A Perfect Barbell Strategy
Updated: Apr 26
The barbell strategy is an investment concept that suggests that the best way to strike a balance between reward and risk is to invest in the two extremes of high-risk and no-risk assets while avoiding middle-of-the-road choices. Believers in the barbell strategy would split their portfolios into two. The first part would be used to buy the safest assets they can find. The second part would then be used to invest in the riskiest assets that can potentially earn out-of-this-world returns. Think private equity, technology stocks, cryptos, etc. Of course, high returns typically come with high risk. The investor might lose everything but at least he has his safe assets to fall back on.
There's Demand And Banks Know This
The barbell strategy is appealing because it satisfies both our greed and fear. Our fear is covered by the safe part of the portfolio. Our greed is also satisfied by the risky portion. Banks know this and they have been capitalizing on this for a long time through structured products. Our previous post talks about this.
However, you will find that most structured products are not worth the fees you pay. They only offer limited upside and you are lucky if you can get any in the end. It is not because the underlying structure is no good. It is because the banks take a big cut out of the structure as fees. This is not transparent to end clients because all they see is the potential product payoff.
You Can Create Your Own
There are complex structured products but once you understand how the simpler structures are built, you can easily create them yourself without paying any fees. For example, equity-linked notes (ELNs) are a combination of a zero-coupon bond and a call option on the underlying stock. Let's say the investor pays $100,000 to buy the ELN. There is a zero-coupon bond that matches the maturity date of the ELN. It is currently priced at 80% of its face value. The bank uses $80,000 to buy the bond so that at maturity, the bank can pay $100,000 back to the investor. The bank then uses the remaining funds, after taking their fees, to buy call options on the stock that is linked to the note. When the note matures, if the call options are in the money, the profit is paid to the investor. Otherwise, there is no extra payout to the investor. So if you can find a suitable zero-coupon bond and call options, you can easily create the same structure in your broker account.
Anything Other Than Options?
Instead of using the leftover cash to buy options, you can invest in risky assets or strategies. The reason why banks use options is because of the embedded leverage that gives the potential high upside. However, some strategies can give the same kind of high returns even without the use of leverage. One of the strategies we run can do this. It is an advanced version of one of the strategies that we teach in our courses. The historical compound annual growth rate of this strategy is 76%. The drawback is that it comes with high volatility although the Sharpe ratio is still above 1. This makes it a very good candidate to use in conjunction with the zero-coupon bond.
We prefer this over options because options come with a binary payoff at expiry. Either it is in the money or it is not. On the other hand, although our advanced strategy is volatile, it is expected to deliver good returns over the duration of the zero-coupon bond. This is based on the historical performance of the strategy. It returned 17.5% last year and it is already up 33% so far this year. Furthermore, profits can be locked in along the way even before the zero-coupon bond matures.
What Is The Catch?
If you think the above is too good to be true, you are partially right. You see, for it to work, we need enough leftover cash after buying the zero-coupon bond to run the strategy. And this is only possible in today's high-interest rate environment. If the interest rate drops back to historical lows again, the zero-coupon bonds would be priced at only a slight discount to face value. The leftover cash after buying the bonds would be too little to run the strategy effectively. Hence, the high-interest rate environment today presents a rare golden opportunity to lock in this barbell strategy. Grab it before it is gone!
If you are interested to know more about how you can create such a portfolio for yourself with the assistance of an Investment Adviser from iFAST Global Market, feel free to drop us a note!