For Jerry Miccolis, the market meltdown of 2008 was particularly shocking. He regards himself a risk guru and yet, like almost everyone else, he was caught by surprise. What's more, he was working on the book Asset Allocation For Dummies, which ultimately was published in 2009. He recalls that this turned out to be both good and bad timing.
Suddenly, post-crash, everyone was talking about risk management investing. But Miccolis found no readily available, cost-effective solutions to the problem of portfolio insurance. After months of research and consultations with experts in a wide variety of disciplines, he concluded that modern portfolio theory was not dead - it simply was not designed to protect against a "black swan" event of the magnitude of the downturn of 2008. As he realized, "modern portfolio theory needed a supplement, not a replacement."
Although Miccolis entered the financial planning world fairly recently - in 2003 - he had a strong risk management perspective and plenty of quant firepower. Along with a B.S. in mathematics from Drexel University, he is a fellow of the Casualty Actuarial Society, a member of the American Academy of Actuaries, a Chartered Financial Analyst and a Certified Financial Planner.
Before becoming the chief investment officer and a principal at Brinton Eaton Wealth Advisors in Madison, N.J., Miccolis spent 30 years in the actuarial and risk management fields. After five years with the Chubb Group, he moved to Towers Perrin, where he ultimately led the largest independent risk management consulting practice in the world.
DAUNTING CRITERIA
But in 2008, the crash pushed Miccolis and his colleagues at Brinton Eaton back to square one, causing them to re-examine every detail of asset allocation theory. Not wanting to throw the modern portfolio theory baby out with the bathwater, he developed three daunting criteria for the tail-risk hedge supplement he sought:
1. Sudden appreciation in severe market downturns. This appreciation had to meaningfully offset the decline with no "give back" during the market recovery. This latter criterion effectively left puts out of the running.
2. Very low cost. Once again this criterion excluded puts as well as more sophisticated choices like collars, which are created by purchasing an out-of-the-money put option while simultaneously selling an out-of-the-money call option. As part of the cost considerations, Miccolis wanted to guarantee no sacrifice of upside portfolio potential.
3. Minimal disruption to the portfolio. This criterion effectively canceled out traditional portfolio protection options like annuities, precious metals and high allocations in cash and/or U.S. Treasuries.
As every investor knows, when markets crash, volatility spikes. This phenomenon provided the seed for a solution to Miccolis' dilemma: how to invest in volatility while adhering to his three criteria. His attention naturally turned to the Chicago Board Options Exchange Volatility Index, which has the ticker symbol VIX. The VIX measures the market's expectations of 30-day S&P 500 volatility implied in the prices of near-term S&P options. This perceived volatility could move in either direction; it is not just bearish.
Because of its negative correlation to the S&P 500, the VIX has the potential to be a useful tool in portfolio diversification. An added advantage is its tendency to be asymmetrical, with drops in the S&P 500 having larger effects on volatility than upswings. Miccolis notes that there can be a downside to using the VIX; some negative factors are that it is expensive and that it has a tendency to lose substantial value over time.
LONG AND SHORT POSITIONS
The Miccolis solution goes long and short on different durations of volatility at the same time. As he describes the approach, "the long position spikes more than the short position in very stressed markets and, as markets recover, the long and short positions cancel each other out, leaving the investor with the appreciation." He first applied this strategy through structured notes, but now uses swaps that he accesses through the Giralda Fund, a mutual fund created by Brinton Eaton.
The swaps in this case are agreements with a bank to provide the Giralda Fund the value of the long-short volatility trade. Importantly, a swap entails no initial investment or capital outlay, greatly minimizing counterparty risk. Different banks provide different versions of this type of strategy, so Miccolis' firm uses several banks - this allows much of the downside risk of these strategies to be diversified away.
This particular strategy has already passed several mini-tests, including the flash crash of May 2010, the Japanese earthquake/tsunami/nuclear crisis, the Arab Spring uprisings and the devaluation of U.S. Treasuries. "In each case," Miccolis says, "the combination of tail-risk hedges spiked up and stayed there creating the stair-step effect we were looking for."
PORTFOLIO CONSTRUCTION
This type of portfolio insurance does not affect portfolio construction. Therefore, a moderate risk portfolio at Brinton Eaton looks something like the following:
* 55% equities (including all cap sizes, all industry sectors, as well as international exposure and emerging markets),
* 30% alternative investments (including real estate, commodities and hedge fund strategies accessed through mutual funds),
* 15% fixed income.
The tail-risk hedge described above remains in the background (since there is no capital outlay, no funds within the portfolio need to be allocated to it) and is simply referred to as a "safety net."
In addition to this elaborate safety net, Brinton Eaton provides numerous other services to about 300 high-net-worth clients, with about $700 million in assets under management. Primary services of the firm include estate planning, income tax/charitable strategies, retirement planning/lifetime cash flow protection and executive compensation strategies.
The emphasis is on service; with 20 employees, the firm's client-to-staff ratio is a low 15-to-1, about half the industry average. At Brinton Eaton, each client is assigned to a team of professionals whose members are based on the client's need. For example, a team may consist of a tax expert, an investment professional and an estate planner.
All client-facing personnel have one or more of the CFP, CFA or CPA designations. In addition, teams are structured according to demographic diversity that Miccolis describes as including a graybeard, a young Turk and a number cruncher. Clients are charged on a two-level scale based on assets under management: 1% on the first $5 million and 50 basis points on anything more than that.
Most of the firm's clients have investable assets of $2 million to $10 million. Over the years, the firm's client roster has become heavy with corporate executives, retirees and multiple generation family members. "We now serve the grandchildren of some of our original clients," Miccolis notes.
As for his clients' safety nets, Miccolis now seems at ease that their portfolios are well designed to deal with any black swans that may be lurking over the horizon.
Jim Grote, a CFP in Louisville, Ky., writes regularly for Financial Planning.
Jerry Miccolis
Brinton Eaton Wealth Advisors
Credentials: B.S., mathematics, Drexel University; fellow, Casualty Actuarial Society; member, American Academy of Actuaries; CFA; CFP
Experience: Principal, chief investment officer and senior financial advisor, Brinton Eaton Wealth Advisors; principal, Towers Perrin; principal, Tillinghast; associate actuary, Chubb
AUM: $700 milion
How I see it: "We now serve the grand- children of some of our original clients."
