Why it's good to have options

As any behavioural scientist will tell you today, we have an uncomfortable relationship with risk. We accept that without it there can be no success, but when it comes to life-changing things like our finances, we’re often rather more begrudging about the trade-off. Our role as investors, is to take on that dynamic and make it work for our clients; to embrace the opportunities afforded by taking risk, and – even more importantly – to make sure we’re taking the right amount for any given client, at any given time. The question we’re going to explore here is what the risk landscape looks like today, and crucially, how we’re managing it for clients.

If you Google investment risk, you’ll be told that there is anything from 3 to 11 kinds, ranging from the obvious to the esoteric. But from a very broad perspective, there are two that matter to the owners of capital; the risk of losing your money, and the risk of missing out on the opportunity to make more. A quirk of financial markets is that when prices rise rapidly, both of these risks can be heightened at once; there can be a greater chance that prices extend too far beyond fundamentals and eventually go into a correction, but there is also the chance that prices keep rising for longer than you expect, and you miss out on the gains. The investors of today are well versed in this dynamic. The post-2008 Global Financial Crisis bull run has been both longer and steeper than many expected, and it left many value investors – who work to strict valuation disciplines – trailing behind those willing to pay a premium for growth.

Today the environment is a little different. After the GFC, central banks pumped liquidity into markets to keep them afloat, while governments attempted to “balance the books” and reduce spending. The net result of which was an asset price bonanza, a near-stagnant global economy and a fairly easy ride for investors, who could buy both bonds and equities without the fear of rising inflation. But today, with even the most austere of governments spending in earnest (here’s looking at you, Germany) and central banks still spiking the proverbial punch bowl, we have a more complex risk environment. We have asset price inflation, but we also have the threat of consumer price inflation, driven in the short term by tight supply chains, and in the longer term by the need for governments to inflate away their rising debt burdens.

So, with all of this in mind, is now the time to reduce equity risk? Or are the tailwinds for equity prices so strong that it would be foolish to fly in the face of them? Arguably, with trillions of dollars’ worth of economic stimulus still in the pipes, there is still a good deal of support for asset prices. A nuanced take on this portfolio construction conundrum is to maintain exposure to upside equity risk, while adding portfolio protection at the margins, and doing so to protect against both upside and downside risk. There are many ways to achieve this, but for simplicity’s sake we’ll explore one here, and that is using options.

A put option can be thought of as a form of insurance. It gives you the choice (but not the obligation) to sell a specified amount of an investment at a certain price, at a certain time. It essentially gives you a floor for capital loss; if you have a put option on the S&P 500 and it hits your target price, then you can sell it for your pre-agreed price, even if it continues to plummet. What’s more, in falling markets, the closer the underlying investment or index gets to your target price, the more valuable the option becomes.

Why is this helpful today? Because equity valuations are relatively high, and the higher they get, the greater the risk of a bear market. But crucially, the existence of a risk doesn’t necessarily mean that it will be realised; a market correction could be years away, and if you only work towards managing downside risk those years might be very uncomfortable indeed. So a further way to both participate and protect, is to tilt your equity exposure towards value equities, which do not have as far to fall in the event of a correction, and also do well in times of economic recovery. Their downfall, of course, is that they don’t necessarily offer the same promise of stratospheric returns as high growth stocks in the late stages of a liquidity fuelled bull market. Which leads us to call options.

Call options allow you tap into the upside of an investment without taking on the downside. They work in precisely the reverse manner to put options, allowing you the right but not the obligation to buy an investment (rather than sell it) at a certain price. We can use these when we see market momentum that could go on for some time, but we don’t want to take on the downside risk. When it comes to growth equities at these valuations, this is a particularly helpful strategy.

Growth equities are rife with stories. You see game-changing technologies, planet-saving innovations and all manner of activity guaranteed to spike serotonin and have you reaching for the “buy” button. Of course, therein lies the danger, and it’s on multiple levels. The headier a stock’s valuation, the greater the risk of a correction in price. What’s more, the hotter a sector becomes, the less scrutiny you see from investors on issues like corporate governance, making exaggerations or downright falsehoods from management more likely to occur. We’ve seen this recently with both Lordstown Motors and Nikola, two electric vehicles companies whose share prices have come crashing down as investors realised that they had significantly overpromised on what they could deliver.

Both of these sides of the options coin are useful today; providing some protection not only for the risk that markets correct, but also the risk that they do not. In a world where inflation is both rendering traditional bonds unappealing, and raising the prospect of a 2013-style “taper tantrum”, they have a powerful role to play in portfolios. It’s worth noting however, that they are not portfolio mainstays; they are tools to be used at the margin, in times of market extremes. We can go through long periods of time where it’s not sensible to pay for protection in this way; times when valuations are low and idiosyncratic opportunities abound. But this is not one of those times; we are at a point of regime change on multiple fronts, and we need to manage risk accordingly.

As we move firmly into a period of significant market regime change, diversification and a dextrous approach to managing portfolios are likely to be key to powering long term risk-adjusted returns. Equities are expensive, bonds even more so, and the negative correlation between the two is beginning to break down, which means that investors today are having to be both nimble and creative to construct well-diversified portfolios.

While short term inflationary pressures have been subduing fixed income markets, we think that a key scenario for multi asset investors over the coming years is financial repression. We have reduced our fixed income exposure to traditional government bonds, and instead focussed on Chinese bonds, which have a positive real yield, a policy mix which is more supportive of creditors, and will benefit from the loosening of foreign investment restrictions into China. We have also provided protection against a deflationary recession environment using call options on bonds, with a defined level of possible loss against a rising rate environment.

The ongoing policy mix is helping to create a loose environment for financial conditions, which is still supportive of asset prices, but we are also mindful of valuation risk as equity markets continue to pierce new heights. To balance this risk, we have shifted our prior (and fairly limited) fixed income exposure into equities, whilst protecting the downside with put options. Within equities, we continue to favour value, equities outside of the US and active management in general. In this period of regime change, we favour managers who can capture the opportunities created by market price dislocation.

Within active management, we think alternatives are playing an increasingly important role in portfolio construction. In order to diversify against equity risk, we are making use of a broad range of alternatives and liquid real assets, from gold and commodities, to actively managed strategies with idiosyncratic drivers of returns, such as long/short strategies, and macro hedge funds.

All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.

This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.