After a remarkably calm 2017, volatility has returned to the markets despite a generally positive economic environment. As of July 31, 2018, there have been 36 days in which the market has closed either up or down 1%; in 2017, that happened only eight times.

Still, since the 10% correction we saw back in March, the S&P 500 has grown by 9.49% total return as of July 31, 2018 thanks to a strong second quarter earnings season and continued economic growth.1 Equities, particularly small cap equities, have performed well (the S&P SmallCap 600 index up 12.03% year-to-date, through July 31, 2018) and the current bull market remains on track to become the longest economic expansion in U.S. history.

In such a volatile environment, many investors may be hesitant to put their money to work — especially if they have recently experienced a significant liquidity event, such as selling a business or offering it to the public through an IPO. The length of this bull market may also give investors pause. While we believe investors should maintain a well-diversified portfolio based on their objectives, there are strategies that allow investors to gain exposure to the potential growth in the market while protecting against volatility. "Structured solutions" provide exposure to the potential returns of an index or basket of securities and may limit the potential downside. These types of solutions can be a great way for investors to put their cash to work while maintaining their peace of mind. Before we delve into these solutions, however, let's first examine what's contributing to the current market volatility.

Uncertainty Drives Volatility

Why are investors more skittish? Well, to begin with, some of the good news we've seen this year (such as corporate earnings performance following the 2017 tax bill that led to 78% of S&P 500 companies beating their first quarter estimated earnings) was probably already priced into the market. In fact, it's likely that optimism around corporate earnings contributed to the strong equity market returns we saw in 2017. The 12% correction we saw in the first quarter — a reaction to an unexpected increase in wage growth that raised inflation concerns — dampened that optimism and revealed a sense of uncertainty hanging over the market.

Right now, many investors feel like they have more questions than answers:

  • Will the tax legislation passed at the end of 2017 ultimately be successful? What will companies do with their tax savings — buy back shares, pay down debt or reinvest?
  • How far will the Trump administration go in applying tariffs to goods from China, Canada, Mexico and the European Union and what impact could retaliation have?
  • Does the continued flattening of the yield curve indicate a coming recession?
  • Which party will control Congress following the U.S. midterm elections, and could a change in control derail the implementation of fiscal stimulus?

These unanswered questions are weighing on the minds of investors and have left the market climbing a steep wall of worry, making it more reactive to certain data, as we saw in the reaction to the wage growth increase in February.

While answers are sure to be forthcoming for some of these questions, we do not expect this political and economic uncertainty to ease in the next 12 to 18 months. Nevertheless, we believe that fiscal policy in the U.S. will create strong demand for the near term and that the expansion will continue through the rest of 2018 and 2019, though perhaps at a slower rate. Despite continued yield curve flattening, we continue to believe recession fears are premature. The trade tensions between the U.S. and its trading partners should ultimately result in an agreement on tariffs, but this could take time.

While we are confident in the positioning of our investment portfolios, which includes a modest overweight to equities and underweight to bonds, we also believe it's important to incorporate alternative investments to help buffer market volatility and rising rates. While a properly diversified portfolio is an essential element of an investment plan, customized structured solutions can be another way to help reduce overall portfolio volatility while potentially adding returns.

For investors with significant amounts of cash on the sidelines, a structured solution may provide the flexibility and risk management needed to get back into the market. This investment allows an investor to put money to work in a more volatile environment by limiting the downside otherwise associated with investing in equities. It can be a better strategy to employ a structured solution rather than waiting for all of these headwinds to get resolved, given the opportunity cost of missing out on potential gains in this strong economic environment.

What Is a Structured Solution?

A structured solution is a note that is similar to a bond in that the investor lends his or her money to an investment counterparty bank for a fixed period of time. In exchange, the bank provides the investor with exposure to an underlying market index, such as the S&P 500, while offering to shield the investor against losses up to a certain point and, in some cases, offering a return greater than that of the index.

For example, consider an S&P 500 Buffered Risk-Enhanced Return Solution (BRERS). The "note" is issued by a counterparty bank, offers an enhanced upside return of 1.5 times greater than the S&P 500 (though capped at 18.25%) and reaches maturity after 20 months. It aims to reduce volatility compared to traditional equity positions by providing a 10% downside buffer.

What this means is that if the S&P 500 generated a 15% return, the holder of a BRERS structured note would enjoy an 18.25% gain. However, if the S&P 500 exceeded 15%, the BRERS investor would not see any further gains. On the other side, the BRERS investor could endure up to a 10% drop in the S&P 500 without seeing any loss of principal, and would enjoy reduced losses should the index drop further. For instance, a -20% return from the S&P 500 would be reduced to just a -10% return from BRERS.

Given our expectation for mid-single-digit equity market returns over the next 12 to 18 months, the structure of a BRERS solution can boost investor returns while minimizing downside risk. There are, however, some potential risks to consider:

  • Daily pricing. The BRERS does not move in lockstep with the underlying index on a daily basis and, due to option pricing, will be valued at intrinsic value only at maturity.
  • Issuer default. Because the strategy is structured as debt, it is similar to holding a bond.
  • Limited liquidity. While liquidity can be sourced from the issuers and the secondary market, it is not guaranteed and investors must be prepared to hold the note through maturity.
  • Dividends and gains excluded. The strategy provides the performance of the price return of the underlying security only.
  • Tax considerations. Typically, gains from a structured solution are treated as long-term capital gains if held for more than one year. However, investors should review the prospectus included in each deal.

Structured Solutions Can Provide Peace of Mind

We continue to believe global growth and robust corporate earnings will help drive equity gains in 2018 and beyond. That said, there are a number of headwinds facing the market and there's always the potential for negative surprises — say, a prolonged period of escalating trade tensions or a surprise outcome in the U.S. midterm elections — that could exacerbate volatility even further. In addition to a well-diversified investment portfolio, investors may benefit from incorporating customized hedging strategies like structured solutions that provide equity market participation and capital preservation in more volatile markets. By doing so, investors can stay focused on their portfolio objectives and not feel as compelled to react every time the market hits a bump in the road.

  • 1. Since March 23, 2018.

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