Looking at risk and return through a new lens

As financial advisers meet with clients to rebalance portfolios and plot the right investment mix for 2022 and beyond, they are faced with the biggest challenge in a generation over some investment truths that must be reckoned with.

First, your clients will almost assuredly lose money next year if they invest in bonds. Inflation is a hefty tax on fixed income and this month, the U.S. posted the hottest inflation report in almost 40 years. Even the Federal Reserve is saying that we should stop using the word “transitory,” and that its initial expectations for inflation missed the mark. We now know inflation is not going away in the near term, and the Fed is signaling rate increases, which will hurt bond holders.

Second, beyond inflation, the macroeconomic data across the U.S. economy continue to be very worrisome. Job growth in particular is abysmal. Nonfarm payrolls increased by 210,000 in November, following a gain of 546,000 the previous month. The November number was well below Wall Street expectations of a 573,000 increase. The labor participation rate was 61.8 in November 2021, a multidecade low, which creates challenges for ongoing economic recovery and overall growth.

Third, the central bank is out of ammunition. The Fed has ridden to the rescue with cheap money since the 2008 financial crisis but is now expected to accelerate the wind down of its bond buying program and quite possibly raise interest rates sooner than central bankers had expected. Meanwhile, fiscal irresponsibility threatens to intensify inflation further and pile onto an already unsustainable national debt. The central bank is in a no-win situation — stop inflation or keep throwing money into the system and inflation will rise. 

Against that draconian economic backdrop, it’s hard to argue the traditional approach of stocks, bonds and cash is a reasonable investment mix to manage risk while still generating returns necessary to achieve long-term goals. 

Still, investors remain keen to stay in the stock market for fear of missing out, and indeed the market is having another banner year, despite increased volatility.

Investors and their advisers must look at risk and returns through a new lens. A growing category to do so is hedged equity solutions for long-term investors seeking the benefits of passive investing and active risk management.

Hedged equity simply involves buying equity in some form, an underlying investment such as the S&P 500, and then securing a hedge to offset losses connected to market risk.

There are many ways to hedge equity, with one of the most common being options contracts that behave in a noncorrelated manner in relation to the underlying investment. While hedging is often considered a short period tactic, long-term investors should consider the benefits of a long-term hedging strategy. This way, you’re always invested in the market but always hedged, too. This bridges the gap that the traditional portfolio cannot.

While options are in fact widely used and can be effective portfolio tools for risk management, many investors may be wary of the unknown and instead prefer the status quo of the 60/40 stock-bond portfolio. The counter is that the current economic and interest rate environment handcuffs bonds and therefore requires new portfolio tools to manage risk while pursuing returns. Opting out of change in one’s investment approach because it appears complicated is like saying you’re not getting an iPhone because your landline is so much simpler.

Advisers are faced with their biggest challenge in a generation but also the biggest opportunity. Those who can steward their clients through this redefined investment landscape and provide thoughtful alternatives to address portfolio risks and objectives will potentially seize on that opportunity, to the great benefit of their clients and their practices. To do so, they must redefine portfolios. The traditional stock-bond combination is for yesterday’s environment. Staying the course is riskier than trying something new.

Randy Swan is the founder and lead portfolio manager of Swan Global Investments in Durango, Colorado.