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 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 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.