Advisor Uses Options Where Diversification Falls Short
Source: FAIQ, Feb. 27, 2019
GARRETT KEYES, REPORTER, FINANCIAL ADVISOR IQ: Hello. My name is Garrett Keyes. I’m a reporter for Financial Advisor IQ. And I’m here today with Jay Pestrichelli, the CEO and co-founder of ZEGA Financial.
How would an advisor go about implementing a hedge in a client’s portfolio?
JAY PESTRICHELLI, CEO AND COFOUNDER, ZEGA FINANCIAL: A lot of folks will create protection through, say, diversification, right? Stocks, bonds, alternatives. But if you look at the asset class performance in 2018, there weren’t very many asset classes that made money. Actually at one point, stocks were down and bonds were down. So diversification didn’t provide the value that they might have thought.
So for us, we use options as a way to define our risk and still have upside exposure. So for example, we build portfolios that are aimed to not lose more than, say, 10% in a 12-month period. And we’re able to put those positions on so that they can continue to stay invested.
GARRETT KEYES: Have markets driven the need for options to be used as a way to hedge versus diversification?
JAY PESTRICHELLI: That’s a great question, because markets do evolve over time. Today’s market is much faster than historical market. So for advisors that use risk managed strategies that are, say, risk on, risk off, and they’ll use some sort of an indicator to switch directions -- by the way, a lot of guys do that, because they realize protecting their clients is important. The challenge is markets are so quick, whether it’s algorithm trading or we’re headline driven, and people are acting with real conviction, you could find yourself late, late getting to safety and late reinvesting.
And so with options, we’re able to hedge all the time. We’ve always got protection on. I can’t tell you when a Q4 2018 is going to show up. We just always plan for it. And as you invest over the long term and you’re regularly locking in gains, rolling up hedges as the market is moving, options give you the ability to have the risk on, but with a profile of being risk off at the same time. And so upside growth, downside protection: Why not have that on all the time?
For us, we think it’s a better way to hit those goals that we lay out for clients with asset allocations that have an equity portion to them.
GARRETT KEYES: So from a perspective that’s focused on the advisor, what would be the benefits for an advisor of using a hedge option strategy or using options to hedge in a client’s portfolio? Not just the client’s benefit, what do advisors get from it?
JAY PESTRICHELLI: Yeah, there’s a couple great advantages for the advisors themselves. The first is it actually gives them a competitive advantage when they’re sitting down with a prospect. Because unfortunately, there are not enough hedgers out there. It is a real industry, there’s billions of dollars assigned to it, but it hasn’t become a mainstream strategy. And so when you could sit down with a client or a prospect and you talk about the options strategies you offer, it’s going to help you close more business, first off.
The second is it allows you to kind of define the risks for the client upfront. There’s no surprises. If I tell you the most amount of risk we’re going to take in the equity market is 10% in any 12-month period, you’re not going to be surprised. When the market drops, when you get a minus 20%, 19.7%, whatever the rate was in Q4, there’s no surprises. And so it removes a lot of client anxiety.
I know a lot of advisors got that phone call from their client in the middle of December going, 'What should we do? Why haven’t we moved to risk off yet? Should we go to cash?' That doesn’t really happen when you’re hedging. So it reduces the anxiety of the advisor and the client at the same time.
And the third advantage -- and this is a great thing about hedging -- is it lines up the advisor’s goals and the client’s goals. Because if you could limit the reduction in assets under management when the market sells off, you’re protecting your client, which is wonderful, but you’re also protecting your business. Your fees aren’t going to drop 25%, 30% when you did absolutely nothing wrong and you take this pay cut, because the assets you’re managing are dropping. So it’s one of those things where if you could line up client benefit and advisor benefit at the same time, hedging is a great thing, because it just protects the client and the advisor at the same time
GARRETT KEYES: Thanks for speaking to me today, Jay.
JAY PESTRICHELLI: You got it. Great to be here.