A key feature of Adaptive’s Forward Test is the ability to simulate the possible effects of downside protection, and to compare outcomes to a portfolio without downside protection. The interaction of Simulation Length, Protection Period, and Protection Level can affect these results.
• Protection Renewals.If the Simulation Length is longer than Protection Period, say five years of Simulation Length and one year of Protection Period, then the simulation assumes renewals of the downside protection at the same Protection Level and Protection Period. This assumption can greatly affect simulation results in part because the Protection Level is expressed as a percentage, so renewals for a rising portfolio will have higher dollar levels of protection, and likewise renewals for a falling portfolio will have lower dollar levels of protection.
There are a few nuances: (1) any Protection Payouts are added to the market value of the portfolio, in effect simulating reinvestment at the lower prices and, in an overall rising market, using Protection Payouts to ‘buy the dips’ as a potentially potent form of countering negative compounding; (2) whether there are Protection Payouts or not, the Forward Test finances Protection renewals out of the market value of the portfolio, meaning that there is some rebalancing to maintain portfolio allocations; (3) the Forward Test uses the current implied market volatility as its assumption for the cost of any renewals during the simulations, but in the real world the cost of renewals will be affected by the market conditions which might price protection higher or lower than current levels.