The efficient market hypothesis (EMH) states that all known information about investment securities, such as stocks, is already factored into the prices of those securities. As a result, no amount of analysis can give an investor an edge over other investors, collectively known as the market.
While we may debate the accuracy of the EMH, one aspect of the theory is worth noting. The EMH does not require that individual investors be rational. Rather, it implies that the market, as a whole, is rational and is always right.
That distinction is important. Individual investors may, and often do, behave irrationally. One such manifestation of this irrationality is “fear and greed” in the market. Greed may cause investors to remain overexposed to the equity markets when they should be paring positions. Alternatively, fear can keep investors out of the markets when they should be investing in them.
It is that second scenario, fear or concern about market downturns, that we will consider in this paper. In addition to discussing how investors may let concern about market downturns lead them to being underexposed to equities, we will propose an investment strategy that may allow investors to gain exposure to the US equity market through a product that may provide downside market protection.
In general, investors tend to be loss-averse, e.g., they prefer to avoid losses to acquiring equivalent gains. In other words, it is better not to lose $5 than to fi nd $5.
In their seminal work, Daniel Kahneman and Amos Tversky identifi ed this tendency of individuals to be loss averse and labeled it prospect theory. By extension, they described the behavior of “losses looming larger than gains.”
In short, prospect theory posits that gains and losses are valued differently. The general concept is that if two choices are put before an individual, both equal, but one is presented in terms of potential gains, while the other in terms of possible losses, the former option will be chosen.
Kahneman and Tversky also proposed that losses cause a greater emotional impact on an individual than does an equivalent amount of gain. Gal and Rucker described “loomed larger” as losses being experienced with greater psychological impact than gains of equivalent magnitude.2
To illustrate, in his classroom, Kahneman would ask his students, “I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?” Most students answered $20. The same “double the loss” requirement occurred when he asked rich people the same questions, but with larger numbers. People are willing to leave a lot of money on the table to avoid a loss. 3
Concerns about market declines, and the ensuing loss of capital, may cause investors to pare back their equity holdings at the wrong time. It may also prevent individuals from investing in the equity market in the first place.
Such a decision may not be in the overall interest of individuals. Why?
Source: S&P Dow Jone Indices Past performance does not guarantee future results. The referenced indices are shown for informational purposes only and are not meant to represent the Fund. Investors cannot directly invest in an index
Despite the attractive long-term returns of the S&P 500, there have been some bumps along the way.
For example, in the aftermath of the run-up in Internet stocks in the late 1990s, the S&P 500 declined over 49% between March 2000 and October 2002 – a period that became known as the Dot.com bust. During the Great Financial Crisis, the S&P 500 declined nearly 57% between October 2007 and March 2009.
A lot of wealth was destroyed during these periods, and during many other market declines. Investors are rightly concerned about the effect that market declines may have on their investment portfolios.
There are many issues that may stir an individual’s concern about investing in the equity market. Corrections, bear markets, recessions, and stretched equity valuations have, in the past, led to market declines.
In addition to the large declines experienced during the dot.com bust and the Great Recession, the market has experienced many other corrections and bear markets. A correction is defi ned as a market decline of 10% while a bear market is defi ned as a decline of 20%.
The chart below highlights that since the S&P 500’s inception in 1958, there have been 31 corrections or bear markets, indicating such a market event may occur every two years, on average. The average length of those downturns was over 200 days and, on average, it took almost a year for the market to regain its peak level again. In some cases, such as the dot.com bust and the Great Recession, it took over four years for the S&P 500 to regain its losses.
Source: Yardeni Research, S&P Dow Jones Indices. Past performance does not guarantee future results
As the chart below highlights, the US economy, on average, experiences a recession every seven years. Recessions are usually accompanied by large declines in the equity market. Since the end of World War II, the S&P 500 has declined by more than 30% on average during a recession.
All of these statistics underscore the concerns that individuals may have regarding investing in the equity market. As a result, they may underweight, reduce, or outright avoid equities in their portfolios. Unfortunately, they may be missing out on the long-term performance potential of the equity markets.
Greater gains in the stock market are needed to offset realized losses. For example, it takes a 33% gain to offset a 25% loss and a 100% gain to offset a 50% loss.
Additionally, it may take a considerable amount of time for the equity market to return to its level before the decline. As Table 1 highlighted, on average, it took nearly a year for the S&P 500 to make back the losses that it experienced during corrections and bear markets. In some cases, such as during the Dot.com bust and after the Great Recession, it took over four years for the markets to recover.
For illustrative purposes only. Not meant to represent the Fund.
Thus, a sound strategy to achieve attractive long-term investment gains may be to avoid, or at least mitigate, losses in the first place.
But, is such a strategy plausible?
According to standard financial theory, investors are rewarded for the risk assumed in their investment portfolio through superior returns. In reality, that has not been the case.
As far back as 1972, Black, Jensen, and Scholes highlighted that the basic tenet of commensurate return for risk assumed by the Capital Asset Pricing Model (CAPM) was not observed in real life.4 Their research showed that returns of riskier securities were lower than those of less risky securities. This implies that constructing portfolios with less risk may yield better investment returns.
Additionally, Blitz, van Vliet, and Baltussen5 highlight that low risk, and specifi cally, low volatility, portfolios outperformed broader equity market indices around the world with lower risk. These do particularly well in market downturns.
More recently, we have seen evidence of this in low-volatility indices. These seek to outperform the overall equity market with lower risk and volatility. These indices work on the principle that portfolios with lower risk or volatility, although they may experience lower returns during strong equity market advances, experience lower declines during market downturns that more than make up for it. Historically, they have provided equitylike returns with lower risk and volatility than the overall market.
For example, the S&P Low Volatility Index has produced a 14.35% annualized return over the ten years ending 12/31/19 versus the corresponding 13.97% return of the S&P 500. At the same time, its risk, as measured by standard deviation6 was 9.16% versus the 12.37% of the S&P 500.7
This research, as well as the returns of low volatility indices, imply that avoiding losses through risk reduction may provide superior investment returns with lower downside risk.
Another means of achieving attractive longterm investment results with lower downside risk may be through strategies that utilize sector momentum.
Momentum is the tendency of stocks that have been experiencing positive (negative) returns to continue to experience positive (negative) returns. Just as individual stocks may experience positive or negative momentum, so may sectors of the equity market. Investing in sectors with positive momentum may offer the potential to mitigate risk and provide downside equity market protection in investor’s portfolios.
Chen, Jiang, and Xhu, found that there are signifi cant positive returns to sector momentum.8 Further, they found that sector ETFs are readily available, and thus, a strategy utilizing sector returns is implementable with reasonable transaction costs.
Faber also wrote a paper highlighting the potential, above-benchmark returns that can be achieved through a strategy utilizing sector momentum.9
How may individuals gain or maintain their US equity exposure while potentially mitigating or reducing their losses during the next market downturn?
The Armor US Equity Index ETF (ARMR) seeks to provide investment returns that, before fees and expenses, correspond generally to the total return performance of the Armor US Equity Index. The index is designed to provide exposure to the sectors of the US equity market that the fund’s index provider believes are most likely to generate positive returns while providing downside protection and experiencing lower volatility relative to the US equity market.
Individual sectors of the US equity market are evaluated utilizing a proprietary market performance indicator (MPI) to estimate those which may offer strong, long-term performance potential with lower expected downside risk. Sector momentum forms the basis for the MPI. Only sectors which score well based on the MPI are included in the index. If no sectors appear attractive based on this metric, the index will invest primarily in US Treasury obligations.
Low-cost ETFs which provide exposure to the sectors selected by the model are included in the index. ETFs may provide broad sector exposure in a cost-effi cient manner and allow the strategy the liquidity to react quickly to changes in market sentiment.
The index is rebalanced monthly to reflect timely insights into market and sector risk and return.
ARMR may provide investors with exposure to the US equity market with the potential for downside protection.
Carefully consider the Fund’s investment objectives, risk factors, charges and expenses before investing. This and additional information can be found in the Fund’s prospectus and Summary Prospectus, which may be obtained by visiting https://armoretfs.com/documents. Read the prospectus and Summary Prospectus carefully before investing.
Foreside Fund Services, LLC, distributor.
Investing involves risk, including possible loss of principal. The Fund’s return may not match or achieve a high degree of correlation with the return of the Index. To the extent the Fund’s investments are concentrated in or have significant exposure to a particular issuer, industry or group of industries, or asset class, the Fund may be more vulnerable to adverse events affecting such issuer, industry or group of industries, or asset class than if the Fund’s investments were more broadly diversified. Issuer-specific events, including changes in the financial condition of an issuer, can have a negative impact on the value of the Fund.
A new or smaller fund is subject to the risk that its performance may not represent how the fund is expected to or may perform in the long term. In addition, new funds have limited operating histories for investors to evaluate and new and smaller funds may not attract sufficient assets to achieve investment and trading efficiencies.
Shares are bought and sold at market price (closing price) not net asset value (NAV) and are not individually redeemed from the Fund. Market price returns are based on the midpoint of the bid/ask spread at 4:00pm Eastern Time (when NAV is normally determined) and do not represent the return you would receive if you traded at other times.