(Photo: iStock)
(Photo: iStock)

What is downside protection and why is it important?

Protecting downside is important because a steep fall, especially in the initial years of investment, can eat into the capital and affect the ability of the portfolio to compound and grow

Investors evaluating actively-managed mutual funds should not only focus on a fund’s ability to earn higher returns than the benchmark but also on how much downside protection it provides. In other words, the fund’s return should fall less than the benchmark’s when markets decline.

Protecting downside is important because a steep fall, especially in the initial years of investment, can eat into the capital and affect the ability of the portfolio to compound and grow. Higher the fall, greater is the percentage gain required to make up the losses. For example, if a portfolio falls by 15% in a year, it requires a percentage gain of 17.64% in the following year to recoup the losses since it will now be earning on a lower base. If the return earned is lower, then it will take the portfolio longer to get back to the level from which it had fallen. This may be of particular concern for investors who may not have the time to make up the losses.

Equity funds use strategies such as extent of diversification, sector and stock weighting and hedging using derivatives to protect downside risk.

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