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Country reportsJuly 2 2012

Investors look to capitalise on equity market uncertainty

As equity markets look set to stagnate for some time, investors want to know not just how to hedge volatility, but how to profit from it.
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Over the past five years, investors have learned, sometimes from bitter personal experience, that markets have become increasingly unpredictable. Even three years ago, sovereign risk was barely considered by investors. Now it is a major focus.

From Lehman Brothers to Greece, a series of crises have forced investors to ask themselves some searing questions about their appetite for risk in sideways markets. These raise fundamental issues about investment behaviour – is it possible to hedge against growing uncertainty, by either minimising the loss or even to invest in a way in which they can benefit from chaotic situations?

The investment climate is such that loss aversion has taken priority over return; while fixed income offers poor return but better security of capital, equities appear to offer little relief. The lack of clarity on the global macroeconomic landscape is the main reason for the recent re-emergence of volatility as an asset class.

“Not only do we have concerns in Europe, but concerns of a slowdown in China and the still very fragile nature of the US recovery also weigh on the market. These problems unfortunately will not and cannot be solved overnight, so investors should expect frequent bouts of volatility coming back into the market over the next several years, which of course is a concern,” says Alfred Lee, vice-president and investment strategist, exchange-traded funds (ETFs) and global structured investments, at BMO Global Asset Management.

Diversification no haven

There is a sharp difference in the investment approach pre- and post-Lehman Brothers’ collapse, says Hichem Souli, European head of the cross-asset pricing team at Société Générale Corporate & Investment Banking (SG CIB). “Before Lehman, people viewed diversification of the portfolio as a safe haven. They generally did not want to hedge and felt comfortable as long as they had a bit of fixed income, commodities and equity. After Lehman, everyone understood that there was no such thing as a safe haven through diversification alone.” 

In an uncertain market, investors are looking to protect against downside risk within their portfolios. Mitigating downside risk can either be made at the asset allocation level, as an overlay using derivatives, or through a variety of hedging or direct adjustments to exposures held within the portfolio.

“In such stressed market conditions, and for some investors because of regulatory constraints, hedging is becoming a key subject. Hence, a growing interest in volatility which tends to be negatively correlated with all traditional asset classes. The main challenge for our engineering team is to provide our clients with the most efficient way to be long volatility while taking into account any client specific constraints,” says Mr Souli.

Initially, he says, investors used the over-the-counter market, typically variance swaps and sometimes via active funds, to gain exposure to volatility. But clients quickly learned that the lack of transparency and liquidity could be extremely difficult to manage over time. SG CIB helped at an early stage to develop ways to address these issues and to further adapt to clients’ risk profiles. 

US and European volatility

Negative correlation

The bank’s SG Index products allow investors to gain pure, systematic and transparent exposure to volatility while addressing the cost of carrying that position over time. For investors looking for equity exposure, SG CIB developed Europremium, which comes in Undertakings for Collective Investments in Transferable Securities format and allows investors to take an exposure on the Eurostoxx in a secured framework provided by an enhanced collar arrangement. The Europremium can then be used as an underlying asset for a wide array of strategies, according to each investor's objectives.

For investors looking for a fixed-income exposure, SG CIB has developed a range of credit and hybrid instruments over the past three years, which now allow for strategies of yield enhancement that are popular in the context of low interest rates. These include credit-linked notes, bond-linked notes and forwards on bonds. Investors are either hedging against volatility, using it to generate alpha, or manipulating it to diversify their return.

“The performance of equity markets tends to be negatively correlated with their volatility: equities have low volatility in positive trends, and high volatility in negative trends. Therefore, adding exposure to volatility to a core equity portfolio can offset the negative losses during market downturns. The resulting portfolio has lower volatility than the core equity investment,” says Ian Merrill, director of investor solutions at Barclays.

He adds that the relationship between equity and volatility returns is usually convex, which means the positive volatility returns during market downturns are higher than the negative volatility returns during uptrend markets.

Many investors have moved into volatility products, explicitly engineered as tools for diversification, displacing other asset classes that have shown closer correlation across the asset class divide. For private banking clients, especially in Europe, the priority is to hedge equity exposures, says Hubert Le Liepvre, global head of engineering within the cross-asset solutions department of SG CIB. The bank therefore proposes strategies that mitigate the downside risk.

“One of our most successful ones both from a commercial and performance standpoint is what we called the enhanced collar. This strategy consists of buying protection on the downside by selling some of the upside, but within an optimised time horizon. This allows the investor to preserve a true equity-linked exposure to the upside,” says Mr Le Liepvre.

“The rationale is to buy protection, as there is still a strong perception of possible equity downside, while embedding the financing of the protection within the solution itself,” he adds.

Exchange-traded volatility

In 2009, the first volatility exchange-traded notes (ETNs) were introduced in the US, providing a convenient and effective vehicle to access US equity volatility exposure. Since then, says Mr Merrill, dozen of volatility ETNs and ETFs have been introduced, offering exposure to volatilities of different markets, and different investing structures and strategies. Volatility ETNs on the Eurostoxx 50 index are available through ETN tracking the Vstoxx indices, such as VSXX and VSXY.

Some of these products base themselves on the VIX, the Chicago Board Options Exchange Market Volatility Index, which uses options prices to measure the market’s expectation of volatility of S&P 500 over the next 30 days.

If one stock is twice as volatile as another, its weight will be half the other’s. It is a simple idea that resonates well with clients

Stéphane Mattatia

The S&P 500 VIX Futures Index Series is a suite of investable indices that offers investors directional exposure to volatility through publicly traded futures markets, and seeks to model the outcome of holding a long position in VIX futures contracts. The VIX provides a lot of insight on investor sentiment and the general mood of the market, prompting a number of banks to offer product suites based in some form of delivering benefits from volatility.

For investors simply looking for a tactical access to volatility, SG CIB’s asset management arm, Lyxor, launched last year the S&P 500 VIX Futures Enhanced Roll ETF. Since volatility itself is not so easy to access, a volatility ETF is the perfect tool, says Stéphane Mattatia, head of equity flow engineering at SG CIB, “because it is liquid, transparent, rule-based and allows investors to capture any volatility spike – while limiting the exposure to the market normalisation when the volatility drops.”

A longer view

A number of banks are offering strategies aimed at capitalising on market volatility or hedging against a down market. Barclays offers a series of ETNs under its iPath platform with the aim of giving investors the opportunity to express a short view on US equity market volatility. It is a way for investors to gain inverse exposures in the volatility markets via products that are designed for a holding period longer than a single trading day.

Mr Merrill says that investing in volatility futures, options or ETNs usually provides negative returns during quiet markets. This negative return can be seen as an insurance cost which is paid for the opportunity to benefit from the positive spikes that a volatility investment may provide during downturns. “What is important is for investors to tune their volatility investment to limit such expenses during quiet markets, but still provide high positive returns during downturns,” he says.

Barclays developed two such strategies, seeking to provide a cost-effective volatility exposure. The bank had already listed on the New York Stock Exchange's (NYSE) Arca platform, the iPath Inverse S&P 500 Vix Short-term Futures ETN, which is linked to the inverse performance of the S&P 500 Vix Short-term Futures Index Excess Return – effectively allowing investors to take a short volatility position in stable markets. The risk to this product is that it will underperform if volatility rises unexpectedly.

As an alternative, the bank developed the S&P 500 Dynamic Veqtor Index, which provides investors with an equity investment hedged by volatility, and varies the volatility percentage of the portfolio according to market signals. This index is accessible through VQT, an ETN listed on the NYSE Arca.

Investors should expect frequent bouts of volatility coming back into the market over the next several years, which of course is a concern

Alfred Lee

Another possible strategy consists of dynamically changing the investment among the different volatility futures. For instance, the S&P 500 Dynamic VIX Futures Index provides a cost-effective volatility exposure by dynamically allocating between short-term and mid-term futures. This index is also listed on the NYSE Arca as the XVZ ETN.

Hybrid solutions

In its cross-asset nature, SG's Solutions department is able to advise clients on overall asset and liability management, or for more specific tasks such as hedging convertibles portfolios. To that purpose, SG CIB notably designs hybrid strategies that lower the cost of protection.

Mr Mattatia says the aim is to build a full range of indices that serve the purpose of helping clients first to generate more performance, and second, to control the volatility of the allocation. This can also be done using research-driven products, and SG CIB launched a Quality Income Index in May 2012 based on the work of its global research team.

This new index comprises stocks that are selected according to a quantitative methodology established over 10 years, and it aims at offering above-average returns, above-average yield and below-average volatility and drawdown. The fundamental concept is that supposedly 'dull' stocks may ultimately outperform more fashionable names if chosen using a suitable methodology.

“When an investor buys a stock that everyone talks about, they pay a premium for that. If you can find from a quantitative standpoint stocks that fulfil certain criteria, such as paying dividends steadily over a certain time period and having a solid balance sheet, the firmness of the company is a good reason to invest in it. So you do not pick the stock because you think that the economy today is favourable or not, you just look at certain indicators and that is how the index is constructed,” says Mr Mattatia.

Another key component of SG CIB’s toolkit is the equal risk contribution (ERC) methodology, crafted for investors who want to have a certain universe of investment for their equity allocation and then want something smarter than the capital weighting methodology, which is the typical weighting methodology of a benchmark index such as the S&P 500 or Eurostoxx 50. The ERC method weights the stocks in the index based on the risk of each individual stock as measured by its volatility. 

“If one stock is twice as volatile as another, its weight will be half the other’s. It is a simple idea that resonates well with clients as it is not something over-complicated, so if you want to have a risk control in the way the index is constructed, it is a very good option,” says Mr Mattatia.

The straddle strategy

RBS Global Banking & Markets has also developed a variety of hybrid strategies for investors to take advantage of volatility and uncertain market conditions. Garrath Fulford, RBS global head of fixed-income, currencies and commodities structuring, says one is through option strategies and variance swaps. One strategy is the delta-neutral straddle – where an option’s delta is its price sensitivity to the underlying asset.

“The investor buys payer and receiver options with the same strike prices, usually at-the-money forwards, and expiries, such that the structure is delta-neutral at inception. Once the sensitivity to the direction of rates has been removed, only a volatility exposure remains,” says Mr Fulford.

More sophisticated clients can use mid-curve options, which are options on a forward-starting swap. Another instrument more commonly used in foreign exchange and equity is a variance swap. In this instrument, the counterparties agree on a volatility ‘strike’. The counterparties then settle the difference between the realised volatility and the strike at maturity.

An increasingly sophisticated investor community will keep the pressure on banks and asset managers not just to hedge against volatility, but to make money from it, too. Volatility may be here to stay, and the opportunity to generate alpha from it will make it an easier asset class to market to investors in years to come.

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