Another key issue is the scaling factor, an optional form of leverage that increases the magnitude of returns or losses, but without the complications or risks typically associated with conventional leverage via borrowed money. For example, Private Wealth Advisors holds Emerald notes for clients with a scaling factor of two; Brinton Eaton opts for a factor of three. Scaling amplifies results, for good or ill, but it also provides a risk-control benefit because it reduces the absolute level of dollars needed to generate a given return/risk profile with the strategy. That's an issue since Emerald's and Astro's results are delivered through notes issued by their respective investment banks, so there's a degree of credit risk to consider. As a result, fewer dollars invested through a single institution promotes diversification.
Another consideration is an SEC regulation that requires the return of any remaining capital to investors when the notes lose two-thirds of their value. The potential risk of forced liquidation during a run of market losses increases with a higher scaling factor. There's also a higher expense ratio as scaling rises. PWA paid a one-time 60-basis-point fee for Emerald, and there's another 1% due for each level of scaling, says Comstock. A scaling of two times, for instance, incurs a 2% fee.
For all the encouraging analysis, some advisors remain skeptics. Michael Edesess, the chief investment officer and founder of Fair Advisors in Denver and the author of The Big Investment Lie, opines in a recent e-mail that Emerald and similar strategies run afoul on two fronts by his reckoning. "One is the good old engineering dictum K.I.S.S. (keep it simple, stupid)." The other is putting too much faith in mean reversion, he writes. "There is no law in financial markets saying that patterns of 'mean reversion,' or whatever that can be statistically observed in historical data, must continue to be observable in future data. So any product that rests on that assumption is on shaky ground."
Perhaps, but in a world hungry for innovation in risk management after the 2008 financial crisis, demand is rising for the likes of Emerald and Astro. Still, it's no surprise that even advisors who are intrigued aren't always in a rush to jump in. Emerald is "interesting," says Chris Cordaro, chief investment officer at RegentAtlantic Capital, a wealth management shop in Morristown, N.J. "It works most of the time, and it's fairly low cost," he says of the strategy, but "it's not going to work all the time." He doesn't rule out using Emerald and Astro in the future. Meanwhile, "we've become far more tactical in our asset allocation. Your better protection is buying asset classes that are cheap, and staying away from those that are pricey."