03/02/2015

Cake, Ice Cream and Protection

The other evening my wife and I had a couple over for dinner. Over the course of the evening we got to discussing what my company’s indexes, the Nasdaq Exceed index family, were created to do. My nine year old daughter piped up and said “explain your products in terms of cake and ice cream.” I decided to take on her challenge. I explained that imagine she had this delicious piece of cake and she was about to eat it but it fell on a dirty floor. With our product, I explained, you would lose a sliver of that cake but would still be able to eat a lot of it. However, in exchange for that protection, even if that cake did not fall, she would have to give up a little of the cake to protect it from calamity. While the adults around the table were impressed with the analogy, my daughter, less than satisfied, asked me what happened to the Ice Cream?!

This true story provides a segue into how I came about developing the index family.

Protecting against the downside is a staple of the modern world – life insurance, health insurance, house insurance, and car insurance are all examples of products which insulate us from the “slings and arrows of outrageous fortune”.  However, “stock market” insurance is not readily available, as investors are reminded once or twice every decade.

One classical form of market insurance is putting a portion of investments into more conservative asset types, such as buying bonds. However, that keeps a substantial portion of appreciation potential on the sidelines, especially in a lower interest rate environment.

Nowadays, there are many equity investment products that are meant to keep those assets productive while still controlling for downside exposure. Most of those products look to mitigate risk through either market timing (i.e., knowing when to move assets out of equities and into other assets such as bonds or cash) or by investing in equities that exhibit lower volatility and/or lower beta (e.g., smart beta).

Using a boat as a proxy for one’s nest egg and analogizing a market crash to a hurricane, market timers would assume they could get the boat out of the water in time and to a safe place, not necessitating Hull insurance (which covers hurricane damage). Barring perfect weather predictions, that strategy may at times cause the market timers to exit when they don’t need to and potentially stay in when they should have left. Alternatively, the lower beta solution is to buy a bulky clunker of a boat – which offers some protection but hardly immunity from natural disaster (e.g., see the Titanic).

The most elegant solution is to do neither of these strategies but instead buy insurance on your boat (like the owners of the supposedly “unsinkable” Titanic did), with the understanding that the annual premium will go to waste if there is no disaster. However, you don’t lose sleep or performance through market timing mistakes and you don’t have to sacrifice the quality of the boat you purchase.

There is a stock market analogy to the insurance, which is using option strategies.

Buying a downside put on the market can effectively protect the nest egg from downward spikes, at the expense of an annual premium which is wasted if the market doesn’t spike down. That “stock market” insurance path sounds a lot more appealing to me than the other protection methods discussed.

However, obtaining this sort of option driven protection is not for the novice. Options are complex, expensive, and very powerful.  Deciding which options to purchase, at what price, and on which underlying securities takes a serious understanding of markets and a significant amount of time, which is why outsourced options solutions make the most sense for many investors.  (See my blog on this topic for greater detail).

Exceed was founded to use option strategies to provide investors with more definition and control. While our products are slightly more complex than the cake protection I described to my daughter, the concept is similar.

One major feature of our products is that rather than require investors to pay a premium for protection, we instead cap upside performance to cover the cost of the downside protection.

Here’s an example – the Nasdaq Exceed Protection Index provides exposure to the S&P 500 with several benefits:

  • Significant protection from market downturns through our portfolio of defined outcome investments, each of which targets annual minimum 87.5% protection against downside performance
  • Historical performance demonstrates significantly reduced volatility relative to both the S&P 500 and minimum volatility indexes
  • The combination of targeted protection from downturns and reduced volatility has led to superior risk adjusted returns in backtested studies when compared with the S&P 500 and minimum volatility indexes

To cover the cost of the protection, we cap upside performance at approximately 15% annually.

Read more about the index here.

 

“DISCLOSURE: Performance figures shown in this blog are for the specified indexes only and do not represent performance by Exceed Advisory or any of its clients. Past performance of an index is not a guarantee of future results. There can be significant differences between the performance of an index and the performance of actual investment portfolios, even when those portfolios intend to mirror the indexes.”

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