The Financial Analyst Journal (FAJ) is a terrific publication put out by the CFA Institute. This group also sponsors the Chartered Financial Analyst (CFA) designation. In a recent issue (September/October 2016), a panel of leading financial experts (Professors Andrew Lo, Robert Merton, Stephen Ross, and Jeremy Siegal) discuss the future of finance and how it can continue to make great contributions to humanity. They agree that financial companies should seek to solve problems rather than simply create more products. One major problem that remains unsolved is that of providing real retirement income to an aging population. Professor Merton argues that the primary source of financing for this has to come from increased personal saving because the other two potential sources, namely government retirement plans (primarily Social Security) and private company plans (notably defined benefit pension plans) are very unlikely to grow. Professor Lo points out that a major problem with individuals managing their own retirements is psychological aversion to the possibility of a huge melt-down in stock prices. This keeps people from owning stocks at all, or prompts them to sell out in the depths of a market decline. In principle, this risk could be mitigated by owning put options on stocks as well as stocks. Combining ideas, the professors seem to support creation of packaged products or “securities” or “funds” that embed put options along with long positions in stocks.
Interestingly, in another FAJ issue in the same year, a professor at UCLA, Evo Welch, reports on an experiment in which he tests out just such a product. Professor Welch simulates a trading strategy that added long positions in index put options to a long stock portfolio. The effect would be to obtain protection against giant downswings in stock prices. Professor Welch was asking the question how much of the large historical return on stocks relative to bonds was compensation to equity investors for assuming the risks of a market collapse. His answer compared the returns on a stock portfolio with and without the put protection. The answer: just 2% of the historical 7% annual outperformance of stocks is explained by catastrophe risk. On the surface, this would appear to suggest a solution to the panel’s concern about investment for retirement. Why not create a security or fund that combined a long position in stocks with long positions in puts? The expected return would be lower than stocks alone, but the downside risk would be greatly reduced.
Oh wait, such packaged products exist. You can hear about them every weekend on AM radio. The pitch goes something like this: “Don’t you want an investment that goes up but never goes down? Call ABC trading company and we’ll show you how to go up when the market rises and not lose a dime when the market falls.” What are the promoters doing? Well, it’s hard to say for sure but it could be that they are doing exactly as proposed in the two FAJ articles – providing a packaged product that combines stock and put (or, equivalently, investing cash into money markets and buying call options on the stock index).
This seems like a great product, consistent with the musings of the great minds on the panel. So what’s the problem? Answer: huge fees! Suppose the expected equity risk premium going forward is 4% (a bit lower than Welch’s historical number). About half of that risk premium will pay for the put (or call) options. Then suppose the product sponsors charge 1% of assets to manage the product and pay another 1% to marketers to bring in investors. We are left with a brilliantly designed product that has expected excess return after fees equal to zero (4%-2%-1%-1%).
This problem, where the fee represents a giant proportion of the potential benefit of a strategy, comes up a lot in the financial services industry, and was the impetus for the whimsical book “Where are the Customers’ Yachts?” first published in 1940 by Fred Schwed. The joke behind the title, of course, is that the prestigious yacht club harbors were filled with yachts owned by financial magnates, but none by the clients or customers of the magnates.
A major disruption in the paradigm of massive fees occurred when John Bogle (founder of Vanguard) combined technology and financial theory to create the first equity index fund back in 1965. The index fund allowed mom and pop to obtain market returns at low cost (less than 0.2% of assets). This is a “packaged” product that enabled the small investor to obtain the benefits of market diversification at low cost.
Perhaps this idea can be extended to other packaged products, like the bundled put idea suggested by the panel and Professor Welch. A hopeful sign in this regard is the rise in automated investment management products such as highlighted in a prior essay (“Wealth front”). It is interesting to contemplate how an automated process to control downside risk might work. One version is simply to follow the Welch strategy of rolling over short-term puts. The effect will be to create a distribution of returns that is “skewed” to the right – that is, the downside is limited while the upside is not. Financial theorists generally disdain this approach as being naïve; in order to obtain the desirable profile of returns you earn a lower long-term return (by 2% per year in Professor Welch’s study). However, when the “big one” comes, if it does, this strategy will strongly outperform.
A second way to implement the protective put strategy is to apply a trading rule that attempts to synthetically create puts by trading in equity futures contracts. Basically, the rule would call for an initial short futures position, which would be extended when the overall stock market declined, and reduced when the overall market rises. This idea was implemented for institutional investors back in the 1980s under the rubric “portfolio insurance.” It worked OK until it failed massively during the October 1987 stock market crash. Collapsing stock prices called for huge sales of futures contracts that the market was unable to execute. The lesson from that experience is that the synthetic put idea is inherently destabilizing, at least it is if sufficient numbers of people engage in the strategy.
The legacy of the 1987 crash is that the implied volatility of low strike stock index puts is very high. This means that the cost of buying insurance is high. However, by using observed historical market prices for options, the Welch study includes this effect. Thus, it appears that it may be feasible to create an attractive, positively skewed, return distribution at reasonable economic cost.