Equity Protection – can it be achieved, what it is and how.

portfolio administration service

We all invest in the equity markets and ride the ups and downs, being confident that in the medium to long term our stock selections will bear fruit. Underpinning this belief is that Australian equities do perform well over time, providing returns above that of fixed interest or cash in the bank. In fact, a recent Fidelity article stated that the Australian equity market has returned 9.55%1 over the past 30 years. Add franking to that and it’s no wonder why we invest. Nevertheless, there are times when we can doubt our conviction or see worries ahead that will affect our portfolio (banking crises, potential wars). Alternatively, equities may have had a period of stellar returns and further rises appear unlikely.

How do we stay confident to have a large proportion of our invested wealth in the market? How can we consolidate large returns without selling our great performing stocks? Sales may incur tax. Rebuying at a later date may have franking credit implications. Are there protection methods?

There is an answer that all investors should be aware of. Equity protection. Know about it, because if you ever need it, an understanding will allow you to act quickly. Equity protection is easily gained via two forms, they are exchange traded and easy to access. This article will introduce both, with a follow up article for those looking for the intricacies.

In the first case, akin the concept of general insurance, put options are a great way to protect investment value. Put options can be either bought on a direct stock or over the ASX Top 200 index. They can be used as a general protection overlay or tactically as a trading/protection tool after large upwards moves, or in periods of market worries. Do not fear options. The buyer of an option has full control over its use. The cost is known with no other costs to be borne. The beauty of exchanged traded options is that they have multiple maturity dates and multiple levels of protection, akin to you being able to choose house value protection for 1, 2… or 12 months and at a chosen value of the house, say 100%, 98%…or even 80%. This gives a huge amount of flexibility to the buyer.

However, since markets are prone to be volatile, options can be expensive. Pricing must be checked by an advisor, however, there are some general measures that in advance can tell us whether options are good or bad value. Like insurance, the best time to buy is when the market is rising and pull back looks unlikely. Importantly investors must have an options account in place to trade options. This is not difficult to achieve2.

A second method for protection is slightly easier to understand and implement. No additional account is needed. You may be aware that the market index can be bought via an ETF, for example, the Betashares A200. This ETF mirrors the performance of the ASX 200 Index. A 1% rise in the index gives a 1% rise in the ETF. Betashares also have an ETF that does the opposite, that is, the ETF value rises when the ASX200 falls on a -1 for 1 basis. This ETF is called BEAR3. Investors can “hedge” their exposure by buying the BEAR ETF. A small problem is that to hedge a whole portfolio, you need to buy an equivalent dollar value. That can be impractical. Betashares have come up with a partial solution, the ETF BBOZ4, which gives twice the opposite performance of the ASX200 index. Thus, if the index falls 1%, BBOZ rises by 2%. Accordingly, less BBOZ needs to be bought to get protection. However, using protective ETFs is a two-edged sword. If the market rises your BEAR or BBOZ ETF value will fall. In that sense it’s a true hedge, it locks in your value (note your portfolio may not mimic the ASX200 index, but that can be adjusted for).

Hence there are two robust methods to protect your portfolio. The first, put options, are a defined cost and protect you against index falls under a certain level for a set period. If the market rises your portfolio still rises in value, however just like insurance, if you don’t “claim” your money is lost.

The second method is using an ETF that is negatively correlated with the index. The ETF protects your portfolio value from the index level at the time of purchase but will lose value if the index rises (offset by your portfolio value rise). Both methods are robust and very commonly used to protect equity market exposure. Importantly with either approach, the investor can choose just partially to insure or hedge the portfolio, not the whole. The financial historian Niall Ferguson recently wrote in the Wall Street Journal “The past half-century has witnessed a dramatic rise in the frequency of financial crises and market meltdowns. We now live in an age of latent financial fragility.”

Understand these protection concepts just in case you ever need them. Best prepared than not.

As always this is general advice and we recommend you speak to your advisor for specific advice.

  1. https://www.fidelity.com.au/insights/resources/adviser-resources/sharemarket-chart/a4-handout-december-2022
  2. Read the ASX options trading booklet for more information: https://www2.asx.com.au/content/dam/asx/investors/investment-options/options/understanding_options.pdf
  3. https://www.betashares.com.au/fund/australian-equities-bear-fund
  4. ASX BBOZ | Australian Equities Strong Bear Fund | Betashares