Throw Out Your Old Allocation Ideas

05/16/2013 7:45 am EST

Focus: STRATEGIES

The old 60-40 allocation rule has outlived its usefulness for investors, says Eric Metz of RiverNorth Capital Management.

Nancy Zambell: My guest today is Eric Metz, the portfolio manager of the RiverNorth Dynamic Buy-Write R Fund (RNBWX), and he also is derivatives strategist at RiverNorth Capital Management. Thank you, Eric for joining me. I appreciate your time.

Eric Metz: Thanks for having me.

Nancy Zambell: Let's talk a little about the obsolescence of the 60/40 model, the old model that recommended investors put 60% of their portfolio in equities and 40% into fixed income, adjusting it along the way as you retire, maybe getting a little more conservative, a little more in fixed income. That worked for a number of years, but it's no longer working, is it?

Eric Metz: It's becoming more and more difficult, that is correct.

Nancy Zambell: I know, in your fund, that you're doing things a little bit differently-using options. I've been reading a lot about 60/40, and most advisors say, we can just tweak it a little bit by adding additional asset classes such as real estate and commodities into your normal equities and bond portfolio. But I've not yet read anything about using options. Why don't you tell us a little bit about what you're doing.

Eric Metz: The 60/40 model, as you stated, is typically 60% equities/40% fixed income. And as the portfolio grows over time, that allocation would shift.

As people are starting to face the precarious nature of the interest rate environment in which we're in, they are a little bit hesitant to allocate 40% of their portfolio to the fixed income space—either from an interest rate risk perspective or because credit spreads have narrowed.

They're starting to shift more towards equities and diminishing their fixed income allocation. While that may be fine—and if your long-term horizon is more bullish for equities than it is fixed income—at the end of the day, what you've inherently done is increased your portfolio's volatility.

What we really try to educate people on is that while essentially you want exposure to equities and less exposure to fixed income, that hidden risk of that volatility can be mitigated with the use of options in a risk-managed way. And that's what our fund intends to do.

Nancy Zambell: I enjoy that you said "risk-managed way." If investors don't currently use options, when they hear that term, they get frozen like a deer caught in the headlights. They're scared because they've heard all of these horror stories of people losing millions of dollars trading these naked options. But that's not at all what you're talking about, is it?

Eric Metz: That's correct. Every option or portfolio is a way to express a view in a security. The risk management portion of the fund is that all the options are not levered at the security level or at the fund level.

That's where people have gotten historically into trouble—not understanding the inherent risks and how they behave—individually by themselves, but more importantly, collectively as a portfolio. When you use them collectively at the portfolio level, they become a very risk-mitigating tool-from selling calls, buying protective puts, buying protective put spreads-whatever the combination might be.

And all this is doing is really just mitigating the portfolio's volatility to a level in which people are accustomed to within their fixed-income portfolio. If you look at a risk-managed options portfolio, the volatility of that portfolio-albeit correlated to equities-has a volatility much more similar to their fixed-income products.

Nancy Zambell: Would you walk us through a sample trade of what you would do? I see in your portfolio that Verizon (VZ) is one of the stocks that you're holding. So what would you do? You would buy the stock, and then what would you do with the option?

Eric Metz: Sure. I can only speak of the December holdings at this point in time, so we can rewind about four months.

At that time, Verizon was in the portfolio, and we deemed that the risk-reward analysis that all of our technology and models help us analyze, is that owning Verizon and being short Verizon call options was a good way to get exposure—beta exposure—to the telecommunication space.

We're evaluating the risk-reward payoff profile of Verizon versus some of its peers, and then looking at those peers relative to the market as a whole—both on the individual company specific basis and then at the sector level as well.

We're doing this in hundreds of securities, analyzing this on a real-time basis. And when we rebalance a portfolio on an as-needed basis, that same iterative process is taking place.

Nancy Zambell: I'm looking at your sector level, and it looks like you're very well diversified for most of the major sectors and groups. When you first do your analysis and review the stocks, do you start with a fundamental analysis, or do you use a combination of fundamental and technical?

Eric Metz: Take it one step further. Because we are an options-oriented volatility portfolio, we try to generate risk-adjusted return based upon the opportunities in the marketplace within the options volatility arena. We choose our securities based upon the opportunity within their options.

For example, with Verizon, we saw the opportunity to profit from Verizon options, regardless of whether or not we thought Verizon was going to go up or down in the next 30, 60, or 90 days.

Now, our philosophy on this is that we are going to be so well-diversified across securities across sectors that at the end of the day, a diversified portfolio will have a very resemblant beta of the S&P 500. And we can hopefully generate a better risk-adjusted return through the trading of the options and let the stocks go where they're going to go.

We don't know where the market's going to go in the next 30, 60, 90 days, nor do we know where Verizon's going to go in the next 30, 60, 90 days. So what we try to do is put ourselves in the best position, using the options to give ourselves the best chance to generate superior risk-adjusted returns.

Nancy Zambell: I know that probably most of your portfolio would be blue-chip companies, just because of their large sizes and the availability of the options. Do you ever go down into the midcap space?

Eric Metz: We have the flexibility to do so if opportunities were deemed worthy in that space. But like you said, the liquidity that coincides in the larger caps within the options, is where we tend to move our portfolio around-simply from an options liquidity standpoint.

Nancy Zambell: What is the minimum to get into your fund, Eric?

Eric Metz: The minimum to get in the fund, I believe, is $5,000 for an initial purchase, and then I believe it's $2,500 at the IRA level.

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