November 12, 2019
by Dominick Paoloni, CIMA®
CIO & Founder
Portfolio Manager, IPSAX
Adjunct Professor, University of Denver
Adjunct Professor, University of Colorado
I have the good fortune to teach and lecture at two respected universities, the University of Denver and the University of Colorado. Most of my lectures and classes center around how our firm uses tools to define tomorrow’s risk today. I first explain to the class that diversification is unable to define one’s portfolio risk as the correlations/relationships of assets in your portfolio are constantly changing. When markets become very volatile, i.e. October of 2008, the relationships of all the assets in the portfolio start moving together, thus diversification does not provide the protection that is needed.
I suggest to the class that instead of diversifying a portfolio, what if we could hedge the portfolio, using hard insurance within the portfolio to define tomorrow’s risk today? Just as we use insurance for our car, home and life, why can’t we use insurance to protect our money?
At this point in the lecture, I give the students a review of how bonds work. I explain that there are different types of bonds (government, municipal, corporate bonds, international bonds, etc.). I explain that if you hold a bond to maturity, the bond will guarantee to pay par value (which is the value at which the bond was originally issued). The guarantee is absolute for US Treasuries, and for non-Treasury bonds, there is default risk, which is the possibility that the bond-issuing entity would fail to make its debt and interest payments. As long as the bond issuing entity is still in business, and not in bankruptcy, an investor knows what their return will be if the bond is held to maturity.
I show the students that if we can combine bonds and tools that define return (options), we can shape the distribution of risk and return, essentially defining an asset’s future return today. For example, if we calculate the present value of all the future cash flows of a US government bond, we can use the present discounted value difference to buy call options, essentially delivering stock market returns without exposing ourselves to the market’s undefined downside risk. Through the use of options, we can define and control our risk exposure. The graph below shows how using a 1-year Treasury can shape your distribution.
By the end of the lecture, I always get the same question, “Why don’t all advisors build structures for their clients?”
This question is not an easy one to answer, but my answer goes something like this: first, many professional financial advisors are influenced by a behavioral effect call the snakebite effect. They may have bought an off the shelf product from an insurance company, such as an index annuity or a CD linked S&P 500 note. Many of these products were misrepresented, and at the end of the day, the investments failed to deliver what was promised. For example, rather than using Treasuries to back their structures, Lehman Brothers chose to use highly risky mortgage-backed securities to build their structured products, which became worthless when their ill-advised foundation collapsed. The second reason is that many advisors only have a general understanding of options and how they can be used.
To help reduce misunderstandings and promote the considerable benefits of using structured products, IPS Strategic Capital frequently offers educational workshops at no cost to financial professionals, explaining how and why Defined Outcome Investments can be used as a tool within their practice. If you would like to attend a lecture on how to build Defined Outcome Investments for your clients, please fill out our Workshop Contact Form (click here), and we will invite you to attend the next workshop.