With the stock market selloff deepening, volatility spiking and major indices falling into bear market territory, advisors and their clients are looking for ways to help shelter their equity portfolios from the storm.
One place they’re seeking risk protection is in the options market, as evidenced by the recent surge in options trading. In first-quarter 2022, according to Cboe, total volume across its four options exchanges was 830.3 million contracts. Average daily volume reached a record 13.4 million contracts traded.
When extreme market volatility occurs, a spike in investor use of options and other derivatives typically has followed. It appears to be a reflexive reaction to market conditions — in this case, macro-driven turbulence — and may be viewed as an indication of forward-looking sentiment.
In many cases, including recently, advisors and retail investors have used options as a form of risk mitigation, or hedge, for equity portfolios. The use of options certainly can be one of the most available and effective ways to hedge to protect a portfolio from drawdowns. Conversely, options also are commonly used to place directional bets on where the market is headed.
However, the former is the approach that is most often implemented by insurance companies and other institutional investors, which comprise the largest segment of options users.
Structured outcome products
Historically, there have been myriad ways to use exchange-traded funds to hedge to protect a portfolio’s equity sleeve. Some of those traditional strategies have evolved into next-generation strategy solutions such as structured outcome products, which seek to offer equity correlated performance with a downside buffer to partially offset market losses.
As one might expect, this type of philosophy has seen a surge in interest from investors. And for good reason. It offers a measure of tangible equity risk management in the face of a market meltdown.
When used as intended, structured outcome products may add a layer of predictability to an investor’s portfolio outcome. They offer synthetic equity exposure that seeks to deliver a predicted investment outcome over a 12-month period, also referred to as the investment period.
Structured outcome products come in variations as well. For example, although most structured outcome products seek to provide a downside buffer to help offset initial equity losses, one structured outcome ETF series also seeks to offer uncapped upside participation (which is limited to a percentage of the overall upside return) in the large-cap U.S. equity markets. This is especially appealing for advisors who believe that equity markets are closer to a bottom than a top, or that equities could experience a sharp snapback, as seen in the months following Q1 and Q2 2020.
With their turnkey structure, structured outcome products enable an advisor to construct a portfolio that has a customized risk tolerance — something clients are asking for amid market volatility and a continued low-yield environment. For clients who want equity exposure to compensate for a lack of yield in their portfolio or still seek and need the benefits of equity appreciation in retirement, structured outcome products can help provide a more conservative risk profile while still allowing participation in the potential growth of equity markets.
In a typical structured outcome series, a 365-day investment period will conclude on the last trading day of the 12th month, with a new investment period beginning on the first trading day of the subsequent month. In practice, this means that each month, as an option period ends at the option expiration date, the fund managers will “reset” the option strategy in that monthly series for another year. Existing investors who wish to participate in the new investment period simply do nothing. The fund’s portfolio managers take care of the rest. Many advisors “ladder” monthly ETFs to try to create a blended downside buffer and upside capture.
These ETFs are designed to relieve advisors or investors of having to trade the equity portion of a client portfolio tactically. The best way to use a structured product is to invest on the first day of the ETF’s investment period and stay in it for 365 days to reap the full benefits of the predicted outcome. In fact, using these strategies in other ways, such as tactically trading them, can sometimes defeat the core purpose of the investment approach entirely. In addition, because they are issued monthly, these ETFs provide advisors with some flexibility to tiptoe into equities and invest as market conditions change, as they bring on new clients or as existing clients come into cash.
In the event an investor purchases shares after the date on which the options were entered into or sells shares prior to the expiration of the options, the buffer that the fund seeks to provide may not be available and there may be limited to no upside potential. The fund does not provide principal protection, and an investor may experience significant losses on their investment, including the loss of the entire investment.
Advisors also use structured outcome ETFs to “toggle” a client’s 60/40 portfolio mix. Because these are equity products but with a buffered risk profile, advisors can increase a portfolio’s equity exposure equity exposure without increasing its overall risk profile. This may be especially effective for clients who need continued growth, for example, in retirement, but don’t want to carry the increased risk of equities.
By their nature, structured outcome products are designed to relieve investors of having a market outlook. As today’s markets remind us, equity returns are not linear; they’re very lumpy. We don’t know when drawdowns will occur or when upside moves will gain momentum. The intent of structured outcome products is to pursue a smoother equity investing experience by buffering downside moves while still providing upside participation. How much upside participation an investor can achieve and whether a strategy is capped or uncapped will differ by product.