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A New Approach to Crisis Insurance

Richard Croft
March 4, 2013
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Invest ‘til May then go away ‘til labor day! That’s a seasonal strategy that has a large following among professional investors. It may be nothing more than advisors taking a break over the summer months making it more difficult for the market to move higher without enthusiastic buyers. Or if may simply be an old wives tale.

Still it was good advice during the last three years where the markets slipped in the summer months only to pick up steam again in the fall. Sometimes the pickup started around the beginning of September other times later in the year.

Regardless following that strategy was good advice during the last three years where the markets slipped in the summer months only to pick up steam again in the fall. Sometimes the pickup started around the beginning of September other times later in the year.

This year we find ourselves at a significant crossroad. There are dire prognostications around the sequestration which is taking place in the US. So-called independent government agencies cite the loss of 700,000 jobs which could lop 0.5 percentage points off US GDP. The bears posit that such dramatic cuts to a fragile economy will cause the markets to sell off.

The bulls see this as a good thing in that it gets lawmakers thinking in terms of government deficits. They argue that government spending and the inability of the various branches of government to get along actually impedes the private sector which is the ultimate driver of real sustainable long term real growth. If the US economy is able to weather the “sequestration storm” it could lay the foundation that gets governments thinking in terms of real deficit reduction. Although in fairness that is an optimistic assumption!

No matter how this plays out investors need to understand that sequestration only scratches the surface of the real deficit danger; entitlement reform! Entitlements are those US government programs like Social Security (Canadian pension and Old Age security being the Canadian equivalent) and Medicare. These programs were not part of the automatic sequestration cuts.

Entitlement programs are the real problem as an aging North American population begins drawing monthly inflation adjusted income on both sides of the border. Canada has been better at tackling these longer term issues, which may explain why our economy seems to be moving in the right direction. At least that’s the view if you buy into the latest spat of earnings from Canada’s major banks.

The bulls contend that if government is taken out of the equation the private sector with be able to operate in a more transparent environment. Transparency allows business leaders to make longer term decisions which with any luck will trigger business spending. Given the right incentive large North American companies that are flush with cash may start to use that money to hire and expand. If the private sector takes up their normal role it could easily overcome any shortfall in government spending and lead to a strong bull market for stocks.

So we come to the crossroad that defines the chasm between the bulls and bears. The trick is to work with what you know and deal with uncertainties as they surface. In this case, we know that investors are complacent as can be seen by the current level on MX’s S&P/TSX 60 VIX® Index. That also tells us that option premiums are relatively inexpensive.

We also know that interest rates are low. While we expect that trend to continue until 2015 it is hard to imagine a scenario where rates decline and bond prices rise significantly. Under that scenario medium and longer term bonds may be the highest risk asset in your portfolio.

That said we also recognize that bonds are a hedge. The objective with fixed income securities is to hold a diversifier within a well thought out portfolio. A kind of crisis insurance! If we take that away from a portfolio we should replace it with another diversifier that will perform if volatility increases should the equity markets succumb to a sharp sell-off.

As we hover at this crossroad some thoughts come to mind. If you are concerned about bearish arguments related to sequestration then buying puts index makes sense. If you don’t want to miss what could be a major bull rally, then buying calls make sense. And finally if you remain cautiously optimistic – which by the way is where I come down on this – then index straddles could be a useful substitute in place of the traditional risk reduction role played by fixed income securities.

Think about it this way. Suppose that you currently hold $50,000 in medium (7 to 10 year maturities) to long term (greater than 10 years to maturity) bonds. Sell the bonds and replace them with cash and a longer term straddle on the iShares S&P TSX 60 Index Fund (TMX: XIU, Firday’s close $18.56).

A straddle involves the purchase of a call and put with the same strike price. Say buying the XIU March (2014) 18 call and March 18 puts for a net cost of $1.60 or better (i.e. $160 per straddle). These are one year options which will be profitable at expiration if XIU closes above $19.60 (the bullish thesis) or below $16.40 (the bear case). The straddle also profits if volatility should rise as both the call and the put will be worth more than the initial purchase price.

Each XIU March (2014) straddle provides crisis insurance equivalent to approximately $1,856 (XIU at $18.56 x 100 shares = $1,856) in medium and longer term fixed income securities. Using our hypothetical example in which we sell CDN $50,000 in medium to longer term bonds that equates to being long 27 XIU March (2014) straddles! The end result is US $4,320 invested in one year straddles plus approximately CDN $44,680 ($50,000 from sale of bonds less $4,320 as the cost of 27 XIU straddles = $44,680 in cash) in cash as our fixed income crisis insurance within a well thought out portfolio.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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