From the June 2008 issue of Wealth Manager Web • Subscribe!

Soft Landing

When the equity averages began to teeter in 2000, Michael Martin turned 30 percent of his portfolios into zero coupon bonds. He hoped to obtain absolute returns during the pending bear market by using the bonds as an uncorrelated asset. The strategy worked. Financial Advantage, his Columbia, Md.-based firm, garnered 8.2 percent, 4.8 percent and 3.0 percent returns over the next three dismal years.

Now the landscape has changed radically, and the Federal Reserve has less room to lower interest rates. Martin recognized he must develop new strategies to protect his clients' assets. So three years ago he decided to use short index products in his own account for a year, as a trial to hone his experience. "Everything is opposite" with such an approach, he realized, "and it takes a long time to build that into your instincts." It also turned out to be painful during the bull market then in force. Nonetheless, the exercise did sharpen his instincts and taught him how these short index products perform.

When volatile market environments lead wealth managers to implement new techniques for hedging portfolios, it is essential to begin by assessing the goals and personal profile of the individual investor. Age and investment horizons are critical for determining the stomach for volatility. Tax considerations vary, and many of the new hedging tools can help wealth managers avoid unwanted capital gains.

Some of the strategies work best on a temporary basis, while waiting for a storm to blow over. "Over the long term you want exposure to equities and fixed income, but short-term markets can be irrational, and investors may have immediate liquidity needs," explains Michael Dellapa, director of investment research at Rydex Funds. If markets appear extremely over- or under-valued, some market timing may be in order. Martin, for instance, only uses inverse funds when he considers the indices to be in the top 20 percent band of his overvaluation range.

When the equity averages began to teeter in 2000, Michael Martin turned 30 percent of his portfolios into zero coupon bonds. He hoped to obtain absolute returns during the pending bear market by using the bonds as an uncorrelated asset. The strategy worked. Financial Advantage, his Columbia, Md.-based firm, garnered 8.2 percent, 4.8 percent and 3.0 percent returns over the next three dismal years.

Now the landscape has changed radically, and the Federal Reserve has less room to lower interest rates. Martin recognized he must develop new strategies to protect his clients' assets. So three years ago he decided to use short index products in his own account for a year, as a trial to hone his experience. "Everything is opposite" with such an approach, he realized, "and it takes a long time to build that into your instincts." It also turned out to be painful during the bull market then in force. Nonetheless, the exercise did sharpen his instincts and taught him how these short index products perform.

When volatile market environments lead wealth managers to implement new techniques for hedging portfolios, it is essential to begin by assessing the goals and personal profile of the individual investor. Age and investment horizons are critical for determining the stomach for volatility. Tax considerations vary, and many of the new hedging tools can help wealth managers avoid unwanted capital gains.

Some of the strategies work best on a temporary basis, while waiting for a storm to blow over. "Over the long term you want exposure to equities and fixed income, but short-term markets can be irrational, and investors may have immediate liquidity needs," explains Michael Dellapa, director of investment research at Rydex Funds. If markets appear extremely over- or under-valued, some market timing may be in order. Martin, for instance, only uses inverse funds when he considers the indices to be in the top 20 percent band of his overvaluation range.

Increasingly, wealth managers are declining to accept the conventional wisdom that it is preferable to weather the storms and disregard the bumps in the road. "Although we rely on an assumption that the U.S. markets will always recover, we must face the fact that there have been fundamental changes in how they work and how the global economy is made up," says Bruce Fenton, president of Boston-based Atlantic Financial. He insists that the days of holding 70 percent of assets in U.S. markets, with a buy and hold strategy, have passed. "We are entering a world no one has yet experienced, at a time when it makes sense to use the most sophisticated tools to avoid pain," Fenton says.

Currency Plays

Fortunately, a plethora of new products has been coming to market that allow retail investors and wealth managers to access many of the tools hitherto limited to institutional managers. Currencies provide a good example. "In the last several years, a host of ways has developed for retail investors to hedge foreign assets, besides the traditional forward markets," says Marc Chandler, global head of currency strategy at Brown Brothers Harriman. New electronic platforms, such as Hotspot FX, offer streaming, competitive spreads and liquidity, so clients can trade transparently with leading forex-dealing banks on a level playing field.

"We have also seen an equitization of currencies, with the advent of ETFs--especially for the euro and the yen," Chandler adds. As investors scour the globe for international opportunities, most neglect the foreign exchange risks that accompany every such foray. While U.S. investors have seen spectacular gains in their foreign equity holdings in recent years, much of that tailwind has come from the translation back to a weaker dollar. When and if the greenback reverses, that fickle wind would also reverse. Consider a simple currency hedge: Suppose you are buying a foreign company, such as Siemens, Nokia or Soci?t? G?n?rale. You could spend $10,000 on the foreign security and another $10,000 on a short euro ETF, which would totally eliminate your foreign exchange exposure.

Inverse Funds

Another popular tool, inverse funds rise or fall in direct opposition from the market and often employ leverage to produce a multiple of the relevant risk or return. In his main portfolios, Martin uses a 5 percent hedge, consisting of a 2X inverse on the Russell 2000 and a 2X inverse on the Nasdaq 100--evenly divided. In total, the leverage adds up to a 10 percent hedge. While those funds trounced the S&P in the first months of 2008, a trading pattern that has emerged recently can affect their use. "Often," Martin explains, "the averages have looked disastrous in the morning, yet recovered by day's end." Inverse funds, of course, move on the opposite path.

Rydex launched the first such fund in 1994, targeting the S&P, and followed with a suite of similar products that tracked the Nasdaq, Dow and Russell averages. In 1997, Direxion Funds and ProFunds came out with bear funds of their own. Subsequent fixed-income products enabled investors to hedge against duration risk, narrowing spreads for high yield bonds, or rising long-term yields. Ironically, the latter usually occurs when economic conditions improve. "If the market heats up, and we see inflation, that drives the long end of the curve," Dellapa explains. Which investors should be concerned about that happy scenario? Consider those who are holding adjustable rate mortgages, which are at risk for substantial rises when they reset.

Wealth managers may well wonder about the advantages of inverse funds. Why not just short ETFs instead? One reason is that individual investors pay higher rates to borrow shares for shorting than do institutions. Second, the funds adjust the positions on a daily basis, so they are always one- or two-times short the market. If you were to try to do this alone, you would be constantly rebalancing! Moreover, an account may not allow for shorting, or the short security may not be easy to borrow.

On the other hand, Martin points out, "None of these products is quite as transparent as I would ideally like." In addition, the fees are much higher than those for ETFs--ranging from about 1.5 percent to 1.8 percent.

Options

Options are hardly a novelty, since their history dates back to ancient Roman speculators. But we have come a long way over the past millennia in refining these tools that permit investors to "tiptoe into the stock market, without taking all the risk," as Vic Schiller, president of Fresh Brewed Media, puts it. Schiller's Charlottesville, Va. firm provides subscribers with a daily model to identify optimal option trade and risk positions--sparing them from complex spreadsheet calculations.

Various motivations prompt investors to use options. Many like them because certain options strategies produce dividend-like income from stocks that do not pay dividends. Although the U.S. equity market has been essentially flat over the past decade, investors who have been using options have continued to make money. Moreover, writing a covered call brings down the cost basis of the investment while "juicing up" the dividend rate, Schiller says. That may mean a yield of, say, 3 percent versus a normal 2 percent for a given stock.

Frequently, clients may already hold a position and want to take some money off the table without actually selling. Perhaps there is a need for immediate cash. Or the stock may still be exhibiting upside potential which cannot be easily timed--it might happen next month or next year. Alternatively, the basis may be so low that the client faces a huge potential capital tax gain. He might even be an insider and thus prevented from making sales.

Keep in mind that one disadvantage of options is that for tax purposes they are treated at the taxpayer's highest income tax rate. Yet even from the tax standpoint, they do offer a benefit. Since the government limits the amount of money that can be sequestered each year in retirement accounts, options provide a method for squeezing in more cash, such as that generated by covered calls.

As noted above, in recent months afternoon market 'fades' have proved challenging to options investors. That trend could easily reverse, posing yet another dilemma for wealth managers. On days when markets open strong, and then flag, managers can quickly lose dollars for customers shortly after a purchase. "When planners are cherry-picking stocks, options allow them to say, 'We're in this for the longer term,'" Schiller says.

Structured Products

Like options, many structured products trade away some upside potential in return for a cushion of protection. These products can include any type of hybrid, designed security and can reference all sorts of variables--such as equities, interest rates, commodities or currencies. The instruments usually extend for approximately 18- to 24-month periods. A typical structure might return up to 100 percent, capping out at around 150 percent to 200 percent. On the downside, holders might get a protective buffer band of about 15 percent. While taking some risk off the books without actually selling out of equities, users can continue to maintain their optimal portfolio allocations.

These capital protection products first became popular in Europe, but are now making inroads in the U.S. The Securities Reform Act, which took effect in December 2005, proved a vital catalyst. The legislation permitted distributors to market the products with their own brochures, rather than handing out a prospectus of 90 pages or more. Several large European banks with already established structured business began to explore how to translate their expertise across the Atlantic.

"Investors who are five years away from retirement may want to remain in equities, while limiting the downside," says Chris Warren, managing director and head of structured products at DWS Scudder Distributors. In a low-interest-rate environment, wealth managers and their clients are looking for enhanced investment opportunities. "Stocks and bonds, with their linear returns, work well for wealth accumulation. They can't deliver the shaped returns of structured products, which give full or partial principal protection," he notes. The payout rates remain simple and transparent--whatever happens to the underlying market or basket of equities.

Portfolio Strategies

Diversification is one of the most basic techniques for hedging investment bets, as every planner knows. Since Harry Markowitz first proposed modern portfolio theory in the 1950s, it has been clear that if you are totally diversified, you will be hedged against all non-market-related risk, but will enjoy no excess returns. In other words, you can buy the total market by indexing the Wilshire 5000, in combination with an international index fund. Doing so, you can also cut down dramatically on fees.

Most wealth managers maintain that clients' overall portfolios should include non-correlated assets such as commodities, real estate, or foreign equities and bonds. It is not so easy. Unfortunately, most foreign markets tend to correlate more and more; commodities run in cycles and produce no income stream.

Diversification theory has been sadly perverted, according to Michael Edesess, author of The Big Investment Lie (Berrett-Koehler; 2007)."The hedge fund sales mill claims you can reduce your risk by adding uncorrelated assets," Edesses told Wealth Manager. "But if these assets have a zero rate of return, such as currency futures, you will diversify at the expense of reducing your returns." In other words, lack of correlation per se is not sufficient. You could add in wagers on this year's presidential election; they would be uncorrelated, yet give no positive expected return.

What managers can do is to rebalance regularly and make volatility their friend. You can even hedge by changing your asset mix dynamically. Imagine that you are in Las Vegas with $200 in your pocket to gamble, but must keep $100 for your fare home. You might start by making $10 bets. If luck goes against you, you might need to reduce the size of your bets to a dollar or fifty cents as you get closer to your floor. Similarly, if a losing market is wearing clients' capital down, a simple strategy can be applied to alter the equity/fixed-income mix.

Investors turn to market-neutral hedge funds in the hope that they will boost returns with diminished risk. That attempt relies on the dubious notion that stockpicking expertise actually exists, and--per Edesess--going short can offer an advantage. "If the market is efficient, all you are doing is neutralizing every purchase with a sale," Edesess says.

Hedge funds can make out a better case for themselves if they pinpoint their expertise and then hedge against fluctuation of the variables they cannot predict. "To the extent clients feel compelled to invest in hedge funds, those are the ones to look for," Edesess advises. In the search for true diversification, one might do better to seek out private opportunities--starting a business of one's own, or investing in an enterprise owned by someone who is trustworthy.

Vanessa Drucker, who used to practice law on Wall Street, wrote about volatility in January's Wealth Manager.

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