A New Strategy for Downside Protection or Yield Enhancement June 7, 2016 by Robert Huebscher Vest Financial Group Inc. was founded in 2012 by Jeff Chang and Karan Sood. Vest is dedicated to serving investment advisor and brokerage firms in bringing wider access to innovative options-based strategies. Vest's products are protection-oriented, providing investors with targeted protection, enhanced returns and a level of predictability unattainable with most other investments services available today, and include technology-powered managed account solutions for financial advisors and technology solutions for brokerage firms. I spoke with Jeff on May 31. Can you describe the history of Vest and its relationship with the Chicago Board of Exchange (CBOE)? Vest Financial was founded after the financial crisis, when a lot of investors lost a considerable amount of portfolio value in the downturn, which brought to light the benefits of protection and how options can help hedge portfolios. What we did was in response to those concerns. We build products using listed securities for investors who are looking for protection. Our commitment to providing investors with those benefits aligned our interests with an organization like CBOE, so much so that we started finding ways to work together and develop products such as indexes. There were certain synergies that we had with CBOE, so in January it took a majority stake in our firm with the idea that we both have the goal of advancing the benefits and the innovation of options. When we founded our firm, we were looking to democratize risk-management and protection strategies that were mostly done by options specialists. Options should not just reside with option specialists. With technology and financial engineering, we believe that these benefits could be made available to all financial advisors and their clients. You offer something called Vest Protective Strategies. Can you describe how those works? Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.
Vest Protective Strategies seek to provide a level of downside protection for an ETF or an individual stock securities or indexes that have listed options that trade on them. Anything that has an option that trades on it can have a Vest Protective Strategy around it. As an example, our S&P buffer-protection strategy seeks to buffer protect against the first 10% loss due to a decline in the S&P 500. For instance, consider our S&P Armor 10 strategy. If the SPY ETF goes down 10%, the strategy would seek to be down zero because the first 10% drop is protected. If SPY was down 12%, it would only be down 2%. That s the definition of buffer protection. Notice in that situation, even if SPY was down 30%, you would only be down 20%. The idea is that from a price-return perspective in a down market, you will always outperform in a down-market scenario because you have that 10% buffer of protection. Since there is no free lunch, how do you pay for that protection? The growth opportunity is capped. As an example, for a given year, the most you can make is 12%. If the S&P is up 10%, you are still making 10%. However, if it s up let s say 15%, you are only going to make 12%. This is really good for individuals, clients who aren t looking to make 20% to 30% outsized returns in a given year. This is for when a client talks to an advisor and says, Just don t lose my money. I don t want to make huge amounts of money and capital preservation is more important. With interest rates so low, as we ve seen over the past couple years, combined with a large portion of the population baby boomers who are near or at retirement there is an increase in demand for investments that have protection but still provide some growth opportunity. A lot of times, investors have a choice. They are either going to be naked equities or low-yield fixed income. If they want to pick up more growth, let s say in the fixed-income space, they either have to take on more credit or higher duration risk. If rates rise, they can experience losses. We are in that middle area between going completely naked equities and transitioning to low-yield fixed income. You mentioned that your strategy can be applied to any security that has an option that is traded on the exchange. What does that include in addition to individual stocks and ETFs? What about the typical advisor who wants to apply it to a mutual fund or to bonds? You can apply it to ETFs. Some of the most liquid listed options are on ETFs, such as SPY. Unfortunately, there are no listed options of mutual funds on the exchange. But in certain situations, we can find some of the more liquid ETFs that best hedge those mutual funds. But we mostly hedge against stocks and ETFs. In the example you described, you can protect against the first 10% decrease in the value of the S&P. Could you also do the opposite and protect against anything greater than 10%, or anything greater than a certain percent? Absolutely. We have a deep protection strategy. Let s say the client doesn t want to protect the first 10%, but they don t want to lose anything more than 10%. Those strategies are also available and they can also be paid for by selling some of the growth opportunity. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.
What are the costs? Let s go back to your original example where you are protecting against the first 10% of the loss, and then on the flip side you are limiting your gains. Is that the only cost? Or is there also a management fee? We use a separately managed account. We are sub advisors, so a lot of our strategies can be found in certain investment products, with banks and sometimes through structured notes. Instead of having a bank hedge a position with options, we actually put on those option positions within the client s account using listed options as a sub advisor. Our management fee is between 25 and 50 basis points, depending on the total assets managed by a particular advisor. We believe that this is very, very competitive, considering where the fees are within a lot of these products and the price point other options sub advisory services charge. Are there any costs that advisors should be aware of, other than the 25 to 50 basis point management fee? There are the commission and trading costs. For a Schwab advisor it would be the commission on the actual options themselves. But that would be specific to the platform the advisors use. What are the limitations of the Vest Protective Strategy? Vest strategies use listed options. Investors get intra-day liquidity on those securities. However, to get the actual outcome, you have to hold the option to maturity. You can liquidate prior at maturity, but you are not going to get exactly what the strategy is intended to do unless you hold to maturity. Since we are using options, some clients may have to fill out additional paperwork to implement these risk-management strategies within their accounts. What are the typical maturities of these strategies? The majority of our maturities are between one and two years. I understand that you can use the strategy for tail-risk, buffer and deep protection, which you described, but you can also use it for yield enhancement and capped accelerated return. Can you talk about how each of those works? For yield enhancement, we can sell some of the upside on a stock or ETF by using a covered-call strategy. However, the key here is that implementing a cover call may be more complex or more timeconsuming than is desirable for an advisor. We help manage that strategy. We manage the option assignment, and if the stock or ETF were to go above the cap level, we manage the sale of shares. This is because if it blows through the call, you have to sell some of the stock to pay for the call. It is especially critical for clients with low basis stock or ETFs that they have written a call on. We manage that process for the client. This allows advisors to enhance the yield within their portfolio without having the time-consuming nature of dealing with those options. Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.
The other strategy is the accelerated return. It takes a particular ETF or stock, such as SPY, and you get similar price return on the downside. However, the upside is leveraged. If SPY were up 5% it would be two times, so the upside would be 10%. However, it would be capped. Let s say it s capped at 15%. If SPY were up 10%, it would be up 15% as opposed to 20%. That s the tradeoff. The downside would be the same as SPY, but the upside would be leveraged up to a particular cap. The strategy is interesting for advisors who don t think the market is going to be up say 20-30% and think it s only going to be up, say, 5-6% this year. It leverages that moderate growth and you can get more for the client. If you think SPY is going to be up only 5%, it gets you 10%. When it comes to volatility reduction, what are the advantages of an option-based strategy as compared to traditional diversification, say diversifying one s equity positions with a fixedincome position? Diversification is the most common way that advisors protect their clients assets, and it has worked for decades. But research has shown that more and more tail-market events have happened in the past 20 years than during the prior 20 years. When those events happen, assets become extremely correlated to each other. Even in a well-diversified equity portfolio, correlations start to increase. When you need that protection the most, diversification may not always be there, given certain situations such as with the market dislocation we saw in 2008. However, protection through options is a lot like buying insurance. We always say on our website there is a less than 3% chance that you will get in an accident, or your house will catch on fire, or even dying, yet you have insurance on those three scenarios. But there is more than a 20% chance that you will experience a market loss in a given year, and a lot of clients don t have insurance for that outcome. There s a 3% chance on the other scenarios, and a 20% chance of experiencing a market loss in your portfolio. So why not protect your clients portfolios? The great thing about the Armor 10 and our buffer protection is that they are not dependent on correlation, meaning that the first 10% drop is protected. Let s say I m trying to insure my car. Through diversification, I have my car, and I buy a skateboard, a bicycle and a boat. That way when my car breaks down, I have a bicycle, a skateboard and a boat to get to work. That is what we call horizontal risk management. Whereas, buying insurance on the actual car itself is vertical risk management, where you increase or decrease the potential risk associated with that asset. You talked about accessing your strategies through separately managed accounts. What are the other ways advisors can access Vest strategies? We have filed for a UIT, and we are looking to come out with exchange traded funds. We filed our UIT through our strategic partner, Elkhorn Securities. This allows commission-based advisors to have access to the benefits of our Vest based strategies at a relatively low cost, so there is no bank credit risk and daily liquidity of the underlying options themselves. We also have filed for a series of mutual funds. These will allow Vest strategies to be more standardized. Our SMAs are customized. The mutual fund allows us to have a standardized offering Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.
that would seek to track an index, such as those on the CBOE website. The same benefits of the Armor 10 can be automatically rolled into a mutual fund. An investor could get a blend of monthly Armor 10 strategies, as if they bought a certain amount in an Armor 10 strategy every month. We are also currently developing an ETF lineup to access these Vest protective strategies. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.