07/14/2015

PLAYING DEFENSE WITH A CHANCE TO SCORE

The investing world is slowly but surely getting a little scarier as flashpoints are adding to the unease of an already longer than typical bull market. Is there contagion from Greece? What is going on in China’s equity markets?  And lets not forget Puerto Rico’s potential default.

Most investors have pressure to generate returns while simultaneously avoiding disasters. The problem is that without a crystal ball, the only way to generate returns is by taking on risk. There is simply no way around this. “High return, low risk” products brings out the skeptic in me – trust me, there is risk somewhere within the package that is applicable to the return. If the risk is not well understood or seems too good to be true it may be best to simply stay away.

Two interesting recent articles drive home some of this line of thinking and begs the question: what is the best way to play defense while staying in the mix for gains?

In “Generating Returns While Protecting Portfolios From a Crash, published in ThinkAdvisor, an advisor discusses using alternatives to diversify exposure. He is worried about the issues raised above and is looking for strategies less affected by the general equity market. A potential solution discussed is Managed Futures, which have been popular in the past due to their very low correlation with the market. However, as the author noted, they have had inconsistent performance. So while the odds are high an investor would see increased diversification from them, there is less confidence in generating consistent returns.

The second piece focuses on a survey of 420 institutional decision makers conducted by State Street; A primary conclusion is that many participants are not protecting their portfolios enough against potential market downturns. Furthermore, when participants do seek out protection strategies, the study finds that they are not exploring the full range of downside protection strategies available to them. One interesting statistic from the study is that a majority of respondents are using dynamic asset allocation, which essentially relies on the strategy getting out of the way at the right moment (perhaps a crystal ball would be helpful here). Another interesting statistic is that approximately 25% of those polled had used hedge funds at some point but no longer do so, which sends a message that the CALPERS decision not to invest in hedge funds going forward may be a trend rather than an anomaly.

Both publications address a struggle of how to balance many competing factors. For instance, how should one balance the beneficial low correlation of Managed Futures with inconsistent and ultimately unpredictable performance? Additionally, the first article stresses the need to identify the right active Managed Future manager and ensure that the manager is positioned properly for this upcoming market. It seems like a lot of decisions need to be made just right (right manager, right strategy, right timing) to have a shot at an effective solution. Along the same lines, State Street also expresses concerns over too much reliance on investing forecasting skills, particularly when it comes to tactical asset allocation.

Defined outcome investing offers a simplified method to participate in equity markets while effectively playing defense. Perhaps I am jaded from 20 years in the industry but one simply cannot get reward without commensurate risk. Defined outcomes clearly define this balance upfront. For instance, our index based strategy looks to limit downside exposure on the S&P 500 to 12.5% on an annual basis. This comes at a cost. We cap the upside at around 15% annually, a healthy return, to pay for the limited exposure down. Thus, the risk / reward equation is clearly spelled out. If the market drops materially like in 2008, you are spared the heartache, taking a minimal relative loss and nicely outperforming. If the market moves up strongly like in 2013, you will underperform but still generate a respectable mid-teen return. It is clear, consistent and provides investors the clarity they deserve.

With an increasing abundance of market uncertainty, we believe that defined outcome strategies can provide the comfort and relative safety that financial professionals and their clients increasingly seek.

A version of this post appeared in WealthManagement.com