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Children ask many, many questions, and more often than we would like, we adults do not have the answers. My daughter asked, “Why is it bad to swallow watermelon seeds?” I don’t know. She also asked how Tim Tebow, quarterback for the U.S. football team the Denver Broncos, passed for 316 yards against the Pittsburgh Steelers, a team with statistically the best defense in the NFL.
Some questions in life are simply unanswerable.
Investors are asking, “What will the outcome of the European debt crisis be?” Regardless of asset class, the performance of most investments over the coming months will likely depend directly on the answer to that very question. At PIMCO, we devote considerable time and resources to answering the question and believe we have good insights. However, any answer to the European question has a significant probability of being the wrong one – especially since the outcome in Europe depends so much on the actions of individual policymakers.
Faced with a tough question like this, portfolio managers have two possible courses of action: feign omniscience and seek to position portfolios for a certain outcome in the face of uncertainty; or admit to not knowing the answer and seek to position portfolios to prosper in the most likely scenarios and hold ground in the least.
We believe the latter is the better course, because the possible distribution of outcomes is becoming bimodal and two extreme destinations appear increasingly likely for almost all asset classes. As a result, the risk involved in choosing the wrong answer is much higher than usual. Furthermore, even a portfolio positioned for the correct final destination may be forced to liquidate prematurely in the face of losses, as fits and starts in Europe have become frequent. In our view, there is an excellent alternative to large directional positions for finding alpha potential in this volatile market, one that lies in volatility itself: the options market. Often overlooked as an asset class and traditionally used to hedge other risks, options – puts and calls whose prices depend on the level of implied volatility – exist in virtually all major markets. In the current turbulent market, we see opportunities to construct portfolios using options that can potentially benefit in a myriad of possible outcomes in Europe.
Tapping into opportunities in optionsWe continue to see opportunities in today’s options market. Not only is there ample room to express views on volatility, but also, options can allow PIMCO to express the complex and nuanced views we may hold in this uncertain environment.
Most users of options tend to be large market participants hedging business risks, creating opportunities for other investors to express a view on volatility itself. For example, participants in the mortgage market may enter into transactions to gain exposure to interest rate volatility not because it is perceived to be too low, but rather to hedge against the prepayment risk embedded in mortgages. Equity investors and insurance companies may buy equity puts not necessarily because the VIX (an index that measures the implied volatility of the S&P 500) appears cheap, but rather in an effort to hedge against a sharp downturn in stocks. Many institutional and individual investors may sell covered calls against outright long positions with the goal of enhancing yield potential in their portfolios and not necessarily as a view that volatility is overvalued.
In addition, many of the traditional relative value investors that provide liquidity to end users of options are seeing their balance sheets decline, creating opportunities for other investors to step in. Wall Street trading desks have generally been scaling back risk-taking in the face of regulation and industry weakness, and hedge funds tend to have a much smaller asset base today than before the financial crisis. While dislocations in the markets have become more frequent and extreme, the competition in chasing those dislocations has diminished materially.
Options also allow PIMCO to express a specific view conditional on the direction of the market. Rather than choosing whether Europe will improve or deteriorate, options can be used in such a way that they kick in only if Europe improves or deteriorates. For example, while obviously concerned about the performance of emerging equity markets if the eurozone unravels, we are quite favorably disposed to emerging market equities relative to developed market equities conditional upon a European recovery. To express this view using options, we might take a long (buy) call position in emerging markets equities versus a short (sell) call position in U.S. equities. If the European debt crisis worsens, both calls could expire worthless. If we see a recovery, however, both markets could rally, and this trade may profit as long as equities in emerging markets outperform those in developed markets.
In our view, most markets have a fat-tailed distribution of potential outcomes for 2012. For instance, the U.S. equity market could conceivably finish 2012 down significantly or up significantly. Similarly, the direction of the price of oil is highly dependent on events that have yet to play out: Oil prices have not declined commensurately with the weakening global macroeconomic outlook and weakening global demand, but rather have been supported by geopolitical concerns in the Middle East. However, if the situation in Europe deteriorates, we believe that the loss in global demand for oil will trump the geopolitics. Meanwhile, if in six months 10-year Treasury bonds yield around 2%, being significantly overweight mortgages could be beneficial. However, if Treasuries have moved significantly in either direction in that time, it could potentially be beneficial to own alternative investments. Options allow the expression of these kinds of conditional views. Likewise, while we have a high degree of conviction that if the situation deteriorates in Europe, 30-year Treasuries are likely to represent the most attractive fixed income asset to own, we have much less conviction that European swap rates will decline substantially, if at all.
Seeking to prosper amid uncertaintyThe questions we are asked in life are not always easy to answer. Conviction, confidence, and decisiveness can often put a child’s worrying mind at ease and at times, they can also help investors navigate rough waters.
Some situations, however, demand a bit more humility. I have faith that my daughter will prosper even if she never figures out how Tim Tebow and his team managed to beat her beloved Steelers. So too, investors can potentially prosper even if they admit that the outcome in Europe and the timing of that outcome are anything but certain. We find that options are one tool that allows us to humbly admit a lack of omniscience as we seek to help investors prosper in an uncertain 2012.
Trade examples are for illustrative purposes only. Maximum gain, maximum loss and breakeven levels will depend on details of the specific trade. Generally speaking, long option positions have downside potential limited to premium paid and short option positions have unlimited downside potential.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. The information contained herein is intended to discuss the investment adviser’s use of options and is not intended nor should be interpreted as a recommendation or solicitation to enter into any specific option contract. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Options involve substantial risk of loss, and are not suitable for all investors. You should consult your financial advisor prior to making an investment decision. Swaps are a type of privately negotiated derivative; there is no central exchange or market for swap transactions and therefore they are less liquid than exchange-traded instruments. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. © 2012 PIMCO
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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