Kyle Grandstaff

Hi. I’m Kyle Grandstaff, Portfolio Manager here at Healy wealth management, and today I’m joined by John Healy, our Chief Investment Officer. And today I wanted to spend a little bit of time to talk about a specialized approach that we have to our risk management, and that’s our use of a hedging strategy, where we use put options to help provide some downside protection, you know, to our client portfolios. And John, can you just give us a just kind of a brief overview of the strategy and kind of why we do it.

John Healy

We  don’t always do it, and we don’t, we don’t forecast the markets, but we know enough about options and pricing of securities to where we see mispricing in the options market, and it’s a sophisticated strategy that really many financial advisors don’t have the capability or the just the way the whole industry is structured to bring this to retail investors, and we have the capability, and we do, so we have this strategy that we think over a long period of time does a better job of providing good returns at less risk.

Kyle Grandstaff 

Yeah, no, I think that’s a great a great overview, John, could you spend just a minute on kind of how it works, and maybe, you know, I can give some context. You know, historically, we kind of see the market, you know, two thirds of the time the market is either up or down more than 10% so either up more than 10% or down more than 10% and this is where the strategy does well. So John, could you just expand on that point about why it works? Kyle’s been here enough to long enough to where he’s kind of learned how we’ve implemented this, and we’re always trying to improve it. But yeah, the historical data shows that about two thirds of the time the market on a given, any given 12 month period, or even 365 day period, is going to be up more than 10% over that period, or down more than 10%

John Healy

two thirds of the time. So in those tails, you’re going to be in those tails about two thirds of the time historically. And being in the middle between minus 10 and plus 10, you’re only in those for a 365 day period. It’s only about 1/3 of the time that you’re you see that type of return from the stock market. So what we do is we look at the pricing of options, different levels below where the market is. The put option, for instance, gives you the right to sell the market at a price, and we do it out of the money which would be below the market. And so that’s a floor. Essentially, it’s a virtual floor, if you will, because it’s a strategy we’re trying to implement a certain maximum drawdown to the portfolio, and we can actually target that and be pretty close. We think, you know, the hedging, if we do a good job with it, will be pretty close to providing that kind of downside protection over a one year period, is what we’re trying to do.

Kyle Grandstaff

Could you kind of touch on why, like, why that this strategy works better than maybe just traditional asset allocation for, you know, just a client portfolio?

John Healy

Yeah, it doesn’t always do that. We’re always looking at comparing it. So we would compare, say, a 10% hedged equity portfolio. So that’s strategy is to try to deliver no more than a 10% decline from now until one year from now. And that’s a point to point approach, The 60/40, traditional stock bond allocation, 60% in stocks, 40% in bonds. You know that may or may not do as well, may not, may or may not, if we had a big decline in the stock market, another financial crisis that 60/40 portfolio is not going to do as well. You’re gonna have a lot more downside, and also in the long run, if you have less downside, little more upside with the hedging strategy, why does that work? I think it just gets back to we’re picking up on some mispricing and adding some more downside protection, short term downside protection, and we’re very careful about not overpaying for the puts, so that in the long run, we’re not going to have any lower total return versus a 60/40, now, there’s no guarantees, but that’s what we’re trying to do, and we’re trying to be disciplined about it and pick up on this mispricing. But people like it because it, you know, most people would rather avoid the short term downside, and you know,

Kyle Grandstaff

They’re willing to give up a little bit of the upside to get that right. We think it,

John Healy

Our clients tell us that, you know, it’s a strategy that helps them sleep better at night. John, could you just touch on a few maybe one of them, a couple of the common questions we get from clients around the strategy? Yeah, I think it’s another reason why a lot of financial advisors don’t, don’t do this type of thing. Really does need to be done in house. You really need to have your own team, like we do, with the history and experience to do it. It’s not something that a lot of third party investment managers offer to financial advisors, so to the retail market, working with families, individuals. You know, unless you’re in a hedge fund, you’re not going to see this type of thing. But, you know, the kinds of questions we get. We try to make it clear that this is not a money making overlay strategy. It’s not designed to add return. It’s designed to protect on the downside in a terrible market and do a better job of protecting without giving up the longer term return. And so that’s that’s probably the main question that people would have, and we try to make it clear that, because when things, when the market goes down, the puts are going to be up a lot. You make a lot of money. It offsets your losses and your equities. And the big question is, well, why don’t you, you know, the market comes back, and people sometimes question, Well, why didn’t you sell the puts at a big profit? When you could have? I said we’re not trying to time things. You know, we are looking maybe to make it better and improve on it. But we’ve had times where we made a lot of money and the puts offset losses on the stocks. People are happy, because the statement values, you know, are not shocking. You know, the market may be down 40% and they’re only down 10 or 15 so they’re happy with that, but then market comes back, and they’re all kind of back to square one, and they wonder, Well, why didn’t you sell the puts and, maybe someday we’ll be that smart, but I don’t, don’t expect that to have. We really just, it’s not there to make money. It’s just there to buffer the downside so you you have a lower risk and in the long run, when we compare to the 60/40, the drag from the puts is not so great that it’s going to lag the 60/40 return in the long run.

Kyle Grandstaff

And it is designed to all you know. It allows us to have if the market’s up 30% you know, this strategy should participate in the majority of of the market’s return. You know, as whereas a 60/40 you might only get 60% participation, because you’re only out allocated to 60% stocks.  You know, John, I think, you know, I think it was a great overview. Before we go, are there any misunderstandings, and you kind of touched on one, but there any other kind of misconceptions our clients kind of have around this strategy?

John Healy

Yeah, I mean, it’s, it’s there to protect you from a horrible market, so that you know, more recent, right now, we’re seeing some downturn in the market. If this continues and this turns into a financial crisis. If you have a 60/40 portfolio, you know you can see more downside than you would if you had a hedged equity portfolio. And you know the misunderstandings, it’s kind of the flip side of that is illustrated that when the market is flat or it’s up a little bit, and it’s not performing well. The hedging strategy isn’t performing well as a 60/40, people might question when they look at their statement, they’d see this one position, the the option, the put option, that would be at a significant loss. And I respond by saying, Well, what we want with that put option, optimally would be for the put option the day after we buy it to go to zero. Because, you know, This put option goes up when the market goes down, and it goes down when the market goes up. So it’s the opposite. That’s why they call it a hedge. It’s opposite. It’s reducing the risk. But if the market goes up a ton, very quickly, you get a huge rally. That put option is going to go down really fast. So that’s really what you want. You want to lose money in the put option as fast as you can, because that means you’re making a lot more money in the short run in the stock market. So that’s kind of the way I illustrate how they go together. It’s, you know, when you when you hedge, you really can’t just look at that position by itself. You have to take it in the put option position by itself. You have to look at it in the kind in the context of the overall portfolio. And a lot of people misunderstand that. They think that every security should be making money, and this, this put option, is really not that’s not what it’s there for. It’s to reduce the risk.

Kyle Grandstaff

And it’s a small it’s, you know, typically it won’t be more than three or 4% of of an accountant. So that small insurance policy is there to to provide that downside.

John Healy

Yeah, and we’re always comparing against a 60/40, or 50/50, it’s not, not going to do well, versus an all equity portfolio. So people who want to have full participation, and it makes sense for particularly younger people or certain circumstances, to have no downside protection when they’re invested 100% in equities. This is not something we would ever do, because all it does is reduce risk. And if you don’t want to reduce your risk, there’s no need for it.

Kyle Grandstaff

They have time on, on their side, to to participate in the, you know, the long term averages.

John Healy

They can ride through the big declines, you know, and that’s the that’s the plan. But many people, they can’t, you know, you’re near retirement. You’re in retirement. You don’t want to suffer through another major financial crisis, 50% drop down in the stock market. So hedging is, we think, very appropriate. And when, when the pricing in the options market is, is accommodative to this strategy, so sometimes it’s not, you know, sometimes when we get to the end of that one year period where we’re trying to protect with the hedging, we’d like to continue with it and roll, but the roll, the puts forward and extend those expirations on put options, and you can’t, because they’re Just not just mispriced anymore. They’re overpriced. You’re not getting too much for that insurance. Yes, too expensive. And so we would then abandon the hedging strategy, and we’ve done this, and just gone back to traditional asset allocations, because it’s the best you can do, and it’s just not in your best interest. It’s not the doesn’t make sense anymore to to implement the hedging. Another, another point that we’ve done we we’ve done it for years and years, and there have been times when we’ve had to stop protect for taxable accounts. It’s a great tax efficient strategy, because it does allow us to do more tax loss harvesting, and we can go for years like we have without you can offset a lot of gains in the equity portfolio with losses from the puts. And so it has been very tax efficient for many years, and then when it doesn’t allow you to continue anymore, then you can take a big tax hit. So it’s got a it’s got a different tax history to it, but people tend to like it because it defer relative to a 60/40, stock bond portfolio, you get more tax deferral typically with the hedge strategy.

Kyle Grandstaff

Right. Yeah, John, I think that that was a great, a great summary of how we hedge here and kind of the strategy that we implement. Is there anything else that you’d like to touch on before we wrap up?

John Healy

Yeah, I think it’s something we can do, and we think it’s in the client’s best interest. It can be hard to understand, but we know what we’re doing and we’re not taking any risk with it, and so we’re comfortable doing it, and we’re going to continue to offer it to our clients and those who aren’t who aren’t comfortable with it and feel like they don’t understand it. We you know, we’re willing to not do it, but it’s here for you, for those people who are intrigued by it, we’d love to talk more with you about it and share more insights as to how it works. And particularly in this market, we tend to find there is more interest in this type of strategy, this type of overlay strategy.

Kyle Grandstaff

Yeah, thanks, John. I think you know, really appreciate you taking the time to discuss hedging. So if you have any questions, please don’t hesitate to reach out. We’d love to hear your thoughts in the comment section below. Please don’t forget to hit the like button and subscribe to our channel. Our mission is to improve the financial well being of our clients by addressing your wants, your concerns and your problems with wise counsel and sound investing. Thanks for joining us, and we’ll see you in the next video. Thanks.