“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.*” ― Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable
Does anything from your recent experience make you feel like Taleb’s poor turkey on the fateful Wednesday before Thanksgiving? Say February 2020, when stocks plummeted from all-time highs to a sharp correction in a matter of days? Or maybe you think of September 2008, when the entire financial system was brought to its knees?
If you feel like you’ve incurred your own “revision of belief” over the past few years — the entire global financial system can’t just collapse overnight, modern science will keep us safe from a little virus, the greatest democracy in the world never has to think twice about a peaceful and orderly transition of power – you’re not alone.
Whether the world truly is more unstable, or it’s just that investors, advisers and analysts have grown gun-shy, a change has been rippling through the investing landscape. Bored millennials making the stock market into a casino grab headlines, but the more meaningful shift may be happening at the opposite end of the spectrum. Controlling risk, even at the expense of giving up some upside reward, may end up being the investment theme that defines the decade.
After all, the investment industry already has built an arsenal of products to make that happen.
“We now have so many instability points that we can no longer model all of them,” said Dave Nadig, chief investment officer and director of research at ETF Database. “Five years ago there was no sense that there was a shoe that was about to drop. Now it feels like there are quite a few shoes about to drop. It is very reasonable to be worried about risk right now.”
One of the most visible industry efforts to address such risk came a few years ago, when the biggest concern among investors was rising interest rates, and the likely end of the longest bull market in history. In mid-2018, a company called Innovator launched one of the first set of products known as “defined outcome” exchange-traded funds . The funds /zigman2/quotes/206033264/composite BOCT -0.03% /zigman2/quotes/207573246/composite POCT -0.03% /zigman2/quotes/200708776/composite UOCT -0.04% use options to allow investors to participate in the stock market – to a degree. Losses are limited, but so are upside gains – and the investor always knows by exactly how much. Innovator’s Defined Outcome products have attracted over $3.4 billion, and a host of similar products from issuers like First Trust and Cboe Vest joined in.
More recently, a firm called Cabana Asset Management took a strategy it had run for client accounts, which rebalances money among various asset classes based on a macro model, and launched a series of ETFs pegged to it . Each of the five ETFs /zigman2/quotes/221121519/composite TDSC -0.08% in the lineup has a particular target (but not a guarantee) “drawdown” – or maximum amount it can lose.
Also in September, a new company called Simplify launched a set of funds , also using options /zigman2/quotes/220749415/composite SPYC -0.38% , to harness the financial-markets concept known as “convexity,” in which bigger swings in the market can mean more upside for the investor.
The trend says a lot about investor psyche, said Corey Hoffstein, chief investment officer of Newfound Research. “Investors seem to be willing to explicitly define the upside they’re going to give up. It speaks to me of a lot of risk aversion and desire for certainty in the planning process.”
But perhaps more explicitly, Hoffstein said in an interview, it also speaks to financial markets so upended by the 2008 and 2020 crises that the asset class ordinarily used to mitigate risk – bonds – largely have been taken off the table.
“A lot of the problems advisors are faced with are what to do with bond allocation,” Hoffstein said. “With 10 year rates /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +0.96% so low, the math is inescapable. Fixed-income may not serve as the yield generator and portfolio buoy as it did in the past. A lot of advisors have been burnt by alternatives and are trying to find alternative methods that have greater transparency.”
Philadelphia-based Kathmere Capital Management, which serves high-net-worth households, uses Innovator products in its model portfolios. Kathmere upped its allocation in May, after the big March crash and the subsequent rebound, CIO Nicholas Ryder told MarketWatch.
“Our thesis was that markets had rallied close to near all-time highs and we thought the balance was tilted to the downside and as a result, we said, let’s move modestly defensive.” But given how little bonds were yielding, and the very real possibility that the only realistic path for rates was up, the firm didn’t want to put money in bonds or cash.
“We think of the Defined Outcome products as another form of defensive equity,” Ryder said.
Not everyone is sold. John Davi is the founder of Astoria Advisors, a New York City-based firm that constructs “institutional-type” portfolios for advisers to bring to individual-investor clients.