Vest: Automation Meets Options In New RIA

You could say we are living in the golden age of financial innovation. The latest RIA to officially "open its doors" to business today epitomizes, in a way, how far technological advances, design growth and massive funding have come to reshape how investors interact with the market.

We're talking about Vest, a company launching out of the famed San Francisco startup incubator Y Combinator. We aren't setting out to endorse this newcomer in any way, but we'd be remiss if we didn't point out just how innovative Vest is to the extent that it offers investors and advisors—through the simple click of a button—risk-hedged exposure to stocks and ETFs that's customized to an individual's tolerance for risk.

The idea here is simple: People want exposure to the market, but they don't like risk.

With Vest, you pick your ETF, you decide how much downside you can stomach, and Vest—through the use of options contracts—offers you that downside protection for a premium.

"There's a certain amount of uncertainty and risk involved with investing in stocks and ETFs, and we're trying to build investments and put guardrails around them," Karan Sood, Vest co-founder, told ETF.com. "We want to mitigate some of the downside risk."

Here's how it works:

Step 1: You put in the ticker of the fund you want. For example, let's use the S&P 500 SPDRs (SPY | A-98).

Step 2: You get a slick little chart that visualizes a potential outcome. In this case, the current price of SPY is $208.83 and you want to protect your investment against a 20 percent decline. Vest is suggesting a strategy with the following payoff:

• If SPY closes above $230/share, you get $230/share.
• If SPY closes between $210 and $230/share, you get the closing share price.
• If SPY closes between $170-$210/share, you get $210/share.
• If SPY closes below $170/share, you get the closing share price plus $40/share.

The idea here is that you'd get most of the upside, and you're protected in most pullbacks. SPY could fall 20 percent and you'd get away almost free.

That protection is achieved by paring a long position in SPY with multiple options contracts because you get paid a premium when you sell call and put options, which offsets the cost of buying the hedge.

If Vest is compelling, it certainly isn't cheap. This trade would cost you about 2.44 percent of your investment to buy the options, plus Vest's investment management fee of 0.5 percent per year. In other words, in an upside market, SPY would have rallied more than 2 percent before you would break even.

There are other things to consider:

·This kind of protection can be very expensive in volatile markets.

According to Vest, hedging your downside for one year in the Deutsche X-Trackers Harvest CSI 300 A-Shares ETF (ASHR | D-60) will cost you 17 percent of the value of your investment. Leveraging that up three times and maintaining the downside protection will cost you 62 percent of your investment.

Investors can try to manage that cost by opting to give up some of the future upside as a way to pay for the insurance instead of paying upfront, Sood says.

"In very volatile times, the benefit of giving up some upside would be high because it would offset the impact of volatility in premium terms," he said. "The price of protection would go up significantly, but the upside you'd be giving up would go toward paying for that protection."

But there's no sugar-coating the fact that insurance costs money, and in a volatile market, you are going to pay up to sleep well at night.

·This works best if you lock yourself in for the targeted duration.

Vest executes these strategies by buying options for you that vest on a certain date in the future. If you exit the position before then, your return may be different.

That's important if markets turn volatile, and the price of the insurance on your position changes as the cost for the options change, Sood notes. But sticking with the plan helps.

·The position will expire at some point, so investors have to roll over that position.

"Because we are giving target return to investor, on the day options expire, investors get the choice to settle in cash and get their targeted returns, or settle in shares of the ETFs," Sood said.

According to him, there's also the possibility of unwinding the position ahead of the options expiration and placing a new position to roll over the exposure.

·Risks associated with trading execution are real.

Getting good execution in the options market is crucial to keep costs in check. There can be slippage in bid/ask spreads—which add to costs—but Sood says Vest takes trading execution very seriously. That's the reason Vest only offers this service on 700 ETFs, focusing on the ones where there's underlying liquidity in the options market.

At the moment, T.D. Ameritrade is Vest's brokerage partner, but the firm is looking to expand its lineup of brokerages in an effort to get the best execution, and to eventually be "execution-platform agnostic," Sood said.

"At this stage we are working with one brokerage partner, who is sourcing liquidity from multiple venues for high-quality execution, but we want to have this available over time to any investor in any brokerage account they have," he said.

Bottom Line

The bottom line here is that Vest makes options-linked investing seem easy. It certainly makes it accessible to anyone.

But investors need to look beyond the slick Web interface and easy-to-use tools, and be mindful that hedging a position through options can be costly, no matter how easy it seems to get it done.

Contact Cinthia Murphy at [email protected].