Expanding Equity Market Participation in Buffered Strategies

In our last piece (Balancing Risk Management and Growth Potential in Equity Investment), we explored how volatility represents a threat to many of today’s investors as they expand equity allocations with the hope that growth can offset an ongoing low-rate environment. We also introduced structured outcome strategies, focusing on buffered strategies that seek to protect investors on the first losses of an underlying equity index or product, providing an option for those investors concerned about equity downside in their portfolios.

Now let’s shift our focus to the upside participation of these buffered strategies. Even for the most conservative investors, equities have been the historical go-to asset class for growth in portfolios. And while managing downside volatility is an important factor in creating a smoother investing experience, capturing as much of those outsized positive return years, or “good” volatility, in equity markets has a significant impact on long-term performance.

This can be seen in the chart below, where we consider the growth of $10,000 invested in the S&P 500 Index since 1988 and then check the impact of removing the 5 best performing years.



For illustrative and discussion purposes only. Source: Bloomberg. Illustration shows the impact of removing the 5 highest return years for the S&P 500 Index. The results shown in the chart represent cumulative performance and do not take into account payment of any fees or expenses. One cannot invest directly in an Index. Performance data quoted above represents past performance and does not guarantee future results. The chart does not represent the actual performance of any TrueShares or other fund.

And therein lies the challenge for buffered strategies. We often remind investors that there is no “free lunch” when implementing risk management tools. Mitigating downside volatility often requires sacrificing upside participation. But when is that trade-off potentially detrimental to a portfolio’s longterm performance? In other words, how much “good volatility” should an investor forego to avoid “bad volatility”?

Evolution in Action: Performance Caps to Participation Rates

In exchange for offering downside risk mitigation approaches, buffered equity strategies have typically only allowed performance up to a “capped” level. Up to the cap, performance is designed to match that of the underlying index or product (gross of fees). Once the cap is reached, any additional performance gains by the underlying index/product is forfeited, thus limiting the potential for outsized gains beyond the capped level.

When TrueMark Investments and SpiderRock Advisors explored the buffered equity landscape, we saw an opportunity to provide another option. Understanding that large positive returns (or “right-tail” returns) are a key driver of long-term performance, what if instead of matching market performance up to a hardcap level, the focus shifted to participating in a certain percentage of any positive performance during an investment period without a hard ceiling?

To begin understanding the logic behind the question, let’s look at historical performance for the S&P 500 Index as a starting point. The illustration below charts the historical distribution of rolling 1-year returns for the index since the end of 1988.

Reviewing the data, we see positive market periods (blue-shaded area) historically:

  • occurred more than 80% of the time and
  • averaged a 17.0% return.

For illustrative and discussion purposes only. Source: Bloomberg, as of 9/30/2020. Rolling returns shown in the chart represent 1-year returns measured on a monthly basis for the previous 1-year period, with the first return measured 01/31/1989. The lines in the chart represent the total number of occurrences for a given return percentage over the full date range noted. Index performance shown is for the S&P 500 Total Return Index and does not represent TrueShares fund performance. It is not possible to invest directly in an index. Values in the chart are rounded to the nearest whole percent. Performance data quoted above represents past performance and does not guarantee future results.

So the takeaway for investors in the S&P 500 Index over the period shown is that when the market was up they would have expected to return around 17% on average.

What’s the Tradeoff? Capped and Uncapped Strategies

What’s interesting is when we review the past performance caps for the strategies designed to offer the most upside (in exchange for a lower downside buffer) in the defined outcome ETF category, we see that those strategies have historically had upside caps between 15%-17% on average, similar to the average positive return for the index.

At first blush, this could lead an investor to think that investing in one of these capped ETFs would offer similar average upside as the market. But that’s simply not true. We need to keep in mind that since the maximum upside that capped ETFs can achieve is the cap level, the possible range of positive returns that an investor could earn is between 0 and the cap level.

Uncapped structured outcome strategies work differently. Rather than offering 1:1 participation with market gains up to a hard-cap level, these strategies seek to provide a participation rate (ex. 80%) on all positive returns. The tradeoff vs capped strategies is the anticipation of slight underperformance at lower market return levels in exchange for participation in outsized market return environment.

To illustrate this point, the chart below shows the expected relative returns of an uncapped strategy with an 80% participation rate vs various capped strategy levels. As one would expect, the largest underperformance (-3.6%) would come against the highest cap level. However, one can also see that as the benchmark returns start exceeding the cap levels, the relative performance starts to improve, reflecting the potential advantage of an uncapped strategy.


For illustrative and discussion purposes only. Does not represent the performance of any TrueShares ETF. It is not possible to invest directly in an index. Performance shown is hypothetical, does not take into account any fees or taxes, and is based on assumptions as noted. The returns streams used in this analysis are hypothetical and are not tied to, or meant to represent, any index or security. They are intended to solely represent a mathematical exercise. IMPORTANT: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.

When Average isn’t All that Average

So now that we’ve explored the difference in approaches between capped and uncapped strategies, let’s take another look at those historical returns for the S&P 500 Index, diving deeper into the positive return periods and focusing on both below-average and above-average positive return data.



For illustrative and discussion purposes only. Source: Bloomberg, as of 9/30/2020. Rolling returns shown in the chart represent 1-year returns measured on a monthly basis for the previous 1-year period, with the first return measured 01/31/1989. The lines in the chart represent the total number of occurrences for a given return percentage over the full date range noted. Index performance shown is for the S&P 500 Total Return Index and does not represent TrueShares fund performance. It is not possible to invest directly in an index. Values in the chart are rounded to the nearest whole percent. Performance data quoted above represents past performance and does not guarantee future results.

As we can see in the table, below-average positive return periods occurred roughly 57% of the time. In those periods, the average return was significantly lower (+10.1%) than the average for all positive markets (+17.0%). Conversely, when the markets outperformed the positive-market average (43% of the time), returns were up on average over 26%, a substantial increase over the positive market average.

Why This Matters for Structured Outcome Investors

Remember that choices for ETFs using structured (or defined) outcome strategies boil down to two alternatives: capped or uncapped approaches. As previously discussed, capped strategies provide 1:1 performance participation up to the cap level and would be expected to outperform uncapped strategies in that range. However, in that environment, the lower the market return level, the smaller the advantage for capped strategies. We can see this reviewing the chart: 80% Uncapped Strategy vs Capped Scenarios – Positive Market, the closer positive returns move towards 0, the smaller the relative outperformance of capped strategies.

For uncapped strategies, their potential advantage appears when periods of outsized positive performance occur. In those markets, capped strategies stop participating as soon as market performance exceeds capped levels for an investment period. Uncapped strategies, on the other hand, continue offering the same participation rate for the period regardless of how large the positive market return becomes. The result? A quickly widening gap in performance between capped and uncapped strategies, such as we see on the right side of the chart: 80% Uncapped Strategy vs Capped Scenarios – Positive Market.

Conclusion

At TrueShares, it’s no surprise that we consider uncapped strategies as the way to go if you believe, as we do, in the impact outsized positive equity market performance years have on long-term portfolio results. We think that the potential relative performance benefits of uncapped strategies in those types of market environments should outweigh any relative underperformance in lower return years. Big picture, we do believe in the power of equities as a primary growth driver for many portfolios and employing a risk managed approach to equity investing will likely be attractive to a sizable group of investors.

With that as a backdrop, if you’re considering buffered equity ETFs, it’s important to explore the various upside capture mechanisms in the marketplace and not solely the buffer levels. This is paramount to developing an effective plan with your advisor that reflects your personalized needs and accounts for longterm capital market expectations.

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