While the stock market was plummeting in the fall of 2008, Brinton Eaton Wealth Advisors, which manages $550 million in client assets, asked a handful of investment banks to devise a powerful new form of portfolio risk insurance. The Madison, N.J., firm wanted a product that would meet three key criteria. It had to deliver gains from spikes in volatility that wouldn't be lost once volatility subsided. It had to avoid correlating closely with other asset classes in a cataclysmic market event. And it had to be cheaper than standard options strategies that force investors to divert too much of their portfolio's wealth from more productive investments.
The advisory firm was looking for "something we can add to client portfolios that doesn't require a huge capital outlay and that would sit there and be unobtrusive during normal markets, but then provide really solid protection if we have another market like the fourth quarter of 2008," says Jerry Miccolis, chief investment officer at Brinton Eaton.
Retirement portfolios must include risky assets if they are to generate the returns people require to secure their financial futures. The problem is how to do that without triggering investors' emotional resistance when the market turns really rocky. Having a good downside protection tool in place is the way to satisfy clients' emotional needs, Miccolis realized.
He recalls that Deutsche Bank suggested a few solutions before it came up with EMERALD in October 2009. EMERALD is an index that aims to capture returns from reversion to the mean (i.e., to normal levels of volatility) on the Standard & Poor's 500-stock index, even amid big moves in either direction during any single week. It does this by trading volatility and swaps, rather than options. (The name EMERALD is a roughly structured acronym for DB Equity Mean Reversion Alpha Index.)
in 2008, EMERALD's return spiked
EMERALD's performance is linked to the spread between the daily volatility and weekly volatility of the S&P 500. For example, in the fall of 2008, brief but sharp rallies interrupted the market selloff, causing daily volatility to top 70% while weekly volatility was around 50%. In the S&P 500, daily volatility has exceeded weekly volatility roughly 70% of the time for the past 11 years, according to the EMERALD prospectus.
Back-testing showed that EMERALD provided an average annual return of about 4% in the 10 years through mid-2008 and then spiked to more than 28% in the second half of 2008, just as most other asset classes were in freefall. Once it rose, EMERALD didn't decline from that level and delivered an additional 2% return in 2009, according to Brinton Eaton. The firm cautions clients that EMERALD isn't a hedge against normal market declines and didn't jump dramatically during the 2000-2002 bear market.
Deutsche Bank offers EMERALD in its pure form to institutional clients. What retail investors get is a promissory note that, when the note expires, requires Deutsche Bank to pay them an amount equivalent to their investment multiplied by the cumulative growth in the index. Due to compliance constraints, Deutsche Bank declined to speak with Bloomberg BusinessWeek about EMERALD, but Brinton Eaton's Miccolis says the bank is offering a similar retail version of the product to several other advisory firms. Brinton Eaton has attached EMERALD to the S&P 500 index, but it can be joined with different assets, he says.
Owning EMERALD entails two key risks. First is the possibility that the index won't behave the way it's expected to if the stock market experiences another abrupt and sharp downturn. The other is counterparty risk—that Deutsche Bank, for whatever reason, won't make good on its promise. Brinton Eaton expresses confidence that the chance of default is very slim because Deutsche Bank is a commercial bank backed by deposits, enjoys a high credit rating, and didn't need to draw on the financial support offered by Germany's government to all domestic banks during the financial crisis.
limiting exposure with 3X EMERALD
Although Brinton Eaton has discretionary authority to introduce EMERALD into the portfolios of its 260 clients without their explicitly opting in, the firm felt it necessary to explain the index in advance because it is so different from other products that its clients typically invest in, says Miccolis. Very few, he says, felt sufficiently uncomfortable to opt out of EMERALD.
Brinton Eaton decided against converting clients' entire equity exposure to an investment in the S&P 500 index with EMERALD attached because that wouldn't allow the firm to enhance their portfolios by investing in equity subclasses such as small caps and global infrastructure—and would also have exposed too much of their portfolios to concentrated counterparty risk. Instead, Brinton Eaton opted for its so-called 3X EMERALD within the structured note, a leveraged arrangement which, for every $100 invested in the note, gives clients $100 of S&P 500 index exposure and $300 of EMERALD index exposure.
The market now recognizes the disadvantages of leveraged ETFs, whose moves in either direction get multiplied by a factor of two or three every day and which tend to erode over the long run. In the Deutsche Bank note, the cumulative movement in EMERALD is multiplied by three only at the end of the 13-month term and isn't subject to long-term erosion, says Miccolis. At maturity, Brinton Eaton plans to buy a new note unless it discovers something better, he adds.
To prevent investors from losing more than their original investment, EMERALD includes a knock-out provision that effectively closes out the note if its value drops during any trading day to a level 65% below its original purchase value. Investors would be paid the market price on the next trading day. Brinton Eaton plans to closely watch any big declines in EMERALD and if a knock-out occurs, the firm intends to replace it with an equivalent note.
Brinton Eaton acknowledges drawbacks to the 3X version of the note. In a February letter to clients that explained EMERALD in greater detail, the firm said the 3X version tracks the S&P 500 index less reliably than the 1X version because the pure EMERALD contribution will be three times more prominent. Other disadvantages are higher odds that a knock-out event will occur and a higher fee.
"close to costless insurance"
The expense ratio for the promissory note includes 0.67% for the S&P 500 piece and 3% for the triple exposure to EMERALD itself. It ends up closer to 4% because of the 13-month term.
Brinton Eaton expects cumulative growth in the EMERALD piece of the note to exceed 4%. "If it behaves as we expect, essentially what our clients are getting—after the anticipated growth in the EMERALD piece—is exposure to the S&P 500 index for less than what they'd be paying to get exposure through a normal ETF or mutual fund, plus catastrophe insurance," says Miccolis. Unlike the premiums you pay on other forms of insurance, he expects clients to recoup their investment, plus sufficient growth to more than cover the fee.
"It is as close to costless insurance as anything we've seen," he says.
Another product that offers downside risk protection using futures and options on equity indexes is SunAmerica 2020 High Watermark Fund (HWKAX), which comprises high-grade U.S. government securities such as Treasury bills, strips, and agency notes with an equity futures-and-options overlay.
Investors receive at maturity the highest net asset value that the shares have reached at any time during the fund's lifetime, even if they are purchased after that high watermark was hit. If they sell the fund before it matures, however, they will get whatever the net asset value is at that time.
Coming soon: Retirement Paycheck Fund
While essentially target-date funds, the High Watermark funds are more flexible than other funds in that category, says Kim Erle, portfolio manager for the High Watermark funds at Trajectory Asset Management, the funds' subadvisor. They aren't structured as funds of funds and they have a more dynamic glide path to maturity that allows the managers to increase or reduce equity exposure, according to market conditions and other factors.
The High Watermark funds use only exchange-listed derivatives, which are more transparent than swaps and avoid counterparty risk. They have an expense ratio of 1.65%. In 2008, the 2020 fund declined 16.7% in value, vs. a 20.3% decline in the nearest benchmark, the Dow Jones U.S. Target 2020 Index.
Trajectory has back‐tested an additional product, to be called Retirement Paycheck Fund. Designed to protect a stream of income, Trajectory hopes to launch it later this year. "It's more powerful than protecting a target date," says Juan Ocampo, lead manager of the High Watermark funds. This product would grow from partial participation in the equity market when the equity outlook is attractive and become more conservative when the outlook is less optimistic, generating premium income from writing call options on the equity market.
The new product would also pay a monthly dividend that, once declared, would never go down, but would only move higher, he says. By providing a reliable source of monthly income, it would be similar to an annuity product and would be even more relevant for most retirement portfolios, says Ocampo.
When it comes to retirement, investors have learned the hard way that wealth preservation is as important as accumulation. Until recently, the belief was that you had to give up some of one to get the other. If new offerings such as EMERALD and the upcoming Retirement Paycheck Fund prove successful, investors may be able to enjoy both.