In February, 2010, we introduced an innovative form of portfolio protection — a strategy that incorporates a proprietary index developed by Deutsche Bank (DB). This index, called EMERALD (Equity Mean Reversion Alpha Index), tends to increase when equity markets exhibit a certain kind of volatility. The protection is based on the tendency for sharp declines in the equity markets to be accompanied by spikes in volatility, of the kind incorporated in EMERALD. DB made their index accessible to our clients in response to the criteria set forth by Brinton Eaton to address our clients’ risk management needs. These criteria are outlined in the supplement to this bulletin.
We made this strategy available to you in a custom-tailored investment, delivered through a promissory note from DB. Within the note, you received the returns of the S&P 500 Total Return Stock Index, plus the returns from EMERALD, with the latter index amplified by a factor of three. Brinton Eaton designed the structure this way to match our clients’ equity needs and to reduce credit risk. More details on our rationale for this portfolio protective device can be found in our Special Bulletin of February 12, 2010.
Unlike other investment vehicles such as mutual funds and exchange traded funds (ETFs), promissory notes come with a maturity date. We set the maturity date to be 13 months after inception, so that any investment gains might qualify for relatively favorable long-term capital gains tax treatment (assuming that the note was held in a taxable account). As the maturity date of March 23, 2011 on the inaugural note is approaching quickly, we would like to review how the note performed and outline our plans for its replacement.
Performance of the Note
Recall that, in normal markets, we expect the note to perform just like an S&P 500 Index fund. But in markets under extreme stress, we expect the EMERALD portion of the note to appreciate to a degree to meaningfully offset the decline in the equity markets.
In the almost-13 months since inception, the note has performed quite admirably. It generally behaved, as expected, just like an S&P 500 Index fund. However, during the “flash crash” in May 2010, we were able to see the benefit of EMERALD in action. The EMERALD portion of the note increased as volatility spiked, and even more importantly, has been able to maintain its higher level as markets returned to normal. The note has therefore substantially outperformed the S&P 500 Total Return Index to date, after all expenses. Including this note as part of your equity position has provided protection to your portfolio without compromising your strategic asset allocation.
If EMERALD has done so well so far, why not take your winnings from the note and run? Well, EMERALD is unlike an investment in stocks or other securities which can become overvalued over time. The performance of EMERALD is due to the daily effects of gyrations in the S&P 500 Index. As long as this kind of market behavior continues, EMERALD remains a sound investment.
While we certainly are pleased with EMERALD’s performance during the term of this note thus far, we also recognize that events such as the flash crash are not typical. Historically, during normal markets, EMERALD’s return has been far more modest. Please understand that if the note had performed exactly like the S&P 500 Index, instead of substantially beating it, we would have been perfectly satisfied. Why? Because that would have meant that we added meaningful protection to your portfolio at no cost. As we said in our original February 2010 bulletin, we expect the protection to pay for itself. It turned out that, over the last 13 months thus far, it has done that and more.
In the wake of the market collapse of late 2008/early 2009, innovation in risk management continues to accelerate. When the note was first issued in February, 2010, the EMERALD product was unique. We are happy to say that there are many more strategies that are being developed by various investment banks, which we have been vetting. One is the Barclays Capital (BarCap) ASTRO (Algorithmic Short Term Reversion) strategy that behaves similarly to EMERALD but has some important structural differences that will benefit you.
So, when the current note matures on March 23, we will replace it with two notes — one from DB and one from BarCap. The note from DB will be essentially identical to the one that is maturing; you will continue to receive the S&P 500 Total Return Stock Index, plus EMERALD amplified by a factor of three. The second note will be from BarCap and will be similar — you will receive the S&P 500 Total Return Stock Index, plus the ASTRO Index amplified by a factor of 2.2. We have determined that, due to structural differences, the ASTRO Index does not require as high an amplification as EMERALD.
There are several important benefits to having both EMERALD-based and ASTRO-based notes in your portfolio. One benefit is that the credit exposure to any one bank is lower than it otherwise would be. Another is that there are differences in how these two indexes work. Having both working for you enhances our ability to effectively manage portfolio risk by diversifying among the tools available. Approximately 80% of the allocation to the new notes will be assigned to the EMERALD-based note and 20% to the ASTRO-based note, as EMERALD has a longer track record.
The amount we invest for you in these new notes may be different from the value of your maturing note. The issuance of the new notes provides us an opportunity to rebalance your allocation to the notes to conform to your target asset allocation.
To summarize, on March 23, your original note will mature and the proceeds will accrue to your account. On the same day, the two new notes will be purchased so there is no gap in the protection to your portfolio.
Further Discussion of EMERALD and ASTRO
Mean Reversion and Mean-Reversion Strategies: An Overview
Equity markets typically don’t move in one direction for long. Declines in equity prices may be interrupted temporarily by upswings, and vice versa. This behavior in the markets is due to how people often invest. Investors may overreact to bad news and send stock prices plummeting, and then subsequently reconsider the news’ true impact causing the prices to rebound. Or “bargain hunters” may rush in to seize what they see as a buying opportunity. This kind of back-and-forth motion in the markets is called “mean reversion” — when a stock’s price strays far from its “mean” (average) long-term trend line, it tends to subsequently revert back toward that line.
Short-term mean reversion in the markets is not new; however, it has increased over the last twenty years. This increase can be attributed to factors such as the increased number of investors, round-the-clock financial news, and the advent of the internet as a trading tool.
With rapid mean reversion, the daily movements in an equity index will often be greater than its weekly movements. For example, say an equity index went from 1300 on Monday to 1295 the following Monday. Chances are, it did not decline steadily — to 1299 on Tuesday, 1298 on Wednesday, etc. Rather it probably bounced around between and beyond the two numbers, maybe 1310 on Tuesday, 1280 on Wednesday, etc.
Both EMERALD and ASTRO are indexes that tend to grow when the S&P 500 Stock Index exhibits short-term (specifically, intraweek) mean reversion. That is, they do well when daily movements in the S&P 500 Index are greater than its weekly movements. How often does this happen? About two-thirds of the time, which makes these indexes interesting enough to construct a viable and sound investment strategy around. In particular, both indexes can form the basis of an innovative approach to cost-effectively protecting a portfolio from catastrophic decline.
How EMERALD/ASTRO Meet Brinton Eaton’s Criteria for Risk Management Tools
Strategies based on these indexes meet the three criteria we established for appropriate catastrophic risk management tools: 1) low cost, including no sacrifice of upside potential, 2) sudden appreciation in severe market downturns with no give-back, and 3) minimal disruption to the portfolio.
1 – Low Cost, No Limit on Positive Returns
During typical markets, a short-term mean-reversion index tends to produce small, steady, positive growth over time. This growth is often sufficient to offset the costs of investing in the index and still yield a positive net return. It is this feature that makes these strategies virtually “costless” to our clients. This makes them compare quite favorably to other strategies such as puts that are quite expensive and thereby divert funds from productive use inside you portfolio. Also, unlike strategies such as collars, there is no limit placed on the positive returns a client can earn — there is no intent to sacrifice any upside potential.
2 – Appreciation in Severe Market Downturns without Subsequent Give-back
What makes these strategies so attractive is how they perform when there is a lot of market turmoil. When markets become very volatile, then the back-and-forth swings can get very large. Using the above example, imagine that in going from the hypothetical index level of 1300 to 1295, the index declines to 1200 on Tuesday, and rebounds to 1400 on Wednesday. This kind of behavior would cause the returns of these strategies to be quite high, thereby protecting your portfolio during chaotic markets.
Just as important, when the turmoil dies down, these strategies maintain their elevated levels. Other types of investments designed to protect portfolios will spike when markets are turbulent and then plummet when markets return to normal, thereby giving back any appreciation they may have had.
3 – Minimal Portfolio Disruption
Since the assets that are invested in these strategies are paired with the S&P 500 Stock Index inside a promissory note, your portfolio stays fully invested in the markets. This is critical, since you do not want to disrupt your carefully considered asset allocation. In other words, you don’t want to dismantle what works in the overwhelming majority of market environments you’re likely to encounter.
When Do These Strategies NOT Work?
No single investment strategy will work in all market conditions, and short-term mean-reversion strategies are no exception.
As the name implies, mean-reversion strategies require reversion to the mean. There is no guarantee that the S&P 500 Index will behave in this way at all times. If the S&P 500 Index moves in the same direction day after day, e.g., plummet every day for a week or more, then these strategies will not provide protection. Fortunately, this scenario is very uncharacteristic of the equity markets in recent decades.
Another scenario under which these strategies will not protect the portfolio is during a more gradual but protracted bear market such as in 2000-2002. They may still earn a small steady return above the S&P 500 Index due to short-term mean reversion, but not enough to provide meaningful protection. However, this is a scenario that Brinton Eaton has already successfully addressed using other risk management techniques, including scientific asset allocation and diligent rebalancing.
As our client, you have clearly benefitted from our use of this form of portfolio protection. However, we are not stopping our quest to deliver even better solutions. We continue to investigate, develop, and test other potential strategies. In the future, we expect to be able to provide even more sophisticated risk management techniques to help you meet your financial goals.
As always, please reach out to us if you have any questions.
Your team at Brinton Eaton
Please Remember: Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Brinton Eaton) will be profitable. Please remember that it remains your responsibility to advise Brinton Eaton, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.