Advisor’s Epiphany Leads to Options

advisors-epiphany-leads-to-option-picture

By: Libby Dubick

Dubick & Associates for OIC Advisor Publications

“We just got audited,” said Dominick Paoloni, President of IPS Strategic Capital, in Denver, Colorado. “After determining that the vast majority of my clients were retirees, and that they were all in options-driven strategies, the auditor asked me if I thought it was prudent.

“Options were originally designed as a hedge. It is true that people use them to leverage their portfolios, and that leverage creates risk. If it’s used in the wrong way it can blow up a portfolio very quickly. When used properly, however, they create an effective hedge, and in most cases in our strategies we strive to be market-neutral so we don’t care if the market goes up or down. I would say that my clients today are far more protected, hedged, risk-monitored and controlled than they were when I was running a global macro top-down portfolio.”

Dominick has been in the financial advisory industry for more than 30 years, but he did not embrace options until 2008. “I came from the world of portfolio modeling. Dr. Markowitz’s book, Modern Portfolio Theory, was published in 1959. A ’59 Chevy would not be called modern, yet I would say that 98% of most pension, endowment and client money is run based on a version of Markowitz’s work; Means Variance Optimization (MVO). That was where I lived for 25 years, and I could talk modeling until I was blue in the face.

“Then the sky opened and I finally woke up. The level of frustration for everyone that was running money using a version of MVO was very high through the dot-com bubble, the 2008 credit crisis and the European meltdown. During these periods we experienced tail events and saw the market fluctuating as much as 10% a week. I saw a breakdown in the concept of asset allocation, which is what we’re taught in our first business school class. I had learned about options when I got my Series 7 license in 1983 but I didn’t really understand what they could do.

“There is no doubt,” he said, “I had an epiphany. It frustrates me that I could have been using options 15 years ago but it was a different world then and I understand that. Today the tools available and the depth of the markets far surpass what they were then.”

Defining Rather than Managing Risk

“When you manage money the classic way, you’re managing risk,” Dominick continued. “Like the manager of a baseball team manages his pitchers. You make decisions based on their talents, on which batters are up and which pitchers to put against those batters for the best statistics. And that’s the way most managers run money.

“The vast majority of portfolio managers value what a company has done, what particular asset classes have done. The managers are deciding whether to put more money into China or into commodities, to create that balance of covariant nature, which is the basis of asset allocation. If stocks go down, they’re going to hope that bonds will go up, and that diversification, that seesaw effect that gives us balance and reduces volatility, will provide a better glide path to reach clients’ financial goals.

“The problem with managing that way is that we’re trying to predict the future based on historical data,” he explained. “Options are a whole different game. When you build a good options strategy and it’s properly put into place, you are defining your profile today for tomorrow. Whether you’re putting in protective puts, collars or VIX hedges, you’re shaping the distribution curve today for tomorrow.

“In my classes I use the analogy of buying fire insurance on my home. I’m not buying it based on the experience of houses burning down in my area yesterday; I am buying insurance today that will shape the outcome if there’s a catastrophic event tomorrow.

“Everyone is trying to create asset models that are stable through volatile markets, which contain the covariant nature of the correlation with other assets in the portfolio,” he added. “But we all know that the only thing that goes up in down markets is correlation. Assets start to move together and the benefits of asset allocation are destroyed. That’s exactly when you need it, when you don’t get it. But, what does an established option hedge position do? It actually becomes more efficient. It doesn’t break down, it becomes more stable.”

Spreading the Message

Dominick’s firm, which is approaching $100 million in assets, was founded in 1993. Since moving into the world of options he has started to add financial advisors and family offices to his base of high-net-worth clients and is reaching out to pensions and other institutional investors.

He also teaches at the University of Denver and lectures at the University of Colorado. “I enjoy teaching and speaking about the principles that I’ve spent a lifetime working with. It’s been said, ‘If you learn from your own mistakes you’re smart, if you learn from other people’s mistakes you’re a genius.’ After a lecture, if someone says ‘wait a minute; this makes a lot more sense than what I’m doing, trying to decide whether I should get in the market or get out’ then I feel I’ve helped to change the paradigm of managing money.

“With options it can be systematic, repeatable, objective and defined and that’s the way I want to run money,” said Dominick, “because at the end of the day all my clients want is a high probability they’re going to hit their financial goals in the end.

“I truly believe that in the next 5, 7 or 10 years, if you’re running money and you’re not using some type of derivatives, hedging or overlay, you’re going to be out of business. Their use is growing exponentially and advisors who don’t embrace them now I feel are going to be left behind.”