Preparing for a market correction

You can make your portfolio correction-proof through specialised products. Here’s an introduction.

Summary: Our newly buoyant market has spawned a range of flexible products and strategies to protect share values in real time. While capital protected products have been available in Australia since the 1990s, a wide range of other innovative solutions have been introduced which investors can choose to suit their individual circumstances. They include various forms of warrants, options and new ETFs.

Key take-out: The variety of protection products allows investors to not only tailor the level of risk they want to protect themselves against, but also enables them to employ long-term investment strategies. The hard costs of option-based protection means they are more suited for shorter-term strategies, while other longer-term products may still require close monitoring.

Key beneficiaries: General investors. Category: Investment strategy.

As the stock markets at home and abroad continue to reach new highs, talk in the markets inevitably turn to the notion of a pullback, a correction, or even ... a crash. (If you want to learn more about the technical prospects of a correction read Adam Carr's recent piece A correction coming?).

Though we have many professionals engaged in estimating and forecasting markets, the plain truth is that nobody knows what the market will do next. Moreover, history suggests that markets can drop at almost any time for almost any reason.

In a recent Eureka Report webcast, participants voiced their growing worries about the prospects for a share market correction and questioned the opportunities to add some protection to their share portfolios.

The great news is that our newly buoyant market has spawned a range of flexible products and strategies available to protect share values, where protection providers can benefit from the ability to hedge their exposures in real time.

Ultimately, every investor must remember there is no such thing as 'free' protection. As a very general rule the more insurance you want to get for your portfolio, the more you will have to pay.

Nonetheless, it will most likely be very assuring to many investors that you do not need to operate in the market without a safety net. Indeed, there are many ways to protect your portfolio ... let's have a look.

The range includes capital protected structured products and investment platforms, through to “stand alone” protection products which can be purchased at a time and in amounts to suit specific investor needs.

The ASX lists two of the most powerful “stand alone” protection products available for share investors: put options and warrants that provide “hard” downside protection, and ETFs and other warrants that allow investors to hedge their portfolios by generating profit as markets fall.

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Capital protected products and platforms

Capital protected products (which guarantee you that you do not lose money) have been available in Australia since the mid-1990s when OM-IP pioneered the issue of long-dated products backed by a Westpac guarantee. These products used a combination of long-dated bonds (which matured at the original capital value invested) and futures and options to generate market exposure. Many of the early series funds in the OM-IP range produced great payoffs – assisted by benign markets and falling interest rates (which boosted the value of the underlying bonds). These products are now issued by the successor to OM-IP, the MAN Investment Group.

These pioneering products were followed by a surge in capital protected products using the so-called “CPPI” technology to manage risk. Most of these performed true to label but when investors used borrowings to buy them, the ongoing cost of interest during and after the GFC caused widespread angst.

Macquarie is one of the few providers of capital protected structured products mainly using its “FLEXI 100” platform – which bundles options and leverage to deliver products which must be purchased using finance provided by Macquarie. Returns from the FLEXI range have been mixed; some products purchased in 2009 and 2010 now maturing with positive returns, but other series have not fared so well.

The appeal of this style of product led to the launch of the first capital protected investment platform by AXA (known as “North”) just prior to the GFC. This platform allows investors to select from a wide range of managed funds and add capital protection, and was marketed aggressively after the GFC.

The problem for this innovative product was that the GFC led to the cost of protection becoming overly expensive, with annual costs of up to 9% per annum for investing with protection removing the otherwise strong benefits. (The platform has been tweaked and is now offered by AMP, after its purchase from AXA).

More recently the BT Financial Group has launched its own “bundled” platform – offering significant improvements in flexibility and costs (we reviewed the BT Wrap Capital Protection platform in mid-last year).

This product uses a tailored form of CPPI technology but allows individual investors to choose the level and term of protection as well as being able to switch off the protection if they choose. Like AMP North, however, the BT product is only available in respect of managed funds – not the first choice for many SMSF and HNW investors who may prefer shares.

Why is “standalone” protection important for share investors?

Capital protected products seem most popular when markets are at their low points – ironically perhaps a less suitable time for their use compared to markets in a bull market phase. The lack of flexibility and choice of many bundled products don’t quite hit the sweet spot for most SMSF investors who cite “investment control” as their main priority for setting up their SMSF.

A more flexible alternative is available with standalone share protection products like options, warrants, and new ETFs, which allow investors to precisely time their implementation of protection strategies.

These products create tools for share investors who want to hold stocks for the long term, as an alternative to the high turnover style of managed funds. For these investors, the adoption of a concentrated, “buy and hold” approach is used to deliver three powerful benefits (and the “stand alone” products help to even further de-risk this style of portfolio):

  1. Access to growing dividend yields: just like a landlord can achieve rental yields 50% and higher over time (based on the original purchase price of the property), share yields on quality stocks can and do grow strongly and provide a great retirement nest egg for their owners.
  2. Growing capital value: As Warren Buffett famously commented that he couldn’t pick the bottom of the market in the GFC, but that he did not want or try to, quality share prices will rise over time because of their growing dividend yields. The Buffett point is that market prices will always gyrate because of sentiment and despite fundamentals, so buying and holding for the long term is a good way to avoid the impact of short term market movements.
  3. Costs and tax management: franking credits on dividends are a powerful benefit to investors (and because they represent tax already paid by the company, they are a legitimate form of tax benefit). Coupled with the concessional CGT rates on shares sold after being held for more than 12 months, share tax benefits are an important part of direct investing.

By using standalone protection products, investors can retain ownership of their share investments at the same time as insulating the capital value of their portfolio against losses. That can be particularly relevant when investors are approaching or in retirement (such that they may not wish to or be able to wait for an eventual share price recovery), or where the share market correction turns into a market crash.

Warrants and options

Options can be used to profit when the market rises ( buying call options) or when the market falls ( buying put options). Obviously, put options are particularly popular for protecting share portfolios.

Put options mean that you can sell shares for a preset price, even when the market price is falling. In practice, most put option holders will cash settle the put option by selling it for a profit – which offsets the loss on the share they own.

The ASX makes put option products available in two ways: on the exchange traded option (ETO) market, or on the warrant market. In financial terms both forms of product behave the same, the difference is that ETOs can be created by retail investors as well as institutions, whereas warrants can only be issued by banks or bank backed providers.

In the case of the ETOs, the ASX requires participants to use the ASX clearing house, which in turn holds collateral to protect option buyers. This is a key investor protection mechanism and avoids the problems of uncollateralized derivatives (which was the key factor in the systemic shock posed by the collapse of Lehman Brothers in the GFC). Details of the ETO market are available here.

The ASX lists individual share options over 74 shares as well as options over market indices like the S&P/ASX 200. Although investors seeking protection may like the opportunity to buy protection over each individual stock, a diversified blue chip share portfolio will have a high correlation with the movements in the broad ASX 200 index, and so for simplicity and convenience it will often be easier to buy protection index options or warrants.

The key financial difference between ETOs and warrant market is that ETOs tend to be issued with shorter maturity dates – with most liquidity available with a term less than 12 months. Warrants tend to have longer terms, with some providers issuing put warrants with two-to-three-year terms.

A key issue for put option or warrant buyers is to understand that the price they pay “decays” constantly through the life of the product, with this “time decay” accelerating as the maturity date of the option or warrant approaches.

The cost of the option or warrant rises as the level of protection it provides increases – so the cost for an “at the money” product is higher than the cost of an “out of the money” product. In practice this actually gives the investor some flexibility, just like you can choose the level of excess that you are prepared to absorb in a home or car insurance contract, so too can you select the level of cover when you buy a put option or warrant.

This is important to assess when you buy options to protect against share prices falling, because the cost subtracts from the overall performance of the portfolio. As a rule of thumb, costs for protecting “at the money” will normally be around 5% per annum, falling to more acceptable levels of 2% to 3% per annum for protection at levels of 80% to 90%.

When the term of the option or warrant is less than one year, the costs will also fall and this may be suitable for investors with a short-term bearish outlook.

Using put options and warrants is relatively easy, but spend some time understanding the key terms including the number of underlying shares to which they relate (known as the “conversion factor”) and pay close attention to the relationship between cost, maturity and exercise price.

ETFs and MINI warrants

The benefit of put options is that they provide “hard” protection. Just like an insurance contract, they pay off when the share price drops. But the hard cost of this protection can be a drag on the overall portfolio, especially when longer-term options are purchased.

As an alternative, some products provide downside protection by hedging in the futures market to provide a different cost profile – there is no initial option premium payable. Instead, the investor will be inversely exposed to the movements in capital value of the share/s to which the protection product relates, such that the product will profit if the shares fall in value, but can lose money rapidly if the shares rise in value instead of falling.

These products come in three main forms: via “MINI” warrants (which we covered in a recent article), contracts for difference (CFDs), and a new listed fund (ASX code: BEAR) which invests in the futures market within the fund itself. CFDs are not permitted to be used by SMSF investors because the CFD provider requires security over the fund’s assets – a “no-go” approach under SMSF rules.

The BEAR fund uses short selling to generate profits when the ASX 200 index falls, but because this happens within the fund itself, there is no margin requirement imposed on the investors. This means the fund is a lower risk way to access the short-selling strategy, compared to entering into futures positions directly.


Graph for Preparing for a market correction

For an investor wishing to protect against, for example, a $100,000 share portfolio falling in value, at the current price of $17.37 per BEAR unit, the investor would need to buy $100,000/$17.37 = 5,757 units.

If the market falls by 10%, the value of the BEAR units will rise by approximately that value, and the investor can either hold the BEAR units (if they are worried about further market falls) or sell them to realise the profit (and the protection that the BEAR unit has provided).

It should be noted that the BEAR fund does not guarantee to inversely track the market movements on an exact one-to-one basis. That being said, its price performance since inception has been closely correlated to the movements in the S&P/ASX 200 index (noting that the BEAR price falls when this index rises, as well as rising when the market index falls). The annual fees for the BEAR fund are 1.19% with additional expense recovery for the fund capped at 0.19% pa.

Yes ...you can protect yourself

The wide range of share protection products means that share investors can tailor the risk that they are prepared to assume, and also allows for long term investment strategies to be undertaken at the same time as protecting against downside risk.

The hard costs of buying option-based protection means that these are most suitable for shorter-term risk management strategies. Short-selling strategies like those deployed by the BEAR fund avoid these upfront costs but require close management of positions as a result.


Dr Tony Rumble provides asset consulting services to financial product providers and educational services to BetaShares Capital Limited, an ETF provider. The author does not receive any pecuniary benefit from the products reviewed. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.

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