Taming your downside

Tips to strengthen your portfolio

May 23, 2016
By BlackRock

The best offense is a good defense. It’s a phrase that could be applied to investing, especially when markets are ornery.

Consider this: The bigger the investment loss, the greater the gain required to break even. Whereas a 10% investment decline requires an 11% gain to get back where you started, a 50% loss would take a 100% gain to make you whole again. With that cold bucket of reality, it can make good sense to try to limit your downside by building some defense into your portfolio.

The importance of limiting
downside risk

Gain required to fully recover from a loss

Limiting Downside risk

Diversification of assets is typically deemed the best weapon to fight risk. But for diversification to be effective, it must be well executed — and that is growing increasingly difficult.

Mark Peterson, an investor education specialist at BlackRock, identifies a confluence of factors that has rendered traditional diversification less effective, and investors perhaps inadvertently assuming more risk than they had intended or imagined.

“Not only have markets become more volatile, but investors seem to be holding riskier assets and funds,” he laments.

One potential solution: emphasizing investments with low “capture ratios.” In other words, constructing a portfolio that seeks to capture less of the markets’ downs (and ups), a strategy that historically has been additive over the long term.

Out of the shadows: The rise of risk

In the fixed income space, the recent rise in risk may come in part from investors stretching for higher yield in a world where interest rates have remained near historic lows. Because there are no free lunches in investing, that higher yield naturally entails higher risk, in the form of either interest rate risk or credit risk.

Interest rate risk refers to the fact that bond prices fall as interest rates rise; credit risk refers to the potential for a company to default on its debt obligations. Interest rate risk is perhaps higher today than it has been in several years. The Federal Reserve (Fed) in December raised interest rates for the first time in nine years. While neither the federal funds rate nor market rates are expected to skyrocket, the Fed is likely to move again. And that will impact bond prices.

On the equity side, Russ Koesterich, Head of Asset Allocation with BlackRock’s Global Allocation Fund, notes that many investors have been turning toward defensive stocks, such as utilities.

“While that intuitively might seem like the ‘safer’ course, defensive sectors generally contain more interest rate exposure than the typical stock,” he explains. “When rates eventually rise (and prices fall), investors who have taken on too much rate sensitivity may experience more volatility than they were expecting.”

Then there’s the issue of correlations, or the extent to which different assets move in tandem. In an increasingly globalized and interconnected world, there has been a natural tendency toward higher correlations.

“The trend toward higher correlations between markets has been in place for years,” observes Mr. Koesterich, noting it became more pronounced after the 2008 financial crisis amid concerted efforts by central banks and policymakers to bolster economies and financial markets. This synchronicity makes diversification of assets a more difficult task.

Equity funds have gotten riskier
over the years

Volatility profile of all stock fund assets relative to the S&P 500 Index


Too much of a bad thing?

“In an environment of higher volatility and rising correlations, investors should ideally be looking for other ways to minimize risk,” says Mr. Peterson. “But we’re seeing the opposite. The last decade suggests investors are expanding their ‘diversification’ into equity categories, the result being greater risk exposure.”

And as shown in the chart above, equity funds themselves are riskier than in years past. Mr. Peterson describes an environment where downside mitigation is lacking in portfolios. This is reflected in high capture ratios. Complicated math aside, the capture ratio quantifies a fund’s performance relative to its respective market or benchmark in both up and down markets. A capture ratio of 1 (or 100%) means the portfolio is moving in sync with the market. Riskier funds have upside and downside capture ratios greater than 1. Funds with less risk have capture ratios below 1.

“Most worrisome for many investors today,” says Mr. Peterson, “is that the downside capture ratios for a traditional diversified equity portfolio exceed 100%.”

4 ways to attack downside

We believe strategies that limit downside capture may help produce higher returns over the long term, even if it means they will sacrifice some upside capture in the process.

“We particularly endorse the idea of employing several strategies that emphasize lower capture ratios as part of a long-term allocation, as not all downside protection will work equally well in every environment,” says Mr. Peterson.

Some investments have been able to capture less of a bad thing

15-Year upside/downside capture ratio of popular investment categories
vs. the S&P 500 Index, Dec. 31, 2015


These strategies seek to manage volatility or emphasize styles that tend to perform better amid bouts of market weakness:

Bonds for ballast

Traditional bonds have shown to offer downside protection when stocks declined and may be well placed in a portfolio today as a diversifier and source of ballast. A mutual fund or exchange traded fund (ETF) benchmarked to the Barclays U.S. Aggregate Bond Index can offer “one-stop” exposure to a large set of U.S. investment-grade bonds.

Global flexible mandates

These strategies provide built-in diversification, investing across asset classes and geographies in pursuit of “equity-like” returns with lower volatility. BlackRock’s Global Allocation Fund is a prime example. It typically invests in over 700 holdings across 40 countries and 30 currencies spanning asset classes, market caps, sectors and regions.

Minimum-volatility strategies

These are strategies that provide equity exposure but with the explicit objective of seeking to minimize the bumps in the road that often cause investors to exit the markets. iShares® Minimum Volatility ETFs have historically lost less during market declines, while still capturing meaningful gains during market upswings.

Funds focused on dividends

Dividend paying stocks can offer attractive relative income, particularly in today’s low-rate environment, and capital appreciation potential. This is especially true of companies that are growing their dividends, as these are typically strong franchises with ample cash flow. They also tend to be lower in volatility.

“Statistically, a company’s commitment to paying a dividend has been shown to provide resilience in down markets,” says Tony DeSpirito, portfolio manager of the BlackRock Equity Dividend Fund. “No executive wants to cut a dividend, so these tend to be well-run companies built to weather diverse markets.” Of course, there is no guarantee that stock funds will continue to pay dividends.

None of these strategies alone or together can completely insulate a portfolio, but they can help mitigate the pain inflicted by market turbulence and a changing risk landscape. And as shown at the start, it’s easier to recover from a stumble than a deep dive.

Talk to your financial advisor about the strategies mentioned here and other options to help balance your portfolio.