21 Mar 2018 3 min read

Looking for opportunities to protect your returns


While the recent market rally will be remembered as one of the smoothest in history, we will undoubtedly come across some bumps in the road. Seeing as we can't predict when that will be, a better question is "when should we be buying equity protection?"  


As we all know, 2017 was a very strong year for equity markets as 'goldilocks' conditions (e.g. strong global growth, supportive central banks and low inflation rates) propelled markets to new highs. Combined with relatively stable long term yields  and a kicker from demographics as recently discussed by Joe England, that has resulted in aggregate pension funding levels climbing high.

The recent rally will be remembered as one of the smoothest (i.e. least volatile) in history – the S&P 500 for example only had two days of price falls greater than 1.5% during 2017.

Volatility levels are a key input to the pricing of equity protection strategies. As markets marched higher the price of protection fell to its lowest levels in recent history, leaving investors in the (unusually positive) positions of benefitting from strong market returns while also being able to protect these gains cost-effectively.

The recent, and well publicised, market wobbles at the beginning of February have served as a reminder that the 'goldilocks' conditions of seen in 2017 are unlikely to last forever. See James Carrick's thoughts on whether equities are overvalued in his recent blog.

However, since mid-February markets have largely regained their composure and recouped much their losses. The S&P for example has regained c40% of its recent losses and is at a similar level to December 2017. In addition, market volatility (and therefore protection pricing) has fallen back to levels similar to the summer of 2017. As a result, equity protection pricing still looks very attractive from a historical perspective.

So what? Some pension funds may be happy enough to sell down a portion of equities. However, many pension schemes will continue to rely on equity-like returns to support funding levels and guard against covenant risk. As such, now may be an opportune time to tactically implement an equity protection strategy to lock-in recent strong performance and benefit from the low cost of protection. Strategically this is likely to make most sense where there are key valuation dates or reporting dates for the pension fund/corporate ahead or where equities look more attractive from a journey plan perspective in a narrower return band (e.g. selling upside to fund the downside protection).


LGIM contributors