Hedges in a Portfolio: Always be Prepared
by Tom Biddison
Anyone who has spent any time on a boat understands the importance of preparedness. Nobody likes to spend their money on life preservers, flares, vhf radios, lifeboats or any of the other safety equipment because they likely will never be used. Calm seas and blue skies can quickly turn and those “useless” safety items suddenly become critically important. This dynamic is also relevant in the financial marketplace when you consider hedges as that safety equipment.
Equity markets tend to rise slowly and fall quickly thereby increasing the importance of consistent hedges in a portfolio. It is not a matter of if you will need to use the hedge, it is a matter of when. When it comes to money the pain of loss is three times more powerful than the pleasure of gain. In a way, we are wired to be poor investors…..there has to be something better than “buy and hope.”
With domestic equities at all-time highs and bond yields at nearly all–time lows, it certainly begs the question, “what other investment tools are out there?” Since 2007, our firm, Cornerstone Advisory LLP, has used Outcome Driven Investments to manage this greed/fear paradigm in the quest to generate attractive risk adjusted returns. The concept is simple in that these strategies generally sell away extreme upside (greed) in exchange for embedded downside protection (fear) and with the prospect of more predictable returns. In practice, the investment is an SEC registered investment contract between two parties outlining the terms of the note (maximum return parameters, embedded protections, upside leverage, etc.). In this financially repressive interest rate environment, Outcome Driven Income strategies are particularly attractive because of their ability to generate mid to high single digit annual yields on strong credit with little to no interest rate sensitivity. They also provide the opportunity to generate positive returns during a falling market environment.
Outcome Driven Income notes are designed to deliver an above average annual coupon while minimizing potential principal loss. In this graph of a sample note, "C" indicates quarters when a coupon was received. "No C" indicates quarters when a coupon was not received. This graph illustrates a one-year note, 8% coupon, 25% coupon barrier, and a 25% principal barrier.
In the spirit of a true skeptic, let’s first look at how the returns are achieved through these notes. The core risk of this investment is the credit risk of the issuing financial institution. Achieving a higher return requires some form of risk with any investment. In traditional asset classes, such as bonds, investors take on additional credit risk, in the form of an increased likelihood of default by the issuing institution, to achieve a higher return. Unlike bonds, these notes provide a different risk structure. They allow an investor to take charge of the amount and the kind of risk as these notes can be created in a variety of ways.
Outcome Driven Investments allow access to the world of customized financial solutions generally reserved for institutional investors and ultra-high net worth private banking clients. These notes can be strategically used as an alternative class diversification tool in your portfolio to create income, protection, and lower correlations to the market itself.
Just as you would never leave shore without your boating safety equipment, always consider your safety measures in the financial market.
Cornerstone Advisory, LLP, is registered as an investment adviser with the SEC. The firm only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. Registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the adviser has attained a particular level of skill or ability.
Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment or strategy will be profitable or equal to past performance levels.
All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals, and economic conditions may materially alter the performance of your portfolio.