Time to take out a little insurance
Time to take out a little insurance
Are you up to speed on securities protection?
Jonathan Chevreau, Financial PostPublished: Monday, June 04, 2007
With stock markets logging new record highs each passing day, advisors may be getting anxious queries from clients concerned about protecting their gains from a nasty stock-market correction.
A timely topic is investment insurance. Consider house insurance, where one pays small annual premiums to protect homes against fire or other disasters. Odds are that nothing will happen to the house but the homeowner doesn't begrudge the premiums that provided peace of mind.
Investment insurance works the same way: You have an equity portfolio for the upside and purchase put options on those securities to ensure the portfolio's value can't fall below a certain level.
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If the market keeps rising, you're happy and don't fret about the premiums spent to achieve peace of mind. If the market tanks, you're protected and relieved your advisor had the foresight to insure your portfolio.
Sadly, not all advisors are knowledgeable enough to do this for clients, or licensed to sell what's required to insure a portfolio. They would do well to read a new book on the topic published by securities lawyer and consultant Robert Goldin.
The first part of Insure Your Investments Against Losses (Bastian Books, Toronto, 2007) looks at techniques for insuring individual securities. It covers the gamut from call options and put options to collars, strangles and straddles. He also looks at strip bonds, futures, principal protected notes, index-linked GICs and other "guaranteed" investments.
Most of the techniques covered require a securities licence -- this book may well motivate those licensed only to sell mutual funds to broaden their focus. Goldin suggests clients looking for such protection dump advisors not qualified to sell options and find ones who are.
The meat of the book is the second half, which looks at how to insure whole portfolios. First it recaps Modern Portfolio Theory, which most advisors view as the foundation of their clients' portfolios. MPT covers such familiar ground as the efficient market, asset allocation, positively and negatively correlated asset classes and alternative investments such as hedge funds, income trusts and precious metals.
However, Goldin does not advocate holding a portfolio of different non-correlated asset classes, or the traditional MPT approach.
Rather than diversifying, he believes in "insurifying."
His term for this is Efficient Portfolio Theory or EPT. With EPT, portfolios consist almost entirely of equity indices, preferably through low-cost exchange-traded funds (ETFs).
By nearly, he means about 96% of the portfolio. The other 3% or 4% is used to buy put options on the indices most reflected in the chosen ETFs.
After assembling such portfolios, you simply insure your investments against losses and sleep soundly at night. "It's that simple," he writes.
For advisors already familiar with options, EPT is a surprisingly simple alternative to other less easily understood alternatives designed to hedge losses. In the book, Goldin says some investment insurance strategies can be performed by do-it-yourself investors while others may require financial advisors "until you feel comfortable implementing them yourself."
Variants of this strategy have been promoted elsewhere. Goldin started to explore the topic when he asked himself why major financial institutions always make money despite the vagaries of the market.
Indeed, finance professor Moshe Milevsky raised similar issues when Manulife Financial unveiled Income Plus. Milevsky said it was possible for investors to "bake their own solution" by combining puts and calls in a retirement collar.
Certified financial planner Fred Kirby, president of B.C.- based Dimensional Investment Planning Inc., is a believer in well-diversified low-cost portfolios of index funds or ETFs. But in a series of client reports on Protecting Your Portfolio, Kirby acknowledged the limitations of Modern Portfolio Theory once a bear market hits.
He found actively managed Canadian equity funds and dividend funds offered better protection than index funds in bear markets.
He also found international equity diversification "fell far short of providing complete safety." It "works when we don't want it to and doesn't when we do."
For clients convinced a market correction is at hand - perhaps because it's the consensus among market timers -- Kirby suggested several steps or half steps investors can take to reduce risks.
They could hedge their bets by selling half their equity positions in tax-deferred accounts and moving the proceeds to cash. Alternatively, they could sell half their registered equities to buy U.S. and Canadian dividend ETFs or mutual funds.
They could also hedge half their equity exposure using a similar approach to Goldin's, although Kirby's suggestions were issued before Goldin published his book.
Thus, for taxable accounts in bear markets, Kirby suggests hedging half a client's equity exposure with a long-term bearishly split strike option index strategy. This locks in a portfolio's value while deferring previously accumulated capital gains otherwise payable in a taxable account.
Kirby cites as an example the SPX mini index [XSP/CBOE], currently trading at 150. For every $30,000 of a U.S.-based S&P500 type of portfolio, investors wishing to hedge half its value simultaneously buy one put contract of XSP December 145 2008 and sell one call contract of XSP December 155 2008 for a net credit of $300 (3 times $100). With the index at 150, the value of each contract is $15,000, effectively protecting half the $30,000 portfolio.
Investors might also consider the new Horizon BetaPro S&P60 Bull and Bear Plus ETFs. The bull version moves in the same direction as the XIUs on the TSX but at double the rate.
Similarly, the bear version is the equivalent of selling the XIUs short, Kirby says, but again at double the rate. American equities can be covered by U.S versions of these funds trading on the Amex: ProShares Ultra S&P500 and UltraShort S&P500.
Kirby hedges only half the equity portion of portfolios because he assumes the first 10% of each move up or down is missed. "Sometimes, the timing of the hedge will be right and will be profitable; other times it will be wrong and there will be an opportunity cost.
But in the long run, it should break even. Its purpose is to decrease portfolio volatility and help keep its value."
jchevreau@nationalpost.com
Are you up to speed on securities protection?
Jonathan Chevreau, Financial PostPublished: Monday, June 04, 2007
With stock markets logging new record highs each passing day, advisors may be getting anxious queries from clients concerned about protecting their gains from a nasty stock-market correction.
A timely topic is investment insurance. Consider house insurance, where one pays small annual premiums to protect homes against fire or other disasters. Odds are that nothing will happen to the house but the homeowner doesn't begrudge the premiums that provided peace of mind.
Investment insurance works the same way: You have an equity portfolio for the upside and purchase put options on those securities to ensure the portfolio's value can't fall below a certain level.
Email to a friendPrinter friendly
Font:
*
*
*
*
If the market keeps rising, you're happy and don't fret about the premiums spent to achieve peace of mind. If the market tanks, you're protected and relieved your advisor had the foresight to insure your portfolio.
Sadly, not all advisors are knowledgeable enough to do this for clients, or licensed to sell what's required to insure a portfolio. They would do well to read a new book on the topic published by securities lawyer and consultant Robert Goldin.
The first part of Insure Your Investments Against Losses (Bastian Books, Toronto, 2007) looks at techniques for insuring individual securities. It covers the gamut from call options and put options to collars, strangles and straddles. He also looks at strip bonds, futures, principal protected notes, index-linked GICs and other "guaranteed" investments.
Most of the techniques covered require a securities licence -- this book may well motivate those licensed only to sell mutual funds to broaden their focus. Goldin suggests clients looking for such protection dump advisors not qualified to sell options and find ones who are.
The meat of the book is the second half, which looks at how to insure whole portfolios. First it recaps Modern Portfolio Theory, which most advisors view as the foundation of their clients' portfolios. MPT covers such familiar ground as the efficient market, asset allocation, positively and negatively correlated asset classes and alternative investments such as hedge funds, income trusts and precious metals.
However, Goldin does not advocate holding a portfolio of different non-correlated asset classes, or the traditional MPT approach.
Rather than diversifying, he believes in "insurifying."
His term for this is Efficient Portfolio Theory or EPT. With EPT, portfolios consist almost entirely of equity indices, preferably through low-cost exchange-traded funds (ETFs).
By nearly, he means about 96% of the portfolio. The other 3% or 4% is used to buy put options on the indices most reflected in the chosen ETFs.
After assembling such portfolios, you simply insure your investments against losses and sleep soundly at night. "It's that simple," he writes.
For advisors already familiar with options, EPT is a surprisingly simple alternative to other less easily understood alternatives designed to hedge losses. In the book, Goldin says some investment insurance strategies can be performed by do-it-yourself investors while others may require financial advisors "until you feel comfortable implementing them yourself."
Variants of this strategy have been promoted elsewhere. Goldin started to explore the topic when he asked himself why major financial institutions always make money despite the vagaries of the market.
Indeed, finance professor Moshe Milevsky raised similar issues when Manulife Financial unveiled Income Plus. Milevsky said it was possible for investors to "bake their own solution" by combining puts and calls in a retirement collar.
Certified financial planner Fred Kirby, president of B.C.- based Dimensional Investment Planning Inc., is a believer in well-diversified low-cost portfolios of index funds or ETFs. But in a series of client reports on Protecting Your Portfolio, Kirby acknowledged the limitations of Modern Portfolio Theory once a bear market hits.
He found actively managed Canadian equity funds and dividend funds offered better protection than index funds in bear markets.
He also found international equity diversification "fell far short of providing complete safety." It "works when we don't want it to and doesn't when we do."
For clients convinced a market correction is at hand - perhaps because it's the consensus among market timers -- Kirby suggested several steps or half steps investors can take to reduce risks.
They could hedge their bets by selling half their equity positions in tax-deferred accounts and moving the proceeds to cash. Alternatively, they could sell half their registered equities to buy U.S. and Canadian dividend ETFs or mutual funds.
They could also hedge half their equity exposure using a similar approach to Goldin's, although Kirby's suggestions were issued before Goldin published his book.
Thus, for taxable accounts in bear markets, Kirby suggests hedging half a client's equity exposure with a long-term bearishly split strike option index strategy. This locks in a portfolio's value while deferring previously accumulated capital gains otherwise payable in a taxable account.
Kirby cites as an example the SPX mini index [XSP/CBOE], currently trading at 150. For every $30,000 of a U.S.-based S&P500 type of portfolio, investors wishing to hedge half its value simultaneously buy one put contract of XSP December 145 2008 and sell one call contract of XSP December 155 2008 for a net credit of $300 (3 times $100). With the index at 150, the value of each contract is $15,000, effectively protecting half the $30,000 portfolio.
Investors might also consider the new Horizon BetaPro S&P60 Bull and Bear Plus ETFs. The bull version moves in the same direction as the XIUs on the TSX but at double the rate.
Similarly, the bear version is the equivalent of selling the XIUs short, Kirby says, but again at double the rate. American equities can be covered by U.S versions of these funds trading on the Amex: ProShares Ultra S&P500 and UltraShort S&P500.
Kirby hedges only half the equity portion of portfolios because he assumes the first 10% of each move up or down is missed. "Sometimes, the timing of the hedge will be right and will be profitable; other times it will be wrong and there will be an opportunity cost.
But in the long run, it should break even. Its purpose is to decrease portfolio volatility and help keep its value."
jchevreau@nationalpost.com
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