Overcoming challenges through portfolio protection
Financial advisors need to implement a new risk management process to protect client portfolios. Historically, advisors have relied on diversification as their primary risk management tool. However, during the global financial crisis, most asset classes declined simultaneously. In short, diversification failed. Financial advisory firms are adding protection strategies to their platforms to fill the gap.
A protection strategy involves assembling and managing a portfolio of hedge assets which are tailored to each client's investments. Typically, a protection strategy is managed to lock-in gains from favorable returns on underlying investments and to harvest gains from the hedge portfolio during severe market corrections. By integrating hedge assets with the underlying investments, risk is reduced and the overall value of the portfolio may be enhanced over market cycles.
It is simply be too time-consuming and expensive for individual financial advisors to design, analyze and implement protection strategies on their own. Milliman works with financial advisory platforms to provide point-and-click access to a full range of protection strategies. With our established processes, industry-standard technology and dedicated team of professionals, we are able to make it easy for financial advisors to protect client portfolios.
There are tremendous benefits from adding a protection strategy to clients' portfolios. We are all aware of the age old saying "Buy low and sell high" when investing in the stock market. However, we also know all too well that the majority of investors actually buy high when the market is strong, and sell after significant market decline. This natural behavior of the average investor is destructive to their portfolios’ total return. An attempt at market timing for most investors turns into buying high and selling low. A protection strategy easily addresses and corrects this natural behavior that is so destructive to investors returns. Milliman employs a strategy that protects the asset growth in bullish markets and defends against the major losses during downturns in the markets, alleviating the self destructive behavior of buying when the value is nearly priced out, and selling after the price has plummeted.
Asset allocation strategies alone aren't enough
Many financial advisors use asset allocation strategies to mitigate risk by diversifying asset class exposure amongst low- to negatively-correlated assets. Harry Markowitz was one of the fathers of asset allocation. In the 1950s he along with many other economists developed mathematical models designed to enhance investor portfolios. Many advisors and investors alike believed in the diversification/asset allocation story, but the strategy fails when all assets become highly correlated.
In 2008, we saw all the equity markets take a historic plunge. A shocking realization was watching commodities drop in line with the S&P500; both dropped nearly 37% in 2008. Many experts believe that the increased access to commodities ETFs and the billions of investor’s dollars lead to the higher correlation of equities and commodities. Early 2008 showed most asset classes moving more and more in sync with the S&P500: S&P500 down 37%, EAFE down 45%, EEM down 55%, REITs down 37%, High yield Bonds down 26%, and Commodities down 37%.
Investors need a protection strategy
Asset Allocation Strategies & Diversification alone are not enough to navigate the volatility and risks of the current marketplace. The hedging strategies that protected the assets of institutional investors can offer significant value for individual investors. A protection strategy that would allow the financial advisor/ investor to build a custom portfolio across all asset classes while accessing a hedging strategy would be ideal. This portfolio would allow the investor to capture much of the upside gains and reduce downside losses.
Many advisors are looking at different ways to protect their asset allocation models. Some of these measures involve shorting securities to provide a hedge for their equity exposure or increasing the percentage of cash exposure. Increasing your cash allocation would create a more flexible account and simultaneously provide a greater cushion in market declines. These strategies could enhance the performance of these models if we experience another year like 2008, but you will be missing out on the equity upside if you are in a larger cash position. By using a protection strategy, investors can have greater participation in growth assets.
How a protection strategy would perform
Figure 3 illustrates how a protection strategy would perform. In this illustration, we compare an unprotected portfolio to a protected portfolio. The unprotected portfolio is invested in U.S. large cap stocks. The protected portfolio includes the same U.S. large cap stocks and hedge assets. The hedge assets are managed on an ongoing basis to preserve the client’s capital over a rolling five-year time horizon. With this protection strategy, the protected portfolio will be cushioned against severe market declines. It is important to note that the protected portfolio will still experience declines in market value. However, the market declines are likely to be much lower than those experienced by the unprotected portfolio.
In addition, the protection strategy is managed on an ongoing basis to lock-in favorable events for the client. In this example, we use a 5% stop loss rule to successively increase the target value which is being protected. With the stop loss approach, investors are more likely to keep gains from a bull market during a subsequent market decline. In addition, the protection strategy is managed to harvest gains from the hedge assets after large market declines. During a severe bear market, hedge assets are likely to grow significantly in value. Upon reaching a pre-set threshold, the protection strategy is reset to its initial starting point. This has the effect of locking in hedge gains during a bear market. This approach of ongoing management of the protection strategy can help clients build and keep wealth over market cycles.
In Figure 4, the Protected Portfolio includes the U.S. large cap stocks and the hedge assets. The protected portfolio experiences more stable returns and avoids large market losses during bear markets. The Unprotected Portfolio experiences wild swings from market turbulence. In addition, most investors returns will be even worse than those shown as the Unprotected Portfolio. Typically, investors rush in after markets have performed well and they exhibit panic selling after a significant decline. This behavior can severely damage returns over time. With a protection strategy, this negative behavior is less likely. Clients are more likely to invest for the long term, allowing them to grow and preserve wealth.
The Protected Portfolio is much better suited to fund a client's retirement income needs. Market declines combined with withdrawals needed for retirement income will rapidly deplete a portfolio. As more and more investors need to draw on their accounts for predictable retirement income, the need for protection strategies increases.
Milliman has a long track record in hedging for our clients
Milliman's Financial Risk Management Practice was established in 1998 to assist our clients in hedging market risk. We have a team of 80 professionals exclusively dedicated to this activity. Through our advisory services and licensing of our technology and processes, we assist with the hedging of over $500 billion of underlying account value on a daily basis.
Milliman's people, processes and technology have been deployed successfully through the bear market from 2000 to 2002 and during the recent Global Financial Crisis. Our approach relies on the simplest, most liquid hedge assets available, and we insist on complete transparency with all of our clients. Simple and transparent; we believe these core values are the reason for our success in the market and for the high reliability of our services.
Milliman is working with financial advisory platforms to implement protection strategies. Through the Milliman Grid Computing Facility, we are equipped to monitor the risk on a 24 hour basis on millions of client accounts. Milliman's Financial Risk Management Practice is an integrated, global operation with our primary operations conducted out of Chicago, London and Sydney. With our three trading floors, we are able to monitor and maintain hedge portfolios around the clock.
By working with Milliman, financial advisory platforms are able to implement protection strategies in the shortest possible time and they can benefit from our many years of work in this field.
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