Investors remain skittish these days thanks to recent global unrest, making the market crash of late 2008 difficult to forget. The memory of that sharp drop in their net worth is still vivid, and they have no desire to repeat the experience.

As a group, portfolio managers and investment advisors were unprepared for this unprecedented incidence of contagion, when all asset classes fell drastically at once - rendering even the best-designed and well-diversified portfolios defenseless against the collapse. 

Investing has always been an exercise in taking and managing risk. But the events of the past few years have changed the game. Whatever you call it - portfolio management, investment management, or wealth management - it is now, more than ever, indistinguishable from risk management. Most investors cannot simply opt out of the game; they have no choice but to be in the markets, in order to secure their long-term financial future and stay ahead of inflation.

In 2011 and beyond, an efficient “safety net” to protect investment portfolios in response to those rare times when all else fails is an essential component of portfolio risk management. However, safety net protection should only come into play when needed - much like a reserve parachute, it is always there in the event of a critical failure, but rarely used. 

The ideal safety net should incorporate three key features

In order for investors to reap the maximum benefit, the ideal investment or safety net should meet the following stringent criteria:

- Very low cost, including indirect costs

- Sudden appreciation in severe market downturns and no “give back” when markets recover

- Minimal disruption to the portfolio

In order to stay true to these three criteria, effective portfolio protection should generate sufficient growth in normal markets to cover its own cost. In extremely stressed markets, it should appreciate dramatically to offset the market decline and maintain that appreciation when markets eventually recover. And it should not dismantle what works in vastly more likely “normal” markets in pursuit of protection against extremely rare events. Solutions that meet all three criteria are very difficult to find; most fail to meet one or more.

Puts and collars are a perfect example. Over a full cycle of market decline and recovery, your portfolio doesn’t realize any net benefit using these traditional devices. Not only are put options expensive, but once the market recovers, they lose value. And, yes, collars defray direct cost, but they do so by giving up some potential future gains - which is the last thing you want to do to recover from a market decline. These approaches violate both the first and second criteria.

“Black swan funds,” currently being offered by some firms, violate the third. By essentially assuming that severe bear markets are the norm, they penalize you in markets that are much more prevalent. 

Exploiting market volatility has the best potential

Certain investments in market volatility have become popular. For example, long volatility plays, such as investing in VIX futures, exploit the fact that sudden market declines tend to be accompanied by spikes in volatility. Their benefits, however, are just as transitory as puts and collars. Worse, they constantly diminish in value and thus are very expensive to hold for any length of time.

A different kind of volatility play, so-called volatility swaps, however, represent a more creative, effective, and efficient approach. Some of these strategies meet all three of the criteria we established for an effective safety net. One particularly effective swap is linked to the spread between the daily and weekly volatility of the S&P 500, exploiting the fact that the S&P 500 Stock Index’s movement from week-to-week is typically less than its daily movement would imply.

Going long daily volatility and short weekly volatility thus results in a modest return that covers the minimal cost of the swap in “normal” markets , and offers the potential for more substantial returns in markets under extreme stress, when the same effect simply gets magnified. There are several products now on the market that take this approach.

Many firms are hard at work creating products that seek to tame risk in order to garner extra return for their clients’ portfolios. As they come to market, however, let the buyer beware - most are being sold to fear, and naïve investors will be taken advantage of. Make sure you vet these “solutions” carefully and compare them thoughtfully to the above criteria. 

But safety nets alone are not enough

It should be noted that safety net protection is just one component of a comprehensive portfolio risk management approach. 

Risk management, in the form of strategic asset allocation and periodic portfolio rebalancing, has always been an integral part of responsible investing and should not be discarded. Now is not the time to throw out the baby with the bath water. However, it has become clear that in today’s complex times - considering the potential of geopolitics and the global economy to disrupt the financial markets - it is simply not enough. New tools must be employed in order to create more dynamic - and more realistic - responses to market uncertainty. 

Among these tools are statistical models and methods designed to deal directly with the ever-shifting nature of asset class interrelationships. A promising development in this area is the increasing use of so-called copula dependency models instead of simple correlations. Also needed are more sophisticated measures of risk that paint a more accurate picture of what can happen when certain things change or go wrong.

An example here is a measure called conditional value at risk , which takes into account the severity, as well as the frequency, of rare and catastrophic events. It is a much more meaningful measure than the traditional standard deviation. There are more like these, and each could be the subject of its own individual article.

A new era of wealth management has begun

In short, the contagion we experienced in late 2008 is rare, and investment advisors might be excused for being unprepared then. But they won’t get a pass next time. They have a duty to protect their clients’ portfolios against the next catastrophe, whatever its cause. The best safety net is one that is fairly unobtrusive during normal market times, but kicks in when it’s needed to provide protection against severe market downturns.

If there is anything that the markets of the past few years have taught the financial advisory industry, it’s that a new era of wealth management has begun. The benefits to those who take up the call?  More secure, well-managed portfolios and, importantly, clients who can invest with confidence.