For many affluent clients, the drive to preserve capital is
stronger than the need for growth, so low-risk hedging strategies with some upside potential become very attractive. Pre-packaged options strategies, such as structured notes that offered principal guarantees and upside potential of an index, provided one path to relative peace of mind.
Then came the Lehman fall--and the less attractive underbelly of its popular structured notes became apparent. Investors discovered that with Lehman Brothers their principal guarantee was only as good as the firm was solid. Lehman being a credit risk was not something most people considered a significant issue before 2008. "The counterparty risk is really what caused the seismic shift in people's interest in replicating structured notes instead of just buying them off the shelf," recalls Robert Gordon, CEO of New York-based Twenty-First Securities, which works mostly with wealth managers, family offices of HNW individuals, and financial institutions.
"An awful lot of investors had been buying structured notes as a way to get involved in the market," observes Gordon, who also serves on industry boards and teaches at New York University. "They wanted a seatbelt. The structured note is a piece of paper you buy that says a bank guarantees you your money back and you get some upside in the market. We suggest that clients would be a lot better off not buying the structured note, but to actually buy the pieces that make it up, such as the options themselves."
Beyond Structured Notes
Gordon looked at the structured note to determine how to build a principal guarantee that wasn't exposed to Lehman-like credit risk. He broke it into the two pieces. First, for example, he could buy a zero coupon bond guaranteed by the U.S. government, so the principal is guaranteed by the government, not the bank that issued the note. Second, he could buy a call option on the S&P 500 to give the solution an upside potential. The call option is listed, so it trades openly on the CBOE and is guaranteed by the Options Clearing Corp. By assembling the components, rather than buying an off-the-shelf package, the investor ends up with much better counterparties. If an advisor assembles the package, the client also saves on structured note commissions.
Taxes are another reason to assemble your own solution. With a structured note that has a principal guarantee, any payments caused by the market going up will be taxed as interest so the income tax rate applies. If an investor buys a call option on the market, any increase in value is taxed at the more attractive capital gains rate (attractive at the time of this writing, at least). This approach to using options directly is also more transparent, notes Gordon. "You can pick up the newspaper and see what the price is, versus being dependent on your end-of-the-month statement and the dealer assigning a theoretical value for a structured note," he says. "The zero coupon bond and the listed option are publicly traded, so they will always have a posted price. For all of these reasons, we tell people that they if they like structured notes, build them themselves.These payoff patterns are a safer way to touch the hot potato."
A Planned Return Strategy
Mitchell Eichen is a fan of this approach to using options for what he calls a "planned return" strategy. He believes that it's a much better alternative to the structured products for his holistic wealth management firm The MDE Group, in Morristown, New Jersey, and for its clients, who are mostly active and retired senior corporate executives and high-net-worth individuals.
In terms of the portion of a client's portfolio devoted to a planned return strategy, Eichen would first look at the part of the portfolio the firm is allocating toward equities for the client. The typical portfolio is between $7 million and $9 million, with several topping $100 million. The equity allocation is between 20% and 40%--and of that amount, up to 15% is directed to the planned return strategy.
"We think it's a much lower-risk bet than a pure equity portion," notes Eichen. "It depends on your outlook. If you're a mega-bull, you would never do this because you'd be capped out. But if you're not a mega-bull and you want to sleep a little better at night, and you don't want to worry about every tick to the downside, especially if you lost a lot of money last year, this approach enables you to sleep pretty well at night and know that--even in a mediocre year--you'll earn a halfway decent return."
While MDE now uses Gordon's Twenty-First Securities Corp. as its broker/dealer to execute options trades, Eichen's firm had previously bought bank notes from a select group of banks, using a portfolio construction process where it had no more than two notes with a given bank over a 12-month period. "But we stopped doing it last September after Lehman--when the banks went into disarray," notes Eichen. "We didn't lose any money on any banks' notes. The payouts delivered because we also had gearing to the downside. We generated alpha on each note, which again was a lot better than the long-only portion of the portfolio."
After Lehman, the firm didn't do anything with bank notes--the markets were just in too much disarray and it didn't want to take on any more bank credit risk. The firm decided to do the options strategies on its own. "I think we can do a better job than the banks in structured products because we can do it at a much lower cost basis," states Eichen. "We have much more control. We're taking a zero credit risk vis-?-vis bank-specific risk. We're able to structure any return pattern we want, and we can do it on any underlying entity and on any underlying index that has material liquidity."
Eichen finds that his clients like the planned return strategy because the options create a degree of certainty--unlike a long-only investment or even hedge-fund investments. "People invest in hedge funds for absolute returns," he observes. "Last year, some of the greatest hedge funds got clobbered and some of the big-name guys put stuff inside of their hedge funds that didn't belong there. And they got stuck. That's not going to happen here. What we do is completely transparent." If a client wants out, the investment is completely liquid because you can sell the underlying index, which is an ETF. The options also trade daily. Normally, clients shouldn't dissolve the strategy early since there's an inherent time premium cost in every option.
Constructing a Strategy
Every two weeks Eichen's firm places a new strategy examining different indices and their liquidity. It's executed as a block for a group of clients. For example, the firm will then buy a long position in the S&P 500 and determine how much of a loss it wants to buffer, such as not losing anything on the first 12% of decline. That becomes the anchoring assumption for building this model--the firm usually anchors on the amount of loss it's willing to take, not the upside potential. Then, Eichen and his associates do the math to figure out how much upside they can achieve at what kind of multiple. The firm runs many variations of each strategy, examining one structure versus another to count the potential benefits and drawbacks.
"Usually, you have to have a point of view going into this," notes Eichen. "Our point of view is that markets are going to be at best a 'nine,' with some potential for decline over the near term. We're not looking for a 30% runaway market. We want to create the highest probability of getting a high single or a low double-digit return. So, if we use a 12% anchoring downside, we can earn--over a 52-week period--twice the return of the S&P, subject to some cap. The cap will vary depending upon market conditions, mostly notably the VIX index. In today's market, you're getting a cap somewhere between 10-and-a-half to 12-and-a-half."
Eichen sees a strong advantage over hedge funds. "People invest in a hedge fund for absolute return," he observes, "not to knock the lights out and not to lose any money. So in this example, we know with a matter of certainty that, if the market is down less than 12% over any given 52-week period, we won't lose any money. You don't know that in a hedge fund."
Lewis Schiff is the principal of Advanced Planning Group, a private wealth specialist for advisors and their clients and author of The Middle-Class Millionaire. He can be reached at firstname.lastname@example.org.