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Unio Capital is an asset management firm—oriented to publicly-traded equities, global in scope, and equipped to manage hedged and long-only portfolios as funds and separately-managed accounts.

In Perspective

Unio's "In Perspective" short-form series covers the Unio team's views on topics ranging from investing to business to economics.  


Protecting a Rising Base—And Building On It

John Allison

When the stock market is way up as the S&P 500 has been—up +167% in just under 5 years (or +23.1% per year)—it is hard to imagine any other way to make money than just "being in the market." Conventional hindsight agrees: just sit tight during bear markets like that of 2007-09, it says, and things will work out. It may take once-in-a-century intervention by the Fed. But the authorities will never leave you stranded. 

Yet markets go down.

The last bear market in 2007-09 involved a peak-to-trough decline in the index of -56.8%—or -44.7% per year over almost 18 months.  Things may have worked out from the bottom of the bear market, but from the peak in October 2007 to the end of November 2013, the S&P 500 index is up a total of 15% over 6+ years, or about +2.4% per year. We may have made up for lost ground, But we haven't gained much new ground.



So the question arises: does it pay to find a better way? If you follow the logic of the next 4 graphics, the answer is yes. It does pay to find a way to limit the downside in bad times – to protect one’s base – even if it means making less than the market in good times. Because, as long as one makes enough money in the good times, protecting one’s base in the bad allows one to emerge from each bear period with a higher base on which to make money in the next bull run – beating the market in the process.

If we looked at 6 years of hypothetical investing in the market – 4 bull years followed by 2 bear years – how might this work? Chart 1 shows year-by-year results for an index and a fund. The index uses actual price returns for the S&P 500 from 1973-2013 but organizes these returns into quartiles for the up-years. Year 1 is the S&P’s top quartile up-year returns in that 41-year period; year 2 third quartile; year 3 second quartile; and year 4 fourth quartile up-year returns.

Years 5 and 6 show -22.7% per-year bear-market returns. These too are derived from actual returns – the average of bear returns for 1973-4, 2000-03 and 2008. Take note that -22.7% per year understates big bear market declines because it excludes that part of bear declines occurring in months falling on either side of calendar years.  For example, in 2008 the S&P 500 was down -38.5%; but part of the bear market occurred in late 2007 and part in early 2009 making peak-to-trough returns -56.8% or -44.7% per year – far greater than the -38.5% we are using in this example.

Finally, we assume a hypothetical fund that is always hedged by being short the S&P 500 – 20% short in year 1 rising to 85% short by year 5 and into year 6. This hedging in the good years means the fund routinely underperforms the index even though its longs are keeping up with it.

Now look at the table on the next page. On the top half you see the year-by-year performance of the fund versus the index; in the bottom half the compounded annual performance compares. By year 4 the index is up about +17% (16.64%) and the fund about +13% (12.84%). The fund underperforms, albeit because it is taking less risk with hedges.

However, by limiting its decline in each of years 5 and 6 to negative 4%, the fund’s compounded annual performance is still +9% (9.25%) in year 5 and +7% (6.92%) in year 6, whereas the index has fallen below the fund in year 5 and in year 6 is at +2% (1.70%) – or 5 percentage points below the fund on a compounded annual basis.



Look at what has happened in terms of a growth of $1,000 in chart 3 below. The index hits over $1,800 by year 4 whereas the fund is at $1,600. But by year 6 the fund is at $1,494 and the index at $1,106. The roles are reversed.



The roles are even more dramatically reversed if bear-market returns are increased to the actual -30% per-year peak-to-trough declines of the three bear markets of 1973-74, 2000-03 and 2007-09. With those declines the index’s 6-year compounded annual returns fall to -2% (-1.61%) versus an  approximate +7% return for the fund – for a compounded annual outperformance by the fund of 8 ½ percentage points. The growth of $1,000 looks even more starkly different with -30% per-year bear-market returns. As you see in chart 4 below, the index drops to just over $900.



In principle, by protecting one’s capital base in bear years even at the price of performing less well than the market in good years, one ends up doing better than the market over a cycle while taking lower risk.

The magic question remains: what does it actually take to do it? Answer: at least:

  1. Strong long-investing: one requires great investing in the up-years to stay close enough to the market despite the brake of hedges.
  2. Hedging ahead of need: hedging is an approximate art, not a precise science, and must be in place before downside trouble
  3. An investment discipline organized to do this: pressing the long-only accelerator while using the hedging brake is a process.

Given the potential payoff – better-than-market returns over a full bull and bear cycle with lower risk taken – it’s worth developing if one has the professional experience and emotional temperament.

— John A. Allison