A Solution For Sequence Of Return Risk?
This morning I received an email announcement/solicitation for what appears to be structured products that similar to the Innovator ETF suite, go long equities and use an options collar to protect the portfolio. A collar sells call options above the market and uses those proceeds to buy puts below the market. This allows price appreciation up to the strike price of the calls and protection past the strike price of the puts. From there, anyone could tweak the strike prices any way they want but sticking to the basic building blocks you might buy a stock at $100, sell a call with a strike price of $120 and buy a put with a strike price of $95. You get any price appreciation up to $120 and are protected below $95.
It appears as though the Innovator funds have a slightly different take on this but the same general idea. The email solicitation I received was for two ETF trackers; the SPDR S&P 500 (SPY) and the other for iShares MSCI EAFE ETF (EFA). Both products have two year terms allow upside participation of 17-19% and limit the downside to just 5%. There are plenty of fees for this (this has been my experience with structured products; they are expensive). For now my interest is not the wrapper as I believe there will be more of these strategies available for less via more ETFs but more the strategy as relates to sequence of return risk.
Sequence of return risk refers to the risk that over some time frame relevant to you, that the market does poorly. An investor is likely to have 8% gains in a down 30% world. Where this is most commonly discussed is retiring in a year like 2007 when a bear market was just a few months away. I am on record as thinking a bear market started last May and have joked about the number of times that has appeared to be right then wrong then right then wrong again and now the yield curve has inverted (this is not a big deal yet, it is too soon to know but could become a very big deal).
Assuming a typical 60/40 equities/fixed income mix, someone who retired on December 31, 2007 with $800,000 could have seen their portfolio drop to $560,000 a year later (a $480,000 equity allocation that cut in half) less another $32,000 for their 4% withdrawal. This is a big hole to dig out from. This scenario would have been partially bailed out by the huge gains in 2009 but what if the market had only gone up 10% that year and in addition to the $32,000 withdrawal there was a $10,000 home repair emergency. That would be a very adverse sequence but plausible.
I was thinking about the above mentioned email at the gym and it occurred to me that the strategy (in a cheaper wrapper perhaps) could mitigate the sequence of return threat. The above $800,000 portfolio would have dropped $24,000 not a quarter of a million.
The tradeoff is missing out on a huge rally. There are not too many years where the S&P 500 gains more than 25% and this strategy would give up a big chunk of that. There a several paths to potentially take if you're concerned with an adverse sequence of returns. You could reduce your equity exposure such that a huge drawdown does not threaten your retirement but you'd be missing out on a huge rally if that was the outcome. That consequence is similar to the collar but with the collar you get the first 17% (in the case of the structured product that was pitched to me). You could buy the structured product and risk 5% (less actually as outlined above). You could not make any changes (this is valid). Finally you could take a more active approach strategically. By that I mean if you had enough money to retire on Dec 31, 2008 and you had the courage to realize "hey, the market is already down 40% and is less likely to drop by 40% after it has already gone down 40%, maybe I should just stay in" then you'd have benefited fully from the bull market that was about to start.
I am not mentioning the name of the company pitching the structured products and I am not justifying the fees, the Innovator funds are cheaper but not cheap but could be worth it and I do believe more of these will come in an ETF wrapper. A little more expensive if your planned retirement turns out to be in year five or eight or whatever into a bull market, might very well be worth it.