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?