On the Holy Grail of 'Upside Participation and Downside Protection'

Abstract

"Upside participation and downside protection" is a popular motto for many investors. It has taken on much more significance in recent years in the wake of the global financial crisis. But how do we define and evaluate strategies from the perspective of "upside participation and downside protection"? In this paper, we present an analytic framework, in which we provide quantitative definition of upside and downside participation ratio, define participation ratio difference as a goodness measure for defensive strategies, and prove a relationship between the participation ratio difference and traditional alpha. As an illustration, we apply this new analysis to the S&P 500 index and its ten sectors and show defensive, low beta sectors tend to have positive participation ratio differences while cyclical, high beta sectors tend to have negative participation ratio differences. This finding is consistent with the low beta/volatility anomaly and it provides another explanation for the popularity of low beta/volatility strategies.

Keywords: Participation ratio, portfolio choice

JEL Classification: G11, G14