Comments on Assumptions

Similar to most investments, there are a host of factors that are situational and must be accounted for on a case by case basis.  Taxes, interest rates, currency concerns, fees, dividends, credit risk, opportunity risk, inflation, deflation, time horizons, transaction costs, liquidity issues, politics, and any number of probable and improbable concerns can affect the performance of a portfolio.

Up until now, we’ve chosen a specific scenario that has assumed three large variables; Interest and Dividends, Stable Bond Fund Prices and Taxes.  Let’s deal with these three now.

Interest and Dividends

While neither of these variables are predictable, we have a pretty good idea of what we should expect over the duration of the options.  Dividends in a well-diversified portfolio normally don’t vary much over a 2-3 year period.

A sudden, drastic move in interest rates could affect the payout of a short term bond fund, but with today’s low interest rate environment, major moves would most likely be higher (more favorable to an IOP), not lower.  Defaults in a bond fund can be a concern.  If the bond fund is buying good credit quality bonds with shorter term durations, the likelihood of significant defaults in the long run are not very high.

Much of the work we do at Desert Rose Capital Management is in this area of fixed income.  We customize the IOP’s fixed income portion for the individual investor to either maximize potential growth, security or a combination both.  Similar to the primary concept of the IOP (earn more with less risk through the use of options), we apply different, but related methods to earn more income with less risk in this subsection of fixed income.

Part of the beauty of the IOP is that the income producing assets normally return a surplus after paying for the costs of the options.  Additionally, since we have such a large fixed income allocation, we are well positioned for deflation, yet we are fully positioned for all of the inflation neutralizing benefits of a strong equity portfolio due to the long term call options.  We will discuss this more in the next section.

Hopefully, by now, you are beginning to see why an Integrated Options Portfolio truly is an evolutionary leap in investment management.

Stable Bond Fund Prices

The value of a bond fund is based on many factors and the current price at any given time will fluctuate.  Although we seek to find growth in the share prices as well as income, our primary purpose is steady income for both short and long term.  Prices will fluctuate over time, but as long as the price is favorable when we sell, it really is not a big concern.

Think of it like rental property, if we bought the rental house for income during retirement, why do we care what the house appraises for while we still own it?  We just want steady rent payments and low costs.  If we can sell the house for more when it’s time to sell, great, but while we need income, we just want income.

One reason why we prefer shorter term bonds right now is because we are in such a low interest rate environment.  The difference in yield between short and long term bonds is minimal and if interest rates rise, the shorter term bonds should not be as adversely affected.  In fact, as bonds mature, those bonds can be reinvested at higher rates, which will improve the yield even more (our primary concern).  This means that the fund price may decline temporarily, but will adjust as the fund’s portfolio adjusts to the new interest rates.   Again, true customization to the client’s time horizon allows us to adjust for short term fluctuations in bond fund prices.

Taxes

This is another area where an IOP can be adjusted to each client’s situation.  With input from the advisor, the client, and a CPA, we are able to adjust how it is managed (when and how gains are taken), how it is structured (municipal bonds, annuities, taxable bond funds, etc.) and where the IOP is held (taxable account, IRA, Roth IRA, trusts, etc.).  Additionally, if you have multiple accounts with different tax treatments, we can coordinate each account to hold the specific securities that will be most tax advantageous.

More Thoughts

Many advisors and individuals are concerned about volatility in the market place, rightly so.  An IOP works great in volatile market conditions, because of the limited loss nature of an option contract and the stabilizing effect of the large fixed income portion.   It is likely for volatility to continue for the foreseeable future which makes the IOP more important now than ever.

The fact that our call option contracts only last for 2-3 years (short-term) is great for long-term performance.  At the end of each option contract, we rebalance the portfolio and repeat the process.  If the market is flat we collect income, if it rises we participate, if it declines we are positioned for significant growth during the recovery

As a final lesson for this section, look at the hypothetical performance charts for three major index funds that show how having an IOP structure changes investment performance versus not having the IOP structure.  Similar results take place with most investable asset classes.

Comparison Charts

Remember it is not what you own it is how you own it.