Written by: Karan Sood, CEO Cboe Vest
Retail investors want three things: asset growth, liquidity at specific points of time in the investment lifecycle, and protection against losses when they capitalize on that liquidity. It doesn’t sound unreasonable, does it? Yet the way that most retail investor portfolios are constructed leaves the investor with serious blind spots.
The traditional approach advocates building a diversified portfolio of asset classes, based on the investor’s risk tolerance. Sounds great, on paper.
However, when analysts evaluate investments for inclusion in portfolios, they use conventional metrics such as annualized return, volatility (e.g., standard deviation), and correlation of returns, none of which account for liquidity timelines and protection against losses that match those timelines. Take volatility as an example. It is used as a key theoretical measure of risk. However, it disregards that the possibility of losing money—or having less of it when needed—is the real and absolute measure of risk. While the two measures are related, the traditional approach assumes them to be the same thing.
It is not surprising then that techniques devised to reduce volatility may fail to reduce risk. The volatility-reducing power of diversification, once hailed as the Holy Grail, failed spectacularly twice in the last decade—in 2001 and 2008. At both those times, numerous asset classes collapsed all at once. That’s because the extent to which asset classes move together is both dynamic and unpredictable. The sudden high correlation among many of the world’s major asset classes in those times was likely not a rare event, but rather the inherent reaction of ever-more-connected dynamics across multiple markets. Even investors with diversified, supposedly non-correlated investments can experience short-term negative returns more often than expected. And if negative returns occur when liquidity is needed (e.g., for retirement, for children’s college tuition, or for a down payment on a home), the results can be disastrous.
Advisors can help their retail clients skirt this dilemma is by taking a page from the risk management playbook created by institutional investors. Instead of starting with a set of investment choices and choosing which securities are “likely” to deliver the best risk-adjusted return, institutional investors begin with set of goals, each tied to a specific time when liquidity is needed, and use specific risk management techniques to achieve those goals.
Pension funds offer excellent examples. They use techniques known as liability driven investing, which includes using derivatives to manage downside risk while growing principal, so they can meet their obligations to policyholders and plan members with a higher degree of certainty. While diversification is a priority consideration, it alone will not ensure liquidity is available when needed. The contractual and temporal nature of derivatives, such as options, provide a greater level of predictability.
Institutional investors recognize that each asset class has its own unique potential risks and returns. Instead of using an unpredictable and fallible correlation, and volatility matrix of multiple asset classes to get to a desired risk-return profile, they use derivatives to reshape the return distributions of their preferred asset class. Protection-oriented investors may use options to trade extreme upside return for protection against more likely downside. Income-seeking investors may sell options periodically to trade the chance of a higher but uncertain return for more certain but lower periodic payments. And more aggressive investors may purchase options to magnify select parts of the upside returns.
This approach of using options to reshape the return distribution in an effort to achieve higher certainty in investment outcomes, which we at Cboe Vest call “Target Outcome Investing” (and others following in our footsteps call “Defined Outcome Investing”), works equally well for individual investors. Regardless of what it’s called, the approach starts with the investors’ goals and liquidity timeline, and relies on options to mitigate risk and/or enhance growth on securities and provide a greater level of certainty to their payoffs.
Despite their benefits, the time-consuming nature of trading options has been among the top reasons advisors cite for not using them in client portfolios . However, this no longer needs to be an obstacle. The number of options-based mutual funds has risen substantially. In the last 10 years, the number of funds went from fewer than 10 to over 150, prompting Morningstar to create a special category for them.
Not using a risk management approach such as Target Outcome Investing can leave investors vulnerable to price shocks, which can strike suddenly and without warning, whether a portfolio is diversified or not. Consider the risk of an investor simply buying an ETF that mirrors the S&P 500. When the bull market turns bear, as it inevitably will, the investor will have no protection on the downside, and certainly no guarantee that they’ll have the money they relied on if they needed it then. Granted, equity markets are known to go up over the long term. But long term is not everyone’s timeframe.
Outcomes should be defined by the investor’s needs and objectives, and portfolios should be built accordingly. Diversification is important, but doesn’t take into consideration investors’ specific cash requirements at set points in time. And, as we experienced in 2008, an allocation of non-correlated assets may not be enough to protect your clients’ investments in times of market duress. OIC Cerulli Financial Advisor Study: How Advisors Use and Think About Exchange-Listed Options