Defining the Outcome

Managing Client Expectations in a Low Return, High Volatility Environment

Should clients accept even lower returns — or take on additional risk?

by Thomas J. Quinn, CFA

Mr. Quinn is Chief Investment & Research Officer with Jefferson National. Following is an excerpt from his Spotlight Report. The entire report can be accessed here. Visit Read our interview with Tom in the March Advisor Magazine.

Since the middle of last year, cracks in global markets have become widespread and well-known. Oil prices have fallen by more than half — at lows not seen since 2003 — causing massive losses in energy related investments.

Emerging market stocks have fallen by more than 25%. All major global equity markets began the year by falling at least 5% in January. And the S&P 500 began 2016 with the worst weekly opening in history.

Volatility has returned. At the same time, the expected returns for safe investments are at record lows. High-quality fixed income may no longer be the best solution for mitigating market risk. This heightens the classic challenge: should clients accept even lower returns — or take on additional risk? This report explains how advisors can help clients achieve long-term return targets, while protecting portfolios from sharp downside risk.

Efficient Frontier Shift

Today’s fixed income investors face a unique challenge. The combination of unprecedented low rates and the likelihood
of rising rates has altered what we can expect from bond portfolios.

With interest rates still at unprecedented lows, rates would need to fall close to zero for a core bond portfolio to provide double digit returns over the next few years. This should have a dramatic impact on investors using fixed income to hedge equity portfolios. This problem is magnified by the fact that the Federal Reserve is in the process of slowly raising interest rates, which can drive returns even lower, impacting the way we think about safe investments.

The current low return expectations for bonds, has caused a considerable shift in the Efficient Frontier. Figure 1 illustrates how returns have shifted downward for safe, low-risk bonds and cash, making the cost of safety significantly higher than it has been historically. This leaves investors with a difficult choice — should I accept an even lower return or take on even more risk?

Many investors have chosen to accept more equity risk in their portfolios over lowering return expectations. This shift in allocation emphasizes the importance of protecting portfolios from downside risk. The risk in equity markets remains, despite years of relative calm. During the last several years, the size of intra-year drops has been uncharacteristically small. Even in a year with strong performance, intra-year drops can be dramatic. The start of 2016 has been a healthy reminder that clients should be prepared for losses of 15% or more within a year, even in a rising market. And advisors should have a strategy in place to proactively manage ‘tail risk’ to help clients avoid emotional responses to losses.

Investment Solutions in Low Return Environment

Clients’ fears and irrational behaviors create added pressure for advisors. With the market continuing to put heightened
pressure on investors to accept a lower return or an increased risk, how an advisor manages client return expectations is
an important balancing act. The first step is to make sure clients have realistic goals and expectations for risk and return
from the very beginning.

Fortunately, there are many solutions that allow advisors to effectively manage the downside risk of portfolios. The various options have different degrees of return potential and complexity. Advisors may turn to traditional strategies, like total return bonds, or risk managed allocations. They may try liquid alternatives, such as long/short equity, managed futures,
multi-strategy, or market neutral strategies. Advisors may also select a defined outcome solution like indexed annuities,
structured notes, or managed option portfolios. Figure 3 illustrates how each of these solutions compares to one another
in regards to investment factors, structural factors and client factors.

Defined outcome solutions, which will be explained in greater detail, rank above both traditional strategies and liquid
alternatives when it comes to addressing the clients’ needs for market participation, transparency and predictability. And
among the three different defined outcome solutions evaluated in this study, the Managed Option Portfolio is the only
solution to effectively and consistently meet all three client needs.

A managed option portfolio helps satisfy the risk-averse client’s need for protection and desire for market participation,
providing a predictable client outcome to help manage expectations, while at the same time allowing advisors to effectively
manage both investment factors and structural factors. With a defined outcome solution in place, the advisor is empowered to make tactical market calls, while alleviating clients’ concerns, and without having to accept the low returns offered by bonds. In order to put the use of a managed option portfolio in context, it is first important to understand the basics of the broader defined outcome market.


What is Defined Outcome Investing?

The driving force behind the $2 trillion structured investing global market is the straight forward appeal of offering investors a “defined outcome.” A defined outcome solution is designed to provide a specific preset level of protection and/or enhanced return allowing for a more defined investment experience. By providing preset levels of protection and return, defined outcome solutions allow investors to experience a controlled range of investment outcomes which they know in advance and can plan for accordingly. This predictability ensures that potential investment results match the investor’s needs, taking into consideration personal factors such as goals, risk tolerance, and time horizon.

Introducing the Exceed Defined Shield Index Fund
Exceed Investments, a New York-based boutique asset management firm, has pioneered the defined outcome investing
space, creating the first and only liquid defined outcome solution. Exceed has introduced a liquid, transparent, defined
outcome solution, the Exceed Defined Shield Index Fund (SHIIX), a large cap-based fund seeking a specified degree
of protection with a maximum gain component. It seeks to track — before fees and expenses — the Nasdaq Exceed
Structured Protection Index (EXPROT1) and is designed to provide a consistent ‘structured’ exposure to the S&P 500. As
shown in Figure 4 above, the strategy seeks to limit losses due to a decline in the S&P 500 to 12.5%, while providing upside
participation capped at 15%. The strategy rolls a portion of the options contracts each quarter to provide a somewhat
consistent defined outcome for investors. The net result is market exposure within a clearly defined return range.

How is this fund different in comparison to liquid alts strategies?
The fund (SHIIX) provides a defined equity exposure with set caps and floors in seeking to mitigate losses in down markets.

  •  Specifically, it offers S&P 500 exposure bounded by gaining no more than a targeted 15% in any given year and losing no more than a targeted 12.5% in any given year.
  • This differentiates it from other strategies seeking to protect from market downturns such as volatility, long/short equity
    and tactical, which typically provide less specific parameters for performance.
  • The manager utilizes liquid, exchange based S&P 500 put and call options and short term, Investment Grade fixed
    income securities, creating a portfolio of rolling “defined outcome” investments.

The index it tracks is calculated by IDC and disseminated by Nasdaq under the ticker symbol EXPROT. The following
section analyzes the EXPROT index to determine how it can be utilized in certain client scenarios.

Read the entire report, Defining the Outcome: Managing Client Expectations in a Low Return, High Volatility Environment  here.

Read our interview with Tom Quinn, Volatility, Efficiency & the Persistent Low, in the March 2016 Advisor Magazine Page 3 Profile.