Portfolio Insurance

Here’s a quick pop quiz: how many people do you know that have assets worth protecting and, in addition, own life insurance as a result? My guess is that most people will say something like: “Almost everyone I know”. Exactly. Here’s my follow up question: is your portfolio an asset that you think is worth protecting? In other words, if you could buy some sort of insurance policy against a major drawdown in your portfolio, is that the sort of thing you’d be willing to consider? Perhaps you’ve never thought of it before, but if your answer to the first question was affirmative, the answer to the second likely ought to be affirmative, as well. And yet…

In early 2020, I repositioned between 32% and 40% of my clients’ equity assets from traditional long-only products to a couple of custom-built inverse notes—one on the S&P 500, the other on the TSX. Basically, these products go down when the market goes up, and up when the market goes down. These products come with “collars”, meaning that there is a limit on the amount that can be lost in a raging bull market scenario. Even though these products could make 40% if the Canadian TSX went down by 40% and 50% if the American S&P 500 went down by 50%, the most anyone could lose on either of them is 10%, no matter how much markets went up. The risk / return tradeoff is asymmetrical in the investors’ favour.

The notes are for two years. They are liquid in the interim and new notes can be used as replacements at any time. For instance, if markets were to rise by 20%, I could sell the existing notes at the maximum 10% loss and replace them with new notes which use the higher benchmark levels as the new baseline.

The Insurance Metaphor

Think of this product as being somewhat like a T-10 life insurance policy. Policies like these are for a ten-year terms and are generally renewable when the ten years are up, only at higher rates (because you’re ten years closer to death) and only until a certain age (typically in your 70s), because the cost of insurance is prohibitive after that point. In contrast, these notes are T-2, meaning they can be replaced every two years, but at nearly identical rates, even if you’re over 100.

Let’s say you had $1 million invested and 30% was in bonds. Of the $700,000 in stocks, there might be $150,000 in the inverse U.S. note (the Shiller CAPE on the S&P 500 is currently around 32) and $100,000 in the inverse Canada note (the Shiller CAPE on the TSX is around 24). The other $450,000 would be invested traditionally. Now, what would happen if the Canadian and American stock markets both dropped by 30%? Under a traditional scenario, a 30% drop on $700,000 would see the value drop by $210,000 to $490,000.

Meanwhile, and in contrast, with $250,000 inverse and $450,000 traditional, the net effect would be $200,000 dropping by 30% for a loss of $60,000—leaving you with $640,000.

The difference ($150,000) is due to the 30% drop on the $500,000 that is cancelled out ($250,000 long minus $250,000 inverse = no change) NOT hitting your account.

Now, let’s look at the flip side. If the market were to rise by 30%, the scenario would be one of the good news simply being “less good”. The $450,000 that is invested traditionally would be up by 30% (to $585,000), but the remaining $250,000 would be down by 10% (to $225,000). Your $700,000 would have grown to “only” $810,000.

Meanwhile, the 100% traditional (i.e. long-only) approach would have seen the portfolio grow to $910,000.

Prospect Theory teaches us that investors consistently experience the joy of a gain only half as strongly as they experience the pain of a loss. If you start with $700,000, you’d have to grow to $900,000 in order to feel happiness that is in keeping with the remorse you’d feel if that investment had dropped to $600,000.

Draw your own conclusions regarding how people are likely to react under both scenarios.

I’m not able to claim to know when the market will drop, why the market will drop, how deep the drop will be or when it will all end. This is an exercise in risk management, not market timing. Are people who buy T-10 life insurance policies guilty of “death timing”? The logic would follow that they are buying life insurance policies simply because they expect to die in the ensuing timeframe. My point is that proper insurance is put in place in case something awful happens—not because you are expecting it to happen. The metaphor isn’t perfect, but I think it explains the reasoning neatly: risk management due to rare circumstances, not market timing based on presumed clairvoyance.

Markets always drop eventually, just as we all die eventually. In both cases, it is folly to presume to know when these events will occur. Why is it prudent to protect against one eventuality and foolish to protect against the other when both are certain to transpire eventually, and no one knows when either will occur? What I know for sure is that we had a yield curve inversion south of the border in Q2, 2019, that this is already the longest-running bull market in history and that valuations are near all-time highs. Given all this, are you sure you don’t think some portfolio insurance is warranted?

A Behavioural Perspective

There’s much that’s been written over the years about behavioural economics, and for good reason. The topic is utterly fascinating and there are several accessible books that are both highly entertaining and paradigm-shifting in their insights. It seems one of the paradigms that still has not shifted is the attitudes many people (and especially many advisors) have regarding how to proceed in highly elevated market conditions.

Three separate Nobel laureates have written books and papers that have advanced our understanding of behavioural economics in general, and behavioural finance in particular. Those three gentlemen are professors Robert Shiller (Yale), Daniel Kahneman (Emeritus at Princeton) and Richard Thaler (Chicago). While many people applaud the insights that these gentlemen have uncovered, relatively few advisors take steps to apply them in their day-to-day practices. Collectively, they are three giants regarding the empirical evidence surrounding financial decision-making.

The irony is that many advisors (and especially many of the best advisors I know) are familiar with their insights, yet few do anything to incorporate those insights into the counsel they provide to their valued clients. As the saying goes, the literate man has no advantage over the illiterate man if he chooses not to read. Similarly, someone might ask: “what’s the use of lauding behavioural insights if you’re not prepared to implement those insights in the advice you provide”?

On 6 January 2020, I appeared on the BNN Bloomberg program “Market Call”. This is something I do 6 or 7 times a year as one of a small cabal of portfolio managers who are invited to appear from time to time to offer thoughts on capital markets and answer viewer questions about problems and products that are topical. I told the country about the strategy I wrote about in the previous issue on that program. Specifically, I mentioned that in addition to a standard re-balancing, I was also placing a two-year hedge on my clients’ portfolios in the form of a pair of inverse notes as a bit of insurance against a market downturn. After the show, I received e-mails that were consistent with what some friends, colleagues and suppliers were saying to me: that I was being reactive and extreme, that I was engaging in market timing, that I thought I knew better than anyone else. With respect, I disagree with these interpretations and alleged rationales.

Here’s why: The decision I made was to re-position between 32% and 40% of my clients’ equity positions into custom-built inverse product options with “barriers” at 10% (meaning the most they could lose on those products was 10%) and that outcome would require markets to go up by more than 10%. Seeing as my clients were all at least 60% “long” in their equity allocation (i.e. their stock holdings were still disproportionately traditional), my clients were still set to participate (albeit modestly) if the market rose. I have since explained the rationale using a metaphor. Think of the approach as being akin to a ten-year renewable term life insurance policy. People don’t buy term insurance because they EXPECT to die, they buy it to protect them IN CASE they die.

The primary concern (there were a few) I had regarding how things might play out was the Shiller CAPE reading on the S&P 500. It had been hovering between 28 and 33 for about three years when I placed the inverse products in early 2020. The historical average is under 17. By any reasonable standard, stocks (particularly U.S. stocks) were expensive. In fact, it has only been higher, and for this long, once before—in the 1990s in the run-up to the so-called dot com bubble around the turn of the millennium. Based on current valuations, the expected annualized return for the U.S. stock market over the next ten years is … wait for it… about -2% (!). The American stock market is already pricier than it was prior to the 1929 collapse, and the overvaluation seems to be getting more pronounced by the week.

Despite my having thought about the valuation problem long and hard for the entire second half of 2019, there were still people who were insisting that I was engaging in market timing and that I “hadn’t thought it through”. Are people who buy life insurance engaging in “death timing”? If they buy life insurance and yet don’t die while it is in place, were they “wrong” to have made the purchase? If they renew for a second ten-year term, are they “doubling down because they got it wrong”? The questions are rhetorical, but necessary, because it seems many people (and, in particular, advisors who understand both insurance and behavioural economics quite well) seem determined to misrepresent the rationale.

John J. De Goey, CIM, CFP, FELLOW OF FPSC™ is a registrant with Wellington-Altus Private Wealth Inc. (WAPW). WAPW is a member of the Canadian Investor Protection Fund (CIPF) and the Investment Industry Regulatory Organization of Canada (IIROC). The opinions expressed herein are those of the author alone and do not necessarily reflect those of WAPW, CIPF or IIROC. His advisory website is: www.standupadvisors.ca.

Note: This article was originally written in February 2020.