Downside Protection: The Price Of Staying Safe

Global equity markets are back at record levels. The S&P 500, Nasdaq and Europe’s Stoxx 600 all sit near all-time highs, driven by optimism over artificial-intelligence earnings, resilient consumer spending and the expectation that interest-rate cuts are approaching. Yet many valuation measures are stretched. America’s total market-capitalisation now exceeds 200 per cent of GDP. Analysts at Bank of America warn that today’s multiples resemble those seen at the height of the 1999-2000 technology boom. The International Monetary Fund has also cautioned that asset prices look detached from fundamentals and that a “disorderly correction” remains a clear risk.

After years of abundant liquidity, investors face an awkward question: what happens if this cycle reverses? The longer markets stay elevated, the sharper the potential realignment. For investors holding large equity exposures, a downturn of twenty or thirty per cent would erase years of gains. That reality is prompting renewed interest in funds that build in “downside protection”, products designed to limit losses rather than chase every percentage point of upside.

Why protection matters now

Downside protection refers to any structure that cushions the effect of a market fall. Some funds use options to cap losses beyond a threshold. Others employ “defined-outcome” frameworks, promising investors that, for a given period, the fund will absorb the first 10 to 15 per cent of a decline in the index it tracks. The cost of this insurance is that the upside is capped and the management charge is higher than a plain tracker.

These strategies appeal most when valuations are rich and volatility starts to rise. They allow investors to stay in the market without bearing the full risk of a correction. In simple terms, they trade a little of tomorrow’s profit for protection against a heavy loss today.

What protection costs

The cost of downside protection shows up in three ways: higher fees, a limit on gains, and the cost of option premiums embedded in the fund. The average annual expense ratio for defined-outcome or “buffer” ETFs is around 0.75 per cent. By comparison, a standard index ETF may charge less than 0.1 per cent. That difference might appear trivial when markets are calm, but it compounds over time.

More significant is the capped return. A fund offering a 15 per cent downside buffer might restrict annual gains to between 6 and 8 per cent, even if the index rises 20 per cent or more. This cap finances the cost of the protection. The structure relies on the proceeds from selling call options to pay for buying puts, creating the buffer against loss.

Timing also matters. Many products reset their “outcome period” annually or quarterly. To obtain full protection, investors need to buy at the start of that cycle and hold until the end. Entering mid-term can reduce or even eliminate the buffer.

Yet the fee and the cap look modest compared with the potential hit from an equity slump. A portfolio that loses 25 per cent must then gain 33 per cent just to recover. Avoiding that hole, even partially, can justify paying a small annual premium.

Evidence from recent years

During 2022, when global markets fell by roughly 20 per cent, defined-outcome ETFs performed as designed. Many limited losses to below 10 per cent, even after costs. Investors who paid the higher fee and accepted the capped upside during the bull run of 2021 were rewarded by a smoother path through the downturn.

Critics point out that since 2020, holders of these products have forfeited about 5 to 6 per cent a year in potential gains relative to a full equity index. Advocates counter that the true value of insurance is only obvious when you need it. For those approaching retirement or managing endowment funds with limited risk tolerance, the avoidance of large drawdowns can outweigh years of small under-performance.

The volatility lens: reading the VIX

A simple way to assess how expensive protection is lies in the VIX, the Chicago Board Options Exchange’s Volatility Index. The VIX measures implied volatility on S&P 500 options over the next thirty days. When it rises, the cost of buying protective puts increases.

At present the VIX sits around 21, up from the lows of 13 seen earlier in 2024. That level is not alarmingly high but signals a market willing to pay for insurance. The long-term average is about 19, so the current figure suggests hedging costs are slightly above normal. When the VIX climbs into the 30s or 40s, as it did in 2020, protection becomes prohibitively expensive. When it drops into the teens, insurance looks cheap but investor complacency is often greatest.

The VIX therefore acts both as a pricing tool and a sentiment gauge. For fund managers that use derivatives, a higher VIX directly raises their cost base. Those higher input prices feed through into tighter return caps or slightly higher fees. For investors, it serves as a barometer: the higher the VIX, the more the market expects turbulence.

How funds implement protection

Most structured protection funds operate by combining equity exposure with derivatives. A manager may hold a portfolio of S&P 500 or FTSE 100 futures and then buy out-of-the-money put options to create a buffer. The cost of those puts is financed by selling call options, which sets the upper limit on gains. Others use collars or option spreads to achieve similar results.

Another approach, known as “risk-managed equity,” dynamically reduces equity exposure as volatility increases. These funds move part of their assets into short-term bonds or cash when risk spikes. While they do not promise an explicit buffer, they aim to reduce overall drawdowns.

Evaluating the trade-off

Whether the cost of protection is worth paying depends on the investor’s horizon and psychology. For those with long timeframes, a fully invested, low-cost tracker may still outperform over decades. For others, pension trustees, wealth managers, or individuals nearing retirement, the smoother ride of a buffered approach can justify the expense.

The key is to understand what you are buying. Downside protection is not a promise to eliminate losses; it is a mechanism to limit their scale. The insurance premium you pay buys stability, not guaranteed profit. When markets continue to rise, it will feel unnecessary. When they fall sharply, it becomes invaluable.

Outlook

With global markets priced for perfection and volatility creeping higher, the argument for some level of insurance is strong. The VIX indicates that hedging costs have risen but remain manageable. Investors willing to sacrifice a little of their upside can still secure meaningful protection against large drawdowns.

The broader lesson is that protection should not be viewed as a cost on profit, but as a safeguard against gross loss. For those who cannot afford a 25 per cent hit to capital, paying 0.8 per cent a year for that assurance is a fair trade. The market may yet climb further, but when the realignment arrives, only those who paid for a seatbelt will stay in their seats.