Understanding downside risk in an era of structural change

Tom Boyle, Fund Manager

The past few years have delivered investors a hard truth: the market does not owe anybody a smooth ride when it comes to investing. The stable period of the 2010s – stable inflation, central banks with seemingly unlimited balance sheets, and muted political volatility – has been replaced by health scares, supply-chain breakdowns, geopolitical instability, inflation, and structural changes in the way we seek liquidity. All these together have collided to create a new backdrop. In this new era, whilst uncertainty is not an exception, that isn’t to say that you cannot use the changing environment to your advantage. How do we embrace volatility, rather than shun it from our minds?

Downside risk for investors means different things for different people. For us, it is the threat of meaningful and permanent loss of capital during market drawdowns. These sorts of drawdowns threaten to change the mentality of us, as investors, and have the risk of changing the livelihood of our clients. When we are building portfolios, it means that our investments stay relevant to the current market scenarios and can remain functional when the inevitable next bout of volatility arrives. This downside risk management is built into our investment process and forms part of our discipline as investors.

Diversification

The first part of downside risk management comes back to ‘the only free lunch in finance’ – diversification. Whilst the classical diversification which underpinned the 60/40 portfolio remains, to an extent, the recent inflation battle and rise in interest rates have seen that relationship breakdown more often than investors would care to admit. We only need to go back to May 2025 for investors to remember the correlation between US government bonds and the US Equity markets to be extremely positive, hurting investor outcomes and going against the psychology which many have relied on for decades.

The ‘new’ diversification requires investors to think outside the 60/40 mindset and consider both the allocation to different asset classes within their portfolio on a ‘risk’ basis (remembering that 20% of 2Y bonds and 10Y bonds are very different things), but also widen the potential toolkit an investor might consider to add orthogonal strategies which seek to exploit different risk premiums to the classic ‘equity’ and ‘rate’ premia’s.

This has caused many large institutions to move towards a ‘Total Portfolio Approach’ where investments are considered on their own merits as opposed to being based on a strategic benchmark. This approach also allocates capital based on ‘risk’ rather than a pound or dollar amount - a way we have been allocating risk in several funds for years now.

Mitigating downside risk through convex strategies

Volatility is usually treated as something to be avoided, but it can be turned into a useful allocation or overlay within a portfolio. Options provide convexity, or asymmetry – small, known costs with the potential for significant benefits in periods of market stress.

There are several different ways in which an investor can use volatility constructively in their portfolio to manage downside risk:

1. Direct Hedging: Buying a Put Option to limit downside or replacing long-only exposure to capture upside and limit downside to a specific cost. These can also be tailored to an investor's macro view to improve leverage and cheapen an option's cost.

2. Convex Strategies: These strategies look to manage downside risk by systematically investing in a portfolio of options using a rules-based strategy. These strategies can be tailored to an investor's geographic exposure, but also look to spend money on an ongoing basis to change the point at which the protection ‘kicks in.'

3. Overlays: Overlays combine either (or both above) into a single product, which allows an investor to hold onto their existing long-only exposure, but benefit from the downside protection which either solution can offer. In an environment of higher interest rates, we are increasingly having conversations with investors about overlays as the cost of capital (and portfolio allocation) remains high.

Alternative strategies around turning points

In the current environment, investors are looking for allocations which have a structural source of carry that does not collapse when equities sell off. Dispersion – a strategy which goes long single stock volatility and sells index volatility has emerged as a compelling alternative. Dispersion generates its returns from the structural difference between the implied volatility of single stocks and the indices in which they are represented in a spread, which is exacerbated by structured product issuance. Dispersion tends to perform the best when markets are under pressure and correlations become unstable. Unlike other carry-oriented strategies, which can bleed when markets are in ‘risk off’ mode, dispersion has held its own during recent selloffs. For investors who are looking for carry which does not simply leverage more traditional betas, dispersion offers a more robust alternative, which helps with downside risk in an overall portfolio.

In conclusion, downside risk is inevitable in any portfolio. However, unmanageable losses do not have to be with the right tools. Investors who embrace modern risk management tools, use volatility products to their advantage, and broaden their investment horizons can be better positioned, differentiate themselves and ultimately end up with better portfolio outcomes.