Risk Assist - pros and cons

A Closer Look at Four Risk Mitigation Strategies

As investors approach the time when they will begin tapping their portfolios to pay for a goal, they need to take steps to protect that wealth they’ve built—even as they may seek additional asset growth between now and then.

“The Need for Risk Mitigation”  showed that these protect-phase clients would be wise to try to mitigate three major investment risks to maximize the probability of achieving their specific goals.

1.  Losing significant amounts of wealth (drawdown)
2.  Missing out on upside growth
3.  Making bad, emotion-driven investment decisions

There’s no shortage of risk mitigation strategies that can help reduce certain risks. But as with all strategies, there are trade-offs. Our analysis reveals that some of the most commonly used risk reduction methods contain fundamental flaws that make them less-than-ideal for investors (and advisors) trying to address those three main protect-stage investment risks.

Here’s an overview of four popular approaches to risk reduction—with an eye toward what they do well, and where they don’t measure up.

Diversification
A well-diversified portfolio, based on the tenets of Modern Portfolio Theory (MPT), is the classic method of minimizing portfolio risk. The logic behind diversification is sound: If you hold assets that behave differently in different market environments, then some investments should become more valuable when others become less valuable —thus helping to insulate the portfolio from major drawdowns.

While a well-diversified portfolio can be a good first step toward managing some investment risks, it might not always be sufficient for protect-stage investors nearing a goal. Diversification’s most notable flaw for protect-stage investors is that it requires future relationships (such as correlation, covariance, distribution of returns) between different investment categories to be both known and stable.

Unfortunately, those future relationships are simply unknowable. Worse, they tend to become quite unstable during market declines —right when investors seeking refuge from big losses look to diversification for shelter.

Timing Strategies
Timing strategies use pre-determined rules —which can be rooted in anything from technical patterns to behavioral psychology—to try to shift assets in and out of an investment, asset class or entire market at just the right moments. Certainly, a rules-based approach can help investors avoid making emotional decisions about their assets. A strategy that says, essentially, “when event ‘A’ happens, take action ‘B’” can potentially shut down reactionary money moves based on the headlines (if it’s followed diligently, of course).

However, timing strategies don’t measure up nearly as well at mitigating the risk of suffering drawdowns or the risk of missing upside gains. The reason: The flawed assumption underlying all timing strategies is the past is prologue—what happened with asset prices previously gives reliable information about what they’ll do next.

But unlike the natural world, where a law like Newton’s Law is constant, financial markets don’t come with consistent, stable rules. Markets evolve and (as noted above) relationships between assets change. A timing strategy without the flexibility to adapt to changing market dynamics and assumptions can struggle to help investors get out of the way of losses —or shift them back in time to capture gains—consistently over long periods.

Market timers’ uninspiring results have proven these time and time again.

In addition, the backtesting that timing strategists often rely on can be problematic. Timing strategies look especially appealing when a strategy’s provider shows the results that investors would have achieved if they had used the strategy during some previous time period. However, it is not always possible to stress the assumptions embedded in this kinds of backtesting —or verify that the signal was not fitted to the data.

Ultimately, market timing demands that investors get two notoriously difficult decisions right: when to exit and when to re-enter. The probability of that happening consistently over time is low, while cost of getting one or both of those decisions wrong can be extremely high. Not a desirable combination for protect-stage investors.

Listed Options
This risk management technique typically calls for purchasing put options on a broad-based index (like the S&P 500) that are meant to hedge the systematic risk or beta associated with a portfolio.

Listed options have important and attractive risk mitigation characteristics. They offer protection against gap risk — large differences in a stock’s or index’s closing price one day and its opening price the next. Listed options are also liquid, transparent and trade on exchanges. Because they allow investors to mitigate risk at a known cost for a window of up to approximately two years, they can help avoid major drawdowns over relatively short risk management time frames.

But listed options can come with opportunity costs that may make them sub-optimal for some protect-stage investors.

Here’s why. Puts are generally more expensive than calls with similar characteristics. A typical option hedging strategy is to partially offset the cost of purchasing put options by simultaneously selling call options. Managers continually using this kind of “collar” strategy in a naïve fashion are usually unable to participate fully in strong up markets—denying investors the capital appreciation they likely need to achieve their goals. Therefore, this strategy may not be best for some investors who are nearing a goal but still need portfolio growth to get them into the end zone.

Some other issues to be aware of:

  • + Options are expensive. It’s not uncommon for a put option program to cost 15% to 20% of a portfolio’s value per year.
  • + Options may experience basis risk, which occurs when there is a difference (or slippage) between an investor’s portfolio and the option strategy designed to protect that portfolio.
  • + It is difficult to determine the likely long-term cost (beyond a year or two) of an options-based hedging strategy.

Portfolio Insurance
Portfolio insurance (or any type of put replication technique) seems like a good idea: hedge the risk in a stock portfolio with a short position in stock futures (the size of which is calculated using a formula for valuing stock options). Just manage the short futures position to replicate the payoff from a put option. Investors buy futures when the market rises and sell when the market falls—a strategy meant to mimic owning a put option on the index.

This approach works fine in most markets. But like Modern Portfolio Theory, portfolio insurance tends to fail exactly when protect-stage investors need it most—such as when prices nosedive rapidly.

This is due to three key design flaws, which can be seen most clearly by examining how portfolio insurance behaved during the infamous October 1987 market crash:

  • + Portfolio insurance incorrectly assumes that investors can trade instantaneously (to a close approximation) and that there will always be a relatively continuous market in which to trade —that is, no large gaps between a security’s trading price from moment to moment. But this simply isn’t the case. Large and sudden price gaps do occur—and they are usually wildly exacerbated during market panics such as the 1987 crash (and, more recently, the “flash crashes” of 2010 and 2015).
  • + Portfolio insurance’s hedging instrument is a form of the very thing it tries to protect. In 1987, for example, portfolio insurance used stock index futures to hedge a portfolio of stocks. When the stock portfolio’s value fell, the portfolio insurance algorithm signaled investors to sell the stock index futures—thus creating a negative feedback loop that worsened the crisis. As portfolio values dropped, portfolio managers were forced to sell more futures (which led to further drops in portfolio values, requiring selling of futures, and so on).
  • + Portfolio insurance requires a very liquid market for its hedging instrument (such as S&P 500 futures). But when markets take a big and sudden hit, liquidity is typically very thin—drastically impairing the ability to hedge at the exact time when hedging is crucial.

Although these flaws —gap risk, negative feedback loops, and hedging instrument liquidity—weren’t apparent to many investors using portfolio insurance back in 1987, there is greater awareness today. Despite that, there are numerous “portfolio insurance 2.0” risk management strategies in the current marketplace. They often use inverse ETFs to accomplish the task that was originally performed by index futures. But the fundamentals are identical—and, unfortunately, so is the potential for negative results from this hedging technique.

What does work?

In our next blog post, we’ll reveal the components of a risk mitigation strategy designed to overcome the biggest threats faced by protect-stage investors as they approach some of their biggest financial goals.

To Download the full report click the button below. To Learn more about Risk Mitigation or about Horizon and how we can empower you, contact us Today at 866.371.2399 EXT.202 or info@horizoninvestments.com.

Categories: Empower