Building Optionality in Your Investment Portfolio

Disclaimer: The article below discusses certain investment strategies, some of which I am using currently in my personal portfolio and some of which I am not.  Do your own due diligence before making an investment decision.  It’s your money; you’re the best person to judge what is best to do with it.

Building optionality in your investment portfolio should be a primary goal for investors looking to mitigate uncertainty while still retaining earning potential.  The combination of downside-limiting assets along with the potential for large upside gains will help you create lasting wealth while being able to sleep well at night.  For example, from peak to trough during the Global Financial Crisis, the S&P 500 dropped 51%.  If you had $10 million invested in the S&P 500 prior to the GFC, at one point you were down to less than $5 million.  Ouch!  Even the most disciplined of investors would have had thoughts of pulling money off the table, probably at the worst possible time.

The S&P 500 took over three years to recover, and the equity recovery starting in 2009 was one of the greatest recoveries in history.  The recovery after the tech bust in the early 2000s, on the other hand, took over four years for the S&P 500.  The tech heavy Nasdaq 100 Index has only recently recovered in 2014.  It took almost 12 years for you to get back to even in the Nasdaq.  Talk about a lost decade!

Before discussing how and where to build optionality into your investment portfolio, let’s discuss the specifics of what optionality provides and why you should seek it out in your portfolio.

What Optionality Provides

First things first, why would you want to build optionality into an investment portfolio?  Remember what the payoff of an option looks like:  Options have limited downside risk while still participating in upside gains.  Of course, all of this comes at a cost.  Actual options (calls and puts) can be, and often are, very expensive.  The goal is to either find under priced options, or build a portfolio that finances, through yield-based investments, the extra cost of buying options.  Yield-based investments should not be limited to fixed income.  In fact, any investment that creates regular yield while being drawdown resilient (e.g. certain volatility selling strategies) should be considered.

Despite the cost of options, adding them to a portfolio can be beneficial in other ways too.  The potential downside risk of most investments means that you have to limit the size of your bet, or risk a substantial loss.  Since options, by their very definition, have limited loss possibility, sharp drawdowns are no longer a concern.  If structured properly, certain types of options give you the ability to build non-recourse, cheap, term financing into your portfolio.  An at-the-money call option only requires a single payment of 5-10% of the total exposure (premium cost was ~ 5.5% as of the end of August 2017).  This allows you to invest 90-95% of the portfolio elsewhere, with the potential to either earn more than 100% of the upside, or invest in safe, yield-based assets that help pay for that initial premium.  You can theoretically have exposure equal to ~190% of your total portfolio value while never fearing a margin call.

Further, you can hold a much more concentrated portfolio.  Diversification is merely an insurance policy against large portfolio losses and itself can come at a cost.  This cost is particularly relevant if that portfolio diversification comes at the expense of return potential, such as including Treasury bonds in the place of stocks in your portfolio.  A well-diversified portfolio may provide you a better risk-return payoff (e.g. a better Sharpe Ratio), but a portfolio grows based on absolute returns, not risk adjusted returns.  A 2yr Treasury bond has an amazing Sharpe Ratio, but also has no growing power.  If you have substantially reduced that risk of loss on your high return-potential assets, you no longer have as great a need for diversification.

Why Build Optionality

If the benefits that optionality provides is not enough to entice you to look for ways to build it, let’s discuss further why you would want to build optionality:

1. The times, they are a-changing: Forgive my Bob Dylan rip-off, but what was right in 1964 is still right today.  The world is always in a constant state of flux, and odds are high that your forecast of the future will be wrong.  Best not to even try; instead set yourself up to succeed in multiple possible outcomes.  Very few forecasted Brexit happening, and even fewer forecasted Donald Trump’s election.  Since you know that you will be wrong, but you don’t know where or when, it’s best to build out a portfolio that limits the damage when you are wrong and allows you to profit when you happen to be right.
2. Volatility is a Given:  Despite the current period of low volatility, volatility in financial markets is a given.  A portfolio that benefits from increasing volatility (being “long vol”) does better in most environments, assuming you haven’t overpaid for it.  On the flip side, most investments involve the ongoing sale of volatility (being “short vol”), which works really well most of the time, until it doesn’t and you get crushed.  They don’t equate picking up nickels in front of a steamroller to selling volatility for nothing!  Make sure you are properly compensated when you go short volatility.
3. Quick Adjustments May be Needed: Given the nature of a changing investment landscape, maintaining the ability to adjust quickly is paramount.  Holding investments that have limited upside potential while locking you in for a substantial period of time (e.g. middle market lending) will provide a sub-optimal performance over an entire business cycle.  Sure, if you time the cycle correctly, odds are high that you’ll do pretty well.  But that’s true for just about every investment.  Instead, stay liquid, or if you are going to use private investments, stay on the shorter duration unless you have strong upside potential.
4. Limit the Downside: While this topic has been discussed briefly above, it’s so important that I’ll expand upon it.  There’s an old saying that the market can stay irrational longer than you can stay solvent.  This is absolutely true.  Nassim Taleb is out with another interesting read on the logic of risk-taking.  It’s worth the 15 minute read.  His basic idea is this: let’s say a single investment has a 99/100 chance of returning 20%, and a 1/100 change of returning -100% (e.g. losing everything).  The probability-weighted expected return on this investment is 19.8%.  For a single, one-time bet, take it every time.  The problem is this: What happens when you have to make that bet over and over again?  At some point, you lose and you’re out.  There’s no coming back if you’ve lost all your capital.  For this single investment, you would need to substantially limit your exposure, because if you have too heavy of a weight to it in your portfolio, it could be ruinous.

Should You Barbell?

The barbell portfolio is one of low risk, fortress-like investments on one side (e.g. US Treasuries) and high risk, option-like investments on the other side.  In this portfolio, you keep the bulk of your portfolio safe, albeit yielding a low return, while still providing sources of upside return potential.  The high risk, option-like investments provide you with potential return, while the low risk, fortress-like investments minimize your downside.  Risky investments are almost always priced on a probability-weighted basis to be money losers, but if you happen to be correct, then the payout is outsized relative to the risk you took.

The logic behind excluding the middle of the road investments (the middle of the barbell) is that their expected return does not compensate for the risk.  Effectively, you retained a lot of downside risk for limited upside risk.  Mezzanine lending (“mezz”) is a good example.  Mezzanine lending is a loan that is behind the senior (first lien) lender and above equity.  Because the mezz lender is behind the first lien and does not have the same rights and reduced risk as the first lien, the mezz lender receives a higher rate of return.  Equity, however, is the only buffer the mezz lender has between getting paid and taking a loss, and equity can disappear very quickly.  While a mezz lender may receive a high single digit or even low double digit return, they take all of the downside risk beyond the equity investor.  The equity investor has bought a long dated call, while the mezz lender is sold a long dated put.  Selling puts is not a bad strategy, but it must be done on a short timeframe (2-8 weeks, instead of years like a mezz lender).

Creating a barbell portfolio is a lot of work, and entails the use of trading strategies that most investors would not be comfortable with.  It requires quite a bit of attention, and is not a “gone fishin’” portfolio by any stretch.  However, if done correctly, it certainly limits the downside while still offering upside returns.

Sources of Portfolio Optionality

Building portfolio optionality is always going to be more difficult and take more effort and knowledge to accomplish than a typical long-only portfolio.  Finding these sources of optionality is almost always worth it though.  With that said, let’s take a look at some actual sources of portfolio optionality:

1 . Deep Value stocks: Deep value stocks may be the most difficult and most crowded trade of any of the sources of optionality.  A deep value stock is one that is trading well below its theoretical intrinsic or liquidation value.  Of course, intrinsic or liquidation values are always debatable, so be careful in your calculation.  In extreme cases, a stock may even be trading below the cash value on the balance sheet.  They may also be “story” stocks that have been in the news a lot.  Yahoo is a great recent example.  Yahoo was once one of the great internet names, but has been largely falling into irrelevance for years.  Once Yahoo sold its operational assets, it was left with a balance sheet of Alibaba stock, Yahoo Japan stock (Yahoo Japan is actually a valuable and profitable company), cash and some other random investment assets.  However, the stock remained trading at a nearly 30% discount to the value of the assets on the balance sheet.  In effect, you could buy Alibaba stock, Yahoo Japan stock, and cash for 70 cents on the dollar.

The issue with a deep value trade is that there are a large number of investors trying to find these stocks, and you have to be careful not to fall into the value trap.  The value trap is simply buying in to a stock because it has dropped substantially.  Perhaps that stock deserved to fall substantially and is finally trading at a reasonable valuation.  Do you know what you call a stock that has dropped 95%?  One that has dropped 90% and then dropped another 50% after that!  Deep value opportunities appear to present themselves often, but be prepared to dig in and do your due diligence.  You must examine every angle and make sure there is actual intrinsic or liquidation value there, and only buy if the stock is trading below that amount.  Have a margin of safety.

2.  Trend/momentum investing: Trend, or momentum (technically they’re different, but for our purposes, they are so related that we’ll treat them the same), investing is the concept of following the herd, and buying what’s been going up and selling what’s been going down.  There is absolutely no rational reason why this should work other than the fact that it takes advantage of human irrationality.  And it has been proven to work across time and across asset classes.  It is also getting easier and easier to gain cheap access to it through the use of ETFs and mutual funds.

Trend following follows a simple pattern: as the stock goes up, the trend follower buys more and as the stock goes down, the trend follower sells (or sells short).  From an option standpoint, this is similar to owning both an out-of-the-money call option and an out-of-the-money put option.  An out-of-the-money call option “goes long” more and more of the underlying asset as it increases in price.  For those familiar with options, the delta of a call option increases as the underlying price increases, similar to how a trend follower buys more and more as it goes up.  On the flip side, the out-of-the-money put option “goes short” more and more as the underlying asset decreases in price.  Again, the delta (in a put case, the negative delta) increases similar to how a trend follower sells more and more as the asset goes down.

3. Venture Capital: Venture capital, by its very definition, is merely a call option on a brand new company.  You invest a small amount, and hope that it takes off to become the next Google.  The initial investment is a small amount relative to what you hope or expect the company to return in the long run.  If the company fails (a substantial possibility), you likely lose all of your initial investment.  This is simply a very long dated call option, where the initial investment is similar to premium paid on the option, and the payoff is dependent on how the company stock price moves.

4. Distress investments: Distressed investments are very similar to deep value stocks, except that you are potentially looking beyond stocks into other asset classes.  Bonds and private investments are the most common examples of distressed investment purchases.  Let’s take a recent example probably still fresh in many people’s minds: the mortgage crisis following the GFC.  In late 2009 and into 2010, the number of nonperforming mortgages (loans where the borrower has fallen behind and is no longer paying) skyrocketed as people lost their jobs.  As a result, many of these mortgages began trading at 50 cents, 35 cents, or even 20 cents on the dollar.  Remember, many of these mortgages were at 80-90% of the purchase price of the home.  Even if you believe that home values had dropped in half (in most cases, it wasn’t nearly that bad), buying the mortgage at 35 cents was like buying that home at a 40% discount.  And that 40% discount included the 50% decline in price.

Similar to an option payoff, there was very little downside, as the purchase price and the value of the underlying asset itself protected the investor.  On the other hand, if and when the economy came out of the recession and home prices recovered or even stabilized, you were well set up for that bond to recover in price and earn a substantial return.  This increase in price of the mortgage bond allowed for upside optionality.

5. Options: Options can provide optionality in a portfolio; who would have guessed!  Call and put options on individual stocks or, more likely, on an index like the S&P 500 or MSCI EAFE can provide downside protection with upside potential.  The problem, of course, is that options have a very explicit cost to them and the market is very efficient (there are a lot of players in the option markets).  There is potential for good investment decisions for long term option owners, as option traders look at options differently.  Option traders tend to hedge themselves, and so are more concerned with the day to day, hour to hour price movement.  You and I, on the other hand, are more concerned about the longer term return potential.  Price is what you pay; value is what you get.  This mismatch in incentives can lead to profitable investments.  We’ll get more into option strategies in a later post.

6.  Cash: Cash as an option?  Of course, why wouldn’t it be?  It has downside protection and can allow you to profit when volatility in the market increases.  Think about holding $1 million in cash in middle 2008.  If you had held $1 million in stock, by the time 2008 ended, you’d have to sell your securities for $700,000 or less to buy something more attractive.  On the other hand, you’d still have $1 million in cash and could invest in any number of things that would have provided an option-like payout.  Investors are often afraid to hold cash in their portfolio, thinking it should always be invested.  Fear of missing out drives this behavior.  This should not necessarily be the case, and holding cash can provide nice optionality in a portfolio.

Optionality Allows Staying Power

Building optionality into a portfolio is challenging and can be time consuming.  It also provides the staying power an investor needs to ride out a stormy market.  We’ve all heard that stocks return 10-12% over the long run, and in fact over the last 20 years, the S&P 500 (as just one example) has returned 10.4% per year.  That return, though, came with a large amount of volatility.  It also assumes that you were invested the entire time, a time in which we saw Gulf War #1, the Tech Crisis, 9/11 and Gulf War #2, and the greatest financial collapse since the Great Depression.  Staying in the market through all of that took a heck of a lot of willpower, and many investors didn’t have it.  Any investor that traded out of the market during downturns likely did substantially worse than 10%.

Adding optionality can allow you to still maintain that upside return potential, while protecting the downside.  This downside protection is what gives an investor staying power to remain invested through the twists and turns that the market ultimately takes.

Keep building my friends.