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Not all bear markets are created equal.
This seems so obvious that it’s hardly worth saying. But it nevertheless is the first step toward wisdom in trying to protect your equity holdings from bear markets. Pick a hedging strategy that isn’t appropriate for a given bear market, and what you thought is good insurance could actually make things worse.
This has certainly been the case in the current bear market, in which many retirees were invested in hedging strategies that worked during the February-March 2020 bear market. In recent months they have discovered the hard way that what works during a short and violent market plunge like 2020’s bear market does not necessarily do well when the bear market involves a more gradual and drawn-out erosion of prices.
Consider the strategy that almost certainly was one of the best performers during the February-March 2020 bear market. It was recommended by Black Swan author Nassim Taleb, which reportedly made some 4,000% by investing a small portion in deep out-of-the-money put options. Though the hedge fund doesn’t disclose the details of its strategies, Michael Edesess (an adjunct professor at the Hong Kong University of Science and Technology) was able to reverse-engineer a portfolio that largely replicated the fund’s performance history.
Read: Are you nearing retirement? Here’s how to transition your portfolio from growth to income.
At the beginning of each year, Edesess’s hypothetical portfolio invests 96.67% in an S&P 500 index fund
SPX,
and 3.33% in an S&P 500 put option that is 60% out of the money and expires two years hence. I calculate that this portfolio lost 17.6% from the Jan. 3, 2022, bull market high to earlier this week (Feb. 21). That compares to a 15.1% loss for being fully invested in an S&P 500 index fund.
The reason this portfolio did worse than the market itself is because its put options suffered from time decay. The market didn’t drop far enough and fast enough to prevent the puts from losing value.
A similar story, though perhaps not as extreme, is told by the performance of long-term U.S. Treasurys, which performed outstandingly during the February-March-2020 bear market. While the S&P 500 was dropping 33.9%, the Vanguard Long-Term Treasury Index ETF
VGLT,
rose 13.4%. Yet long-term Treasurys have been an exceedingly poor hedge during the current bear market: The VGLT has dropped 27.0%–nearly 12 percentage points worse than the S&P 500.
Fixed index annuities
At this point in the discussion, you’re probably wondering if it is possible to insure your equity portfolio from all bear market losses. The answer is “yes,” but you have to give up a big portion of the stock market’s upside in order to purchase that insurance. I’m referring to fixed income annuities (FIAs), which in effect are insurance contracts that allow you to participate in the stock market’s upside while guaranteeing that you never lose money.
Given the disappointing performance of many bear-market hedging strategies, many retirees are giving serious consideration to buying this extra level of insurance. Whether an FIA is appropriate for you depends on a number of factors, including your risk tolerance and your willingness to pay the “premium” for this insurance.
That premium is a function of your participation rate—the share of the price-only gains that you earn when the market rises. This participation rate varies according to market conditions, but is usually well below 100%. Currently, for example, according to Adam Hyers of Hyers and Associates, a retirement-planning firm, an FIA benchmarked to the S&P 500 has a 55% participation rate. That means that, in return for paying the annuity provider 45% of the S&P 500’s gains as well as all dividends, you are guaranteed not to lose money.
There are many different varieties of FIAs, catering to a variety of risk preferences. For example, Hyers said in an email, in return for capping your potential profit in any given year to 15%, you can purchase an FIA that provides you with a 100% participation rate.
Participation rates, caps, and other contract details change frequently, so if you’re at all interested be sure to discuss the various options with a qualified financial planner. For example, the last time I mentioned FIAs in a column, which was last summer, the participation rate for an FIA benchmarked to the S&P 500 was 30%–as opposed to 55% today.
The bottom line: It is possible to sidestep all bear market losses. But, as usual, there is no such thing as a free lunch, and you will have to pay for such insurance.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.
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