Discussions about investment strategies are often presented as a debate: it’s active vs. passive. Either you are a Boglehead or you’re not.
But investors are increasingly leaving behind the binary argument in search of next-generation solutions. “Third way” approaches, including smart beta and defined outcomes, are designed to take advantage of the efficiency of index-based passive strategies, while also laying claim to the downside protection and upside outperformance provided by active funds.
Since 2008, there have been huge inflows into index-based strategies, and as the indices have climbed steadily in AUM, so too have returns. Active managers would point out that if the markets had gone sideways or down, they might have been able to bring more alpha to the table. But with low volatility and correlated markets, there have been few opportunities to generate excess returns.
In recent months, however, active strategies have begun to attract more interest. The markets have been a bit rockier, with extended periods of relatively high volatility. Frankly, the bull market is getting a bit long in the tooth, having been on a straight up path for the past six years. Is it time for active funds to prove their worth? Even with somewhat higher fees, they may be poised to outperform.
But a better question might be: do you really have to go from passive to active in order to capture alpha? Investors instead could turn to index-based products that propose more sophisticated strategies than simply tracking a benchmark.
Examples include the ever-growing variety of smart beta strategies such as low volatility funds and liquid alt funds, including some of the hedge replication funds in the marketplace. Tactical and black box strategies can also be utilized to create more sophisticated passive products that may deliver greater flexibility in side-stepping or even taking advantage of a bear market.
There is a niche but growing strategy that provides yet another alternative to active management for investors seeking a controlled investment experience – defined outcome strategies. These seek to provide an even more nuanced response to market fluctuations, with index-linked products that are managed under a rules-based system. Specific levels of protection and/or enhanced return are put in place at the time of investment. Targets can be set in this manner because defined outcome strategies use options, which provide the ability to buy or sell the market at pre-determined levels.
With a defined outcome approach, investors can experience a controlled and predictable range of investment outcomes that they know about in advance and can plan for accordingly. This predictability allows investors to align investments with their risk/reward profile, taking into consideration personal factors such as goals, risk tolerance, and time horizon.
A conservative defined outcome strategy might, for example, target a maximum upside gain of approximately 15 percent and a maximum downside loss of approximately 12.5 percent. Investors would know that in a bear market, their portfolio might lose slightly more or less than the target floor, but it would never drop by, say, 30 percent.
Other protection themed equity products tend to mitigate rather than eliminate the exposure. For instance, there is no limit to what losses can be borne within low volatility strategies - there is simply the assumption any losses will be less than the overall market. In addition, low volatility funds set targets based on historical volatility. In contrast, defined outcome strategies use current market characteristics in their design. And unlike traditional structured notes, the new strategies are generally low fee, liquid, transparent and simple to execute.
Standardized, predictable and consistent, defined outcome approaches may help to mitigate against risk and ambiguity aversion. By combining targeted protection from downturns with reduced volatility, they offer investors a best-of-both-worlds approach, bridging the line between active and passive investment strategies.
Joseph Halpern is founder and CEO of Exceed Investments, a New York-based boutique financial services firm that provides defined outcomes indexes and investment products that balance protection and upside performance for investors.