The investing world is slowly but surely getting a little scarier as flashpoints are adding to the unease of an already longer than typical bull market. Is there contagion from Greece? What is going on in China’s equity markets? And let’s not forget Puerto Rico’s potential default.
Most investors have pressure to generate returns while simultaneously avoiding disasters. The problem is that without a crystal ball, the only way to generate returns is by taking on risk. There is simply no way around this. “High return, low risk” products brings out the skeptic in me - trust me, there is risk somewhere within the package that is applicable to the return. If the risk is not well understood or seems too good to be true it may be best to simply stay away.
This begs the question: what is the best way to play defense while staying in the mix for gains?
In a State Street survey of 420 institutional decision makers, a primary conclusion is that many participants are not protecting their portfolios enough against potential market downturns. Furthermore, when participants do seek out protection strategies, the study finds that they are not exploring the full range of downside protection strategies available to them. One interesting statistic from the study is that a majority of respondents are using dynamic asset allocation, which essentially relies on the strategy getting out of the way at the right moment (perhaps a crystal ball would be helpful here). Another interesting statistic is that approximately 25% of those polled had used hedge funds at some point but no longer do so, which sends a message that the CALPERS decision not to invest in hedge funds going forward may be a trend rather than an anomaly.
In recent discussions on these topics, I have heard several advisors propose the use of alternatives to generate returns while protecting portfolios from a crash. A strategy a couple of advisors focused on is Managed Futures due to their low correlation with the market. However, at the same time, there was concern over historically inconsistent performance - so while the odds are high an investor would see increased diversification from them, there is less confidence in generating consistent returns.
The quandary for investors becomes how to balance many competing factors. For instance, how should one balance the beneficial low correlation of Managed Futures with inconsistent and ultimately unpredictable performance? Additionally, identifying the right active Managed Future fund – i.e., a manager and approach you trust, is crucial. It seems like a lot of decisions need to be made just right (e.g., right manager, right strategy, right time) to have a shot at an effective solution. Along the same lines, State Street also expresses concerns over too much reliance on investing forecasting skills, particularly when it comes to tactical asset allocation.
Defined outcome investing offers a simplified method to participate in equity markets while effectively playing defense. Perhaps I am jaded from 20 years in the industry but one simply cannot get reward without commensurate risk. Defined outcomes clearly define this balance upfront. For instance, our index based strategy looks to limit downside exposure on the S&P 500 to 12.5% on an annual basis. This comes at a cost. We cap the upside at around 15% annually, a healthy return, to pay for the limited exposure down. Thus, the risk / reward equation is clearly spelled out. If the market drops materially like in 2008, you are spared the heartache, taking a minimal relative loss and nicely outperforming. If the market moves up strongly like in 2013, you will underperform but still generate a respectable mid-teen return. It is clear, consistent and provides investors the clarity they deserve.
With an increasing abundance of market uncertainty, we believe that defined outcome strategies can provide the comfort and relative safety that financial professionals and their clients increasingly seek.
Joe Halpern is the CEO of Exceed Investments, an investment company focused on developing next-generation structured investments.