With bonds offering poorer yields, many advisors are adding more equity allocations to core portfolios. The effect of this, while improving potential returns, is to introduce more risk into a portfolio than may be desirable.
“As bond yields have moved to historic lows across the curve, investors are tempted to compensate by adding equities to portfolios instead of bonds,” said John Wilson, CEO of Sprott Asset Management. “In many cases they can find equities with higher dividend yields than offered on bonds and as an asset class - the earnings yield of the stock market is still much higher than the bond yield offered by fixed income.
“That being said, there are substantial risks. First, a dividend yield isn’t guaranteed and can be cut without warning (an experience shared by many energy income investors over the past two years). Second, there is substantially more risk to the principle invested in an equity relative to the principle in a bond. Equity takes the first loss once a firm’s capital structure becomes impaired and, even without an impaired capital structure, can suffer losses due to changes in sentiment regarding the company, its industry or even the market as a whole. So while equities can and have offered better long term returns than fixed income, they do so at a substantially higher risk profile.”
So, what is the solution? According to Wilson, alternative equity funds can be used more like the bonds of old: providing lower risk with reasonable returns. They can exist in several forms, one of which features the use of options to provide downside protection. If the market falls below a certain level, the options kick-in, buffering the descent and, at a certain point, contributing positive gains.
“An index put option is a security paid for with a fixed premium which expires on a set date,” continued Wilson. “The option rises in value if the stock market declines beyond a set value but expires worthless if not.
“In many ways an index put option is comparable to an insurance policy. You buy a policy for a set period of time and pay a premium (which is typically a small percentage of the value of the asset you are protecting) to do so. If nothing bad happens, the policy expires and you renew by paying a new premium - but if something bad does happen, you receive compensation, net of your deductible.”
In addition, alternative equity funds allow an advisor to keep their equity exposure at what may be the end of a bull run, while protecting their downside should that market begin to turn.
“How returns are generated can often be even more important than the size of the return generated,” continued Wilson. “In other words, a very large return over an investment period is relatively useless if the volatility of generating the return is too high for the investor to handle… think of a flight that gets you to your chosen destination twice as fast but does so by making you feel like you were about to crash several times along the way.
“The right alternative strategies can give clients returns that are sufficient to meet their investment objectives, but do so in a way the client can handle.”
For a look at seven ways an alternative fixed income strategy can outperform, download the thought paper at sprott.com/unconstrained