What's Ahead:
- Smart beta, factor funds, and dynamic asset allocation are just a few portfolio strategies Wall Street has created to help investors combat high stock market volatility.
- Structured notes are different in that they don’t require the time and effort to implement and manage compared to the latest low-volatility product or allocation tactic.
- Notes offer equity-like upside potential with downside risk protection and can be tailored to an investor’s unique risk/reward preferences.
Smart beta strategies were all the rage a few years ago. Managing an equity portfolio with certain tilts and so-called “factor exposures” sought to produce better risk-adjusted returns. The premise was solid, as empirical evidence over the decades indeed proved that there were optimization techniques portfolio managers could employ that captured certain alpha sources that didn’t appear to stem from simply adding to risk.
What Worked Once Often Fails Later
Like many financial market innovations, we have seen such smart beta plays wane in popularity as their performance against the broad market wavered. Moreover, recent declines – like those in late 2018, March 2020, and throughout 2022’s bear market – all seemed to feature equity correlations going to one. Perhaps another strategy is needed to protect portfolios when volatility strikes.
Using Structured Notes for Downside Risk Mitigation
One method that has the potential to effectively reduce portfolio volatility includes structured notes as a core holding. Structured notes are designed to mitigate risk through downside protection, with enhanced yield or enhanced market upside participation opportunities.
Notes are built using a zero-coupon bond with an options package layered on top. They feature a defined maturity date, typically within two to five years. The options piece of a note’s construction establishes a protection level and potential payoff at maturity. It’s common for investors to carve out a portion of their equity position and reallocate toward notes with an equity index as the underlying asset.
Structured Notes: Four Components
Correlations Climbing
Before smart beta plays became popular, professional money managers often added to safe-haven assets like U.S. Treasuries when volatility was thought to be on the rise. After all, for much of the past three decades, government bonds acted as great diversifiers during stock market drops. That approach, however, has proved to be futile in 2022 with both fixed income and stocks falling together amid surging interest rates.
Rethinking Asset Allocation Strategies
Financial institutions are now getting crafty with new tactics to help investors weather persistent volatility without relying on the bond market. There’s a new technique known as “dynamic volatility management” catching some press. It’s a flashy new name and brand, but it is similar to an old-school method known as “risk parity.” That’s a portfolio management style in which a specific volatility level is targeted, and asset class weights are dynamically managed to keep total volatility at the desired level. Diving deeper into portfolio theory, the equity slice of an allocation is then constantly adjusted through “tactical asset allocation” (without shifting the “strategic asset allocation” to a high degree).
Complicated Is Not Always Ideal
Is your head spinning yet? These quantitative methods can work well and be inexpensive when programmed correctly, but constant buying and selling often drives up taxes and increases trading costs through slippage. What if there were a simpler way that did not require getting in and out of stocks and bonds? Structured notes as an equity replacement can be an effective solution.
An Alternative to Low Volatility Strategies
Investors writ large want equity-like returns without accepting high volatility. However, as advisors are fully aware, 100% stock market exposure, through either active managers or low-cost index funds, might work out perfectly on a spreadsheet forecast, but retail investors commonly have a tough time enduring a full bear-market cycle. Being able to sleep at night is important for risk-sensitive investors. Structured notes, by way of their built-in downside protection, reduce overall portfolio volatility without having to trade in and out of core pieces of an allocation.
It’s also important to remember that Wall Street’s low-volatility solutions come and go. They might be popular for a while due to impressive backtesting results and a period of decent performance, but real-life returns during the following market cycle often fall short of the models’ promises. We saw this with portfolio insurance decades ago, managed futures funds following the Great Financial Crisis, and just recently with smart beta and factor funds. You can count on Wall Street to produce new products with impeccable back-tested returns in 2022’s challenging environment in the near future.
Notes Are Designed to Weather Stock Market Volatility
But why not stick with simplicity and an approach that has worked throughout past bear market cycles? Structured notes take advantage of elevated volatility and higher interest rates through their components. Moreover, today’s technology has brought down costs, and competition among competing issuers helps ensure the lowest possible price for retail investors. Once invested in a note, you can simply hold it to maturity and focus on other areas of your life rather than having to constantly adjust your allocation. It’s also easier on the advisor who can then devote time and energy to financial planning activities.
Allocating to Notes
The first step is to select an asset class where downside protection is desired. An investor then reallocates a portion of the asset class to a structured note. That exposure then improves the risk/return profile of a portfolio. Barrier and buffered protection alternatives can help fine-tune a desired risk/return profile. You can further define your outcome using either growth notes or income notes. The former features an upside participation rate on the underlying asset’s price appreciation, while the latter often offers higher yields than what are available in similar credit assets.
The Bottom Line
Investors seek portfolio solutions that buffer against volatility but still participate in stock market appreciation. While there are active strategies devised by Wall Street that look great in backtests, a more efficient way to keep equity-like potential with the convenience of built-in downside risk mitigation is through structured notes. Today’s technology and competition bring down costs, making notes an effective low-volatility alternative for a range of investors.
Please see our Halo Disclaimer for other important disclosures.
