The key to active management in many markets may not be alpha generation, but beta avoidance when the market declines. Just avoid the pot-holes when the market declines and you will do a good job preserving long-term wealth. Preserving wealth during the occasional big down moves is more valuable than generating alpha every year. It is just that those times of large downside risks come infrequently, so you have to be prepared with a strategy for when those big negative events occur. However, it is not easy to prepare and wait for the big event at the expense of trying to find those special alpha opportunities everyday.
The focus on downside protection is simple. The magnitude of a down market event is significantly larger than the alpha that can be made from specific asset selection. Size matters. Avoiding a bad security selection when it may be less than 5% of the portfolio is not as important as getting out of beta exposure that could represent well over 2/3rds of the total market exposure and perhaps more of the portfolio risk.
Alpha can be eroded over time through competition. Management of a down market cannot be minimized through more competition. The savings from downside protection is huge given the measure of volatility drag. A 20% decline needs more than a 20% gain to offset the loss. The bets rule of money management is simple, don't lose money. Nevertheless, this does not mean that an investor should play defense and not take risks. Taking risk is important. Taking away risk at the right time is even more important.
There are two major approaches to downside protection or beta avoidance. One is anticipatory beta strategies which try to get out before market tops or bottoms and trend beta or projection beta avoidance which gets out after the market top or bottom based on the market trend. The market has to turn down first then action is taken.
The focus on downside protection is simple. The magnitude of a down market event is significantly larger than the alpha that can be made from specific asset selection. Size matters. Avoiding a bad security selection when it may be less than 5% of the portfolio is not as important as getting out of beta exposure that could represent well over 2/3rds of the total market exposure and perhaps more of the portfolio risk.
Alpha can be eroded over time through competition. Management of a down market cannot be minimized through more competition. The savings from downside protection is huge given the measure of volatility drag. A 20% decline needs more than a 20% gain to offset the loss. The bets rule of money management is simple, don't lose money. Nevertheless, this does not mean that an investor should play defense and not take risks. Taking risk is important. Taking away risk at the right time is even more important.
There are two major approaches to downside protection or beta avoidance. One is anticipatory beta strategies which try to get out before market tops or bottoms and trend beta or projection beta avoidance which gets out after the market top or bottom based on the market trend. The market has to turn down first then action is taken.
Anticipatory beta strategies may generate less volatility but is much harder to implement. The anticipatory beta will avoid the market top. Trend based adjustments are inherently more volatile but will be easier to implement. The exit could be at the same price as the anticipatory beta but after the market top. We can show the difference through a simple graph.
Let's look at a simple market cycle with a market top. The trend following strategy will always be late with a trade because the market has to turn down in order to sell. Trend-followers have to see the trend develop. The trend-follower will also be late on the exit from a long position because he has to wait until there is some profit give-back. Hence, there is more volatility. The anticipatory beta manager tries to avoid the peak and if successful will not have a profit give-back. If the anticipatory trader can exit close to the top he may be able to better profit than the lagging trend-follower. If he exists too early, the trend-follower may take more risk but end with a higher profit.
The manager has to understand the trade-off of trying to call early the market top based on non-price information or accept the added ex post "risk" from trend-following but with greater certainty of the market move. The trend-follower does not believe in his ability to call tops or bottoms. The anticipatory manager has more confidence in his skill for calling peaks and valleys. The strategy choice is based on their confidence in downside management.
Let's look at a simple market cycle with a market top. The trend following strategy will always be late with a trade because the market has to turn down in order to sell. Trend-followers have to see the trend develop. The trend-follower will also be late on the exit from a long position because he has to wait until there is some profit give-back. Hence, there is more volatility. The anticipatory beta manager tries to avoid the peak and if successful will not have a profit give-back. If the anticipatory trader can exit close to the top he may be able to better profit than the lagging trend-follower. If he exists too early, the trend-follower may take more risk but end with a higher profit.
The manager has to understand the trade-off of trying to call early the market top based on non-price information or accept the added ex post "risk" from trend-following but with greater certainty of the market move. The trend-follower does not believe in his ability to call tops or bottoms. The anticipatory manager has more confidence in his skill for calling peaks and valleys. The strategy choice is based on their confidence in downside management.
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