The Power of Downside Protection - Beware Your Intuition!

Two Years Into a Pandemic

As we mark the second anniversary of the COVID-19-induced bear market, reflecting on equity market return dynamics during this period can provide valuable insight into the power of downside protection. Throughout a full market cycle, superior returns, and ultimately risk-adjusted returns, can be achieved in various ways, but generally they require a combination of both offence and defence. In bull markets, investor attention is usually focused on the thrill of the ride, with risk considerations largely playing second fiddle; however, downside protection can be just as, if not more, important through a cycle. Ultimately, the compounding of returns over time is heavily influenced by how resilient a portfolio of equities is during periods of crisis, in conjunction with its upside capture. A breakdown of the past two years is instructive in this regard.

Pandemic Pain & Stimulus Gain

Starting at the pre-pandemic peak for Canadian equities on February 20, 2020 —a record high at the time—the arrival of COVID-19 and the brief, but intense, bear market that ensued erased more than one-third of the value of Canadian equities over a mere five weeks. As per the S&P/TSX Composite TRI graph above, this painful bear phase was short-lived but extremely impactful. Similar to the uncertainty of the early days of the pandemic from a health standpoint, fear dominated most global equity markets and Canadian stocks reached their nadir on March 23, 2020. Following a coordinated effort by central banks to ballast markets, a new bull market began in the spring of 2020 and remains to this day. While the emergency stimulus laid the groundwork, progress with vaccine development in late 2020 led to a full recovery in Canadian equities and new all-time highs. By mid-February 2022, the Canadian equity market resided more than 20% above its pre-pandemic high. The strength of the recovery may cause more bullish investors to question the importance of downside protection, but there’s a strong case to be made for prioritizing risk management in a portfolio today.

Outsized Impact of Downside Protection

It’s crucial to remember that excess returns on the way down are worth more than excess returns on the way up. In other words, negative and positive percentage changes are asymmetrical. For example, a decline of 50% followed by a gain of 50%, leaves an investor much worse off than where they started (a net 25% decline to be exact). A 50% decline requires a full 100% gain to regain lost ground. By extension, for an active manager a percentage point (or 100 basis points “bps”) of excess return in a down market is worth considerably more than a percentage point of excess return in an up market.

In the 38 calendar years since the inception of Franklin Bissett Canadian Equity (FBCEF) in 1983, there have been 11 years of decline experienced by the S&P/TSX Composite Total Return Index. Of those 11 years, FBCEF – Series F outperformed the Index nine of those times or 82% of the time.

Using that same timeframe, there have been 47 quarters of decline for the Index and FBCEF – Series F outperformed the Index 35 times or 74%.

Looking at the Bear Beta and Downside Capture Ratio, the metrics show that FBCEF Series F has outperformed the Index during market downturns.

Not All Excess Returns Are Made Equal

As the relative return experience above shows, outperforming on the way down more than compensates for the underperformance on the way up. Stated more generically, “basis point for basis point” excess return in the form of downside protection is much more impactful than excess return through upside participation. We believe this is a natural feature of our investment approach, and while perhaps less exciting, is nonetheless a critical element to our success over the long-term. The difference in duration between these two phases is also notable, given the brief 32-day period where outperformance was so high. Also to consider is the fact that this two-year period isn't the beginning or end of the story; rather, it’s illustrative of how successful active management can be when using a healthy consideration of risk, which provides a critical foundation for compounding returns over time.

A Risk Aware Approach to Downside Protection

At Franklin Bissett Investment Management, our investment style emphasizes full-cycle fundamentals and valuations over fleeting fads or cyclical swings, with visibility to future secular growth and profitability critical elements to our approach. Emphasizing effective capital allocation, owning financially stable businesses, as well as portfolio construction considerations, ensure that risks are recognized, intentional and optimized, not simply minimized. With an approach that emphasizes the handicapping of risk/reward, solid downside protection has contributed nicely to compounding returns over time.