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The Investment Secret of the Pros
Since the first neanderthals realized that you can store grain over the winter and have more to plant next spring, people from all walks of life have puzzled over the problem of maximizing their investment returns while minimizing, or completely avoiding, losses.
This is the “financial-planning paradox.” The Oracle of Omaha, Warren Buffett, captured it in his two investing principles: 1) don’t lose any money, and 2) always keep rule one in mind. Is that even possible? Can an investor make decent returns without taking risk? To explore whether this is even possible, let’s first examine the process of traditional investing. A simple diagram known as a “money-made” chart is useful in understanding how investments behave.
Figure 1 illustrates a simple example with a traditional
asset like a stock. The x-axis shows different prices of the stock, and the y-axis shows the amount of money you would have made or lost if you invested. For example, if you were to purchase this stock for $5 and the price rose to $10, if you sold it, you would have made $5. If you purchased the stock at $5 and it dropped to $0, you would have lost your entire investment. The likelihood of your losing money is called risk. Ok, so what would a riskless investment look like in a money-made diagram? If you found a potentially lucrative investment with zero risk, you would have found the holy grail of investing, and Warren Buffet would pay his respect with a gold chalice inscribed with “Never lose any money”, and a silver chalice inscribed with, “Always remember rule number one”.
But what would this look like? Well, it would mean your investment neither makes nor loses money below your buy-in price, but above the price you bought-in at you would participate in the asset’s gains and make money.
Figure 2 illustrates this concept as a money-made diagram. The hockey-stick shape is unique, and you can see that below $5 you don’t lose anything. There are no negative numbers. Yet above $5 you are making money and doing a happy dance.
Now that we understand what a riskless asset would hypothetically look like, would it be possible to find, or construct one? The hockey-stick shape would be an important feature in this riskless asset. If you scan the entire universe of financial products, you will find that call-options possess this unique shape. What is a call-option, is it dangerous, and how much risk does it have?
Well, in simple terms, a call-option is just a discounted stock. Who doesn’t like a discount right? Figure 3 shows how a call-option works in a money-made diagram. You can see that you can buy a $5 asset for
$2. If the stock goes up you make money, if the stock goes down you will only lose $2. Darn! The call- option looks good, but it is not a riskless asset. The risk is reduced, but not gone.
What if we got someone else to pay for the call? That is where the U.S government comes in. Uncle Sam borrows money from businesses and individuals with the promise of giving their money back later with a little extra money. Let’s say you only have $3 and need that money to buy gas so you can drive home.
However, you also want a $2 ice cream cone from Sweet Cream Cones. While you are agonizing over not being able to afford the sweet treat, Uncle Sam comes up and asks if he can borrow your $3 for an hour. He promises to give your money back with $2 extra ($5 total) as a fee for the privilege of borrowing your money. You know that Uncle Sam is very trustworthy, so you agree. After an hour, you get your money back, and now you can afford both the $2 ice cream cone and have $3 for gas to get home. In short, Uncle Sam bought you an ice cream cone! Using this concept, we can have the U.S government finance (instead of by?) our call for us, as seen in figure 4.
Let’s say you were looking to buy a broad-market stock index for $5, but you were not interested in the risk
of potentially losing your money (Figure 1). What you could do is take $3 and loan it to Uncle Sam with an agreement to receive $5 after a year and take the other $2 and buy a Call-Option on the Broad-Market. At the end of the year, you will receive your
$5 back, guaranteed – no risk, but you will also receive whatever gains the market makes over $5. This type of investing product is called an Index Treasury Note (ITN). Figure 5 illustrates this, comparing the ITN (orange) money-made chart (no risk) to that of the straight market (blue). In effect, we have just created a riskless asset.
The use of options is ancient. One of the earliest recorded instances involved a philosopher named Thales of Miletus. Thales was an astronomer who predicted a year in advance that the olive harvest would be plentiful, while his peers all projected an olive shortage. To demonstrate his belief in his prediction, he went to all the local olive press owners and purchased the exclusive option to use their presses after the next harvest. The harvest was plentiful as he foretold, and Thales made a fortune, as he owned the rights to the presses needed to make olive oil.
There are countless examples of the rich using options to make money. Why hasn’t Warren Buffett paid his respects with a Golden Chalice for the riskless Index Treasury Note yet? It is because he has been using this strategy for decades and is smiling now that you’ve finally caught up.
One of Warren Buffet’s favorite plays is using options to gain market exposure while selling insurance through Geico to finance it. If you don’t have billions of dollars at your disposal to buy an insurance company though, using an Index Treasury Note will have the same effect, but on a more manageable scale. The rich have been negotiating options contracts for the last millennia to offload risk from their portfolio. Now because of over-the-counter exchanges, which guarantee the contracts against default and other risks, the common investor, for the first time in history, is able to use this valuable financial instrument as a strategic part of their portfolio. More than that, when paired with high interest rates on U.S T-Bills, Index Treasury Notes shine as the No-Brainer investment in today’s market environment.
At IPS Strategic Capital, we specialize in crafting custom-built structured notes (Index Treasury Notes) that far exceed anything on the market todayin terms of maximizing potential gains while minimizing risk. Our competitors are offering investments with less potential for gains for comparable or higher risk. The reason we can offer better products is that IPS is a fee- only custom money management firm, and we eliminate the middleman by constructing the notes ourselves. Regardless of your risk profile, we can customize Notes for you that offer better value and superior performance than those currently being offered by our competitors.
The low-risk structured notes from IPS (Figure 6) offer full downside protection against market losses while also giving uncapped upside participation in market gains. Our closest competitors currently offer downside protection, but also cap performance, locking you out of full participation in market gains (Figure 7). Our competitors also offer longer-dated notes, which lock your money up for 2 years, as opposed to the 1-year commitment with IPS.
The medium-risk, IPS Buffered and Uncapped Structured Notes offer a margin of safety against market losses while providing excellent participation in market gains (Figure 8). Our closest competitors offer a similar, capped product that only allows for a 10% participation in market gains (Figure 9).
The IPS Leveraged and Buffered Structured Notes offer a margin of safety against market losses while also offering upside participation that exceeds market gains (Figure 10). Our closest competitors offer a product with a very small margin of safety against market losses while also capping upside gains. A holder of the IPS Leveraged and Buffered Note in 2023 would have made 26.42%, outperforming the market by 2.42%, while the holder of the Innovator Note would have made 24%, matching the market performance.
Please note, our notes matched or exceeded market performance while shielding our clients against the majority of market risk, customized to their risk profiles.
The IPS Note offers a 12-month lock-up with up to 85% market participation and no cap, contrasting with the Innovator Note’s 24-month lock-up and a 10% gain limit over two years. For example, if the market rises 20% in the first year, the IPS Note would gain 17% and become liquid, while the Innovator note would gain only 10% and remain locked. If the market declines in the first year, the IPS Note won’t lose value and can be restructured, unlike the Innovator Note. If the market rebounds after the first year, the IPS Note can capitalize on the gains, while the Innovator Note cannot.
The IPS Buffered Note, depending on market conditions, can offer 22% downside protection with up to 100% participation as opposed to Allianz, which offers the same downside protection with a 10% cap.
The most aggressive IPS Note can deliver 15% downside protection with up to 110% upside uncapped. The
Innovator Note, in contrast, offers 9% downside protection with a 12% cap that is 2x leveraged on the upside.
How Do Structured Products Compare to Market Returns?
IPS Fully Protected Note compared to the S&P 500 over the past 20 years: If someone had invested in one of our Fully Protected Notes at current interest rates, they would have outperformed the S&P 500 (Figure 12) and seen a cumulative return of 787% as compared to the S&P 500’s 537% (Table 1). Moreover, the ITN has a maximum drawdown of 2.2%, as compared to the S&P 500’s -37%. Because IPS Strategic Capital builds their notes using U.S Treasuries, there is no safer investment available that will protect principal with a government security, protect against market losses, and provide superior participation in market gains. Not only is the ITN incredibly safe, it has the added bonus of offering the ultimate diversification, combining the safety of a government bond with exposure to the whole of the S&P 500, which encompasses international diversification across all sectors.
The information in this article should not be misconstrued as an offer, nor a solicitation, to buy or sell securities. Any past performance of any investment(s) does not necessarily indicate the future performance of any investment(s). No client, current or prospective, should assume the future performance of their investments will be profitable based on historical performance. Any backtest charts and data presented are purely hypothetical and do not represent the performance of accounts managed by IPS Strategic Capital. The results were obtained by applying a rules-based investment process to historical data. All investments have the potential for profit and the potential risk of loss. Changes in investment strategies, contributions, or withdrawals may cause the performance results of one’s portfolio to differ materially from the reported composite performance. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s portfolio. One should always consult an investment advisor before making any investment decisions.
One should always consult an investment advisor before making any investment decisions as well as consider the investment’s objectives, risks, charges, and expenses carefully before investing or sending money. This and other important information about the strategy is available upon request.