Defensive equity offers way to stay in aging bull market
Money managers are fielding an array of new strategies targeted at asset owners who feel they can't pull back from global equity markets now despite growing fears of a correction — or worse.
Many of those strategies rely on put and call options to limit the bite a market sell-off would take from portfolios that are becoming more equity-heavy now — despite record highs for U.S. stocks and hefty valuations elsewhere — as rock-bottom yields rob the time-honored alternative, sovereign bonds, of their defensive charms.
In May, for example, Parametric Portfolio Associates LLC, the Seattle-based quantitative affiliate of Eaton Vance (EV) Co., launched a global defensive equity UCITS strategy designed to outperform "in negative, flat and modestly higher" markets, according to the firm's literature. After four months, the new fund has $280 million in client assets, but U.S. and global iterations of the strategy launched over the previous six years have combined client assets of $6 billion now, up from $4 billion a year ago.
Thomas Lee, Minneapolis-based managing director, investment strategy and research, with Parametric, in a recent interview said the strategy's "base portfolio" — split 50-50 between an MSCI All-Country World index fund and U.S. Treasuries — offers the virtue of half of MSCI ACWI's volatility at the price of half the returns. Parametric looks to fill that gap through "systematic sales of fully collateralized options" — selling short-dated, out-of-the-money call options against its equity holdings and short-dated out-of-the-money put options against its holdings of U.S. Treasuries.
That mix of options should "allow us to harvest 250 to 300 basis points of incremental return" — enough to deliver better returns, with 40% less volatility, than a fully-weighted MSCI ACWI strategy under market environments marked by annual gains of less than 9% or 10%, said Mr. Lee.
That risk-reward tradeoff could appeal to a growing number of investors if the global equity market rally continues this year, leaving some feeling like "cattle being led to the slaughter," said Mr. Lee.
Other big money managers have reached similar conclusions.
Earlier in the year, New York-based Morgan Stanley (MS) Investment Management, working in tandem with its investment banking colleagues, launched a strategy designed to limit downdrafts to 10% of the portfolio while minimizing hedging costs to let clients continue to capture the bulk of market gains.
"Pension fund investors need strong risk asset performance but cannot afford market corrections," said an MSIM report earlier this year.
One of the report's authors, Joseph McDonnell, London-based managing director and head of EMEA portfolio solutions, said the new strategy's equity return engine — with equal sleeves for four different factors: size, value, momentum and low volatility — is designed to outperform an MSCI ACWI index which is biased toward two structural factors: large-cap and growth.
A rules-based asset allocation engine shifts portfolio assets to cash from equities as realized volatility rises, while put options — protecting 90% of the portfolio's value — limit potential losses.
Mr. McDonnell said the strategy grew out of talks with insurers grappling with new solvency capital requirements that pegged reserves, for equities, at 40% of the value of their holdings. The structure of MSIM's strategy, built around put options and volatility-driven shifts to cash, effectively cuts that reserve burden to 12%, allowing insurers to hold more equities or the same amount with less capital set aside.
Outperform in down market
In the same interview, Paul Price, MSIM's London-based global head of distribution, said if equity markets tumble 10% to 20%, protected equity products "will outperform every other equity product."
Mr. Price said it could take a while for investors to warm to strategies with unconventional structures, but probably not too long.
"We think next year protected equity … will be a central theme for institutional investors," whether they implement that desired protection themselves or look to managers to do so, he said.
Julien Halfon, a London-based principal with Mercer's strategic solutions group, agreed. Early adopters have used such strategies in recent years but the level of interest among pension and insurance clients is picking up dramatically now, moving those strategies closer to becoming a mass-market option, he said.
The evolution from static approaches to long-dated options, in which downside protection would become less meaningful as markets pushed higher, to dynamic approaches, which reset option coverage as markets rise, has made such strategies more effective, said Mr. Halfon.
More of Mercer's clients are asking about these protected equity strategies, and Mercer is dedicating more resources to studying them, he said.
Meanwhile, the low to negative yields on sovereign bonds continue to short circuit any meaningful move away from equities.
Investors' traditional means of positioning portfolios for downside risk — selling equities and buying fixed income — looks to be an "expensive strategy" today, with sovereign bond yields near historic lows, noted MSIM's Mr. McDonnell.
For the first time in 35 years, clients are as concerned with the risks of holding fixed income as they are about holding equities, agreed Hamilton Reiner, New York-based managing director, portfolio manager and head of U.S. equity derivatives with J.P. Morgan Asset Management (JPM).
J.P. Morgan's hedged equity fund, which just recently achieved the three-year track record needed for investment consultants to give it serious consideration, uses a put option spread — buying puts 5% out of the money and selling puts 20% out of the money — while selling out-of-the-money call options to help cover the costs of the hedge.
The strategy aims to help clients capture 70% of equity market upside with half the volatility and downside protection, said Mr. Reiner.
A growing number of institutional clients are looking at the strategy as a means of adding equity market exposure at the expense of fixed income without taking on more portfolio risk, he said.
And even with a bull market that some say is long in the tooth, there are signs some asset owners are looking to add more equity exposure now.
Australia's Future Fund, in its update for the quarter ended Sept. 30, reported shifting roughly A$2 billion ($1.5 billion) into developed market equities from cash and bonds — lifting an allocation that had stayed between 14.9% and 15.3% over the previous six quarters to 16.8% of the fund's A$135 billion ($106.4 billion) portfolio.
A spokeswoman for the fund cited "improved global growth" and a lessening of some risks for the move.
Meanwhile, a Singapore-based senior sales executive with a global money management firm, who declined to be named, said institutional client flows to equity strategies have grown to record levels this year.