The Affluentialist: Preserving Capital for the HNW

In terms of the portion of a client's portfolio devoted to a planned return strategy, Eichen would first look at the part of the portfolio the firm is allocating toward equities for the client. The typical portfolio is between $7 million and $9 million, with several topping $100 million. The equity allocation is between 20% and 40%–and of that amount, up to 15% is directed to the planned return strategy.

"We think it's a much lower-risk bet than a pure equity portion," notes Eichen. "It depends on your outlook. If you're a mega-bull, you would never do this because you'd be capped out. But if you're not a mega-bull and you want to sleep a little better at night, and you don't want to worry about every tick to the downside, especially if you lost a lot of money last year, this approach enables you to sleep pretty well at night and know that–even in a mediocre year–you'll earn a halfway decent return."

While MDE now uses Gordon's Twenty-First Securities Corp. as its broker/dealer to execute options trades, Eichen's firm had previously bought bank notes from a select group of banks, using a portfolio construction process where it had no more than two notes with a given bank over a 12-month period. "But we stopped doing it last September after Lehman–when the banks went into disarray," notes Eichen. "We didn't lose any money on any banks' notes. The payouts delivered because we also had gearing to the downside. We generated alpha on each note, which again was a lot better than the long-only portion of the portfolio."

After Lehman, the firm didn't do anything with bank notes–the markets were just in too much disarray and it didn't want to take on any more bank credit risk. The firm decided to do the options strategies on its own. "I think we can do a better job than the banks in structured products because we can do it at a much lower cost basis," states Eichen. "We have much more control. We're taking a zero credit risk vis-?-vis bank-specific risk. We're able to structure any return pattern we want, and we can do it on any underlying entity and on any underlying index that has material liquidity."

Eichen finds that his clients like the planned return strategy because the options create a degree of certainty–unlike a long-only investment or even hedge-fund investments. "People invest in hedge funds for absolute returns," he observes. "Last year, some of the greatest hedge funds got clobbered and some of the big-name guys put stuff inside of their hedge funds that didn't belong there. And they got stuck. That's not going to happen here. What we do is completely transparent." If a client wants out, the investment is completely liquid because you can sell the underlying index, which is an ETF. The options also trade daily. Normally, clients shouldn't dissolve the strategy early since there's an inherent time premium cost in every option.

Constructing a Strategy

Every two weeks Eichen's firm places a new strategy examining different indices and their liquidity. It's executed as a block for a group of clients. For example, the firm will then buy a long position in the S&P 500 and determine how much of a loss it wants to buffer, such as not losing anything on the first 12% of decline. That becomes the anchoring assumption for building this model–the firm usually anchors on the amount of loss it's willing to take, not the upside potential. Then, Eichen and his associates do the math to figure out how much upside they can achieve at what kind of multiple. The firm runs many variations of each strategy, examining one structure versus another to count the potential benefits and drawbacks.

"Usually, you have to have a point of view going into this," notes Eichen. "Our point of view is that markets are going to be at best a 'nine,' with some potential for decline over the near term. We're not looking for a 30% runaway market. We want to create the highest probability of getting a high single or a low double-digit return. So, if we use a 12% anchoring downside, we can earn–over a 52-week period–twice the return of the S&P, subject to some cap. The cap will vary depending upon market conditions, mostly notably the VIX index. In today's market, you're getting a cap somewhere between 10-and-a-half to 12-and-a-half."

Eichen sees a strong advantage over hedge funds. "People invest in a hedge fund for absolute return," he observes, "not to knock the lights out and not to lose any money. So in this example, we know with a matter of certainty that, if the market is down less than 12% over any given 52-week period, we won't lose any money. You don't know that in a hedge fund."