The Silver Lining of Bear Markets

by | Jul 6, 2022 | Market Updates

A high level of our portfolio construction process could be summarized as an attempt to hold less bonds and more stocks. We think this allocation shift allows portfolios to be better positioned moving forward. More potential for return, therefore, less exposure to longevity risk. 

We spend so much time in our communication discussing the importance of risk management. The ongoing focus on risk is because of my opening sentence – our entire process is about shifting exposure to more of the ‘risk assets’ and less of the ‘conservative assets’. We want to be crystal clear on how we manage the risk associated with this shift.   

I’ll breeze over our view that the bonds of tomorrow look different from yesterday’s bonds, and the default line of thinking about the relationship between stocks and bonds (likely broken), and investors that do not adapt allocations are just asking for longevity risk to creep into their future financial discussions. Here let’s just focus on the point of today’s note – the benefits of owning volatility

To us, volatility is an asset class – we think holding it can improve potential for return without increasing your portfolio’s risk.  It’s a different diversifier than bonds, and one that shouldn’t negatively impact return potential like bonds do.  

In other words, we’d prefer to hold small slivers of negative return potential that carries convex payoffs when volatility rises, rather than large slices of things (bonds) that have negative real returns and may or may not help when volatility rises.

 

The potential benefits of owing volatility:

 

  • Allows an allocation to position for more return potential (less bonds, more stocks)
  • Defends against drawdown (typical volatility ownership for us is market hedges that go up when markets fall)
  • Creates capital to deploy when the opportunity is more attractive (as market prices drop, having profit from hedges to add to cheapened stock is a good thing)

 

We believe owning volatility can help both upside and downside metrics. The original plan was to discuss the silver lining of lower valuations. We will save that one for next month as today’s note should serve as a segue.  Our focus today will be on benefit #3 above only. 

Specifically, we will discuss how we can pick up more shares of companies we like, at lower prices – thanks to our long volatility exposure (market hedges). 

This information is generic, but it’s relevant to what’s happening in your portfolios. The actions we will discuss below have been occurring year to date and even more so in June. Please reach out and we can share more color

 

Your Portfolio 

 

Let’s imagine you own an exchange traded fund (ETF), and this fund only owns stock in a single company. This company is what we call a compounder. It’s the type of business that has a runway for growth, great margins, and even pays a dividend. Remember, a stock is a claim on future cash flows and this is a business where we’d like to own those claims! 

In addition to the stock of a single company, the fund also holds a put option on the company. A put option is the right to sell something at a specified price. A put option is a hedge and can be classified as long volatility exposure!

Let’s recap before we move on…we will add some names and pricing detail for clarity here:

 

Your Perspective

 

You own $100,000 of The Hypothetical Fund. From your perspective, your statement would look something like this:

The Fund’s Perspective

 

Now, let’s look at the HYPO fund’s actual holdings. Remember, you own an ETF so the manager is going to share the actual underlying holdings in the fund daily. 

Let’s assume that the only money the fund manages is your $100k. That fund manager is dealing with two things, the stock they own and the put option on the stock as their protection. 

For simplicity, I’m just adding the value of the put option. We won’t get into option symbols, quantities, or pricing. Hopefully this will keep things clear, so we avoid option greeks and any complexity that’s just not needed here. 

 

Here is HYPO’s holdings in chart format:

 

 

Notice a couple of things:

  • The proportion of stock ownership is much larger than the hedge on that ownership. 
  • As a shareholder of 4000 shares of HYPO, you own 990 shares of stock in BEST 

 

Market Sell Off

 

Let’s assume there’s bad news in the overall markets and it sends all stocks lower:

  • The bad news is that the BEST stock position gets hurt in the market turmoil and your stock position held within the HYPO fund loses value.  
  • The good news is that the company you love is now trading at a cheaper price. If you only had cash laying around to buy more…

 

Let’s just assume BEST loses 25% of its value. The stock price drops from $100 to $75. Let’s also assume the put position held within HYPO protected 50% of the market drop. If you lost $24,750 (loss of $25 x 990 shares you own) that means your put gains $12,375 of value and now carries a total value of $13,375. 

Here’s what your statement now looks like:

And here’s what the manager statement looks like:

 

Your only holding is the HYPO ETF, so it makes sense that your portfolio fell by the exact amount as HYPO. They both went from a value of $100,000 to $87,625.  While you didn’t love losing nearly 12.37%, the good news is that avoiding the entire 25% drop in BEST stock created an opportunity. 

The manager has profit from the hedge they had in place. It’s this profit that explains why the manager was able to sidestep some of the drop.

Now, the manager has the ability to monetize the hedge by selling some of it, since it’s become oversized relative to its initial position. They take the profit and deploy back into the compounding machine known as BEST. This 25% drop in price created the opportunity to pick up 165 more shares at a more attractive price without any new dollars out of your pocket.

Let’s make sure we understand what happened…

 

Recap

 

Your statement still looks the same as last time: 

 

You still have 4000 shares of the ETF and your account value is down 12.37% since you invested $100k. 

What hasn’t changed is the shares of HYPO own. Your fund still looks the same in that you hold 4000 shares of the ETF itself, but under the ETF’s hood, you have ownership of MORE shares of a stock you love – at a lower price!

You went from owning 990 shares of BEST stock to now holding 1155 shares. 

Here’s the final look at the manager’s holdings within HYPO after they monetized the hedge: 

Why This Matters

 

This type of approach allows you to accumulate more and more shares of stock without ponying up more and more capital. This is part of the silver lining of market turmoil when you have ownership of volatility. 

More shares entitle you to more dividends, more upside if price move higher, etc. It’s a powerful way to improve outlook if you can buy more of companies you like at lower valuations. 

Notice we didn’t illustrate sidestepping all volatility of the markets. No risk = no return.

But used proactively, hedges can not only soften downside, but create dry powder in a selloff that can be redeployed back into businesses generating cash flow. A small slice of protection, for increased ownership of cash flows…a nice rebalancing bonus for long-term investors including volatility as an asset class.

Disclosures

 

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

No representation is being made that any model or model mix will achieve results similar to that shown and there is no assurance that a model that produces attractive hypothetical results on a historical basis will work effectively on a prospective basis.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2207-5.

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