"My clients avoided the 2008 stock market decline," he says. "They know there is a cost to hedging and that it may not work 100% of the time. But when the stock market drops 5%, you don't know if it will drop 50%."
Meanwhile, David Wright, manager of the Sierra Core Retirement Fund, as well as separate accounts totaling $600 million, uses stop losses on broadly diversified portfolios of mutual funds to limit tail risk. His goal is to limit volatility to 4%. On the upside, his goal is a 10% total return. Investments that are more volatile than their historical averages are sold. On the upside, he uses moving averages and other measures to get back into the market.
In 2008, the fund lost just -3.3%. In 2009, it gained 30.8%, according to Morningstar Inc.
"Our goal is to limit the downside," he says. "One-third of the time we get false alarms that result in small losses. But trailing stop losses under every position reduces risk."
Research shows that portfolio hedging insurance programs can be effective. For example, a study by Milliman Inc. in Seattle, found that put-option hedging programs saved insurance companies $40 billion during the financial crisis in 2008 and 2009. Dynamic hedging programs used to protect variable annuity account values tied to death and living benefit guarantees were 93% effective. Their hedging programs were 93% and 94% effective in 2008 and 2009, respectively.
Put-option hedges can be used within a mean variance framework, according to research by two finance professors, Mark Broadie of Columbia University and William Goetzmann of Yale University. So financial advisors include put options in their optimizations that include stocks, bonds, cash and other asset classes. The study, which examined performance over seven decades, found that the "insured portfolio achieves high long-term returns while mostly avoiding bear markets." Their working paper, Safety First Portfolio Insurance, can be found on the Social Science Research Network (www.ssrn.com).