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Use derivatives to reduce volatility

By Killian Plastow
3 minute read

Long-term institutional investors should consider writing equity put options as a means to lower volatility while maintaining returns, Neuberger Berman has said.

Investors increasingly need to take new risks to meet their mandates, Neuberger Berman chief investment officer of multi-asset class strategies Erik Knutzen said, however the need to manage risks effectively is still a priority.

“The traditional way to manage downside risk is to buy insurance, and the most straightforward way to buy insurance in your portfolio is to buy put options on your most volatile investment category, equities – the only problem with that is that insurance is very expensive,” he said.

Mr Knutzen said that to buy this kind of portfolio insurance on S&P 500 stocks costs around 1.5 per cent of equity returns per month, and that over a 12-month period, this 18 per cent fee would be more than double the 9 per cent returns many equity investors expect from their portfolio.

“There are people who buy those, not 12 months in a row at 18 per cent, but hedge funds and others that want to protect their books over short periods of time, and when faced with that kind of expense, we would assert that the proper approach would be to write that insurance and earn that 18 per cent per year,” he said.

Writing put options on the S&P 500 generates similar returns to owning those stocks, Mr Knutzen said, however it does so with “about a third less volatility”, and that drawdowns experienced by S&P 500 put writers between January 1990 and January 2017 were lower than those experienced by security holders.

“Writing puts essentially acts as owning low volatility equity, which is something that many investors are seeking to own,” he said.

Mr Knutzen did however caution that this strategy still came with risk, and investors need to be mindful of whether the strategy suits their investment needs.

“It’s a risk taking activity – but it’s also a risk taking activity for which you are compensated, so who are natural risk takers to engage in this activity? We would argue that it’s long-term investment funds,” he said.

“We’re not recommending to our clients, nor in our books are we writing put options on an equity book, we’re writing put options on top of cash, or very liquid, very safe collateral, so we’re not doubling down our risk by writing put options on top of equities.”

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