In today’s market environment, one of the smartest moves an advisor can make in their client’s portfolio construction is to “own volatility.” What do we mean by that?
First, let’s think about what a client is trying to accomplish: pursuing or preserving the comfort that comes with knowing their expenses can be met for life and hopefully beyond.
But let’s say a couple is fortunate enough to save $2 million by age 65. If they plan to spend $100,000 per year, they’ll need to invest or their savings will be completely gone in exactly 20 years. The “safe” choice is government bonds, which may yield 2% per year — if the client is willing to lock it in for those 20 years. An advisor can offset some of the inflation and taxes that eat away at purchasing power, but what if the client lives longer, has unexpected expenses or wants to leave money to their family?
Owning equities is a must for this couple. But what about the risks that come with owning stocks, i.e., losing money. How do we balance the opposing risks of longevity and drawdown? A 60%-40% allocation of stocks and bonds has been the default setting for a so-called balanced portfolio. But really, it’s not balanced. The ups and downs of the stock market mean that even with 40% in bonds, virtually all of a portfolio’s movement is tied to what the stocks do.
Is your client comfortable banking on stocks only going up? If their earning years are behind them and they have no new deposits to make, the excess movement reduces their compounded return, and 30% to 50% market drops trigger a range of emotions. Market corrections hit hard once you retire. Forget about growing; substantial gains are needed just to recover losses.
Make volatility your ally
So what choice do you present to your clients? More bonds to smooth out the ride? More stocks to make up for the drag of today’s low bond yields? A stash of cash to buy into the next big drop?
We think there is a better way to tackle this: own the stocks, and own some volatility. Own volatility as an asset class to go with (fewer) bonds and (more) stocks.
But how? We think the answer is put options, which give the client the right to sell the index at the chosen strike price versus a call option that gives them the right to buy it. While a call option is designed to participate in the upside, a put option is designed to rise in price when the market falls. Consider it a form of insurance, providing a hedge against falling stock prices. Now if stocks rise, your put options will fall in value, but in the right proportion, those stocks would help your portfolio rise by more than when the options fall.
How do options help?
With put options, the goal isn’t to prevent portfolio value falling when the market falls, it’s to prevent a rise as well. But by owning volatility, you cushion it, and the great thing about a put option is its limited risk and unlimited upside known as asymmetric payoff potential. Buying an option for $1,000 means we can lose up to $1,000, and not a penny more. If it pays off, we can make multiples of that $1,000. That potential payoff comes with a low success rate, but so does hitting a baseball, where a 30% hit rate gets you in the Hall of Fame.
How much do we need?
Let’s remember that we use these options to improve the portfolio, not because we want to speculate on every market move. Because the potential payoff is asymmetric, we need just a small sliver of this asset to accomplish our goal of reducing drawdown. Done efficiently, we see no need to have more than 2% of a portfolio dedicated to this.
What are we giving up?
As a responsible advisor, you’ve explained to your client that there is no free lunch. Allocating to put options means pulling it from something else. In today’s environment, in our view, that’s bonds. But with rates as low as they are, we actually see that as a benefit.
Still, options do cost money. Allocating 2% of a portfolio to put options is diverting to something that decays a bit every day, quite possibly on its way to a total loss. That said, 1) we don’t just sit on the options and let them expire worthless, and 2) If a put option drifts towards zero, it’s a safe bet your stocks have helped your portfolio nicely.
Why?
Now that we’ve covered the mechanics of buying volatility as an asset class, let’s try to be crystal clear on why we do it.
- Reduced reliance on bonds: We don’t like the return potential and aren’t convinced of huge diversification benefits from these low rates. You can make the case that “safe” bonds can reduce portfolio volatility, but they also reduce potential return.
- Freedom to own more stocks: By owning volatility, we can confidently adjust our asset allocation to own more of the asset class with actual potential — equities. Stocks might currently be expensive and may not repeat the gains of recent years, but owning a broad set of businesses with the ability to raise prices is the best inflation hedge going, in our opinion.
- Dry powder in sell-offs: Not only can we move some of our bond allocation over to stocks to increase the potential long-term return, we can use the put options with the goal of creating what everyone wants in a correction — cash. We’re not going to just watch our 2% of options become 6% and do nothing. We’re going to calmly adjust our hedges back to the target weight and make that cash available for redeployment into stocks. Something about buy low, sell high?
Theory into practice
There was a time when implementation of such a plan beyond a household or two would have been impossible. Thankfully, the ETF structure has made it possible to deliver these portfolio enhancements simply and efficiently, opening the opportunity for individuals to more comfortably pursue their goals.
We think leaning on the benefits of traditional asset allocation makes sense and we just happen to believe that ultra-low interest rates dictate some flexibility of thought. By taking a sliver of the portfolio and allocating to volatility as an asset class, investors can transform a “buy-and-hope” approach into a more sustainable, confident approach to financial independence.