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Why Downside Protection May Matter More Than Upside Growth

by: Russell Investments
Summary

The global macroeconomics and geopolitical outlook remains highly uncertain - suggesting that an environment of low rates, sluggish growth and high valuations may linger well into 2020.

Against this backdrop, preserving capital may be more important than seeking the growth of capital, i.e., downside protection.

Strategies that provide both potential upside and downside protection can help enable investors to weather market changes and stand better chances of outperforming benchmarks.

Amid ongoing trade tensions and slumping growth worldwide, the global macroeconomics and geopolitical outlook remains highly uncertain - suggesting that an environment of low rates, sluggish growth and high valuations may linger well into 2020. This uncertainty presents a challenge for investors who are looking to generate attractive returns while preserving capital during periods of market volatility, such as what we witnessed this past August.

Against this backdrop, preserving capital may be more important than seeking the growth of capital, i.e., downside protection. It matters because in the investing world, losing less means requiring less to bounce back.

In fact, avoiding losses appears to be more important than achieving gains.

The following chart shows the historical returns required to recover after a drawdown.1 The returns investors need significantly increase as losses deepen after a period of underperformance. For instance, a drawdown of 20% requires a return of 25% to recover, whereas a drawdown of 50% would need 100% to regain ground. This example demonstrates that a dollar of excess return in a down market is worth more than a dollar of excess return in an up market. To achieve long-term growth, it is inherently important to not only grow the upside, but it is arguably even more important to protect the downside.

Drawdown chart

As data show, strategies that provide both potential upside and downside protection can help enable investors to weather market changes and stand better chances of outperforming benchmarks. With valuations still at historically high levels, how can investors identify such opportunities? Our answer: Diversification.

How diversification may help during times of uncertainty

In recent years, Russell Investments has consistently advocated for investors to consider a global multi-asset approach to investing for a multitude of reasons, chief among them our belief that doing so puts clients on a smoother path toward meeting their goals. While the objectives of multi-asset strategies may vary, some are designed specifically to help provide investors with better downside protection while providing the growth they require. A multi-asset approach can help achieve these goals through three main phases:

Design
In the design phase of a portfolio, when asset allocations are established, a nuanced asset allocation may help to capture the things in between core equity and bonds - bank loans, high yield debt, emerging-market local and hard currency debt, mortgage-backed securities, and other alternative strategies - that are not modeled in a traditional 60/40 fixed-income and equity allocation. This differentiated approach to diversification is designed to deliver growth, and, perhaps more importantly, to minimize the big downward dips.

Construct
When the portfolio is actually built, we believe a true multi-asset approach applies a wide network of skilled, active money managers who specialize in each asset class. This may be complemented by passive exposures and specific positioning strategies to seek to effectively manage the total portfolio. Spreading such a broad net for manager expertise can help act as an additional layer of diversification to help against downside risk.

Manage
After the portfolio is built, we believe a true multi-asset approach means continuing to dynamically manage that portfolio. This dynamism across asset classes is intended to help manage downside risk and gain exposure to high-conviction investment opportunities. This can include managing a portfolio of physical securities - such as stocks or bonds - or implementing overlay-based strategies such as options, currency forwards and futures.

The bottom line

Combining all these levers, a multi-asset approach may help investors with downside protection.

It's understandable that so much of the world is chasing growth. Growth is enticing. But we believe savvy investors will focus on what the data tells us. And the data shows that protecting against downside just may get you more bang for your buck.


1 This was calculated using mathematical principles of percentages. For example, a 10% loss of $100 is $90. An 11% gain - or an additional $10 - is needed to go from $90 to $100. A 20% loss of $100 is $80. A 25% gain - or an additional $20 - is needed to go from $80 to $100.

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

Investing involves risk and principal loss is possible.

Past performance does not guarantee future performance.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

This material is not an offer, solicitation or recommendation to purchase any security. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Please remember that all investments carry some level of risk. Although steps can be taken to help reduce risk it cannot be completely removed. They do no not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Investments that are allocated across multiple types of securities may be exposed to a variety of risks based on the asset classes, investment styles, market sectors, and size of companies preferred by the investment managers. Investors should consider how the combined risks impact their total investment portfolio and understand that different risks can lead to varying financial consequences, including loss of principal. Please see a prospectus for further details.

Indexes are unmanaged and cannot be invested in directly.

Russell Investments' ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments' management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.

Copyright © Russell Investments Group LLC 2019. All rights reserved.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty.

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