Editor's note: The following article was written by Kevin Simpson, president and chief compliance officer of Capital Wealth Planning, LCC in Naples, Fla. He has been a licensed financial consultant since 1992. He can be reached at firstname.lastname@example.org. His company's Website is www.capitalwealthplanning.com.
In these turbulent times finances are a constant worry, even for those who have plenty.
The affluent often make the same mistakes as everybody else when it comes to money management. They don't create a plan and stick to it. People have a tendency to chase fads or hot tips. There are select firms throughout the country that specialize in a protective technique that can dramatically reduce investment risk, while creating monthly cash flow and portfolio upside.
As 2008 has proven, the old adage of "buy and hold" has less relevance in this type of market. Over 50% of all trading activity is being executed by institutional investors. Market volatility is higher than ever before.
This massive short-term trading has changed the playing field substantially as the practice has evolved over the past 20 years. This means that the traditional thought process of buying good companies and holding them for profit has become more than challenging that ever before.
Shareholders of large companies have seen little in the way of growth -- in some cases to a staggering degree. The share price of
is basically the same as it was 10 years ago. General Motors share price is basically the same as it was 50 years ago. What is the individual investor to do?
Successful money managers believe the very purpose of any asset is to create income. They argue that stock and bond portfolios have received preferential treatment as an asset class for far too long. These traders demand that stocks and stock funds produce substantial revenue on a consistent basis. Using a safe financial strategy, a few specialized firms take the unusual position of performing this revenue-generating task monthly. Traditional firms do not take the time, energy or effort to create this income, especially on a monthly basis.
The strategy has been described as "renting" their client's stocks or funds. Everyone can relate to the term "rent." You buy property and collect monthly rent based on its cost or market value.
Bonds, notes, and mortgages are required to pay cash returns. Why not stocks and funds? Stock dividends are one source of income, but in most cases are far too low to be considered an acceptable return.
Experienced money managers demand a much higher rate of return. In real estate, most savvy investors purchase property that produces rental income so they can get a return on their investment. You, too, can create substantial cash returns by "renting" the access to your stocks and funds by optioning them to prospective buyers at predetermined prices. The cash returns from this low-risk, sell-only options strategy is the way to produce monthly cash income with low risk.
Always remember that cash cannot be eroded by market conditions.
By selling call options on stocks or funds that you own ("covered calls"), you are "renting" (with an option to buy) your stocks and funds to an investor who is willing to pay "rent" for the chance of owning your stocks or funds at a future higher price. The price and time limit are set in advance.
The option buyer's motive is controlling the stock or fund for a brief period of time without spending much money. Sellers, on the other hand, are content to collect the rent and sell their stocks or funds at higher prices with a limited upside. You, as the option seller, are then free to replace it and/or select another to start the whole process again. Most of the time the options expire at the end of the option period (ie. one month) and you simply keep the rent.
Investors do not purchase investment property without the intention of collecting rent, so why purchase stocks or funds without an intent to rent them? You as a shareholder are entitled to fair equitable cash flow from your stocks or ETFs.
ETFs, which stands for Exchange Traded Funds, are a relatively recent innovation. The first commercially available ETF -- the
(Standard and Poor's Depository Receipts) which tracks the S&P 500 -- was launched in 1993 by State Street Global Advisors and the American Stock Exchange.
In 2000, Barclays Global Investor's iShares came to the market, dramatically accelerating the popularity at ETFs. In recent years, ETFs have been among the fastest growing financial products in the world. According to Morningstar, there are currently 691 ETFs for investors to choose from. Two hundred, or about a third of the total, were launched last year alone.
ETFs are investment portfolios that trade like individual stocks on an exchange. They hold a basket of securities designed to track the performance of a sector or an index with a specific investment objective.
The evolution of the ETF has led to a secondary strategy that centers on the concept that each portfolio should be hedged. Thus, new ETFs have become available that are counter to an up market -- the value goes up when the market or certain segment goes down. Managers hedge accounts with appropriate levels of short ETFs, whether they be sector- or index-oriented. Short investments trade inversely with the stock markets.
In other words, they go up when the markets go down, thereby protecting accounts during bearish times. Covered-calls are also written on the short ETFs to produce additional "rent". This is a great way to protect assets in a declining market. They are also highly optionable and bring in tremendous cash flow or "rent." The option revenue can be so large on inverse ETFs that they can effectively create a self-financing hedge for their long positions. That is, the rent in one year's time can add up to as much as a quarter or half the cost of purchasing the ETF.
All accounts are encouraged to allocate at least a portion of their assets to a hedged or short position. The percentage of this allocation would be determined by your optimism or pessimism and your individual risk tolerance. This simply insures a portion of the assets by providing some downside protection. In down markets, these allocations actually increase in value.
These inverse ETF investments can be used to hedge a long position, they are designed to move in the opposite direction of a benchmark. Unlike a bear fund, which attempts to make money through active short management, these are passive products mirroring an index or sector.
If the benchmark moves 1 percent, the inverse product would move negative 1 percent. Some ETFs are actually leveraged 2:1. They aim for a rate of return twice that of the underlying index or sector to which they are tied. They accomplish this leverage through the derivatives market. If the market moves in your intended direction, your return in greater. The risk is that, if things move against you, your losses are compounded.
A popular strategy used by many professional hedge fund managers is to offset two investments in the same industry or index. One is held long and the other is sold short. The goal of this strategy is to realize a profit to the extent that the long position outperforms the short. ETFs can be used as either the long or the short sides of this paired strategy. The covered call writing component of both the long and the short creates the cash-flow from both sides of the market. Don't forget that the covered call limits the upside of both sides. You or your money manager must be very careful not to be too greedy when determining your strike prices for both the long and short positions.
It can be very tempting to jump into the "short-selling arena" in the wake of this financial crisis. Don't underestimate the risk and don't go it alone. If you have a bearish slant, turn to a professional firm who specializes in balanced portfolio management.
Needless to say, hedging does not mean eliminating risk. And there are certainly other hedging techniques. You could buy protective "puts" or you could simply cash out of an investment that you think may be poised for a drop and don't hang on when market forces are against you. Any experienced trader will tell you not to remain on a sinking ship.
This has been a challenging year for many buy- and- hold investors. To protect your nest egg that you worked so hard to build up, you should explore appropriate hedging techniques.
By utilizing inverse ETFs and by "renting" your stocks via covered calls, you can hedge your downside and you can create cash-flow in your existing investment account.
Despite the complex nature of these trading strategies, at its core they offer common-sense results. They reduce investor's risk levels and provide additional sources of monthly cash flow that can add up to significant sums. For those of you who haven't heard of these techniques - the secret is now out of the bag.