Institutional investors generally cite three overriding objectives for fixed-income allocations: stability, yield and diversification. However, the "ballast" value of bonds can begin to deteriorate in certain economic environments, a circumstance that can also dull the diversifying impact of fixed-income allocations as normally inverse correlations begin to align.
Consider the impact of rising interest rates. During the first half of 2018, whenever the 10-year Treasury yield either approached or eclipsed the psychologically important 3% threshold, both equity and bond markets fell sharply. This was among the primary catalysts driving spikes in the CBOE Volatility index "fear gauge" in February. Research published by UBS, meanwhile, noted that against a backdrop of rising inflation, correlations between equities and bonds could be expected to edge even higher. This is fueling misgivings that if macroeconomic uncertainty translates into market volatility, fixed income on its own might be ill-equipped to offer the diversifying exposure that has traditionally helped soften prolonged downturns.
Many asset owners, as a result, have turned to liquid alternatives such as variable long/short funds to guard against unexpected market swings and further diversify their equity exposures. Another alternative — one perhaps better aligned to the role of traditional fixed-income allocations — is a volatility-harvesting strategy, pairing fundamental, bottom-up analysis with short equity call options, or buy/write securities. These strategies can deliver a stable return stream that maximizes risk-adjusted performance, while offering considerable downside protection to preserve capital amid unexpected market events. The synthetic-yield instruments created by volatility-harvesting strategies — utilizing options to effectively turn equity investments into a yield-generating bond — typically produce annualized income well in excess of a given company's investment-grade corporate debt. However, as most active managers well know, philosophy, process and execution do matter.
Consistent philosophy; distinctive outcomes
While it might sound complicated, success in harvesting market volatility ultimately rests in the fundamental analysis that informs the determination of intrinsic value. Similar to an actively managed value strategy, volatility-derived alpha stems from bottom-up evaluations that uncover stocks with attractive value characteristics, strong business fundamentals and compelling catalysts to drive business momentum. The analysis in many ways is not unlike the scrutiny bond investors apply to determine the predictability of cash flows. This analysis identifies the "intrinsic value" of a given company over the investment horizon and corresponds to the level where a given stock would find valuation support even amid disappointment vis-à-vis the company's market expectations.
With a determination of a stock's intrinsic value in place — representing the price at which a company's worst-case scenarios are baked into the valuation — calls are then sold, with a strike price equal to or lower than the intrinsic value, against the security at an "in-the-money" level. Typically, the strike price ranges from 15% to 20% below a company's current valuation. The analysis, from a risk management perspective, is again akin to how fixed-income investors assess adverse scenarios to determine an issuer's creditworthiness. This structure, which is long the stock and short the "deep-in-the-money" call (typically 20% below the current stock price), effectively turns the stock into a synthetic yield structure (or bond). The resulting structure provides an implied yield often commensurate with equities, while also offering considerable downside protection and reduced volatility of returns. Additionally, the alpha (or yield) generated by the strategy is from volatility as an asset class and not from equity beta. This serves to diversify overall portfolio correlations.
To be sure, not all volatility-harvesting strategies are cut from the same cloth. Most fund managers that use equity buy/writes to manage risk and produce options-driven income will primarily apply the construct to an exchange-traded fund or index such as the S&P 500. The CBOE S&P 500 BuyWrite index is an example of this type of approach. The calls that are sold are short-dated and are "at the money." This approach offers some exposure to the broader volatility asset class, but due to the short duration and at-the-money strike prices, it offers little downside protection and little reduction in overall portfolio volatility.
Using the concept of intrinsic value; increasing the duration of the options' expiration serves to decrease the volatility of returns, increase the probability of absolute return, and deliver steady returns commensurate with equities and high-yield bonds over market cycles. The concept of "intrinsic value" imposes risk management and structural downside protection into volatility strategies and its implementation effectively allows the investor to isolate volatility as an asset class to access its benefits. Index-based strategies still give the investor exposure to volatility but do not have the same level of risk reduction, structural downside protection or diversification benefits. As such, index-based strategies are not as suited to being fixed-income replacements. Fundamentally driven volatility-harvesting strategies, on the other hand, tend to perform more like traditional fixed-income investments in that they provide a true ballast function amid excessive market swings.
Interestingly adding both index buy/write strategies and fundamentally driven volatility-harvesting buy/write strategies into a portfolio, while reducing overall equity and fixed-income allocations, should reduce overall portfolio volatility, but at the same time can maintain or increase overall expected returns, diversify alpha sources and reduce correlations.
The upshot for investors is that by focusing on fundamentally driven volatility harvesting strategies, the benefits of volatility as an asset class can be accessed. Those primary benefits are reduced portfolio volatility, structural downside protection at the position level, increased Sharpe ratio and diversification away from fixed-income and equity alpha sources.
Performance plus stability
Against the backdrop of an extremely accommodative monetary policy over the past nine years (the "Fed put"), there might have been little justification for investors to protect themselves against market volatility. As the "Fed put" recedes amid a rising-rate environment, strategies that can both mute the coming volatility and actually capitalize on market vacillations can go a long way toward smoothing out both short- and long-term performance.
In 2018, investors already have absorbed two rate hikes, and the Fed has telegraphed an additional two quarter-point hikes in the second half with four more expected to occur next year. In addition to growing trade concerns and the flattening yield curve, the Fed's move to normalize monetary policy has been contributing to increased volatility.
According to DataTrek Research, in the first six months of 2018, the S&P 500 had logged 36 trading sessions in which the index either gained or lost more than 1% of its value, a pace that would easily eclipse the historic average over the past 60 years. Moreover, the VIX saw spikes in February that were among the largest of the past five years. The pronounced market moves provide a reminder that volatility is one of the most mean-reverting measures in all of finance.
As the perception of risk is further factored into the market, volatility should only increase, allowing volatility strategies to benefit in the form of higher call prices. From an investor's perspective, this translates into higher expected returns and even more downside protection. The real benefit for investors is the consistency of these strategies during both normal market periods and during stretches marked by turmoil.
At a time when correlations between equities and bonds are aligning, the uncorrelated nature of volatility harvesting strategies provides a valuable diversifier. And while volatility strategies can offer equity-like returns, it's ultimately the stability the strategy delivers — complementing the ballast function of bonds — that makes the volatility asset class such a natural complement to traditional fixed-income allocations.
Todd G. Hawthorne is a portfolio manager in the Greenbrae, Calif., office of Boston Partners and the lead portfolio manager of its Redwood strategy. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.