Understanding Your Account Statement: Specifically The Effect of the Options Hedge

Late summer of this year, after 10+ years of riding what is now history's longest bull market, our assessment of general conditions deteriorated to the point where we placed higher (though not overwhelming) odds of a bear market occurring over the coming 12 months than we had at any time since the beginning of the 2008 recession. 

Having done the work, developed and back-tested our methodology, having personally experienced every market event from the 1987 "crash" forward, it would be utterly irresponsible, and an outright shirk of my/our fiduciary responsibilities to continue to manage portfolios as if everything under the surface continued to be a-okay.

So then, we had to decide how to do it? How do we batten down the hatches a bit, so to speak? 

Well, one way would be to simply sell stocks -- to in effect reduce each client's equity allocation. But by how much, 10%, 50%, 70%? And, of course, in non-retirement accounts there's potentially 10 years of unrealized capital gains (taxes!) to contend with. 

So let's say we cut our equity exposure by 50%, that's a lot for sure; but if the next bear market matches the past two we're talking a 50+% decline in stocks. 

So would one welcome a 25% hit (50% of their 50% in stocks) to one's equity portfolio, even when the market went down by twice as much? I don't suspect every one would!

Considering the above, considering that not everyone (particularly our retired clients) would be feeling at all secure after a 25% hit to their portfolio, we decided we needed to be surgical with the protection element. That's where the options came in.

Yes, we went through this with you initially, but it's been awhile, and now that the market has continued to meander higher (which is the best scenario, by the way), we're fielding a few questions about what's showing up on the monthly statement -- since the options hedge declines in value (showing a losing position on the statement) as the market rises.

Here's a real life example:

This client is highly risk tolerant, and, therefore, has a 100% allocation to equities. 

First we'll take a look at the performance for one of their accounts; year-to-date through today:  click each insert below to enlarge...



Now here's the year-to-date graph; blue line representing the account, green representing the benchmark equity index (the market):



Note how the blue line mirrored the green until roughly mid-July (when we applied the collar), then how its movements flattened out, relative to the market, thereafter. 

Of course the optics were great as the market declined, but not so great as the market rallied back -- to the point today where the account slightly underperforms the market. 

Now, immediately upon applying the hedge, the graph, from that point forward, essentially compares apples to oranges; as the portfolio no longer captures the downside risk (well, no more than 5% at options expiration) of the overall market. And, of course, while it would be nice, we can't hedge away the risk without at the same time giving up some of the upside. 

As you may recall, to pay for the protection we implemented a "call spread" that allowed the account to capture 2% of the gain above where we implemented the collar, the performance then goes flat for the next 8% rise in the market, then captures the gains from that point on.

Now the statement.

Here's from the client's November account statement:


Note that the account began the year at $450,799, the client added, or transferred in, another $375,000 during the year, has realized $11,456 in dividends and interest, and $85,705 in market appreciation. 

By the way, if you're thinking that the $97,000+ at the end of last month ($101,000+ as I type) amounts to more than 20% of the beginning balance -- or if you're thinking it's not 20% of the beginning value plus the $375k added -- it's that investment calculators do what's called a "time weighted" calculation that factors in contributions, withdrawals, and their timing (the bulk of the 375k came late in the year). 

Of course the point I want to make has to do with the $22,775 "loss" circled in red, that's the net loss of the collar as of November 30th. It's also netted within the gains calculation. I.e., notice "TOTAL ASSETS" in the lower left corner; that shows $945,736, which is what the account would've been worth had the collar not been applied. I know, bummer!, but, again, we were going to cut the risk one way or another; had we simply sold a bunch of the client's stocks they'd have less (perhaps a lot less) than the $945,736 in that scenario as well. 

Bottom line; when comparing the use of options (clearly defining the risk), versus simply selling stocks, the optics are different, but the certainty of the options strategy makes it absolutely worth it.

Lastly, when we're talking non-retirement, or taxable, accounts, there's an added benefit that can be a big deal when it comes time to rebalance: In essence, when we either roll out of the options, or they expire, if they're in a loss position the client gets to take it as a tax deduction (against future gains, and a small portion of ordinary income); in effect recapturing, through their tax return, a good chunk of the "loss". 

From our vantage point, the tax advantage is awesome, as it allows us more room to reallocate the account when needed without the client incurring capital gains taxes (i.e., the loss on the options offsets the gains in the portfolio).

One more example: Here's the return calculation, and chart, for a more moderately allocated client:



Here's the graph:



As in the first example, the return referenced is net of the "loss" ($19,000+ in their case) on the options collar.

Hopefully, if you're at all wondering, the above will make sense of your monthly statement for you.

Please don't hesitate to give us a call if you have any questions.

Have a great weekend!
Marty