While the new year's market mayhem has refocused investor attention on downside protection, Axel Merk warns that standard risk-reduction strategies are not without their own risks.
Nevertheless, the Merk Investments gold and currencies portfolio manager lays out the options for investors seeking to crash-proof their portfolios in 2015 in his latest commentary published Wednesday.
The volatility that has slashed stock prices (and lifted bonds) in the first few trading days of the new year confronts investors with the challenge of determining whether the market shift is a buying opportunity or signal of worse to come.
But the fund manager is seizing the moment to remind investors of a fundamental investment principle that is meant to avert such painful decisions: diversification.
Properly achieved, diversification may be the one path permitting investors to have their cake and eat it too — by participating in a bull market while gaining protection against extreme events.
In his commentary, Merk first explores alternative forms of portfolio protection of which he is unenthusiastic, cautious or sharply critical.
One approach is insurance via structured products, but that involves counterparty risk — the possibility that the issuer cannot back up its liabilities.
One can mitigate counterparty risk through put options, since the options are cleared through exchanges. But Merk is still skeptical because of the cost of such protection.
"Just like flood insurance, the worst time to buy insurance is when one is in the middle of a flood," he writes.
But even were one to buy during a drought, he warns that costs will tend to rise amid period renewals based on three factors: as investors extend the duration of their protection; as they seek increased protection against loss (i.e., limit the amount they are willing to lose); and as market volatility increases.
The upshot is that put options can cost investors 4% to 5% annually to protect against a 15 to 20% market decline — and that's in a low-volatility environment.
