Are these products as toxic as portfolio insurance, or merely irrelevant?
Traditional corporate cash investments remain uninspiring, especially since the Securities and Exchange Commission tightened quality criteria for money market funds. So bankers, working hard to cauterize the parts of treasurers’ brains that learned from the financial crisis that you can’t have extra return without extra risk, have been busily rolling out tomorrow’s potential headline disasters. One that has received widespread press coverage in the past 12 months is the so-called “risk-controlled index” product.
One would have to be born in or before, say, 1965 to have been in the markets in a meaningful way during the portfolio insurance gold rush that accelerated the 1987 crash. Since risk-controlled investments are portfolio insurance by another name, with a bit of enhanced-index nostalgia from the early 1990s mixed in, the bankers who are pitching it are either too young to realize they’re repeating history, or they hope this of their clients.
Existing risk-controlled products are based on the S&P 500, the STOXX and the DAX, their sub-indices, and others. They sell exposure to the underlying index when volatility rises (like portfolio insurance) and park the cash in some sort of yield-generating asset like a bond portfolio (similar to enhanced-index products, which used options to take the index exposures). Why a treasurer couldn’t achieve this with a simple stop-loss order or option, combined with a Treasury bill sweep account, is unclear. But if treasury were to put its portfolio allocation decisions on auto-pilot, like portfolio insurance converts of the 1980s, risk-controlled indices is the way to go.
These products do, however, require one to believe that volatility is more a predictor of asset price movements than a consequence of them. If that’s not the case, by the time higher volatility has rung the bell for these instruments to sell, the losses are already piling up. As those who watched their portfolio insurance schemes sell into the plunging market during the 1987 crash learned, selling at that point has the unfortunate consequence of locking in losses.
Worse, most stock trading today is done by trend-chasing algorithms. The idea that there will be any spoils for the risk-controlled types to savor after the algorithmic vultures have picked the market clean in microseconds seems pretty far-fetched.
Cash managers juggling billions while watching negative interest rates erode their war chests can be excused for searching high and low for investments purported to break the link between risk and yield. But they’d do well to remember, when listening to pitches for products such as these, that you just can’t have one without the other.