Portfolio Protection... How To Utilize Shaped Returns

Includes: EFA
by: Thomas Biddison, III


Structured Notes that generate shaped returns as part of portfolio construction.

Linear versus Shaped Returns.

Portfolio protection strategies.

Combining Shaped and Linear Investments for Total Return

As investors, we all want to "buy low and sell high." That's easy to understand in principle, but very difficult in practice. Why is this so difficult? The answer is simple. For the average investor, 80% of investment decisions are based on emotion. As human beings, we are wired to be bad investors. Investors often follow the herd mentality of buying and selling. We buy when we are euphoric and markets have experienced recent success (the point of Maximum Financial Risk), and sell when financial markets are experiencing stress and volatility (the Point of Maximum Financial Opportunity).

How can people battle their inner demons to become more disciplined investors? The traditional strategies of proper allocation, diversification, rebalancing, and index investing have, and will continue to be, core strategies for success. These traditional portfolios consist of stocks, bonds, and mutual funds, which provide linear returns. Linear return refers to the 1 for 1 relationship of the return path with the performance of the referenced asset. Investors participate 1 for 1 on both the upside and downside of their stock investments. What if one could include shaped returns to complement these traditional, linear investments?

Shaped returns for Growth

Designing a shaped return is all about give and take, managing greed and fear. Imagine making an investment in an index where the investor will not absorb the first 20% of the downside move, and will also earn an enhanced return on the upside. "Too good to be true," you say. Well, this is how it works. Institutional firms can manufacture an "Outcome Driven" note with embedded downside protection and enhanced upside by creating an investment linked to the lesser performing of two equity indices. For example, over the next 3 years, investors will receive 1.8X the lesser performing return of the S&P 500 and the Eurostock 50, while the first 20% of the downside capture is hedged from loss. If the index is down more than 20%, the loss from there is 1.25:1. Let's look at some scenarios based on 3 year price returns:

S&P 500


Note Return

Scenario 1



36% (20 X 1.8)

Scenario 2



0% (within the hedge)

Scenario 3



-12.5% (10 (amount below 20% downside hedge) X 1.25)

There are many different structures that firms may use to express their market views. For instance, there are strategies designed to adhere to the following investment thesis (we call these Outcome Driven Growth Strategies):

Thesis: Deliver a higher probability of high single digit to low double digit annual returns in a rising equity market, but reduce or eliminate downside capture in a falling equity market.

How it works: Investors are willing to sell away the "excess return" over a stated period of time in exchange for an enhanced return and embedded downside protection. An example would be a 24 month note linked to any index, let's assume EFA, the developed international ETF. Investors would receive 2X the upside price return of EFA, not to exceed 24%, and they would completely hedge away the first 10% of any downside index movement over the term of the note. Let's look at a few scenarios:

EFA price return Note Return Rationale
10% 20% 10% X 2 leverage factor
28% 24% Max return reached
-11% -1% 11% minus 10% hedge

The Investment Vehicle

The investment instrument used to deliver this shaped return is referred to as a structured note. Structured notes are issued by major investment banks such as JPMorgan, Goldman Sachs, and Credit Suisse. Simply stated, they are a combination of a zero coupon bond and options strategies on the represented underlying index the investor intends to track. There are a few key risk factors that investors need to understand. They are credit investments at their core, so the main risk is that investors will need the issuer to be solvent at maturity. The notes look like corporate bonds on custodial statements and may be traded on a smaller secondary market, but it is generally best to hold these to maturity. Our firm tends to use maturities ranging from 13-36 months, but it is possible to create much longer durations.

A Complement to Traditional Asset Management

The traditional, time tested principles of asset management continue to be relevant today. It is important to build prudent risk adjusted portfolios with varying asset classes and periodically rebalance the portfolio to maintain the appropriate allocation. We believe it is prudent to use shaped return strategies to complement the long only equity investments in a portfolio. Narrowing the range of returns through outcome driven investments and blending these strategies with traditional long only strategies should naturally create a smoother return path.

Disclosure: I am long EFA, IVV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: SX5E