Client Memo: Additional Ways to Reduce Risk and Protect Your Recent Gains

This is part II of “What We Are Doing in A Likely Low Future Returns.” You can read that here.

In part I of this memo, I detailed how current valuations suggest that future returns will be downright terrible. Goldman Sachs recently updated their projections, which suggest only 3% nominal returns per year over the next decade. Other investment banks have similar projections.

That is because future returns are highly dependent on two variables: future earnings growth and current valuations.

Earnings growth is already expected to be above trend thanks to productivity gains brought on by the implementation of Artificial Intelligence.

Current valuations are nearly two standard deviations above the mean- something that happens less than 5% of the time.

So, what do we do about it?

Our firm is predicated on being at the vanguard of knowledge and trends. We don’t ‘babysit assets’, which is an industry term for investing your capital and collecting fees not doing anything proactively.

We are constantly trying to ascertain where is the best return achieved per unit of risk assumed.

Given the big gains we’ve achieved the last couple of years – having achieved the correct positioning on both the stock and the bond side – we want to protect those gains rather than go for broke and try for another home run.

The sports analogy would be, we’re up by three touchdowns in the fourth quarter so let’s implement the prevent defense and make sure we don’t give it up.

If you saw the presentation I gave recently, we introduced buffer ETFs and structured notes as new concepts to most people. The first thing I will say is that these are being used to reduce risk, not increase it.

Essentially, protect the gains we’ve achieved by protecting on the downside while still being able to participate on the upside.

Buffer ETFs are simply index exposure, like the S&P 500, but with protection on the downside (the buffer). That protection could offset the first 9%, 10% ,15%, 30%, or even 100% of losses.

Of course, there is no free lunch. The protection comes at a cost. The cost is a cap on the amount of upside you experience. Most of the caps are between 10%-13%. So if the index is up 18%, you miss out on that extra ~5%.

The great thing about these is you get to experience the first 10-13% of gains but get to protect against the first 9-30% of losses. One key advantage is most of the returns of the index in any particular year fall within those two numbers (-30% to +13%).

I am willing to forgo returns on some of my equity exposure above ~13%, in order to protect on the downside on the first 15% of losses.

This is how we protect against some potential losses while being able to participate in the upside of stocks.

Structured notes are another risk management tool aimed at lowering downside potential but keeping exposure to the upside if markets continue to move higher. They are an investment product, typically issued by a bank, designed to produce market linked growth with far less risk normally found in stocks.

Put in simple terms, like buffered ETFs, their goal is to protect principal at some level while allowing investors to participate to the upside.

As investing’s Swiss Army knife, notes can be used to add risk, remove risk, or create a variety of different risk-reward scenarios. In this sense, notes can help bridge the gap between stocks and bonds. We would primarily use them to reduce risk.

How do they work?

Let’s use the following as an example:

In essence, you get all the upside of the S&P 500 but are protected against the first 20% of the downside in the index over the five-year period.

Relative to buffer ETFs, they are the same but without the cap. In other words, the one big negative of buffer ETFs is abolished with a structured note.

So, what’s the catch?

The only catch is that you are sacrificing liquidity. These can be difficult to sell so we want to make sure we are willing to hold the note to maturity. In the case of the example above, for five years. These notes can be structured with shorter time periods- as short as a year making them ideal for a small portion of your portfolio.

Our goal would be to stagger the maturities between 1 and 5 years, depending on the client to reduce risk through diversification.

Remember, the goal here is to reduce risk, not add to it.  We have a big lead, and we want to protect it.

If you have any questions or concerns, please DO NOT HESITATE to contact me or the team and we can set up a zoom call.

As always, we appreciate the trust and faith you have in us with your hard-earned capital.

Sincerely,

Mark J Asaro, CFA