An equity collar strategy offers a different take on risk management.
Asset allocation and diversification are the
principal risk management tools used by an advisor in a typical client
portfolio.
But Thomas Schwab is one advisor who feels those
tools don't go far enough in protecting clients. It's a lesson Schwab
says he learned as an advisor at Smith Barney on September 11, 2001-and
the days of panic and fear that followed on Wall Street.
"I realized that even when I was holding hundreds of
stocks, I wasn't hedging against event risk like 9/11," says Schwab,
founder and chief investment officer of Summit Portfolio Advisors LLC
in Maui, Hawaii. "I went looking for something that would limit
systemic risk."
Schwab, of course, wasn't the only investor who has
been looking for safety since 2001. The terror attacks and the bear
market sent most investors scurrying for safety, driving up demand for
products that provide varying degrees of asset protection.
Among the offerings investors have flocked to are structured notes,
index annuities, principal protected funds and other products that
offer a level of downside protection.
Schwab, however, took a different route. He decided
to use equity collars-typically used for clients in heavily
concentrated equity positions-as a standard risk management device in
all portfolios.
By purchasing a put and call option simultaneously
with the purchase of every 100 stocks, Schwab puts a downside and
upside limit on his client's positions. The end result is a guaranteed
limit on losses, at the cost of an upper limit on gains. "You basically
are putting a floor on how low these stock positions can go," he says.
The strategy is gradually gaining acceptance among
both clients and advisors. Summit Portfolio Advisors, which Schwab
founded in September 2005 with his son Joe, who is CEO, currently
serves 30 clients with about $6 million under management. (Schwab's
daughter Elizabeth joined the firm later and serves as president).
Schwab also generated some buzz when he gave a
presentation on his equity collar strategy at the national conference
of the National Association of Personal Financial Advisors (NAPFA) this
past spring.
"I think he got a pretty good response," says Sidney
Blum, who chaired the 2006 NAPFA conference committee. "A lot of our
clients are looking for ways to reduce risk or to earn income that is
somewhat less risky. His strategy of locking in a range of possible
returns is appealing for certain clients."
Ron Miller, owner of Resource Management LLC in Waimanalo, Hawaii, says
he intends to start using the strategy for his own clients. Miller, a
retired dentist, started his advisory firm nine months ago and is
serving 30 clients with nearly $10 million under management. After a
visit from Schwab eight months ago, he invested his personal assets in
Schwab's collar strategy, reaping an 11% return with a portfolio that
limited losses to 5%.
Now he's planning to use it to diversify client
portfolios. "As I get more familiar with it I'll probably recommend it
for smaller portfolios that are risk-averse," he says.
Miller feels devoting part of a portfolio to the
strategy is a good diversifier and feels it is a way to get "safe"
double-digit returns. "Most people are concerned about the risk of the
market," he says.
While other products also provide downside
protection, Schwab feels his equity collar strategy has a leg up on the
competition for two reasons: The firm's fees are simple and
straightforward, and it allows for strategic stock selection rather
than indexing.
The firm charges an annual asset management fee of
80 basis points. There is no account minimum, but the firm's minimum
fee is $100 per quarter. (The firm is currently offering a
55-basis-point fee to advisors who bring in assets of $5 million or
more).
As a general rule, Schwab says his clients
portfolios are collared with a maximum downside risk of 10% and an
upside potential of 20%. The range, however, is often tuned to suit the
risk tolerance of specific clients.
Portfolios are comprised of no more than 20 individual stocks, usually
large caps with dividend yields and a diversified industry
representation, with terms of slightly more than a year. A typical
$100,000 portfolio will be comprised of ten stocks, he says. "Because
the collar limits systemic risk, you don't have to be that
diversified," he says.
Another factor in stock selection is ensuring the
cost of the put option is cancelled out by the sale of the call option
and/or dividend yields. In most cases, Schwab says, collars in a
portfolio are zero-cost.
In one example, Summit bought 100 shares of Apple
Computer Inc. on December 1 at $90.87, with a collar of $85 to $110,
which provided downside protection beyond 6.7% and an upside limit of
20.8%. The cost of the put option was $9.20, while the sale of the call
option brought in $9.00, for a net collar cost of 20 cents.
In that same portfolio, meanwhile, Cigna Corp.,
bought at $125.05 with a $120-to-$140 collar, results in a net collar
credit of $1.00, plus assumed dividend income of 13 cents during the
collar term. That results in a break-even deal if Cigna falls to
$123.92 at the collar's expiration.
Schwab also notes the strategy is not strictly buy-and-hold and does
include some active management. In cases where share prices rise or
decline steeply, for example, Schwab may rewrite a collar to minimize
losses or maximize gains.
"We are really trying to keep the collar cost as a
neutral factor and we are just really trying to find where we can get
the highest amount of potential return for the unit of risk we are
taking," he says.
While the collar strategy seems well suited for
older clients who are concerned about sustaining losses in their
retirement nest eggs, Schwab feels other groups can benefit. He feels
that young and aggressive investors could use collared portfolios as a
substitute for some of their fixed-income allocations.
"We really see this as a bond alternative for
clients who are longer term," he says. "If you think stocks are better
than bonds, and don't need current income from bonds, consider putting
money into this instead of bonds."
He bases this belief on a backtesting of the
strategy that shows how, over time, a collar strategy will underperform
the S&P 500 but still bring decent returns with a guaranteed range
of possible outcomes.
When tested against data spanning 1926 to 2005, the
collar strategy would have resulted in an annualized return of 9.0%,
Schwab says, which is close to the 9.02% annual return that would have
been achieved by a portfolio comprised of 52% S&P 500 stocks and
48% five-year Treasury notes. The annualized return of five-year
Treasuries during the time period was 6.6%.
The key difference between the collar strategy and
the 58/48 portfolio, Schwab says, is in the range of possible outcomes.
During the studied time period, he says, the 58/48 strategy resulted in
yearly outcomes ranging from 28.94% in gains to 23.65% in losses. The
collar strategy range was fixed at between 20% gains and 10% losses.
Collaring Peace Of Mind
January 1, 2007
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