5. Dynamic Asset Allocation: Portfolio managers can actively adjust portfolio composition by reducing assets that involve high risk during adverse market scenarios. Such decisions are based on trend analysis through the study of economic factors, technical indicators, and quantitative models. 
6. Derivatives Trading: The short-term tactics of buying and selling derivatives can be a potential hedge against downside risks in the near future or to make gains on certain solid market expectations.
7. Stop-loss Orders: Another critical measure adopted by traders in financial markets to avoid loss is stop-loss orders. It results in the automatic selling of the assets that fall to a certain minimum threshold, as stated by a trader.
8. Cash and Cash Equivalents: Maintaining sufficient liquidity in financial markets by keeping cash reserves or investing in assets that can be easily converted to cash gives extra power to sell off investments with high downside risk and buy potential assets at their lowest possible values. 

Some of the covered call ETF downside protection assets are JPMorgan Equity Premium Income ETF (JEPI), Global X NASDAQ 100 Covered Call ETF (QYLD), and Global X S&P 500 Covered Call ETF (XYLD). Let us see how such investment strategies facilitate downside risk management with the help of the following examples. 

Example #1

Suppose Starlight Ventures invests $10 Billion in PR Entertainment Ltd. through a structured deal whereby it agrees to invest in exchange for the holdings compulsorily convertible into equity shares. This would make it easier for Starlight Ventures to liquidate its investment at any time. 

To ensure the safety of the company’s investment, Stacy, the head of finance, recommended entering into the above-mentioned structured deal in private equity. She knew this would enable Starlight Ventures to manage its risk and enhance liquidity, given the investment was in billions of dollars. 

This means it is a key measure for downside protection, as an investor can opt for private equity downside protection avoiding high-risk exposure altogether. 

Example #2

An April 2024 post explains why risk mitigation through downside protection is important under the current circumstances prevalent in financial markets worldwide. 

Los Angeles County Employees Retirement Association (LACERA) is in the process of adjusting its investment strategy by shuffling asset allocations. This involves reducing its allocation to growth and real assets, such as global equity and real estate, and reallocating these funds to investments with stronger downside protection and more moderate return potential. 

It is also considering investment-grade bonds and hedge funds in this equation. Due to considerable concerns about interest rates moving in directions that may not suit LACERA's investment goals, Jonathan Grabel, LACERA's Chief Investment Officer, believes it is wise to revise their asset allocation strategy. 

Earlier, the exposure to illiquid private credit and private equity in the hope of earning higher returns amidst low interest rates was significant, but he stated that this needed to be changed to align with LACERA's risk management objectives.

Example #3

Many traders, investors, portfolio managers, and fund managers rely on financial instruments and assets for downside risk management based on risk tolerance. Exchange Traded Funds (ETFs) are a great option for this. According to Nasdaq, the five prominent downside protection ETFs that gained popularity in 2023 are:

1. ProShares VIX Short-Term Futures ETF (VIXY): It allows investors to replicate the returns of the S&P 500 VIX Short-Term Futures Index.
2. Simplify Tail Risk Strategy ETF (CYA): It hedges diversified portfolios in a scenario where significant equity sell-offs occur in the market.
3. Noble Absolute Return ETF (NOPE): It enables investors to take a long position in best assets during market uptrends and a short position in best assets in the phase of market downtrends.
4. Cambria Tail Risk ETF (TAIL): It puts the investors’ funds in the US stock market based on out of the money put options.
5. AGFiQ US Market Neutral Anti-Beta Fund (BTAL): It yields profit irrespective of the market movements until the low-beta securities perform better than the high-beta securities.

As asset prices are susceptible to financial market fluctuations, it becomes essential for traders, investors, portfolio managers, and fund managers to manage downside risks. Due to this, they prioritize downside protection. Its importance has been discussed below. 

• Defensive Approach: Traders and investors treat this form of protection as a defensive strategy that prepares them for the worst conditions possible.
• Preserves Capital: It saves an entity’s initial capital invested in financial markets from losses beyond their risk-taking capacity when the market is seen performing poorly.
• Long-term Objective: The focus is on achieving long-term financial goals like wealth accumulation or stable income while mitigating short-term risks. Fund managers particularly focus on this.
• Risk Management: While portfolio managers employ various downside risk management strategies to avoid losses on each asset, they are able to bring down the overall risk level of an investment portfolio using this method.
• Superior Portfolio Performance: With strategies like dynamic asset allocation, fund managers often adjust the portfolio composition to make it more stable and resilient.
• Beats Market Adversities: Investors and traders can face adverse market scenarios or conditions with well-curated downside protection measures.
• Builds Investor Confidence: Investors feel more confident about actively participating in financial markets when they are able to avoid downside risks.