Everywhere you look there are stories about the market hitting record highs and growing concerns about the probability of a major near-term correction. Of course, if stock market moves were so readily predictable, we would all have become wealthy a long time ago.
But while no one knows what the market will do tomorrow, let alone next week or next year, the odds of some kind of a correction increase as the major market indexes tick higher and we move further away from the last major decline of 10% or more, which dates to the summer of 2011.
As this scenario unfolds, it's likely that advisers surveying client portfolios may be starting to feel a little nervous and are looking for ways to protect the gains of the last several years. Many approaches have been tried but few have proved to be reliable in the face of a broad market sell-off. The list includes portfolio insurance, options strategies and broad asset class diversification based on the principles of modern portfolio theory. When the time came to test them in real-world conditions, each of these methodologies proved flawed.
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For those old enough to remember the 1987 market crash, the mere mention of “portfolio insurance” is likely to evoke feelings of anger and incredulity. At its core, this was a simple and seemingly good idea: if an investor holds a portfolio of stocks, hedge it with some short positions in stock futures with the size of the position being determined by a calculation based on the then-newly derived Black-Scholes model for the valuation of stock options. That short futures position was then managed in a manner meant to replicate the payoff from a put option.
FLAWS OBVIOUS
In retrospect, the flaws in this strategy were obvious — the assumption that there is a continuous market in which to trade, the use of stock index futures to hedge a basket of stocks and the need for liquidity at the time of maximum risk. These shortcomings were brutally exposed on Black Monday, Oct. 19, 1987, when the Dow Jones Industrial Average dropped more than 20% in a day, creating a powerful negative feedback loop and obliterating liquidity.
Listed options, generally puts, also havebeen tried and found wanting. They do have some advantages — liquidity, transparency, and easy availability via the exchanges — but they are expensive.
Structured notes are yet another option for principal protection. But these “bespoke” notes are often hard to trade and, because a financial institution creates them, they assume the potential credit risk associated with that institution. Further, for investors with a tactically managed portfolio that necessarily will change over time, there is no way to price a derivative on that portfolio (you have to know what the dynamics of a portfolio will be over time in order to set the price).
The problems that arose with MPT in 2007-08 have been well documented. In general, Harry Markowitz's pioneering 1950s work demonstrated the benefits of broad portfolio diversification. It assumed the ability to manage risk, as defined by volatility, by holding a broad range of noncorrelated assets. Unfortunately, in the recent market crash, nearly every asset class went down together, with the exception of U.S. Treasuries. Diversification provided little protection.
Cash, of course, is another option but investors are often reluctant to move most or all of their assets out of the market for reasons both psychological and practical, and timing is always an issue.
NEWER APPROACH
A newer approach to portfolio protection attempts to address both the cost and liquidity issues, while continuing to provide market exposure. It uses U.S. Treasury zero coupon bonds with a duration matched to client needs and a switching algorithm to allocate assets from a model portfolio built using exchanged-traded funds into the bonds and back. The use of Treasury zeros addresses many of the known problems in historical portfolio protection — the hedging instrument is decoupled from the asset it's protecting; it's liquid; and the issuer is less likely to default. Further, because these bonds are available in a broad range of maturities, a protection program can be put in place to meet various time requirements without the need to roll over any hedging security.
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Portfolio volatility is forecast based on individual client holdings, the current interest rate environment and the time period covered by the principal protection program. Based on these parameters, a calculation is done to determine the “trigger points” for reallocating assets from the portfolio to the zero coupon bond holdings and back. A reallocation can be triggered by improvements to the initial assessed analytics. Movement into the zeros provides some income, as well as a certain amount of downside protection, and buying and selling in the Treasury market is generally very efficient. Principal protection is not a guarantee against loss or declines in the value of the client's portfolio; it is a risk mitigation strategy that seeks to control the risks in today's market environment.
As a practical matter, this type of program seeks to trigger only during severe market declines while remaining “off” for sustained market rallies.
It may be that the chorus of voices calling for a market correction turn out to be a perfect contrary indicator, but advisers can hardly be faulted for considering a more conservative posture at this juncture. As such, it makes sense to take a fresh look at the new tools available for managing volatility and risk.
Robbie Cannon is president and chief executive of Charlotte, N.C.-based Horizon Investments.
