What sources of market returns can withstand late-cycle uncertainty? By identifying the right ingredients, we think investors can create an allocation with the potential to overcome new challenges and perform well over the long term.

Market risks are rising and returns across asset classes are likely to be moderate from here on out. Investors, meanwhile, must choose among a plethora of options, from actively managed portfolios to an increasing number of passive smart-beta portfolios, which aim to deliver performance driven by market factors. As a result, every choice creates exposure to different betas, or market returns.

But which betas are right for the tests that lie ahead? In today’s environment, we think it’s time for investors to consider the right balance between maximizing returns and protecting against future losses. That means finding investments whose returns in rising markets (upside capture) exceed their losses in falling markets (downside capture), relative to a given benchmark.

The right upside/downside capture ratio will vary, given differing risk appetites and investment horizons. But achieving it may help investors enjoy a smoother pattern of returns through volatile markets. This is important for two reasons. First, it can help investors avoid a classic investing mistake by panicking and selling low when a downturn hits. Second, for baby boomers who are nearing or early into retirement, minimizing potential losses is crucial when it’s time to sell funds for spending needs.

Riding the Ups and (Especially) the Downs with Better Betas

Some investments have an inherently more favorable upside/downside capture ratio than do other similar risks. We call them better betas. Most important for this late point in the economic cycle, their outperformance is often down to better downside protection.

Over a 10-year period, a global fixed-income allocation hedged to the US dollar earned 91% of what a US-only investment-grade allocation did in a rising market, while suffering just 68% of the losses. The illustrative examples below represent just a few of the many different ways investors can build portfolios to capture better betas than do standard equity and fixed-income benchmarks (Display)