Hortz: Can you explain the methodology you used in your analysis of each strategy?
Robinson: We wanted our analysis to objectively illustrate the pros and cons of various approaches to downside protection, rather than to proclaim some absolute truth. Like most things, this is not a one-size-fits-all solution.
To accomplish this, we looked at each of the 11 strategies through two lenses.
First, we tested the effects of incorporating each instrument as a 20% allocation in a traditional portfolio. We used a standard 60/40 portfolio of stocks and bonds as our baseline because we believe it to be a fair point of comparison for goals-based advisors. This allowed us to assess how incorporating each instrument as a 20% allocation impacted a portfolio during the four largest market declines since 2000, as well as over the full market cycle from 2000 to 2020.
Second, we considered each strategy as a standalone investment. This allowed us to prescribe a “behavior score” by combining traditional quantitative risk/return metrics with qualitative measures that can be strong indicators of whether, and for how long, an investor will stick with an investment. This standard focuses on practicality and investor behavior.
Hortz: Can you further discuss your “behavioral score?” How did you develop the scoring metrics and how should advisors employ these scores in their analysis of these strategies?
Robinson: While traditional investment evaluation often stops after the quantitative analysis of risk/return metrics, we think this is short-sighted because it misses a key consideration: How is an advisor’s client going to feel about the investment’s behavior in both up and down markets? Practically speaking, if an advisor must continually explain why a certain investment consistently generates losses, even if it quantitatively benefits the overall portfolio, the optics become highly difficult to defend to clients.
To objectively evaluate this, we prescribed a score ranging from 3 to 11 to each instrument based on their rating in three areas:
1. Maximum drawdown—This risk/return metric captures the absolute pain an investor feels when the instrument declines in value.
2. Maximum underperformance compared to a traditional 60/40 portfolio—This captures the relative pain an investor feels when they eyeball their investment versus a common benchmark.
3. Transparency —This refers to access, visibility to the rules that drive the strategy, and the ability to see the underlying portfolio holdings (all characteristics that help an advisor explain the approach to clients and verify that a strategy is being managed as expected).
We would not recommend that an advisor only consider the instrument’s behavioral score when evaluating which method of downside protection is appropriate for their client portfolios. We simply think it is an important—yet too-often overlooked—input for making challenging decisions about how to manage downside risk.
The goal is to keep clients on a straighter path toward the long-term goals they have agreed upon with their advisor, right? Both parties succeed when the portfolio is created in a way that the client can stay anchored to during various market environments. Let’s say a particular client is incredibly uncomfortable with substantial deviation from traditional benchmarks. Then, the behavioral score can help an advisor identify that instruments like the VIX or an inverse S&P 500 strategy may not be suitable for this client since each scored very poorly for drawdown and underperformance (non-qualitative investment considerations the client feels strongly about).