The volatility of equity markets has been low for several years and consequently the cost of put-options that pay out in the event of a market slump are cheaply priced. But is it an appropriate strategy for institutional investors? Three experts give their views.
Jerry Haworth, chief executive and chief investment officer of 36 South, the London based hedge fund, sees market conditions as providing the “perfect storm of opportunity” for purchasers of equity insurance or put options.
He says that in scenario testing, his Kohinoor Core Fund could have achieved, on average, a 140 per cent pay out if equity markets had fallen by 30 per cent at any point between 2011 and 2013. The opportunity is even better now that volatility is lower, he believes. 36 South, in the words of Haworth, “trawls” the world derivative markets looking for value propositions from options. His view is that since the height of market volatility in 2008, the pricing of options has slumped and generally sellers of options are misvaluing the risks.
“Option sellers are complacent and willing to sell options incredibly cheaply,” he says. Furthermore, low interest rates are forcing yield hungry investors into investments with mis-priced risk.
“Option prices are unnaturally low with regards to their potential pay-off, we can find opportunities with minimalrisk and huge potential gain.”
This approach to investing is not for everyone. Indeed, Haworth is happy to admit that his clients have lost around 5 per cent a year, while awaiting a big pay out. But he describes the cost as similar to insurance.
“The last three years have been one of declining volatility, so our clients are happy our losses are quite benign. That 5 per cent they are losing every year they see as an insurance cost.” The theory goes that payday should come at the time it is most needed. i.e. when traditional portfolio of assets are suffering losses.
Haworth believes that the high equity weighting of Australian superannuation funds makes them ideal candidates for adding this kind of fund to help ameliorate the massive potential drawdowns in another systemic crisis. Research cited by the firm points out that in 2008 Australia’s super funds had the 2nd worst investment performance for private pensions in the 30 OECD countries, after Ireland.
Haworth says there are not many true portfolio diversifiers that can be relied on to perform in highly stressed market scenarios, and he hopes to gain significant traction amongst institutional investors as the benefits of long volatility assets become more widely known.
No bargains to be had
John Pearce, chief investment officer of Unisuper, in his most recent investment bulletin to members of the Unisuper superannuation fund, asked why news headlines focused on issues of macro-economic concern failed to cause more equity volatility of late.
He believes it is because market volatility is a function of not only news that surprises, but also the market’s ability to cope with such surprises.
He says: “Markets are most vulnerable to bad news when they are overvalued and over-leveraged, and we do not see evidence of either in the current environment.”
Speaking to Investment Magazine he also queried whether options were cheap at the moment. “Short term implied volatility is still very low because we have been in a very low volatile environment. But if you look one or two years down the track and try and buy some protection it is not that cheap.”
As such, he said, Unisuper does not have any explicit downside protection.
“We have this quality bias in the portfolio. I have a degree of comfort ourportfolios will outperform and in the event, if there is a sell off, they will recover quicker.” He added that during the GFC quality companies did not “miss a beat” in terms of dividends and that their share price recovered in a couple of years.
Only for some
Investors historically have not been well served by buying equity puts or options on volatility indexes, states Travis Schoenleber, managing director of Cambridge Associates. He believes they are best used by investors whose circumstances make them especially vulnerable to severe drawdowns, but that those with long-term time horizons will lose out.
He says: “Tail risk hedging strategies or overlays, by definition, can go through long periods of poor returns, should be understood as paying a premium (return reduction) for insurance protection, sized accordingly, and weighed against alternatives such as lowering equity beta exposure or holding cash as dry powder through tactical asset allocation shifts.”
He adds that implementation is critical and must be considered within the context of opportunity costs, the possibility of lower returns, and diversification already built into the portfolio to provide liquidity and downside protection.
Anthony Limbrick, head of quantitative research at 36 South and Travis Schoenleber of Cambridge Associates will be speaking at the Absolute Returns Conference, the InterContinental Hotel, Sydney on September 18th
To find out more visit www.absolutereturnsconference.com.au