In early September I wrote about the effects of uncertainty on financial markets and investing. There is a high level of correlation between fear and ambiguity, which the recent market downturn snapped into focus. When all is going well, whether in the markets or generally in life, people feel rather good and tend to focus less about what may go wrong in the future.
But when things aren’t going well or as planned, our minds seem to launch a critical review process, whereby we create a narrative and attempt to use that in guiding us to a solution. The worst is not knowing the root of the cause or the solution, or whether it will all get better or worse.
October Swoon Aside, What’s Next for Financial Markets?
October marked the worst month for U.S. markets since the 2008-2009 Great Recession. Toward the end of October, after the Nasdaq led the markets down roughly 9%, a colleague sent me a message from a pundit on one major news channel stating that the stock markets will collapse. My colleague also noted that a few clients had nervously sent it to him asking for advice. In turn, I did a Google search on a market rally and sent him the first article that popped up stating another pundit who believes we will rally into the end of the year. We can all prognosticate but the reality is that the market is so dynamic with many inputs and information. Still, it is simply impossible to know what the future holds for the market.
Source: Yahoo Finance, Jan 1 – Oct 31 2018
Now rational minds can point to strong earnings, low unemployment, and other positive economic data. And I am in agreement that the world is not ending and in fact seems like it is going relatively well for business; this is why the Federal Reserve (Fed) is raising interest rates. The Fed is tightening money supply to both attempt to maintain a reasonable growth and inflation trajectory, while reloading its ammunition to provide support for a possible market downturn.
Let’s face it, we can never guess as to when the next market downturn will happen. Yet, we are currently facing increasing interest rates and uncertainty around trade wars that will likely result in less business spending and stressed balance sheets.
The point is that market direction is ambiguous at best. So now that we are snapped into focus on the negatives of the market what can be done? How have the strategies we are invested in faired? More importantly, what insight do we have going forward? Unfortunately, hedging strategies tend to be ambiguous. And when the market goes down, the fear of the market decline amplifies the discomfort around ambiguity.
Options a Tool in Mitigating Uncertainty
Options are a tool that can mitigate this uncertainty. A put is the right but not an obligation to sell stock at a specific level for a period of time. A put is basically an insurance policy on the underlying security it is placed on. The downside of both a put and insurance is that it cost money to purchase. One way to lower the cost of insurance is to take a deductible. For example, if you have home-owners insurance covering $100,000 of damages it may cost you $500 a year but by taking a deductible of $5,000 prior to the insurance company providing coverage that cost may decline to $300. A put conceptually works the same way in that placing a put at the current level of the market will be materially more expensive than buying a put 5% lower than the current market level.
Source: Hypothetical return profile for (1) stock, (2) at the money put on the stock (3) out of the money put on the stock and (4) combination of stock and put
Two additional disadvantages associated with options create further difficulties for advisors. Options are difficult to use within single accounts due to client sign-off and understanding as well as the need for margin accounts in many instances. Options are also complicated. While options are extremely flexible, it is potentially difficult to put together strategies using multiple options in regards, which strikes to use and what duration to select among other necessary variables that need to be decided.
Using Mutual Funds and Structured Notes to Gain Defined Exposures
Fortunately, one can access option strategies within a number of vehicles. Choices are increasing within the mutual fund and ETF structure and structured notes provide access as well. Generally speaking, open ended product like mutual funds and ETFs may be better suited for models and the ability to provide a swatch of clients a relatively defined exposure to the markets over the longer term. Structured notes, meanwhile, will provide a more defined experience with more flexibility to take advantage of either a curated experience or opportunistic trade or market entry point.
The most recent downturn provides the opportunity to apply both. For example, a structured note may be a preferred vehicle to adjust a more conservative, nervous client’s exposure with either a buffered product, which will provide a level of initial protection down yet still provide participation up. When the market falls swiftly, like October, volatility picks up which allows for generally better characteristics than had been attainable over the last couple of years. Or conversely, for clients that may be more aggressive, it is the opportunity to allocate more capital to equity markets in a more conservative fashion and for a specified period of time.
For investors, this is an optimal time to reassess holdings and decide whether a more defined hedge equity product may be prudent. Either a buffer or shield/collar strategy which uses long downside puts to provide a tail risk hedge are now available in mutual fund wrappers. The strategy can replace a portion of the equity sleeve or placed within the alts sleeve depending on the advisors philosophical approach.
In summary, markets are ambiguous enough on their own. When looking to use hedge products it may make sense to not only reduce the volatility and risk of the downside but also the uncertainty that is unfortunately present in most hedging strategies in the market. Options are unique in their ability to provide certainty to one’s exposure. While hedge-focused mutual funds and ETF strategies using options will lose a little of that definition due their open-ended structure they will provide more definition then most other hedge products in the market.