As the US stock markets have done well for the past 8 years, many investors wonder if their portfolios are positioned well for potential market corrections. Though it is impossible to predict the future, expecting volatility in the coming years is a safe bet. Market volatility is normal, and feeling uneasy about a lower portfolio value is normal too. Historical analysis shows that pullbacks of 5% have occurred about once a quarter, and pullbacks of 10% are likely to occur once per year. Large pullbacks greater than 20% tend to occur just once per market cycle. It is especially important to be mindful about how to dampen portfolio volatility in the later stages of the business cycle.
With the memories of large losses in stock markets in year 2008 when S&P 500 Index lost 38%, many investors feel like allocating more to bonds and cash now to reduce volatility of portfolios. However, while bonds are part of a diversified portfolio, bonds are not paying much interest and the value of bonds tend to go down as interest rates are likely to increase in the future. Money market funds are earning less than 1% and are not likely to provide returns exceeding inflation. At Echo Wealth Management, we have considered various alternative strategies to reduce equity risk and have implemented three equity alternative strategies in our client portfolios.
One of the equity alternative strategies is hedged equity strategy that can hedge against equity’s downturns in order to help investors stay invested by avoiding the emotional mistakes of getting out of the stock markets near the bottom. This is not a hedge fund (with tax form K-1), it is a liquid equity alternative solution that is engineered to be constantly hedged.
Downside protection: This disciplined option overlay is combined with an enhanced index portfolio. Buying puts at 5% below the investment and selling puts at 20% below this investment aim to limit declines in this investment to a negative 5% in any given quarter (capped at negative 20%). So if the investment declines 16% in one quarter, this investment is only down 5%. To generate additional cash flow, calls are sold at 3.5% to 5% above the investment price that allows this investment participate in about 3.5% to 5% upside in any given quarter. While this is riskier than a bond, it has much more upside potential and it is not sensitive to interest rates.
Options are used for risk mitigation, not leverage: Options can be used to reduce losses or enhance return by leveraging. This particular strategy does not use leverage to enhance return. Its main goal aims to provide significant downside hedge by forgoing some upside potential using index options. Its target beta is 0.5 that has about half of the volatility of S&P 500 Index.
No market timing, constantly hedged: Despite an average intra-year drop of 14.2%, the market ended the year higher than it began 76% of the time according to S&P 500’s calendar year return every year since 1980. Frequent pullbacks in the market can be unsettling, and can encourage market timing, but investors should not jump ship. A fully invested portfolio would have returned nearly double one that missed the 10 best days in the market in the past ten years (7.68% annualized return fully invested vs. 4% annualized return if missing the best 10 days) according to S&P 500 performance between January 1, 1997 and December 30, 2016. Therefore, work with your advisor to choose the risk level you are comfortable with to design your customized portfolio by using various strategies including hedging, then do not try to time the market. This hedged equity strategy in our client portfolio has risk profile similar to 60/40 balanced fund.
As you can see, there are many ways to manage risks of portfolios to enhance risk-adjusted rate of returns. In general, we tend to target 10-20% allocation to liquid alternatives such as this one in addition to using long-only equity (40-60%) and fixed income (10-40%) considering clients’ time horizon, willingness and ability to tolerate risks, tax brackets, and investment experience.