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Investors can control volatility, but the tools are not for novices

Options and products using options, such as structured notes, can provide a defined level of control in equity investments

Feb 19, 2015 @ 12:21 pm

By Joseph Halpern

Investors have been experiencing heightened volatility amid growing concern that, after six years, the equity markets may be signaling a pullback is approaching. Fixed-income markets are offering little solace as rates in the U.S. and in many other developed economies are approaching zero.

Investors know that no rules dictate how far or fast markets may move to the downside, as periods such as 2008 have demonstrated. This uncertainty of potential outcomes can wreck havoc on portfolios being managed for long-term returns.

A number of financial products attempt to address this turmoil and provide a level of control to equity investing, that is, low volatility. However, these solutions tend to mitigate rather than eliminate the exposure. For instance, there is no limit to what losses can be borne within low-volatility strategies — there is simply the assumption these losses will be lower than the overall market. Truly controlled environments are essentially unattainable through most conventional equity solutions.

(More: Investors flock to low-volatility ETFs as stock market swings widen)

Still, with options and products using options, such as structured notes, investors can achieve a defined level of control within equity investments. Options are contracts that allow the holder (buyer) to go long or short an underlying security at a defined level.

Unfortunately, consistently putting on this defined level of protection using options can be difficult. Some reasons include:

• Complexity: Working with options can be a difficult exercise for the uninitiated.

• Strike price: Most options trade at standardized strike prices, which may not provide the precise protection levels sought.

• Time period: Options are term-dated products with market-driven start and end points. Investors need to figure out the period for which protection is warranted and then find the closest market dates that work. Because of the term-dated nature, the protection needs to be renewed at certain intervals, starting the cycle over again.

(More: Know a client's emotional biases to get through volatility)

• Costs: Options providing downside protection may be costly, especially if the market is nervous about a downturn.

The combination of complexity, strike difficulty, term nature and fees makes it highly difficult for the uninitiated to consistently use options to protect a portfolio. Effectively using option strategies can be complex and is often best outsourced for all but the most experienced investors. Still, there are some solutions that are accessible to advisers, investors and money managers, including:

• Structured notes are the most defined and straightforward, as they are obligations of the issuing bank to deliver some predefined return. However, as IOUs of the bank, they are illiquid and carry concentrated credit risk. In addition, they tend to have high fees and lack a level of transparency.

• Separately managed accounts provide a more tailored fundlike experience for larger investors; these solutions can be customized to individual needs such as desired market exposure.

• Hedge funds provide substantial options expertise and outperformance opportunity, often at the expense of high fees, illiquidity, and nontransparency.

• Various mutual funds and ETFs featuring options-related strategies. While lacking the precision of a structured note and adding cost to the DIY path, these vehicles provide a middle-of-the-road solution that offers a controlled environment without the major drawbacks of the other solutions. Recently, the Chicago Board Options Exchange reported a definitive list of options-related funds available in the market today, a list that is almost certain to continue growing.

New and innovative defined-outcomes strategies are changing the landscape for both sophisticated and individual investors. Products that provide standardized exposures to the market will let investors of all types achieve clear and targeted exposures that match their objectives and market outlook with greater efficiency than the currently available solutions.

Selecting the right tool to balance protection and upside performance is as much about the investor's needs and outlooks as it is about efficient solutions.

Joseph Halpern is founder and CEO of Exceed Investments.

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