From an investment perspective, these are truly extraordinary times. Despite being in the midst of one of the worst economic recessions in history, highlighted by double-digit unemployment rates and record corporate earnings declines, broader market indices continue to flirt with record highs on a daily basis. This disconnect between market prices and economic reality has been fueled by unprecedented monetary and fiscal stimulus, coupled with overly exuberant investor sentiment regarding recovery prospects. While those who bought the dip back in March may feel somewhat vindicated for their aggressive posture, industry professionals seem to think the market’s run-up these past few months is somewhat unwarranted given economic realities on the ground. In the face of this paradoxical relationship between market values and economic data, investors are faced with the unique dilemma of trying to participate in equity markets without overly exposing themselves to the eventual correction so many are convinced is on the horizon. Fortunately, there are several tools available to investors that are geared toward achieving this overarching goal. Specifically, we believe utilizing fixed-index products is an excellent way for investors to substantially reduce their exposure to market downturns, while maintaining their ability to participate in a portion of the market’s upside potential.

“However, in recent years, fixed-index products have evolved to enable the same level of protection while simultaneously expanding return prospects for investors.”

Historically, the guaranteed principal protection offered by these vehicles has been very popular with conservative investors who were willing to sacrifice upside potential for safety. However, in recent years, fixed-index products have evolved to enable the same level of protection while simultaneously expanding return prospects for investors. Typically, the returns for these vehicles have been tied to the performance of a traditional market index (such as the S&P 500). In the past, these vehicles did provide investors with the ability to participate in gains afforded by broader equity markets; but any gains were typically capped at modest rates of return (4-6% annually). However, in recent years, these vehicles have evolved to include proprietary investment options, often comprised of a combination of equity and fixed income investments, that offer greater exposure and diversification, while still providing the same downside protection inherent to traditional products. At a time when we believe markets appear to be overbought and the risk of event-driven volatility seems to be exceptionally high, these vehicles provide an alternative hedge against downside risk while still enabling investors to potentially benefit from more robust gains should markets climb higher. All things considered; fixed-index products should not be expected to outperform greater public equity markets over the long-term. Their primary purpose is protection. However, we believe their enhanced investment optionality may provide a more profitable alternative to bonds and certificates of deposits (CDs), particularly during periods of low/negative real interest rates (as seen today).

For years, high-net-worth investors have achieved this goal by utilizing sophisticated options strategies. However, for the vast majority of investors, large insurance carriers provide an excellent way to deploy this type of investment program. Specifically, fixed-index products establish a floor underneath the investor’s principal while simultaneously allowing them to participate in the equity market’s upside potential. Said another way, insurance carriers guarantee the original investment will not decrease during years of market decline, while still allowing investors to earn meaningful returns in years when markets outperform traditional safer strategies. To some the prospect of guaranteed principal protection coupled with modified growth opportunities may sound a little too good to be true. However, by peeling back the curtain on how these products are structured we learn that these investment opportunities are not only real but can also offer additional benefits and protections beyond the investment objectives.

So how does it work? To begin, each type of fixed-index strategy requires an initial investment. Whether it be a one time, upfront lump sum or a regularly recurring contribution. An investor’s principal is defined as any funds directly contributed, on their behalf, into the fixed-index vehicle. As contributions are received, insurance companies invest the vast majority in predictable bond and fixed income portfolios. Due to the size and longevity of the insurance company (insurers are some of the largest investors globally in fixed income investments) they are able to hold positions in illiquid investments with longer durations that allow them to capture an “illiquidity premium” ensuring longer-term, positive-return prospects ⁱ.

While this added transparency helps explain how guaranteed principal protection is established, it does not explain how potential returns associated with a market or proprietary index are able to be passed along to investors. The answer lies in what insurance providers do with the remaining investment that is not placed into fixed income securities. This is used to purchase call options on the specific index the investment is tracking (i.e. S&P 500). Since call options increase in value exponentially when their underlying investment goes up, the insurance company is left with a profit that can be passed along to the investor. In essence, the call options are able to produce an outsized gain that is more closely aligned with what returns would have been on a direct investment in the actual index.  When the index is up, the call options are exercised realizing the gain, and then a portion is passed on to the investor.  If the index is negative, the call options are held until a future date or let to expire. What’s more, in years where gains are earned and added tax-deferred to the investment’s overall accumulation value, the resulting account value becomes the new investment floor, “locking in” gains in years they are earned that can never be affected by future market/index loss.

In a nutshell, the purchase of bonds provides the downside protection and the purchase of options provides the upside potential for growth. Since the investor’s principle is never technically invested in the market, their principal assets are not exposed to market risk.. However, there is more to these types of investments than their ability to provide safety and growth. Depending on which type of fixed-index vehicle you choose, some products provide access to perpetual streams of tax-free income, tax-deferred growth, sizeable death benefits, and chronic illness/long-term care benefits.

There are, however, some limitations to fixed-index products that should be considered before committing to these investments. For example, while significantly more liquid than prior generations of these vehicles, fixed-index investments tend to have restrictions on how much cash can be withdrawn early in their lifecycle (typically 7-10 years). Furthermore, investors looking to obtain the market’s full upside potential are unlikely to do so in years of significant market gains. Lastly, given that not all insurance companies are the same, not all versions of fixed-index vehicles are of the same quality as others. As such, it is important to consult an independent financial professional to help navigate the plethora of options available.

In summary, fixed-index investments may be appropriate for individuals considering ways to increase asset protection without significantly compromising their appetite for growth. In today’s environment, where we believe frothy market valuations run counter to underlying economic fragility, fixed-indexed strategies can be useful tools for navigating uncertainty and mitigating downside risk. Of course suitability must be determined before pursuing fixed-index products. As always, it is encouraged to consult a fiduciary financial advisor to assess the merits of any investment opportunities under consideration.

1. Center for Capital Markets – The Role of Insurance Investments in the U.S. Economy (Winter 2019)

Disclosures:

Past performance is not indicative of future results. The opinions expressed are those of the Integrity Financial Corporation (“Integrity”) and should not be taken as financial advice or a recommendation to buy or sell any security. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Material presented has been de-rived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. Investing involves the risk of loss of principal. Investors should ensure that they obtain all current available information before making any investment.

The S&P 500Ò Index is the Standard & Poor’s Composite Index and is widely regarded as a single gauge of large cap U.S. equities. It is market cap weighted and includes 500 leading companies, capturing approximately 80% coverage of available market capitalization.

Integrity Financial Corporation is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Integrity, including our investment strategies, fees and objectives, can be found in our Form ADV Part 2, which is available upon request.

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