The problem with this kind of passive, buy-and-hold approach is that it has unlimited downside risk. The market can sell off by 20%, 30%, 40% or more and has done so many times through history. Such losses can be catastrophic and require years for a portfolio to recover.
To protect against these types of major losses, the second component of the DRS is to overlay the ETF positions with put options to hedge against downside risk.
The return profile of this combined equity-and-hedge position is seen in the gold line below:
The gold line lags the S&P 500 in up markets but is still upward sloping, so the DRS’s potential upside capture is not capped.
In down markets, however, the value of the hedge is readily evident. As the S&P 500 drops, the hedged equity positions flatten out. At a certain point, the slope of the curve is flat or 0, meaning that the hedged equity position is insulated from further losses in the market. The value of downside protection is clear and is explored in-depth in previous blog posts on avoiding large losses and the importance of distribution of returns.
That said, in a flat or up market the hedge does act as a drag on performance.