Executive Summary
Learning about stock options is a staple of investment education; whether it's the investment section of the CFP certification curriculum or the Series 7, virtually all planners learn about the basics of stock options. However, in practice, options are very rarely used for hedging the typical client portfolio, due to a number of reasons. Nonetheless, there is perhaps an even better use of options for hedging - not to protect a client portfolio from the next bear market, but to protect the profit margins of the financial planning practice!
The inspiration for today's blog post comes from a number of recent conversations I've had with financial planning firms about how to protect themselves in the event that there is another bear market underway soon (European debt crisis, U.S. debt ceiling implosion, double-dip recession, or whatever your market concern may be!). When financial planning practices are small, the easiest way to survive a bear market is through new client growth; for example, a practice with $50 million under management can try to pick up five new clients during a bear market at $1 million each, to offset the market impact of a 10% decline in balanced portfolios. However, as planning firms grow, this becomes increasingly more difficult. A $500 million practice would require 50 new clients to make up the same market decline. A $1 billion practice would need 2 new $1 million clients per week, all year long, to make up a 10% decline in the asset base due to a market event.
So how else could revenue be protected? Options strategies! After all, at the end of the day, the single greatest impact to an AUM-based firm's revenue is market volatility - and that's exactly what options are designed to hedge! And since even other types of financial planning business models have some direct or indirect exposure to markets in their revenues (since so many financial services activities, from investments to insurance to mortgages, seem to slow down in the midst of a market crisis or severe recession), in theory any financial planning firm could benefit. But we'll start with a typical AUM practice.
As a starting point, let's assume a financial planning firm has $200 million under management; with an average billing rate of 1%, the firm has $2 million of revenue, and if they operate with 40% direct expenses (professional planning staff) and another 40% of overhead (administrative staff plus other typical overhead expenses), resulting in a 20% profit margin, they have $400,000 of owner profits after all costs. Assuming there is little adjustment in their expenses in the event of a bear market (which is a conversation for another time), a 20% decline in the asset base due to a significant bear market could wipe out profits completely, and/or even force firm owners to put capital into the company. We'll assume that a 20% decline in the diversified assets of the client base would equate to a roughly 40% crash in equities.
So basically, in order to protect profits, we need to mitigate the impact of a 40% equity decline. To avoid owners being forced to contribute capital, we need to hedge against an equity decline in excess of 40%. So what would this cost?
As of this morning, the S&P 500 is trading around 1325; a 40% decline from here would take the S&P 500 down to a price level of 800. Looking at current options quotes, an individual could buy an Index Put option on the S&P 500 at a strike price of 800 for about $30 per share with a June 2013 expiration date.
With a $2,000,000 revenue stream, and a current index level of 1,325, and the aforementioned index option multiplier of 100, the firm would could buy $2,000,000 / 1325 / 100 = 15 options contracts. At the current price of approximately $30/share, this would cost the planning firm 15 x $30 x 100 = $45,000.
So let's look at the result. The cost of $45,000 is about 2.25% of revenue, reducing the profit margin from 20% down to 17.75%. However, it is currently early July of 2011 and the option expires in late June of 2013; thus, in reality, the firm is really spending $45,000 over the span of just about 2 years, for an annual cost of only $22,500, or about 1.13% of revenue. Profit margins drop from 20% to just below 19%. Owner profits decline from $400,000 to just under $380k.
But what's gained? If the market crashes at any point in the next 2 years, and falls below 800, the revenue is partially protected against the decline. If the S&P 500 dropped to 800, the planning firm could easily see the entire asset base fall 20% to $160 million (assuming a 60/40 portfolio where bonds generate a slight positive return against the 60% of the portfolio that fell 40%) and revenues fall $400k to $1.6 million, wiping out profits. However, if the S&P fell further from there to 700 (another 12.5% decline from a price level of 800), the 15 options with an index multiplier of 100 would be worth more than $150,000, providing funds to the planning firm to help mitigate the further decline in profits.
In addition, it's worth noting that the market doesn't HAVE to fall all the way to 800 to profit. These options are traded live on the market exchange, and are liquid enough to be sold for a reasonable price at any point along the way. For example, if the market actually fell "only" 30%, bringing it down to a strike price of about 925 (which means the option is still $125/share out of the money) - the price will still likely rise dramatically. After all, buying a current June 2013 option on the S&P 500 that would be $125/share out of the money - e.g., at a strike price of 1,200 - is currently trading at $110/share. Thus, assuming all else was equal, if the market fell to 900 tomorrow, the options would actually already rise to a value of $165,000, and the $115,000 appreciation would go far in offsetting the profits lost in an "only" 30% market decline. (In practice, the price of the option after a market crash could be less than $110/share, if some time has passed and the value has decayed if the option is closer to its expiration date; on the other hand, a sharp decline in the markets tends to result in an increase in expected volatility, which boosts the price of options, so in the immediate aftermath of a post-crash decline the option price could be much higher than $110).
Certainly, more sophisticated options strategies could be implemented, including selling calls to give up a portion of the upside of the market to help mitigate the cost of the puts, or staggering the strike price or expiration dates of the puts, or rolling shorter-term puts rather than buying one longer-term put. But the underlying principle is still the same: for a relative modest cost relative to the revenues of the firm, you can protect a significant portion of the profits from market declines. And because options can always be liquidated, even before expiration, even a put option that was out of the money, and remains out of the money, can still appreciate significantly and help to cushion market losses.
So what do you think? Is this a valid consideration for protecting the profits of a financial planning firm against market declines? Could this be implemented in a brokerage account on behalf of the firm as a way to stabilize against market risk, even if options aren't used for individual clients? Does the cost and benefit trade-off seem appealing to you?
Good luck!
The problem is the false sense of security such a strategy can generate.
What if the decline in balanced portfolios is from a rise in credit spreads, not a decline in the S&P500?
What if the downturn lasts more than one year, your options may only pay once.
Maybe the practice owner should just sock away a bit of the owner profits each year, to draw on during the bad years.
Maybe the firm could change its pricing structure to include a component that is fixed rather than percentage based.
Sometimes we search for elegancy in complexity, when simplicity would do just fine.
Anonymous,
The example I provided here was simply based on all stocks as an example. You could certainly hedge credit events as well, or however else you wanted to handle things.
The article assumes you protect yourself with options on an ongoing basis. You can do this every 2 years (or annually, or however you wish to roll your options). If the downturn continues for several years, so too does your portfolio insurance.
Yes, you could sock away an enormous pile of profits as reserves, but the entire principle of hedging is that this isn’t always necessary. Having a giant pile of cash is not the only way to manage risks. Arguably, it’s actually pretty low on efficiency amongst the list of choices to manage risk.
I could insure against an untimely disability or the risk of my house burning down by just saving an enormous portion of my income in cash as well, but we’ve all acknowledged that’s an impractical solution. Why can’t we use a similar insurance and hedging strategy for our businesses, too, when the options (pun intended) are readily available for use?
To me, the complexity is figuring out how much to save against an unknowable decline of unknowable magnitude. The simplicity is just to hedge the entire tail risk off the table completely.
Respectfully,
– Michael