A new type of fund called “target band” fund is supposed to smooth the ride on Wall Street as MarketWatch submits in “Putting a speed limit on risk and return:”
We have target-date funds. We have target-risk funds. We have absolute return funds. And now — just in time for this year’s market volatility — introducing “target band” funds.
Target band funds use options to place a “collar” on a portfolio’s losses and gains. They’re not available to the masses just yet, but Kent Smetters, president and founder of Veritat Advisors, plans to roll out these funds — which are now in beta testing — this summer. If ever there was a time for such funds, especially for those want to preserve wealth and have some certainty around their portfolio outcomes, now would be it.
…
In the case of Veritat Advisors, Smetters is creating a family of funds that would offer investors the chance to put targets on, or a band around, how much they might lose or make in any given year. Investors, for example, will get to choose whether they want to lose no more than 10% and make (currently) as much as 12% (the TB10), or lose no more than 20% and make as much as 25% (the TB20).
Smetters will do this by investing in the Standard & Poor’s 500-stock index and then using a zero-cost collar. He’ll be buying out-of-the-money, one-year puts for downside protection and selling out-of the money, one-year calls that will pay in full for the put. Here’s how Smetters describes it: “Veritat Advisor’s ‘Target Band 10%’ protects against losses above 10% by overlaying the S&P; 500 with one-year option contracts,” he said. “This insurance is funded by forfeiting positive gains above a certain threshold, currently about 12%. The performance of the client’s account, therefore, is effectively ‘banded’ between a loss of 10% and a gain of about 12% per year.”
In the old days, sophisticated investors might have referred to this as a version of portfolio insurance. But portfolio insurance, according to Smetters, has negative connotations. What’s more, it’s not really what he’s creating at all. “Unlike previous attempts at ‘portfolio insurance’ or ‘stop loss’ orders, the TB10 risk management system does not rely on markets remaining liquid,” he said. “All of the TB10 protection takes the form of absolute contracts that are backed by the Chicago Board Options Exchange.”
…
As for whether target band funds will sell? In a world where investors buy target-date funds and target-risk funds and absolute return funds, the short answer is yes. However, just as happened with those funds, a bit of investor education will be in order. And explaining how target band funds work without getting too deep into the weeds could be a challenge, according to Sullivan, who — in the interest of full and fair disclosure – also sits on Veritat Advisors’ board of advisors.
The other issue has to do with human behavior. Investors say they would be happy to buy a fund that puts a band around their returns and losses. They’ll soon get a chance to actually do what they say. Leave it up to Wall Street to come up with a fancy new product. To me, it seems like a bad idea to be limited with upside gains of 12% while having a downside risk of 10%. That’s not a good risk reward ratio. Here’s how we accomplish the same thing but with unlimited upside potential using trend tracking. Upon executing the purchase of an investment, we immediately establish a trailing sell stop point of 7%. In other words, as prices rise, the stop loss point rises as well. This essentially fulfills 2 functions: 1. It limits our losses in case the trade goes against us, and 2. It locks in our profits if prices continue to rise until the trend ends when it bends, and we get stopped out. It couldn’t be any simpler; your downside risk has been clearly defined and your
[Emphasis added]
upside potential is limited only by the duration of the major upward trend.