Volatility fears push nervous investors toward puts

Investors increasingly are hedging downside risk through put options as a way to stay in attractive equity markets while dealing with their fears of increased volatility and market shocks.

“We are seeing more and more conversations and people looking at puts as a product,” said Hamilton Reiner, New York-based managing director, head of U.S. equity derivatives at J.P. Morgan Asset Management, and a portfolio manager. JPMAM has $1.7 trillion of assets under management.

A number of pension fund officials around the world, contacted by Pensions & Investments, declined to comment for this story. One said options form a part of the portfolio, but they are not a central instrument.

“As we came into May and June this year, we have already seen an increase in hedging activity” by market participants, said Colin Graham, London-based chief investment officer multiasset solutions and head of tactical asset allocation and research at BNP Paribas Investment Partners, which has e492 billion ($537.3 billion) in assets under management.

A put option allows an investor to sell a security at a certain price in the future. It is used most frequently to guard against share price declines.

Money managers would naturally look to government bonds and other defensive assets for safety. However, low interest rates and the correlation between these traditionally safe-haven and riskier assets mean investors are looking to implement these instruments.

“It is thinking about the alternative,” said Michael Spinks, co-head of multiasset at Investec Asset Management in London, which has $115 billion in assets under management. “If you are not going to buy a put, either accept high levels of volatility, or you have other ways of protecting your portfolio.”

Mr. Spinks said Investec now is using puts in the U.S., because of valuation risk.

J.P. Morgan's Mr. Reiner is sympathetic to this view. “The U.S. market still has the battle scars of 2008 and 2009, and we are six years into a bull market, which people are cautious about. Economic indicators were slightly soft in the first quarter. That backdrop means people are more cautious.”

Other geographical plays right now focus on Japan. “The idea of hitting air pockets is making us nervous,” said Adam Ryan, head of diversified strategies team and a portfolio manager at BlackRock Inc., in London. “We are building in insurance premiums, particularly in markets that we think have run a long way; Japan has run a long way.”

There is even a put option for the unusual, but much feared, circumstance under which unexpected correlation occurs between certain assets. “We are in a world where bonds and equities fall at the same time. It is always a fear at the back of your mind as a multiasset portfolio manager” that it will happen, Mr. Ryan said.

BlackRock in January and February implemented a put option in the strategy contingent on bonds and equities falling at the same time. “(The options) have been cheap because the pricing is based off recent correlation between bonds and equities, which has been very low,” Mr. Ryan said. “We want to hedge against an environment where the correlation rises and both assets fall.”

Morgan Stanley Investment Management, which has $406 billion in assets under management, is selling put options, rather than buying.

“That is a different purpose to limiting exposure to a market,” said Andrew Harmstone, asset allocation portfolio manager at MSIM in London. The manager sells some of its equities, replacing them with exposure by selling put options. “That separates the asset allocation decision from the income decision. By using them in this way, we can maintain some asset allocation as we wish, but use puts to generate some additional income,” Mr. Harmstone said.

MSIM is also creating liquidity in the market through this put option sale. “If someone is buying a put option, there needs to be another investor selling it,” Mr. Harmstone said.

But selling a put option must be carefully controlled, as a put option automatically moves further into a market when it declines, and out when it rises. MSIM controls that by accepting the increased move to take advantage of cheaper pricing, or by selling liquid future contracts to offset exposure, Mr. Harmstone said.

Henderson Global Investors Ltd., which has £89.4 billion ($135.9 billion) in assets under management, uses options for currency and government bond exposures within its unconstrained and derivatives-led portfolios, such as absolute-return and total-return strategies. “It is not just for hedging — we can use a put option to express a negative view on a market,” said Donal Kinsella, London-based fixed-income investment director.

“If we think a market will go down, we can use a put option to make money, or generate positive performance, as opposed to capping the downside, which is more likely used in equities.”

Henderson recently used a put on the exchange rate between the euro and the dollar, to take advantage of expected discrepancies between the currencies. “The best way to express those views is using a put option on the downside. We cannot lose more than the cost we pay for the put option. If the currencies move in our favor, we can generate income,” Mr. Kinsella said.

Mr. Spinks said Investec is using call options. “We swap out of an equity for a call option. We still get the downside protection, but we also participate in the upside.”

He said this was added to the portfolio last summer, when volatility was cheap, and made call options a cheaper alternative to put options.

The call option allows an investor to buy a security at a certain price some time in the future. Call options typically are used in rising markets.

As with any form of insurance, there is a price to pay. “We are pretty selective about when we use them — valuation and price we pay are critical,” Mr. Spinks said.

When they look too expensive, executives will find another way of solving the problem. “If we see hedging as expensive, such as the current European market because of volatility, we would just sell the underlying equities,” said BNP Paribas' Mr. Graham. At the end of May, his team sold its long-equity positions in portfolios. “We decided to sell rather than try to judge it using options, as we thought the options market was well priced for a fall.”

“Whatever you pay for those options, that is a drag on performance,” JPMAM's Mr. Reiner said. “But you are getting from that the ability to stay invested, and protection, and the ability to sleep at night.”