ETFS FOR SCAREDY-CATS
You want to get a piece of the bull market while eliminating catastrophic losses? follow the lead of twenty-first securities.
You want to get a piece of the bull market while eliminating catastrophic losses? Follow the lead of Twenty-First Securities.
In a toppy market, investors suffer terrible mental torment awaiting the next crash. Ministering to them is Robert N. Gordon, portfolio doctor. One patient: a forlorn taxpayer sitting on a highly appreciated $51 million collection of blue chips. Using a deft combination of put and call options, Gordon has all but locked in the gain while sidestepping tax rules designed to punish people who hedge away their risk.
Gordon works with a lot of investors like this one. “The last thing they want to do is pay a capital gain tax, but they want to lighten up,” he says.
Gordon is president and owner of Twenty-First Securities, a boutique broker in New York City that handles difficult trades, the ones requiring a knowledge of both option math and tax law. At one point his firm was overseeing $5 billion in short sales against the box, which until 1997 was a way to defer capital gains taxes by holding long and short positions simultaneously. Congress ended that particu-
lar tax dodge, but Gordon has a lot more in his surgical kit.
As a niche broker specializing in arcane tax-avoidance techniques, Gordon is like a Talmudic scholar when it comes to the tax code. For example, he knows, inside and out, Reg. 1.246-5(c) (1)(iii)(B), which sets out when a tax-sparing hedge crosses the line into a forbidden straddle. But he is also adept at the glad-handing side of the brokerage business.
One lead came in from a course on investment taxation that Gordon teaches at New York University. A former student got in touch, asking whether a technique he remembered from class would be helpful when his family sold its hot-dog business. Twenty-First got that assignment. The value at stake ran to nine figures.
If you don’t own a private jet you are probably not cut out to be a customer of Twenty-First. But Gordon is willing to share some of the techniques he uses on large accounts and to show investors of more modest means how they can get similar results using exchange-traded funds.
Given the stock market’s quadrupling from its 2009 low, would-be users of ETF-based hedges fall into one of two camps: Timid Bull and Protect What I Have. The first group fear missing out but also fear getting injured in a correction. Is there a way to be in the market while reducing or eliminating the possibility of loss?
Banks have products to fulfill this need: certificates of deposit with payoffs tied to the S&P 500 index. Gordon picks up a recent offering from J.P. Morgan and deconstructs it. It’s not a particularly bad deal, he says, since the CD is priced at only 3.8% over its intrinsic value. But the seven-year CD has two big negatives: If you need to get out early you might have a hard time selling it, and it delivers all its return in the form of highly taxed interest income.
Gordon has his big investor clients replicating CDs like this using zero-coupon bonds and “flex” options, which are custom-made contracts that can be designed to deliver a precise duration and payoff pattern. Using options, he can turn more than half the return into favorably taxed long-term gains.
At Fidelity Investments you can order up a flex option on State Street’s S&P 500 ETF (SPY)—but only if you’re looking for at least $13.6 million of market exposure. What if you’re a smaller player? You have to use off-the-shelf options traded on the Chicago Board Options Exchange, where the ante is one contract controlling $27,100 of SPY.
Using retail options, you may wind up with a slightly different mix of potential payouts than whatever your bank is peddling this week, but you will accomplish your goal of getting some action from the stock market while insuring against a financial crisis. Your liquidity will be higher and your taxes lower than with the bank product.
You could, for example, buy Vanguard’s S&P 500 index fund (VOO), then protect it with put options on SPY. Why buy the ETF from Vanguard? Because it has lower expenses. Why buy put options on the other S&P 500 ETF? Because they are more liquid. SPY has 4,300 times as many options outstanding as VOO does.
With SPY trading at $271, the put expiring in June 2019 and exercisable at $250 was recently priced at $12. This insurance is good only against crashes; in a correction smaller than 8% the put expires worthless.
There’s a booby trap here that your broker may neglect to mention: If the ETF is held in a taxable account, the options have to go in an IRA. Mess this up and you’ll get nailed by the straddle rule, killing the favorable tax treatment granted to the ETF’s dividends and capital gains.
What does Twenty-First do for Protect What I Have customers? Roy Haya, 45, the firm’s chief derivatives trader, runs regressions of clients’ portfolios against dozens of ETFs. The game is to find options on a fund that tracks an established portfolio very closely, yet does not flunk the straddle test.
That game is surprisingly easy to win. The IRS assesses the similarity between two portfolios not by calculating a correlation but by counting shares. You might feel a twinge of guilt taking advantage of the agency’s naïvete, but the emotion will pass quickly.
A well-diversified collection of highly appreciated blue chips is likely to have a fairly high correlation to the S&P 500. If it does, puts on SPY are a way to sleep better at night. As for tax compliance, you can either go through with the share-counting ritual or just take Haya’s word for it that no portfolio of fewer than 121 stocks creates a straddle with SPY. All else failing, hide the put in your IRA.
Gordon, 65, recently widowed, has two kids, neither particularly interested in Wall Street. What’s going to become of the firm? Gordon says that Haya has an equity stake.
If that stumps you, given that Gordon owns the whole thing, you don’t think like a derivatives guy. Turns out Haya has a call option on shares of TwentyFirst. Some kind of tax angle is involved. These guys don’t miss a beat.
“There are times when fear is good. It must keep its watchful place at the heart’s controls.” —Aeschylus
By william Baldwin Robert Gordon with 19th- and 18th-century orreries from his collection. The solar system is not quite as complicated as tax rules.