The “best of both worlds” is one way to look at it. Savvy individuals now can use sophisticated equity risk-management tools previously available only to the institutional investor. Coupled with financial products designed to minimize market risk, they enable investors to eliminate two huge sources of worry. The real concern that some unforeseen (accounting, geopolitical, demographic, budgetary, terrorist) event will have a dire negative impact on your stock portfolio? Gone. Justifiable misgivings caused by financial products designed to limit your upside to a mere fraction of the market’s? Gone.

This strategy can be likened to putting your money to work in two places at the same time— in the equities market and in a “hedge” account. Using the 3-year performance of the S&P 500 under four hypothetical return scenarios, let’s see what happens to a $1 million portfolio that closely mirrors the index:

A) Strong Bull market with 30% returns per year (akin to Q2 1995–Q1 1998). As you can see, the hedging strategy can show >100% upside capture even in a strong Bull market.

B) “Historical average” 11% per year performance. In an average market, your upside capture still can be >100%.
C) “Flat” market with 0% per year returns. In a “flat” market, the performance nearly is equivalent.

D) Savage Bear market with negative 14% per year returns (akin to Q2 2000–Q1 2003). The hedging strategy strongly outperforms as a result of its loss minimization structure. While the equity Buy and Hold strategy resulted in a nearly 33% cumulative loss over 3 years ($673,536 final value), the hedged account still holds $936,279. The hedged account value actually increased, but capital gains taxes incurred on the hedge transaction result in small net loss.

This all is accomplished via a fairly simple (two-step) process. First, the investor uses equity holdings as collateral for a nonrecourse loan, provided by a national financial services firm. The investor still owns the stock(s), along with the ongoing upside potential. Because this is not a stock sale, tax consequences are not part of the transaction. Further, the loan is designed so there are no lender penalties if the investor later decides to cede the collateral. If the stock’s value declines, the investor simply “walks away” from the loan.

Next, the loan proceeds are used to establish the hedge account. A number of low-risk strategies designed to ensure principal return and protection can be employed. One common method entails the purchase of a fixed annuity designed by an international insurance company for use with this transaction. Should the stock market go down the tubes, the investor cedes the collateral and retains the hedge account, subject to some capital gains taxes. If the market shoots skyward, the investor can keep both the hedge account and the gain on the collateralized stock holdings. The loan even can be restructured so as to capture the gains in the stock, and establish a new hedged account value.

Applicability is extensive. Say you loaded up on Google at the IPO. You don’t want to sell because you’d have to pay the capital gains tax. Besides, Google might go up to infinity! Conversely, a meltdown always is a possibility. Using this strategy, you can eliminate the risk of loss associated with a significant drop in the stock price and still retain your upside potential. This strategy also can dramatically enhance the performance of a diversified portfolio. Using this technique you can, in effect, hang on to your winners and cull your underperformers without any significant loss. Or perhaps you have a concentrated stock position. You recognize the inherent risk, but do not want to sell. Use this technique to minimize your exposure.

Bottom Line: Every pension manager, professional money manager, and institutional investor recognizes the breach of their fiduciary responsibility that would result if they did not take steps to mitigate financial disaster. You owe it to yourself and your family to do the same. Do you want to eliminate the possibility of losing money in the stock market? Using strategies such as have been described, there is no reason for you to have money “at risk” in the market. The question becomes, “How much money would you invest in the stock market if you knew you wouldn’t lose?”

Mark Boehm, CWPP™ is a Texas Medical Association Insurance Trust (TMAIT) advisor. For more information on the topic discussed in this article, contact him at 972-395-8464, or alphawealth@verizon.net.