What's Ahead:
- Credit risk is not something typical stock portfolios face—risk is driven almost exclusively by equities during periods of volatility.
- A hedged-equity approach, which layers structured notes on top of a portfolio of stocks, bonds, and alternatives, can improve the risk-return profile of an allocation.
- Investors can stick to their investment plan while advisors can free up time to focus on additional value-add activities.
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Sometimes you don’t understand what you own until volatility spikes. Recall back in 2008 or at the depths of the 2020 COVID-19 drop in the stock market how correlations seemed to go to one? A diversified portfolio suddenly wasn’t so diversified. That’s how traditional asset allocation works, though. During the good times—when volatility is in check—pairwise correlations between stocks and among sectors often retreat, making it easier on stock-pickers trying to beat the market.
It’s also a less stressful period for financial advisors who employ common asset allocation strategies. A mix of U.S. large- and small-caps, value and growth funds, foreign and emerging market shares, and high-grade and high-yield bonds looks great on a spreadsheet. It also performs as designed during periods of relative tranquility.
When bear markets strike, though, diversification sometimes seems to just stop working. The 60/40 portfolio, for instance, got smashed in 2022 amid higher interest rates and as long-duration equities, which command a large share of the S&P 500, took a beating. Small caps performed even worse for the year while ex-U.S. equities stumbled during the first half of 2022 due to a surging dollar and turmoil in Europe and Asia.
This opens a “risk-reward gap” when using traditional asset allocation strategies. We find that even with a balanced portfolio, there is an alarmingly high 95% risk exposure to equities when dissecting risk-factor contributions. In contrast, credit risk amounts to an extremely low percentage as does interest-rate risk and idiosyncratic risk. The challenge is to include other assets and investment vehicles to design allocations that offer true and durable risk mitigation.
So, what’s the solution? Is there a free lunch? What magic elixir do we have up our sleeve? Of course, we do not have the perfect cure. Nobody does. But what we can do is manage risk better using technology and financial innovation that has come about in the investment industry in the last several years.
Enter: Structured Notes
Structured notes can be used to alter a 60/40 portfolio and improve it to a 50/30/20 allocation of stocks, bonds, and notes using a core-satellite approach. This isn’t your old-school, core-satellite strategy, however. With this innovative method, we propose using structured notes as a portfolio’s core rather than a “satellite” as many advisers treat notes today. By “layering” structured notes on top of a long equity sleeve, an investor can earn enhanced upside potential with an added level of downside protection. The strategy treats many layers of a portfolio as complementary, not siloed, standalone holdings.
The Asset Allocation Revolution
For example, let’s say an allocation has an 11% weighting to U.S. large-cap core. Traditional practice says that one or two active funds or just a single passive ETF can suit the bill. What Halo asserts, however, is that 8% goes to a fund while 3% is invested in structured notes. The same strategy is employed with other styles including small caps, foreign developed market equities, and emerging market stocks. In all, a portfolio with a 50% equity exposure includes a 20% position in notes.
Hedged Equity Framework
The basic approach to portfolio construction has changed little over the past few decades. Equities provide returns for accepting risk; bonds are used for protection.
This simplified approach, demonstrated by the ‘60/40 stock-bond’ portfolio, has worked well for many years. Historically, investors would have been justified in owning traditional bonds in the face of low return expectations, given bonds have produced a powerful source of diversification to equities.
However, a growing consensus now sees market portfolios delivering returns far below both historical levels and investor targets. Equally critical, though less prominent, the inability of fixed income to provide either compelling returns or risk diversification (limiting downside risk) suggests investors are better served looking for fresh portfolio construction ideas.
To more efficiently reduce equity risks common to entire portfolios or an exposure to a specific allocation sleeve, Halo prefers structured notes. Because the correlation-based defense bonds have traditionally offered is becoming less reliable, notes are quickly gaining in their appeal to modify a portfolio’s risk-reward profile without venturing into unfamiliar hedging strategies such as options overlays or similar approaches.
By layering notes with existing exposures, investors can remain in asset classes they’re familiar with. However, a needed layer of structural defense is added—one that is not reliant on future correlations, as in classic portfolio management techniques. In this sense, a hedged-equity strategy featuring structured notes can fill the roles that bonds have played in balanced portfolios in the past: to dampen equity risk while supplementing capital growth through consistent income.
By layering notes, four benefits emerge:
1. An improved risk exposure
Growth notes, with enhanced upside participation and downside protection through the use of a zero-coupon bond and derivatives package, can help lower overall portfolio volatility while increasing return potential. While there is some credit risk introduced, the risk-reward gap described earlier asserts that traditional assets in fact do not have material credit-risk exposure. Moreover, through hard and soft protection (barriers and buffers) with note-enhanced equities, the allocation’s standard deviation can be reduced when volatility rises in the broad market. In a sense, the notes help in the investment management process by offering an efficient way to play both offense and defense.
Complementing a Portfolio With Structured Notes: A Better Sharpe Ratio
2. More value to the client from the advisor
We like to describe managing client emotions as the so-called “art” of investment management. But it’s not enough to simply prepare investors for turbulent markets. Advisors must combine the art and science of planning and investment management. Structured notes through the Core-Satellite 2.0 approach help achieve that mission.
Layering structured notes on top of a long equity sleeve can help make up for poor performance elsewhere in the portfolio—perhaps from an active fund that produces unimpressive returns. Additionally, a better risk-reward portfolio frees up an advisor’s time to focus on value-add planning activities such as tax planning, risk management, estate planning, and retirement strategies. Finally, there’s also more time for business development, not to mention an advisor’s emotional well-being being protected.
3. Tax-loss harvesting opportunities
Building on the notion of greater advisor alpha, equity-linked structured notes used with active and passive funds can bring about tax-loss harvesting potential. For instance, should one active fund be down in a year, the advisor can simply swap the losing fund for more passive exposure in a similar fund or ETF or add to a note with a comparable underlying asset. You can almost think of a note as being a hedge against an active manager’s uncertain return.
We like to think of the long equity fund sleeve as a “cash toggle” in that it can be used to tactically tilt the allocation, provide short-term cash needs as well as offer tax-loss harvesting opportunities. What’s great about selling from a fund and buying a similar-performing note is that it generally does not count as a disallowed loss via the wash-sale rule.
Taking a step back, advisors can have confidence in the portfolio-building process by utilizing Halo’s robust team of specialists who can walk advisors through the note-layering approach. Once the advisor is comfortable with how the portfolio is constructed, Halo can offer ideas for other strategic allocation moves (not just short-term tactical ideas) using notes.
4. Get invested, stay invested
The goal of using structured notes is to build long-lasting portfolios that have the potential for durable risk-adjusted returns across a range of market conditions. True diversification means not relying on any single environment to succeed as an investor. The problem with typical portfolio management styles is that they fail to deliver diversification right when it is needed most: at the point of maximum pain. That leads everyday investors to make bad decisions at the worst time (think October 2008, March 2009, March 2020) or get involved in highly risky activities when there’s excess froth across financial markets. Does the “behavior gap” ring a bell? It’s real, but it doesn’t have to wreck a client’s long-term objectives.
Getting invested is one thing. Staying properly invested is a whole ‘nother. With structured notes as a core part of the portfolio, an advisor is able to keep their clients on track. Emotional swings are less severe, and returns can be more consistent. There’s also flexibility for the advisor in that she can layer on as much downside risk protection as she wants based on a single client’s risk and return objectives. That tailored approach also promotes an allocation that can be stuck to (for lack of a better word).
The Bottom Line
A hedged equity framework featuring notes offers advisors several benefits meant to make their job easier and promote portfolios that feature an improved and durable risk-reward profile. As technology and innovation bring costs down and improve transparency, structured notes can now be more effectively and practically incorporated into portfolio construction strategies.
Please see our Halo Disclosure Page for important disclosures.
