The perils of replacing a safe asset class with a ­trading strategy

By David Peartree
BridgeTower Media Newswires

If safety were your primary concern, what would you think about a trading strategy called "the Iron Condor?" This is not a hypothetical, because there is such a strategy and, as of early last year, it had attracted over $5 billion of investors' funds. This is a cautionary tale.

Successive years of frustratingly low yields on conventional fixed income investments-CDs, money market funds, US T-bills and other investment grade bonds-have sent many investors in search of better yields. The dilemma of low yields also provided an impetus for investment firms to design new products to address the problem. Even now, more than 10 years after the great financial crisis of 2008-2009, the yield on the 10-year U.S. Treasury is only about 2%, well below its long-term average.

One brokerage firm has been marketing a strategy called the Yield Enhancement Strategy (YES), also known to industry insiders as the Iron Condor. More on that later moniker in a bit. The YES strategy was sold as a "conservative" and "low risk" strategy to wring more yield out of a portfolio otherwise subsisting on the sub-par yields offered by the more conventional options noted above.

Here's how it works. The YES strategy invests using a four-part options trade: two trades generate income by selling options and two trades attempt to hedge risk and potential loss by buying options. The options are puts and calls using S&P 500 Index futures.

The strategy is also known to traders as the Iron Condor. "Iron" indicates a trading strategy using puts and calls. "Condor" comes from the visual created when the trades are plotted on a graph. The graph lines resemble, at least with some imagination, a pair of wings on a big bird, such as a condor. Under optimal conditions-that is, when the market is experiencing low volatility-this strategy can generate small profits, thereby giving a modest boost to the investor's overall yield. The Iron Condor is essentially a bet that the underlying futures options will trade within a limited range.

The point is not to dissect exactly how this trading strategy works but simply to note that it's complicated. But wait, there's more. The strategy includes a "leverage" component. Leverage is finance-speak for borrowing. In this case, the investor's account can be used as collateral so that any losses incurred by the strategy would be covered using other assets in the investor's account which might, at that same time, be experiencing losses.

The strategy is not only complicated, but also expensive. The annual cost of the Yield Enhancement Strategy is reportedly 1.75%. Conventional fixed income assets can be purchased for far less. Fixed income mutual funds typically have annual expenses less than 1%, and low cost index funds often have annual expenses well under 0.1%.

This is not a knock on all options strategies because they can, in fact, be used in a conservative manner. But as one manager observed, the problem with this particular strategy is that, "things get worse as the trade goes against you." At the end of 2018, that's exactly what happened.

The YES strategy works well when market volatility is low, as it had been for much of the time the strategy was offered. In December 2018, however, market volatility spiked to the highest levels seen in years. Pending complaints allege that some investors incurred losses of 20% or greater.

The brokerage firm that sold this strategy to investors has defended itself by claiming that investors were adequately warned in disclosures of the potential losses they could suffer. They may have a good defense because, as we've repeatedly noted, it's largely a caveat emptor world for investors. If investors were adequately warned, yet proceeded, then they may bear the risk.

Even if the defense has merits, that still leaves the actions of the brokerage firm open to question. Did they do the right thing by selling clients a complicated options strategy-because, in all likelihood, few investors go looking for such complexity-or would those investors have been better served by working with a fiduciary advisor who would never have placed them in such a product when safety and capital preservation were their primary objectives?

But let's go back to the beginning and suggest a better way for investors to evaluate such "opportunities" than simply relying on the disclosures. According to news accounts, the investors drawn into the YES strategy pulled funds away from the conventional asset classes used when safety and capital preservation are the objectives: cash, cash equivalents and investment grade bonds. They exchanged a conservative asset class for a trading strategy, perhaps failing to realize that the two are not the same thing.

An asset class is a category of investable assets about which we can set reasonable expectations for returns and risk. Stocks and bonds, and all of their sub-categories, are assets classes. Cash and cash equivalents are another asset class. Investors seeking safety and capital preservation generally restrict their investments to asset classes such as cash, cash equivalents and investment grade bonds expecting both a limited upside and a limited downside. With investment grade bonds, for example, we can set reasonable expectations for returns simply based on the current yield. Historical data also allows us to make reasonable assumptions about how the bonds will perform under various market conditions.

But a trading strategy is not the same as an asset class. The returns from a trading strategy depend on market conditions but also on the skill or luck of the traders to take advantage of those conditions or to avoid being clobbered by them. Before turning to a trading strategy, investors in the Yield Enhancement Strategy would have been well-served to remember a few basic principles.

First, a trading strategy is not the same as an asset class. If safety and capital preservation are the primary objectives, investors should stick with those asset classes with a historical record for meeting those expectations and which can reasonably be expected to continue to do so.

Second, chasing yield invariably means taking on greater risk.

Third, complexity and cost are not the investor's friends. They are red flags. Investors should be wary of investment products they don't understand.

Fourth, before buying an investment product, especially one built around a complicated trading strategy, investors should always ask themselves how they could lose money and how much.

Seen in that light, perhaps a complicated and expensive options trading strategy wouldn't have seemed like such a good idea for an investor's safe money.

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David Peartree is a registered investment advisor offering fee-only investment and financial planning advice. This column is a collaborative work by David Peartree and Patricia Foster. Patricia Foster is a securities law attorney who represents clients in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. The information in this article is provided for educational purposes and does not constitute legal or investment advice.

Published: Thu, Aug 15, 2019