How's That Hedging For Your Revenue Working Out?

Posted by Michael Kitces on Thursday, September 22nd, 9:29 pm, 2011 in Practice Management

Market volatility is a stressful time, not only for clients, but often for planners as well. Not only does client activity rise, with more phone calls, meetings, and some hand holding, but at the same time revenues come under pressure, as new (and sometimes existing) clients often become less willing to implement, and firms with revenue is tied to the markets can actually see an outright decline in income. But the latter part, at least, is not something you have to just accept; there are ways to hedge the revenue and profit risk in your practice, and so far, those strategies are doing exactly what they're supposed to!

The inspiration for today's blog post comes from a conversation I just had with a financial planner, who asked me how things were going with the hedging strategy using options I suggested on the blog earlier this year as a practice management technique.

As you may recall, I had given an example of a financial planning firm with $200 million under management, and with an average billing rate of 1%, the firm has approximately $2 million in revenue, resulting in approximately $400,000 of owner profits ($100,000/quarter) assuming a 20% profit margin and $1.6 million ($400,000/quarter) of overhead, fixed, and direct expenses. At the time, the markets (as measured by the S&P 500) were at 1,325.

With today's volatility, though, the S&P 500 is now down at 1,130, a decline of almost 15%. If the typical firm client was invested in a 60/40 portfolio (where bonds are up a few points since July), the firm's asset base is down approximately 8% to $1.84 million. If the firm still faces approximately $400,000/quarter in direct expenses, while quarterly revenue has dropped to $460,000, owners profits will decline from $100,000 this quarter to only $60,000 for the quarter, as the firm owners bear the entire brunt of the revenue decline.

However, the blog post suggested buying 15 put options on the S&P 500 with a strike price of 800, expiring in June of 2013; at a then-current option price of $30/contract, the total cost would be 15 contracts x $30 / contract x 100 option multiplier = $45,000. So what would have happened with the significant market volatility since I originally wrote this on July 11th?

As of today's market close, the S&P 500 put option at a strike price of 800 is worth just shy of $70/share, based on the bid/ask quotes at the close of the market today. With 15 contracts, this means the value of the hedges is 15 x $70 x 100 = $105,000, a rise of $60,000 from the original quote 2 months ago.

So what's the end result? The options hedging has already helped to mitigate the profit loss entirety for the current quarter; the loss in profits from the market decline was $40,000 for the quarter, and this small amount of options made up $60,000 of the loss (in excess of the "cost of insurance" in the first place). To be fair, if the markets stay at this level, the cumulative profit loss for the practice will be $40,000/quarter x 4 quarters = $160,000 for the year, which is not entirely offset by the options (nor was it intended to be). However, if the practice is well-managed and includes some flexibility in staff compensation - for instance, bonuses based on revenue growth that don't have to be paid in down markets - that allows the firm to further save on payroll expenses, reducing overhead and staff expenses from $1.6 million to $1.5 million.

Thus, it's possible that the combination of effective practice management (saving $100,000 of staff expenses in a down market through proper compensation structuring) and options strategies (making $60,000 in a down market through options hedges) may fully offset a $160,000 annual decline in profits to the owners, despite the significant market turmoil and material market correction. Or alternatively, the owners could use the increase in the value of their options hedge this quarter - which more than completely offsets the quarterly profit decline as Q3 comes to a close - to manage the current quarterly profits downturn, and have another 3 months to make ongoing adjustments to deal with the new level of revenue for the firm.

The bottom line is that the volatility of revenue and profits - often a criticism of using the AUM business model - is not something firm owners just have to accept. There are tools - like options - that can help to manage, hedge, and mitigate the risk. And the volatility of the recent months provides a case-in-point example of the strategy working, exactly as intended.

So what do you think? Are options strategies - for the firm itself - a valid tool for protecting profits and ensuring the ongoing survival and success of the practice? Does the cost and benefit trade-off seem appealing to you?

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  • http://www.mayflowercapital.com Don Martin, CFP

    Excellent post, but I would handle it differently. During boom times I would spend more on the firm for business development and data base and research, thus generating costs and suppressing profit. These expenses would be disclosed to employees as temporary and cut during a crash. Further, the expenses in yet another different strategy could be increased during a crash to find more clients when others are cutting back on advertising. Then the costs and tax deductions could be carried forward or carried back generating corporate tax savings.
    I would not feel comfortable hedging with stock market Puts because if my forecast was wrong I could lose money on Puts and if the clients also lost money on the same trade they could fire the firm causing a double loss.

    • Michael Kitces

      Don,
      A few quick comments here...
      - I think most firms have a tendency to expand business development during booms, and then pull them back during difficult times (both by trimming costs, and simply due to the higher level of service burden to worried clients). I have to admit, I don't think this is constructive. It exacerbates the boom/bust cycle of the firm, as most business generation comes during booms and then during and immediately after a crash, the firm is down on revenue from the decline AND has cut back on business development. I've seen a number of firms that wanted to use such environments to proactively grow the firm while others are cutting back on advertising, but in practice it seems to RARELY ever happen; usually, the firm is too busy, too profit-crunched, or both.

      - Regarding the options, see the prior post. I'm assuming the Puts will usually be wrong. This is insurance. The strategy I outlined costs less than 1%/year in profits. We have no trouble paying on E&O insurance we never expect to make a claim on, or homeowner's insurance, or any other number of insurance policies. This is the same thing. The fact that your "premiums" may be lost if there's no crash is simply part of the deal with insurance.

      - The strategy I'm suggesting is to do this with the business' money, NOT your clients' money - simply because the practical, operational, and implementation challenges for doing this kind of options activity across all client accounts is not feasible for most firms. So you'd be doing this in your business' own account, NOT your client accounts. Your clients aren't risking any loss on options investing here. And notably, the whole point of the put is to hedge - it's value goes up (exponentially) as your client accounts decline, and goes down in value as your client accounts rise. It moves in the opposite direction. Think of it as a highly volatile, negatively correlated asset for your practice to invest in, to stabilize your business income, relative to just being "long-only" in your clients' investment accounts.

      Respectfully,
      - Michael

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