(Forbes) Like a surgeon’s scalpel, derivatives can be used to create investment miracles, but if used imprudently their inherent leverage can kill wealth very quickly.
Whether they’re generating income to offset cash drag, capturing tactical opportunities, or enhancing the efficacy of multigenerational estate planning, option strategies can uniquely address challenges for the ultra-high net worth family office with few if any unknown deleterious collateral effects using a small portion of a portfolio's risk budget.
All that is needed is a well-thought-out thesis, a plan of attack and some expertise in navigating through capital markets.
In an earlier article, I outlined the basic tenets of an options strategy that essentially underwrites publicly-traded insurance policies with pre-defined levels of risk. Such strategies can be especially effective when they’re targeted towards a specific sector/industry/market or country.
For example, when a market or country has a particularly bullish outlook for the short term, this can present an ideal opportunity for this type of strategy. To provide a specific instance of how this works in practice, this was the exact strategy I once took after identifying a bullish outlook on Brazilian equities over the short term, after their markets drastically sold off.
To reflect this thesis, I wrote put options on a Brazilian ETF that was at-the-money – i.e., a strike price equal to the current trading price – and used those proceeds to fully fund the purchase of at-the-money call options. In fact, in that one instance, markets were paying over $1.00 per share to take on this long Brazilian exposure that was created synthetically using derivatives. Brazilian markets subsequently rallied, making this an extremely successful strategy in a short period of time.
On a similar note, with some creative thinking, the benefits of using options within a multi-generational planning context are nearly endless.
To provide an example of how they can be used to magnify and enhance estate planning, consider how derivatives could be applied to Grantor Retained Annuity Trusts. GRATs are specially-designed estate planning vehicles to allow for the efficient transfer of wealth through asset appreciation to desired beneficiaries without the incurrence of a taxable gift transfer tax. However, for the vehicle to be effective, the underlying investment must be successful. That means the annualized performance must beat a federally mandated minimum return over the life of the GRAT, which is set and fixed at the inception of the GRAT vehicle.
Accordingly, the pressure is on the family office manager to select just the right investment for that GRAT term, although financial alchemy using options can enhance GRAT efficacy both on the upside, as well as the downside. There are other proactive planning strategies an advisor can implement to greatly enhance GRAT performance, but for this article we’ll stay focused on using options.
As a hypothetical, assume a family office structured a 2-year GRAT in the beginning of 2017 and funded it with the EEM ETF, which tracks the MSCI Emerging Markets Index. Just over two months into the GRAT, the investment would have already appreciated almost 10%, handily outperforming the hurdle rate. Now assume the family office’s outlook called for EEM to appreciate another 5% to 10% over the remainder of 2017. If the index climbs any further than that, they would be willing to take the profits and move on to the next investment within the GRAT.
Armed with this outlook, the family office could purchase one at-the-money call option with a 1-year maturity, which would be fully funded by writing two out-of-the-money call options that are over 10% out-of-the-money. Now, if the outlook is correct and EEM appreciates another 10% by year-end, the underlying GRAT experiences almost twice the appreciation because of the leverage created by the at-the-money long call options. If EEM continues to climb, the family office sells its shares via the short call options and moves on to the next successful investment, locking in a ~30% return (versus 20% without options) for the first year of the GRAT, all but assuring a very successful GRAT outcome. More importantly, all the incremental return of that GRAT would inure to the benefit of the GRAT remainder beneficiary.
Keep in mind that this 10% incremental return was achieved without any out-of-pocket capital or legal costs. And if the decision was made to actively trade both the long and short calls, depending on price volatility before maturity, it would be possible to capture several turns of profits, now making the gains from the options the predominant key drivers to the GRAT’s success. With clever use of financial alchemy, the family office is running two GRATs at the cost of one. In other words, they’re experiencing the benefit of two GRATs with one pool of balance sheet capital, simply by selling and purchasing insurance policies on underlying equity beta at minimal cost to the family office.
To emphasize, however, the direction and the construct of this type of options strategy must be guided by an investment outlook or all bets are off. Further, there’s a caveat to this discussion – be very careful when using long and short options strategies while long similar underlying exposure to prevent unwanted tax implications.
The theory behind options that underpins their diverse applicability is simply fascinating.
Despite the tectonic nature of this portfolio and balance sheet utility, derivatives remain largely misunderstood in the family office realm.
Warren Buffet's investment philosophy produced unprecedented wealth simply by buying companies that underwrote insurance policies at the right prices and utilizing them in the right manner. John Bogle taught us the benefits of investing with plain vanilla, the cost-effective market beta for our strategic asset allocation decisions. Why not learn from these pioneers and leverage their success in this low-interest environment, where family office managers and financial advisors are finding it increasingly difficult, if not impossible, to capture sustainable alpha. By taking these innovative strategies one step further, the benefits of derivatives can be applied to enhance wealth across multiple generations.
