Close Close

Portfolio > Portfolio Construction

From Lost Stock Decade, an Asset Class Is Born

Your article was successfully shared with the contacts you provided.

Consider this example: In January 2000, a 50-year-old client had $2 million, and his retirement was looking reasonably secure. But by 2002, if he was lucky, he’d only lost half his nest egg. By the fall of 2006, again if he’s lucky and had a good advisor, he’d climbed back to $1.7 million or so. Then, by April 2009, he’d lost another half and was down to about $850,000. Today, his portfolio is back to nearly $1.3 million, but his prospects for an early retirement have vanished—and his future isn’t looking nearly as bright.

These days, every financial advisor is familiar with this scenario, regardless of their personal experience: As clients approach retirement age, their time frame for riding out major market corrections shrinks, exposing the flaw in traditional asset allocation. In fact, the entire advisory profession is wrestling with the problem of what to do about it. While there are a number of strategies that purport to offer a solution, until recently, none have convincingly overcome the likelihood of actually increasing risk rather than reducing it, or the potential for adding substantially higher costs.

Sure, you can limit risk by reducing exposure to equities, but in the current ultra-low interest rate environment, portfolio growth will slow to a crawl, requiring the downward revision of many retirement plans. What’s more, with massive global debt levels nearly a lock to drive interest rates up, bond holdings don’t look nearly as low-risk as they used to (it was recently pointed out to me that when interest rates go up 1%, long-term bond values fall in the neighborhood of 19%). That leaves moving aging clients into all cash, which, after any inflation, means dwindling portfolios; that doesn’t bode well for rosy retirement plans either.

Another option, of course, is to try to “time” market downturns through strategic or dynamic asset allocation, a direction in which many advisors are turning, or at least exploring. The problem with this solution is that myriad studies and loads of anecdotal evidence suggest that even if such timing is possible, success on a regular basis requires such a specialized talent that its use for managing retirement portfolios on an industry-wide basis seems irresponsible.

That leaves us with hedging strategies: using sophisticated financial instruments to limit the downside exposure of equity or debt holdings. We know that large institutional investors have used hedging strategies to manage their portfolio risk for years, often quite successfully. Yet, the relatively high cost of both the hedging vehicles themselves and the expertise to use them effectively has prohibited their use in all but the largest retail portfolios. At least, that’s been the case until recently, when the explosion in the size of the retail retirement market combined with its huge demand for better risk management, has motivated the financial industry to make hedging tools more affordable.

I recently discovered just how far this trend has progressed when I was introduced to Harry Clark, founder and CEO of Clark Capital Management Group in Philadelphia. A 40-year veteran of the financial services industry, Clark founded CCMG 25 years ago to manage retail portfolios. It wasn’t until the mid-1990s that he began to feel uncomfortable with increasing market volatility and started to look for better ways to manage portfolio risk. It was during this time that he realized volatility itself could be thought of as an “asset class” and therefore managed within an allocated portfolio. But the cost of hedging strategies was a major limitation.

CCMG’s big break came when Clark’s theory was put to the test in 2001. “The dot-com crash was a big turning point for us,” he remembers. “Both because even back then, our portfolios did better than most; and because in the aftermath, a growing number of more sophisticated risk management products were introduced into the retail marketplace.” During the recovery of the following decade, the firm became a TAMP and focused its business on managing assets for clients of independent advisors and on other TAMP platforms, increasing its assets under management from $500 million to $3 billion today.

For CCMG, the most notable development of the new millennium was the creation of the S&P 500 volatility index, or VIX, in 2004 by the Chicago Board of Options Exchange. The following year, Standard & Poor’s launched a pair of VIX futures indexes: the S&P 500 VIX Short-Term Futures Index (SPVXSP) and the S&P 500 VIX Mid-Term Futures Index (SPVXMP). “Being able to use the contracts on the VIX is a major step toward making hedging strategies available to retail investors,” he said. “We actively manage them—holding them when the market is trending down and selling them for additional profits when it’s trending up—which has reduced our cost of hedging substantially: from about 5.5% a year down to around 3.5%.”

The VIX is an effective hedge against equity risk because of its low correlation to the S&P 500 Index. According to Morningstar Direct, the VIX correlation with the S&P 500 from Jan. 1, 1996, to Sept. 30, 2011, was -67%. A look at Figure 1 (see left), which shows a graph of the monthly movements of the S&P 500 versus the VIX, reveals that while their magnitudes may vary, the VIX moved in the opposite direction of the S&P 500 (up or down) in 63 out of 69 months from January 2006 through September 2011.

Still, 3.5% a year isn’t an insignificant cost for a retiree’s, or a pre-retiree’s, portfolio, which raises the question that all hedging strategies need to answer: Is reducing the risk really worth the price tag? The answer depends on the hedging strategy in question, and even more importantly, on the investment manager’s ability to use that strategy effectively. In the case of CCMG, a look at how its strategies performed during the subprime meltdown provides a pretty good answer.

For instance, from September 2006 to September 2011, the S&P 500 had a cumulative return of 2.27%, or 0.39% annually. Its biggest single-quarter loss was -21.94%, and it had a maximum drawdown of -50.94%, from which it did not fully recover during this period. At the same time, CCMG’s Global Equity Hedged Model Portfolio returned a total of 46.8%, or 6.95% annually, with a worst single quarter of -9.15% and a max drawdown of -28.35%, from which it fully recovered in less than two years.

To put these figures into perspective, if the 50-year old client in my initial scenario had his $2 million in the Global Hedged Equity Portfolio with similar results, he would have only lost $500,000 in 2001, another $850,000 between 2007 and 2009, and ended up with slightly more than $2 million today (some 50% better than he would have done in the S&P 500)—and his portfolio would have survived a pretty rough decade intact, despite the cost of hedging. For clients at or near retirement who can’t afford to take another major hit to their portfolios, the peace of mind from this kind of hedge could be invaluable: particularly in the increasingly uncertain times in which we find ourselves today.


© 2023 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.