Sovereign wealth funds and other investors keen to hedge global equities exposures may find traditional equities derivatives too expensive. One salesman at a US-based investment adviser argues they should look to fixed income, particularly to US corporate bonds, as a substitute hedge for stocks.
This is not the usual approach, but one US pension fund has recently undertaken such a trade, says Stephen Jimenez, head of Asia-Pacific investor relations at Boca Raton, Florida-based III Associates.
He joined the firm in California this year after working at US alternatives investment company Coast Asset Management, where he was also involved in Asia sales.
Triple-I runs approximately $1 billion in funds, including a long/short credit fund, and around $500 million in segregated portfolios. The total AUM had peaked in 2008 at close to $5 billion but suffered from redemptions, margin calls and valuation losses during the credit crunch. Its main fixed-income fund suffered poor performance that year but has been positive in 2009 and year-to-date.
In addition to managing money, the firm has an advisory business, and one of its areas of specialisation is helping asset owners with long-term and tail hedging (that is, hedging against unlikely but huge market movements).
Before the credit crunch, investors could buy low-delta options in equities or fixed income at low premiums. A market move of 1.5x standard deviation could pay out 10x the initial premium, meaning insurance was cheap and pay-outs were big.
(Delta means the value of the option changes in line with the value of the underlying. Delta-one means a one-for-one relationship; low delta suggests a greater change in the value of the option. A standard deviation of 1 means a typical dispersion of outcomes/values of the underlying security or index.)
Since 2008, however, when many governments imposed bans on short-selling stocks, the cost of buying equity derivatives has soared – even after many bans were lifted or eased, says Jimenez.
This leaves investors with either impractically expensive hedges in equity futures and options, at a time when they are more concerned about tail-risk or long-term protection.
That’s why Triple-I is pitching the idea of finding suitable hedges in other asset classes, even if this leads to basis risk (the risk of imperfect hedging with futures, such as a different price between the asset to be hedged and the asset underlying the derivative, or a duration mismatch).
Today, equity derivative pay-outs are only 2x the premium, but in bonds, pay-outs can range as high as 6x because of low interest rates and tight spreads. Moreover, the implied volatility of futures on many equity indices such as the S&P500 is higher than, say, 10-year historical volatility. That means options are expensive, because there’s so many participants betting on puts against the index. That kind of fear makes hedging against a drop in equity markets very expensive.
“Sovereign wealth funds aren’t getting paid to take risk in their hedges, not even if they hedge with [US] Treasury derivatives,” Jimenez argues. “So why not hedge equity exposure through corporate bonds?”
This would have been heretical pre-crisis, but the manner in which all risk assets correlated to one in the wake of the Lehman Brothers collapse in September 2008 has made the idea possible, he says.
“We’re trying to buy volatility where there’s at least a 5x pay-out and you get paid if the market moves by a standard deviation of 1.5x,” Jimenez explains.
He says such hedges needn’t be complex; an investor could buy a one-year option against a bond or a bond index over 15 years, paying relatively low premiums
He acknowledges that few investment boards of trustees are prepared to make that kind of call, however, given the premium costs. (This is why Triple-I provides a consulting service as well as sells funds or segregated mandates; the advisory service also allows clients to take profits at will, as opposed to being subject to a fund’s redemption rules.)
Triple-I looks for the right index where not only are the premiums affordable and the pay-offs worthwhile, but where there is a likelihood of a 1.5x standard deviation move in an underlying, which would trigger the pay-off. It doesn’t just buy and hold these positions, but actively trades them, either as better opportunities emerge or to protect against time decay.
For example, Jimenez says at current levels such a decline in the S&P500 is quite unlikely. Investors who prefer to hedge in other equity markets might find an index such as the Dax or the Eurostoxx50 more likely to suffer such a fall in the event of global turmoil. The basis risk would be rendered irrelevant in a situation where all global equity indices were suffering.