As investors, we all want to “buy low and sell high.” That’s easy to understand in principle, but very difficult in practice. Why is this so difficult? The answer is simple. For the average investor, 80% of investment decisions are based on emotion. As human beings, we are wired to be bad investors. Investors often follow the herd mentality of buying and selling. We buy when we are euphoric and markets have experienced recent success (the point of Maximum Financial Risk), and sell when financial markets are experiencing stress and volatility (the Point of Maximum Financial Opportunity).
How can people battle their inner demons to become more disciplined investors? The traditional strategies of proper allocation, diversification, rebalancing, and index investing have, and will continue to be, core strategies for success. These traditional portfolios consist of stocks, bonds, and mutual funds, which provide linear returns. Linear return refers to the 1 for 1 relationship of the return path with the performance of the referenced asset. Investors participate 1 for 1 on both the upside and downside of their stock investments. What if one could include shaped returns to complement these traditional, linear investments?
Shaped returns for Growth
Designing a shaped return is all about give and take, managing greed and fear. Imagine making an investment in an index where the investor will not absorb the first 20% of the downside move, and will also earn an enhanced return on the upside. “Too good to be true,” you say. Well, this is how it works. Institutional firms can manufacture an “Outcome Driven” note with embedded downside protection and enhanced upside by creating an investment linked to the lesser performing of two equity indices. For example, over the next 3 years, investors will receive 1.8X the lesser performing return of the S&P 500 and the Eurostock 50, while the first 20% of the downside capture is hedged from loss. If the index is down more than 20%, the loss from there is 1.25:1. Let’s look at some scenarios based on 3 year price returns:
There are many different structures that firms may use to express their market views. For instance, there are strategies designed to adhere to the following investment thesis (we call these Outcome Driven Growth Strategies):
Thesis: Deliver a higher probability of high single digit to low double digit annual returns in a rising equity market, but reduce or eliminate downside capture in a falling equity market.
How it works: Investors are willing to sell away the “excess return” over a stated period of time in exchange for an enhanced return and embedded downside protection. An example would be a 24 month note linked to any index, let’s assume EFA, the developed international ETF. Investors would receive 2X the upside price return of EFA, not to exceed 24%, and they would completely hedge away the first 10% of any downside index movement over the term of the note. Let’s look at a few scenarios:
EFA return = 10% Note return = 20% (10% multiplied by 2)
EFA return 28% Note return = 24% (Reached max return)
EFA return -11% Note return = -1% (11% loss minus the 10% hedge)
The Investment Vehicle
The investment instrument used to deliver this shaped return is referred to as a structured note. Structured notes are issued by major investment banks such as JP Morgan, Goldman Sachs, and Credit Suisse. Simply stated, they are a combination of a zero coupon bond and options strategies on the represented underlying index the investor intends to track. There are a few key risk factors that investors need to understand. They are credit investments at their core, so the main risk is that investors will need the issuer to be solvent at maturity. The notes look like corporate bonds on custodial statements and may be traded on a smaller secondary market, but it is generally best to hold these to maturity. Our firm tends to use maturities ranging from 13-36 months, but it is possible to create much longer durations.
A complement to Traditional Asset Management
The traditional, time tested principles of asset management continue to be relevant today. It is important to build prudent risk adjusted portfolios with varying asset classes and periodically rebalance the portfolio to maintain the appropriate allocation. We believe it is prudent to use shaped return strategies to complement the long only equity investments in a portfolio. Narrowing the range of returns through outcome driven investments and blending these strategies with traditional long only strategies should naturally create a smoother return path.
Disclosures: Cornerstone Advisory, LLP, is registered as an investment adviser with the SEC. The firm only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. Registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the adviser has attained a particular level of skill or ability. Information presented does not involve the rendering of personalized investment advice and should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client's portfolio. Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. There can be no assurances that an investment or portfolio will match or outperform any particular benchmark. Examples should not be construed as representing the performance of Cornerstone Advisory, LLP, or any of its advisory clients. All returns will be reduced by advisory fees and other expenses.