Cross-Pollination: Volatility & Options

In our continual search for differentiation in this fiercely competitive investment biosphere, we remain intrigued by the idea of cross-pollination between investment strategies. After all, regardless of strategy, all investors share a common goal: capital compounding through the creation of return asymmetry over time. Fundamental investors often shy away from options and volatility, labeling them as too complicated and esoteric. Are they truly that complicated, or merely made to seem so by industry participants enamored with jargon and befuddlement?

In this brief video (8:30-8:35am time slot), Richard “Jerry” Haworth of 36South shares a few thoughts & observations on options and volatility that all investors can incorporate into their portfolios.

Summary Highlights:

Options (a type of “volatility assets”) are a potentially rich source of alpha since pricing in options market are mainly based on models, not fundamental analysis. Occasionally massive mispricings occur, especially in long-dated options.

Most wealth is generated by luck or asymmetry of risk & return. Most options have asymmetry. Long options positions (especially long-dated) behave like “perfect traders” – they always obey stop loss (downside is limited by premium outlay) and positions are allowed to run when working in your favor (especially as delta improves for out-of-the-money options).

Options also have natural embedded leverage (especially out-of-the-money), providing cheap convexity. Better than debt, because it’s non-recourse – max loss is limited to premium outlay.

Volatility (a $65 trillion notional market) is counter intuitive – people tend to sell vol when low, and buy when high – great for contraians who like to buy low and sell high. Natural human behavioral bias makes it so this phenomenon will never go away.

Portfolio managers are in the “business of future-proofing people’s portfolios” – seeking to maximize return while minimizing risk and correlation. The “further you get away from $0 the more you are future-proofing a portfolio…” But this is extremely difficult to implement well, especially in low interest rate environment where future expected returns are difficult to find.

Short-term downside volatility is noise. But long-term volatility on the downside is permanent loss of capital – counter to goal of “future-proofing” portfolios. When people think about risk, they tend to use volatility as proxy for risk, but this is a very limiting definition. Volatility has been minimized by low rates, which has lead people to mistakenly think that we’ve minimized risk since we’ve minimized volatility. Classic mistake: people are now taking on “risk and correlation that they don’t see…for returns that they do see.”

Correlation – only important in crisis, no one cares about correlation when asset prices going up. Perceived vs. Actual Correlation: dangerous when you think you have a “diversified” portfolio (with low correlation between assets) when in reality correlation of assets in portfolio actually very high. People focus on minimizing correlation, but often fail when truly need minimized correlation (example: during a systemic crisis).

Writing / shorting volatility (such as selling options) in a portfolio increases yield & adds to expected return, but makes correlation and risk more concave, with a tendency to snowballs to downside. Whereas long volatility assets are convex, it takes slightly from return (cuz premium outlay) but offers uncapped expected return on the upside.

A Chapter from Swensen's Book

Given his reputation and the title of the book, we would be remiss not to feature excerpts from David Swensen’s Pioneering Portfolio Management. Below are portfolio construction & management highlights from Chapter 6: Portfolio Management. The manager anecdotes in this chapter are fairly interesting too, providing readers a window into how an institution (Yale/Swensen) evaluates its external managers. Portfolio Management, Risk, Expected Return

“In a world where risk correlates with return, investors hold risky assets in pursuit of returns exceeding the risk-free rate. By determining which risky assets are held and in what proportions, the asset allocation decision resides at the center of portfolio management discussions.”

“…the complexities of real-world investing drives a wedge between the easily articulated ideal and the messy reality of implementing an investment program.”

Putting aside whether you agree that risk is correlated with return, it is safe to postulate that markets are (usually) efficient enough to require investors bear some degree of risk, in the pursuit of any rate of return above the risk-free-rate. The portfolio management process involves determining which returns are worthwhile pursuing given the associated risks, and relative to the risk-free rate. However, sh*t happens (“a wedge between the easily articulated ideal and the messy reality”). So how does one navigate through the “complexities” and “messy reality” of implementation? Read on…

“Some investors pursue active management programs by cobbling together a variety of specialist managers, without understanding the sector, size, or style bets created by the more or less random portfolio construction process…Recognizing biases created in the portfolio management process allows managers to accept only those risks with expected rewards.”

“Disciplined implementation of asset allocation policies avoids altering the risk and return profile of an investment portfolio, allowing investors to accept only those active management risks expected to add value.”

“Concern about risk represents an integral part of the portfolio management process, requiring careful monitoring at the overall portfolio, asset class, and manager levels. Understanding investment and implementation risks increases the chances that an investment program will achieve its goals.”

“Unintended portfolio bets often come to light only after being directly implicated as a cause for substandard asset class performance.”

Awareness of what you own (the risks, expected return, how the holdings interact with one another, etc.) is an absolutely necessity. This concept has surfaced many times before on PM Jar, likely indicating that it is an important commonality across different investment styles and strategies.

Leverage, Expected Return, Risk, Volatility

“By magnifying investment outcomes, both good and bad, leverage fundamentally alters the risk and return characteristics of investment portfolios…leverage may expose funds to unanticipated outcomes. Inherent in certain derivatives positions, leverage lurks hidden in many portfolio, coming to the light only when investment disaster strikes.”

“Leverage appears in portfolios explicitly and implicitly. Explicit leverage involves use of borrowed funds for pursuit of investment opportunities, magnifying portfolio results, good and bad. When investment returns exceed borrowing costs, portfolios benefit from leverage. If investment returns match borrowing costs, no impact results. In cases where investment returns fail to meet borrowing costs, portfolios suffer.”

“…portfolio returns should exceed leverage costs represented by cash, the lowest expected return asset class.”

“Sensible investors employ leverage with great care, guarding against introducing materials excess risk into portfolio characteristics.”

Traditional academic leverage discussions focuses on the theoretical spread between cost of borrowed capital and what is earned through reinvestment of borrowed capital. While this spread is important to keep in mind, the actual utilization and implementation of leverage in a portfolio context is far messier that this elegant algebraic formula. There are many other articles on PM Jar discussing leverage in a portfolio context.

Leverage, Risk, Volatility, Derivatives

“Simply holding riskier-than-market equity securities leverages the portfolio…the portfolio either becomes leveraged from holding riskier assets or deleveraged from holding less risky assets. For example, the common practice of holding cash in portfolios of common stocks causes the domestic equity portfolio to be less risky than the market, effectively deleveraging returns.”

“Derivatives provide a common source of implicit leverage. Suppose an S&P 500 futures contract requires a margin deposit of 10 percent of the value of the position. If an investor holds a futures position in the domestic equity portfolio, complementing every one dollar of futures with nine dollars of cash creates a position equivalent to holding the underlying equities securities directly. If, however, the investor holds five dollars of futures and five dollars of cash, leverage causes the position to be five times as sensitive to market fluctuations.

Derivatives do not create risk per se, as they can be used to reduce risk, replicate positions, or increase risk. To continue with the S&P 500 futures example, selling futures against a portfolio of equity securities reduces risks associated with equity market exposure. Alternatively, using appropriate combinations of cash and futures creates a risk-neutral replication of the underlying securities. Finally, holding futures without adequate balancing cash positions increases market exposure and risk.”

One must tread carefully when utilizing derivatives not because they are derivatives, but because of the implicit leverage that comes with derivatives.

Liquidity

“Less liquid asset types introduce the likelihood that inability to vary exposure causes actual allocations to deviate from target levels…Since by their very nature private holdings take substantial amounts of time to buy or sell efficiently, actual portfolios usually exhibit some functional misallocation. Dealing with the over- or under-allocation resulting from illiquid positions creates a tough challenge for the thoughtful investor.”

“…rebalancing requires sale of assets experiencing relative price strength and purchase of assets experiencing relative price weakness, the immediacy of continuous rebalancing causes managers to provide liquidity to the market.”

Expected Return, Risk

“Returns from security lending activity exhibit patterns characteristic of negatively skewed distributions, along with their undesirable investment attributes. Like other types of lending activity, upside represents a fixed rate of return and repayment of principal, while downside represents a substantial or total loss. Unless offset by handsome expected rates of return, sensible investors avoid return distributions with a negative skew…negatively skewed return pattern exhibits limited upside (make a little) with substantial downside (lose a lot), representing an unattractive distribution of outcomes for investors.”

Baupost Letters: 1997

Continuation in our series on portfolio management and Seth Klarman, with ideas extracted from old Baupost Group letters. Our Readers know that we generally provide excerpts along with commentary for each topic. However, at the request of Baupost, we will not be providing any excerpts, only our interpretive summaries, for this series.

Mandate, Trackrecord, Expected Return

For the past several years, Klarman had invested heavily into Baupost’s international efforts/infrastructure because he believed that opportunities in the U.S. marketplace were less attractive than those found abroad, due to increased competition and higher market valuations.

Did Baupost’s flexible investment mandate give it an advantage in trackrecord creation and return generation?

For example, a healthcare fund cannot start investing in utilities because the latter provides better risk-reward, whereas Baupost can invest wherever risk-reward is most attractive.

The trackrecord creation and return generation possibilities for those with more restrictive mandates are bound by the opportunities available within the mandate scope. Baupost, on the other hand, has the freedom to roam to wherever pastures are greenest.

Cash, Expected Return, Risk Free Rate

In the category of largest gains, there was a $2.2MM gain for “Yield on Cash and Cash Equivalents” which at the end of Fiscal Year 1997 (October 31, 1997) consisted of $39MM or 25.5% of NAV.

In 1997, cash earned 5-6% ($2.2MM divided by $39MM) annually, in drastic contrast to virtually nothing today. I point this out as a reminder that historically, and perhaps one day in the future, cash does not always yield zero. In fact, cash interest rates are often highest during bull markets when it’s most prudent to keep a higher cash balance as asset values increase.

For those who fear the performance drag from portfolio cash balances, or those who feel the pressure to “chase” yield in order to boost portfolio returns, this serves as a reminder that cash returns are not static throughout the course of a market cycle.

Hedging, Cash

At 10/31/97, value of “Market Hedges” was $2.0MM, or 1.4% of NAV. Hedges were also the source of his second largest loss that year, declining $2.1MM in value.

That’s a whole lot of premium bleed worth $2.0MM or ~1.5% of NAV! Interestingly, this is almost the exact gain from portfolio cash yields (see above). Coincidence?

If you believe that the phenomenon of the last 20 years will continue to hold – that interest rates will increase as the underlying economy recovers and equity markets move higher, then one can roughly use interest rates (and consequently portfolio cash yields) as a proxy to determine how much hedging premium to spend.

Theoretically, this should be a self-rebalancing process: higher cash yields in bull equity markets = more hedging premium to spend (when you need it most) vs. lower cash yields in bear equity markets = less hedging premium to spend (when you need it least).

Cash, Opportunity Cost

Klarman comments that cash provides protection in turbulent times and ammunition to take advantage of newly created opportunities, but the act of holding cash involves considerable opportunity cost in the form of foregoing attractive investments in the interim – but investors must keep in mind they cannot earn investment returns without actually investing.

After a temporary hiccup in the markets, Klarman discusses portfolio repositioning: adding to some positions while reducing or deleting others, to take advantage of the shifts in the market landscape.

It’s a delicate balance determining when to deploy capital, and when to hold it in the form of cash. You can’t run an investment management business holding cash forever – that would make you a checking account with extremely high fees.

The second point serves as an excellent reminder that the “opportunity cost” calculation involves not only the comparison between cash and a potential investment, but also between a potential investment and current portfolio holdings.

Derivatives, Leverage

Klarman held a wide variety of options and swaps in his portfolio, such as SK Telecom equity & swaps, Kookmin Bank equity and swaps, etc.

In Klarman’s writings, you’ll generally find warnings against using leverage, and equity swaps definitely constitute leverage. I wonder if the derivative swaps were a product of his interest in emerging markets. For example, perhaps Baupost was not able to trade directly in certain markets, and therefore utilized swaps to gain exposure through a counterparty authorized to trade in those countries.

When To Buy

In a market downturn, momentum investors cannot find momentum, growth investors worry about a slowdown, and technical analysts don’t like their charts.

In extreme market downside events, patterns & trends in liquidity, trading volume, sales growth, etc. – that may have existed for years – disintegrate. Therefore, investors who rely on those patterns and trends become disoriented, which then fuels and reinforces more market chaos. This is what we witnessed in 2008-2009, and the time for fundamental investors, and those with intuition and foresight, to shine.

Capital Preservation, Compounding,

Over time, by again and again avoiding loss, you have taken the first step toward achieving healthy gains.

Volatility

Toward the end of the December 1997 letter, Klarman praises his team of analysts and traders who, like himself, hate to lose money, even temporarily, for any reason at any time.

So let it be written! Klarman acknowledges that he doesn’t like to lose money, even temporarily in the form of volatility. 

36South: Profiting from the Tails

Many have read about Cornwall Capital (I wrote about them awhile back), a firm that successfully profited from shorting subprime CDS. Those who enjoyed the Cornwall Capital piece are in for a treat. Below are highlights extracted from an Eurekahedge interview with Richard Hollington of 36South, a hedge fund that also specializes in profiting from volatility and tail risk. This piece is a little longer than our usual articles. There is a lot of good commentary below on how to source, execute, size, and manage portfolio hedges. However, reading this article does not a hedging expert make. In other words, I don’t recommend trying this at home.

Hedging, Derivatives, Fat Tail, Barbell, Sizing, Expected Return, Volatility

“The underlying philosophy is that markets are rational most of the time but 5% of the time rationality gets thrown out of the window, whether because people have made money too easily and become complacent or have lost money too quickly and are so distressed that they are off-loading assets below their intrinsic worth. The emphasis of this approach is market psychology. We search for fear, greed, hysteria and mania. We sell into a bubble about to burst and buy into a post-crash recovery. Bubbles as we know, can take time to play themselves out over an extended period of time and their turning points are normally associated with high volatility. This makes the method of investing in an opportunity critical. Normally it is better to wait until the bubble is bursting as the markets tend to go a lot higher or lower than one thinks. The downside to this is that the move might be over in a short period of time.”

“Our investment methodology is to BUY ONLY long dated “out-of-the-money” options. This methodology has some excellent features…these options can return multiples of the original investment. We look for options that have the potential to return between 5 and 10 times the original investment. Because of their high reward characteristics, only 10-20% of the fund need be invested in these options to achieve our target returns of 15-25%. Our worst case loss is thus known, being the amount invested in options…Our rationale here is that one can never get killed jumping out of a basement window!”

“We zero in on…situations by using our in-house developed ‘Quadrivium’ Methodology. Quadrivium literally means where four rivers meet and a strategy which conforms to criteria required in each of the four circles in our approach will be selected to form a portion of our risk portfolio. The four criteria are used in conjunction with each other in order to ‘ensure that one reality respects all other realities’ as Charlie Munger put it so well. These criteria are:

• Volatility has already been covered. We ensure the option (using volatility as a proxy) is cheap enough to provide the leverage we require for the level of risk.
• The next criterion is to look at the technical picture of the market to seek confirmation that there is potential for market movement to the extent and in the direction that we require to attain a multiple return on the option price.
• The next criterion is fundamentals in that market/asset/option to corroborate our view. We have developed a framework of economic indicators that we monitor in each of the markets we have selected to trade. We are specifically looking for flaws in the structure of markets which are caused by government policy and supply demand imbalances.
• The next step in the process is based on the sentiment prevailing in the market that we wish to trade. Sentiment often becomes deeply entrenched at market tops and bottoms to the extent that supporters of the status quo can become aggressive in defense of their beliefs. In order to gauge the prevailing sentiment in the market we use Internet searches for key words and couple this with feedback obtained from diverse media coverage. These media opinions can reflect ‘irrational exuberance’ or deep-seated pessimism on a particular stock, index, commodity or currency. These quotations from seasoned professionals in the financial markets encapsulate the essence of this driver of our trading philosophy.”

“Since we know exactly what the current option portfolio is worth we can safely say that this is the absolute worst-case meltdown in the fund based on market risk. This would be an extremely unlikely scenario because long dated options always have some time value and it would mean all positions have moved against us in all asset markets and volatilities have collapsed at the same time. We manage each option on a stop-loss methodology. The stop-loss is based on the number of times the initial option premium multiplies. The first stop is instituted when the option premium has increased three fold. At this level a 60% stop on the option price is registered. As it moves to four times, the stop is tightened to 50% and so on until a maximum of eight times when the stop will be 10%. At this point in time the option has earned the right to discretionary stop-loss status as long as it does not hit the 10% in place. A profit target is then calculated which is based on a three standard deviation move above the 200-day moving average. We will also sell options which have only a year to run if they have not achieved the minimum 3-fold increase and are still worth something.”

Lessons from Jim Leitner - Part 1 of 3

In Steve Drobny’s book The Invisible Hands, there’s a wonderfully insightful interview with Jim Leitner, who heads up Falcon Investment Management, and was previously a member of Yale Endowment's Investment Committee. Leitner is an investor who has spent considerable time contemplating the science and art of investing, making money opportunistically across all asset classes, unconstrained, focused on finding the right price and structure, not losing money...and remaining humble (an increasingly rare quality in our industry).

His very clearly articulated thoughts about hedging, risk management, cash, and a number of other topics are profound. Below is Part 1 (please also see Part 2 and Part 3) of a summary of those thoughts. I would highly recommend the reading of the actual chapter in its entirety.

Cash, Opportunity Cost, Liquidity, Derivatives

“Cash always gives the lowest return when modeling on a backward-looking basis.” This is why endowments, etc. tend to hold very little cash, because they construct their portfolio allocations looking backwards, based on historical returns.

But if we construct our portfolio allocations on a forward looking basis, “…cash is the essential asset. When other assets have negative return forecast…there is no reason to not hold a low return cash portfolio.”

Also, by looking backward, we tend to ignore the “inherent opportunity costs associated with a lack of cash…cash affords you flexibility…can allocate that cash when attractive opportunities arise.”

“The correct way to measure the return on cash is more dynamic: cash is bound on the lower side by its actual return, whereas, the upper side possesses an additional element of positive return received from having the ability to take advantage of unique opportunities.”

“Holding cash when markets are cheap is expensive, and holding cash when markets are expensive is cheap.” As equity or other assets get more expensive, it’s important to hold more “cash and cash-like assets” because it decreases the potential for downside volatility.

It’s important to have cash on hand in case assets or securities become cheap because redeeming from existing allocations or selling existing positions takes time.

Hedge funds and some investors that use derivatives and swaps have the ability to gain large notional exposures (via these derivatives) while holding cash in reserve – a nice luxury.

AQR Tail Risk Hedging Whitepaper

Tail risk hedging (and hedging in general) has been a hot topic of discussion in recent years. With the market rally and the VIX back down to historically low levels (~15 as of this writing), I thought it appropriate to share a paper published by AQR Capital Management in the Summer 2011 (AQR Tail Risk Hedging Whitepaper). Many thanks to the Reader who was kind enough to share this with PM Jar.

Note to Readers: AQR often defines risk as volatility. Regardless of whether you agree with this definition, the paper is a worthwhile read as AQR makes astute and interesting observations.

For example, hedging has a number of implementation challenges:

• How much one is comfortable losing (and over what period of time)
• Sizing the hedge appropriately relative to the notional value one wishes to protect
• The psychological difficulty in sticking to an insurance program after years of negative performance

Most importantly, if the goal for hedging is to alter the volatility profile of the portfolio return stream, the paper outlines a number other methods to achieve that goal without spending protection premium.