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Risk premia investors adapt
with defensive strategies

GlobalCapital, June 2018

Investible index platforms, which provide passive tailored exposure to different investment themes, are offered by many investment banks and have seen huge inflows from clients ranging from sovereign wealth and pension funds to sophisticated asset managers. But since a simultaneous bond and equity sell-off in February, equity markets in the US and EU have been more fragile.

After February, concerns about rising rates, the end of quantitative easing in Europe and the tech sell-off in March have made investors more cautious. Going short implied equity volatility, an investment strategy that was hugely successful last year, was dealt a blow by the huge explosion in the Vix index in February.

The Vix is an indicator for implied equity volatility on the S&P 500, calculated using options on the index. Short equity volatility strategies are now treated with more caution by clients of investible index platforms, with certain strategies specifically put in place to profit from subsequent spikes.

Profiting with Volatility

JP Morgan has seen considerable interest from clients looking to get exposure to a bespoke version of its intraday momentum strategy, according to Arnaud Jobert, head of investible index structuring at the bank.

"Intraday momentum strategies have been a big focus of my team as investors have been increasingly looking for diversified and defensive strategies that are likely to generate positive returns in stressed times, provide increased reactivity, good cost of carry and profit-taking capabilities,” he said.

The strategy that clients of JP Morgan have particularly been interested in is a version of the intraday momentum strategy that goes long the Vix. However, the strategy only does so when a “barrier” on the level of the Vix, determined during a trading session, is breached in the subsequent session. So if the Vix goes above the determined point, the strategy automatically goes long the front month futures contract of the Vix, then closing the position overnight, locking in gains.

“Since investors go long roughly 20% of the time, there is a very good cost of carry in normal times, unlike going long implied volatility with a standard put option, for example,” said Jobert. The strategy also has a "dynamic fixing system" that slows down execution when liquidity is poor and accelerates it when liquidity is high. This was specifically designed to mitigate the impact of stressed market situations, such as those in February, when liquidity for Vix futures contract was temporarily sparse, making exiting positions more difficult. When the Vix spiked in February, it sank exchange traded products, such as the XIV offered by Credit Suisse.

While the S&P 500 and other indices were clearly affected by the equity and bond sell-off, the huge short volatility positions held by many in the market had helped the Vix spike much more than it would have done otherwise, as investors and fund managers tried to rehedge their positions.

This led to a feedback loop, driving the Vix higher, leading to increased focus on liquidity when taking a position on the index now. When in doubt, diversify But worries about the volatility explosion in February haven't scared investors away from short volatility strategies. Many equity derivatives strategists had a feeling that a "correction" of sorts was coming with regards to short volatility, though none knew exactly when. Investors that got out in time would have netted returns equal to taking a six times levered position on the S&P 500, according to UBS research last November.

Shane Edwards, global head of structuring for equity derivatives at the Swiss bank, told GlobalCapital that clients were still interested in going short implied volatility. However, they are now determined to do so across a range of asset classes such as crude oil, FX and rates in the hopes that it will help them diversify that element of their portfolios. "In the current low rates environment, there are not enough attractive carry trades in the market, so short implied volatility is still quite popular with clients, despite the spike in February," said Edwards. "Leveraged certificates are also being discussed as a way to limit losses to invested capital." More generally, clients of JP Morgan and UBS have taken a particular interest in more defensive strategies as the economic climate has seemed less certain. Since February, as one macro strategist noted in late March, bad news has shaken markets more than it did towards the end of last year, when investor sentiment was strong. Most strategists expected a bullish run for equity markets in the US in Europe, with both jurisdictions gracefully adjusting to a higher rates environment.

But the February sell-off wrong footed markets, and the subsequent tech sell-off triggered by concerns over Cambridge Analytica and the policing of big tech, as well as trade war fears, have contributed to a less bullish, more cautious atmosphere. Caution sets in At UBS, clients have been demanding more exposure to commodities strategies, both in the form of smart beta solutions and long-short pure alpha solutions. While smart beta and pure alpha mean different things to different bankers, the former generally refers to going long an index that is tilted to favour a specific investment strategy. For example, a value strategy on the S&P 500 could see greater weightings for cheaper names on that index in the hope that they will outperform the index as a whole.

Long-short pure alpha solutions are generally associated with risk premia strategies. They involve mixing and matching different strategies in a portfolio of indices to create custom exposure that is market neutral, in theory performing decently in favourable and stressed market scenarios. Edwards added that interest in the commodities strategies has primarily stemmed from their tendency to be less correlated to risks in the equity and bond market cycles. Both JP Morgan and UBS have seen increased interest in different hedging strategies in their index platforms.

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