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Equity protection, it’s the same as buying a car really

Buying cars and protecting yourself from equity market falls may not appear to have much in common. But you might choose to do both if you had the option…

“Don’t confuse the cost of something with the way you fund that purchase”

A seasoned investor uttered these words to me many years ago and they really stuck. As a result I have always been very aware, when assessing an opportunity, to allow for how accessing the opportunity is to be funded. As those of you who read my last post will know, equity protection is close to my heart. Cars are too, so I couldn’t resist the temptation to bring them together.

Imagine you want a new car while there’s a big car sale going on. Great news if you're going to write a cheque for that car (who writes cheques these days?), but potentially less good if you need to sell your current car to fund it. In that instance whether it is a good time to change to the new car depends on the value of your current car relative to the new one you fancy.

Evaluating market opportunities to implement equity protection is much the same. Having decided to protect your portfolio against market falls, it’s best to assess opportunities in light of how one intends to fund the cost of protection. The two main ways one can fund this purchase are:

  1. Pay upfront for the protection (i.e. write the cheque)
  2. Sell your right to potential future equity returns in excess of a certain limit. This can generate the money needed to then pay the insurance premium for the downside protection. Interestingly this has been the more popular strategy recently

So let’s revisit the eternal question of “is now a good time to implement equity protection”. Spoiler alert, (pun intended) it can depend on how you intend to pay for it. Let’s take a quick look through each lens in turn.

Writing a cheque

The chart below plots equity market levels versus the cost of equity protection as a percentage of equity value. Each dot represents the data point for a given month. The ‘best’ opportunities are those dots appearing in the top left hand corner of the chart. i.e. investors will typically have benefited from higher equity market levels (towards the top) and the cost of locking in those gains will be relatively cheap (towards the left).

Looked at through this lens, the fact that the green dots are to the left highlight that 2018 looked like a good time to write a cheque, but the yellow dots being mostly to the right shows that the case was less compelling in 2012, when the cost of protection was relatively higher. 

Selling away upside to buy downside protection

The next chart again shows the equity market level, but this time the scale from left to right highlights the level of potential upside retained. Through this lens, ‘best’ opportunities are highlighted by dots appearing in the top right hand corner of the chart. i.e. investors will typically have benefited from higher equity market levels (towards the top) and also get to retain relatively more future equity upside (further to the right).

Looked at through this lens, one can make a compelling case that more recent times have been more opportune to implement a protection strategy funded by selling away rights to future equity upside.

So sometimes perception is indeed reality. To spot an opportunity to implement an equity protection strategy it is best to be cognisant of how we intend to pay for the protection. An opportunity to write a cheque may or may not be an opportunity to sell away upside and vice versa.

It appears that the case for equity protection has been more compelling recently (e.g. 2018) viewed via either lens, as opposed to 2012 when it very much depended on how that purchase was funded.

Much like wearing glasses, it’s best to look through both lenses to make sure you see all opportunities (or scratches if you’re buying a car!) 

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