Downside Insurance: Why Picking a Market Top is Risky Business for Managers

Steve Kanaval  |

Greece exiting the Euro is in the news cycle and with the availability of many ETF products, which offer downside protection, there is ample opportunity to buy some protection. The days of shorting the S&P Futures contact or buying individual stock put options at the CBOE are a thing of the past. Today, a manager can buy downside protection with a 2x or 3x return if, in fact, the market tanks like it is doing this morning. The issue becomes for anyone who wants to buy downside insurance, is how much are you willing to pay for that insurance and how much of the portfolio you hedge.

If you are a long-only portfolio manager, you have a benchmark index and in most cases it is the S&P 500, Nasdaq or the Russell Index. Today, your benchmark index is flat .08% in the S&P 500, + 4.3% in the Nasdaq and +4.8% in smaller stocks in the Russell. This is important because this is how you get paid as a manager. Let's do the math:

Manager  1: YTD S&P500 +.08% -   Manager Total Performance for Fund + 3% = (Net + 2.2%) gain

Manager  2: YTD Nasdaq +4.3% - Manager Total Performance for Fund + 3% = (Net - 1.3%) loss

Manager  3: YTD Russell + 4.8% - Manager Total Performance for Fund + 3% = (Net - 1.8%) loss

Now keep in mind the manager gets paid out at the end of the year and he has an agreement where he gets 20% of the return and his client keeps 80% of any gains. If there are losses, the manger gets zero (except for a management fee on the total assets of 1-2%) so the manager has the second half of the year to try and get paid. If he loses - say 5% - he must make up that 5% before he can collect anything except his management fee (they call this high watermark). This means that if the Dow starts to tank and he was hedged, flat or in cash, the index could finish the year down 10%, and he is down 2%, then he gets paid when he makes back his 2%.

Now let's look at returns for the S&P500 since the market crashed in 2008:

2008: down 36.55%         

2009: up 25.94%

2010: up 14.82%

2011: up 2.10%

2012: up 15.89%      

2013: up 32.15%

2014: up 13.48%

2015: ????

In the 7.5 years since 2008, the indexes have been higher and most mangers have been paid for exceeding their benchmarks, but 2015 could possibly look like a version of 2008, and no manager would be surprised if the indexes closed down 10% for the year or even more. Indexes can close down 20% and not be out of line for a healthy retracement. If you are a manager, you are watching closely today to determine if you will purchase downside insurance so you could bank a profit if the year finishes down 10%. Hence, if you are up 2%, you get paid when all other managers take home a big goose egg. This will keep the kids in private schools and be great bragging rights at Christmas parties over the holidays. The other danger is that if you lose the same as the index, your client will say, "I can lose money on my own - you're fired".  So there is much danger picking this top..risk is a double edged sword.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:



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