Financial Advisor Magazine is an industry publication that offers, according to their slug, “Knowledge For The Sophisticated Advisor.”  I was asked to provide comment for an article appearing in their May 2010 issue titled “Watch  Your Investment Tail”

The article describes how advisors are increasingly using portfolio insurance strategies to help them avert losses.  In my opinion, knowing which plays to run (offensive or defensive plays) will help investors greatly.  Unfortunately, most investors (and most advisors) do not even know which team is on the field.

Here is the article:

May 2010 issue
Watch Your Investment Tail

Advisors are using options to insure portfolios against “once in a lifetime” losses.
By Alan Lavine

Advisors, under pressure from clients to avert new losses like those that hammered portfolios in 2008, are increasingly turning to portfolio insurance strategies.

Among those most widely used are put and call options, inverse exchange-traded funds and tactical asset-allocation strategies. Their aim: to protect client portfolios from “tail risk”—losses typically greater than 30% that fall 2.5 standard deviations below mean returns.

While many advisors may be sick of hearing about standard deviations, one out of every five trades at TD Ameritrade today involves options, says Steve Quirk, the company’s managing director of trading. Most frequently, advisors and investors are selling cash-secured puts to establish long stock positions. This arrangement allows the investor to buy a security at a price lower than its current trading level.

Financial advisors are also selling covered call options against long positions in exchange-traded funds and stocks to improve performance. The income from the covered call options cushions the portfolio against losses if the market declines. However, if the market rises, the stocks can be “called away” by other investors, forcing a covered call holder to give up the stock and repurchase it at a potentially higher price. Quirk warns that advisors should be wary of selling calls too close to the money.

In today’s world, portfolio insurance makes sense. There have been massive stock market declines in the past 23 years—in 1987, from 2000 to 2002 and again in 2008—even though, according to mathematical probability distribution, these kinds of losses are supposed to occur only once in a lifetime.

And Robert Wiedemer, an economist and co-author of the 2009 book Aftershock, foresees yet another such “fat tail” event in the financial markets. “Fat tails exist in financial market returns,” he declares. “These tails can severely affect performance for years as investors re-evaluate their portfolios and asset allocations.”

Still, even if hedging programs offer one solution, there is no free lunch with them. In a rapidly declining stock market, the cost of writing covered call options or put options is prohibitively expensive. Besides enduring transaction costs, investors can get whipsawed by market timing.

Hedging programs are not perfect. Adjustments must be made in real time.

“Actual experience will undoubtedly develop differently,” says Lawrence Carson, vice president with RGA Reinsurance Company in Chesterfield, Mo.
“Over time, you will be over or under hedged with any hedging program.”

TD Ameritrade’s Quirk says advisors frequently engage in option overlays. This involves taking a long and short position in the market by writing calls and selling put options. As a result, the risk exposure of the stock or exchange-traded fund is reduced.

Other moves to reduce risk include:
• A bear put spread. With this, you sell one put and buy one put at a higher strike price.
• A put back spread. Here, you sell one put and buy two puts at a lower price.
• A bear split strike price combination. This means you buy a put and sell a call at a higher price.

There are a number of portfolio insurance software programs that help advisors hedge against losses. These mathematical models tell investors when to use derivatives, based on stock market beta values and other measures of volatility. The hedge should have a strong negative correlation to the assets in the portfolio.

Many advisors also look to alternative asset classes to reduce risk. “There are still no magic bullets, but some new investing strategies are emerging that can help protect a portfolio from major losses and still offer plenty of upside,” says Jerry Miccolis, the chief investment officer at Brinton Eaton in Madison, N.J.

Miccolis invests up to 35% of his client’s assets in alternative investments, including managed futures, market neutral strategies and absolute return strategies, in addition to real estate and commodities.

He also has a position in a custom structured note created by Deutsche Bank called EMERALD. This promissory note works by exploiting the equity market’s quirky behavior. The S&P 500 index moves a great deal from day to day, but rarely moves in the same direction for many days in a row, and its movement from week to week is typically less than daily movements would imply. There are usually intraweek reversions—even during market collapses.

EMERALD exploits this behavior by placing daily bets. “The hedge is one that kicks in when you most need it, but doesn’t represent a drain on your portfolio in normal times,” Miccolis says.

Some advisors conduct stochastic simulations to find the middle—the best combination of assets that hold up well during periods of low volatility and stable correlations and also during periods of high volatility and rising correlations.

Richard Michaud, president of Frontier Advisors, Boston, uses an optimization model called “Resampled Efficiency” to reduce tail risk. “Even small changes in optimization inputs often lead to large changes in [traditional] optimized portfolios,” he reports in a research study posted on his Web site (www.newfrontieradvisors.com).

He uses “resample efficiency” to optimize and rebalance portfolios. The methodology uses Monte Carlo simulations to resample optimization inputs. The rule computes a “need to trade” probability. An optimized portfolio can be rebalanced when another asset mix shows a greater probability of success.
“Resampling creates additional returns and new optimization inputs that are statistically equivalent to the original set,” he says. “The efficient frontier portfolios based on these new inputs are likely to look very different.”

Other financial advisors include tail risk hedging in portfolio management strategies. Dynamic hedging is one type of program that incorporates the use of put options to limit the downside. This type of program considers a hedge ratio—the amount of put options needed to hedge against the risk of losses. Put option hedge positions are rebalanced as market conditions change.

The dynamic hedge takes into account the amount by which an option’s price will change for a corresponding change in the price of the underlying security. This is adjusted as the price of the portfolio it hedges changes. Meanwhile, the change in the price of the option also is hedged.

Ric Lager, president of Lager & Co., Minneapolis, says his portfolio program helped him almost entirely avoid the 2008 financial meltdown. Lager typically manages 401(k) plan assets of $500,000 to $1 million for clients in their fifties. He hedges client retirement savings with put options in their taxable accounts.

Lager makes hedging decisions based on a program designed by Dorsey Wright & Associates, Richmond, Va. He hedges his portfolio, based on long-term, medium-term and short-term price trends and bullish percentage measures. Then he sells stocks and moves some money to cash and/or hedges some positions with puts.

“My clients avoided the 2008 stock market decline,” he says. “They know there is a cost to hedging and that it may not work 100% of the time. But when the stock market drops 5%, you don’t know if it will drop 50%.”

Meanwhile, David Wright, manager of the Sierra Core Retirement Fund, as well as separate accounts totaling $600 million, uses stop losses on broadly diversified portfolios of mutual funds to limit tail risk. His goal is to limit volatility to 4%. On the upside, his goal is a 10% total return. Investments that are more volatile than their historical averages are sold. On the upside, he uses moving averages and other measures to get back into the market. In 2008, the fund lost just -3.3%. In 2009, it gained 30.8%, according to Morningstar Inc.

“Our goal is to limit the downside,” he says. “One-third of the time we get false alarms that result in small losses. But trailing stop losses under every position reduces risk.”

Research shows that portfolio hedging insurance programs can be effective. For example, a study by Milliman Inc. in Seattle, found that put-option hedging programs saved insurance companies $40 billion during the financial crisis in 2008 and 2009. Dynamic hedging programs used to protect variable annuity account values tied to death and living benefit guarantees were 93% effective. Their hedging programs were 93% and 94% effective in 2008 and 2009, respectively.

Put-option hedges can be used within a mean variance framework, according to research by two finance professors, Mark Broadie of Columbia University and William Goetzmann of Yale University. So financial advisors include put options in their optimizations that include stocks, bonds, cash and other asset classes. The study, which examined performance over seven decades, found that the “insured portfolio achieves high long-term returns while mostly avoiding bear markets.” Their working paper, Safety First Portfolio Insurance, can be found on the Social Science Research Network (www.ssrn.com).

And here is a link to the actual article.

What are your thoughts?  Do you feel portfolio insurance is necessary for individual investors to manage the risk?

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