Peter Miller, Anshul A. Shah
Because most of the risk in a typical balanced portfolio comes from equities, an effective way to help stabilize portfolio volatility is to dynamically adjust the portfolio’s equity exposure in response to market conditions. PIMCO has examined various methods of implementing such volatility management and concluded that S&P 500 Index futures may be the most efficient tool for doing so. Equity index futures can be used by a portfolio manager to implement changes to equity market exposure in a cost-effective manner while leaving the rest of the portfolio unchanged. S&P 500 futures, specifically, offer potential benefits including high liquidity and low transaction costs compared to other futures contracts.
Equity exposure: the source of volatilityPortfolio volatility is often driven by equity exposure. While fixed income assets certainly exhibit a degree of volatility, equity risk dominates most balanced or traditional portfolios, as shown in Figure 1. As a result, stabilizing portfolio volatility across market environments generally requires dynamically adjusting portfolio equity exposure:
Such a dynamic strategy can be implemented in three main ways: directly trading physical equity assets, buying or selling equity index options, and transacting in equity index futures. Each approach has potential benefits, risks and costs for investors to consider.
Weighing three approaches to adjusting equity exposure Physical equity assets: The main benefits of trading physical equity assets – including stocks, funds and ETFs – are precision and flexibility. When de-risking a portfolio, the portfolio manager can pinpoint and sell those specific sectors or positions that he/she deems too volatile. When re-risking, he/she can purchase those assets that he/she deems most attractive. The portfolio manager thus retains the ability to granularly manage the portfolio based on his or her risk and return expectations.
However, trading physical assets can have substantial drawbacks. Critically, transaction costs and the potential for illiquidity can materially impact performance. Wide bid/ask spreads and high commissions may significantly reduce returns, especially if the portfolio manager de-risks or re-risks frequently in an effort to tightly manage portfolio volatility. Selling individual equities, especially in large volumes, may also take a long time to accomplish in illiquid markets and may even cause the stock price to move against any remaining positions. These problems are typically more likely to arise in stressed markets, when de-risking quickly may be most critical.
Another disadvantage of trading physical assets is its complexity. It requires the portfolio manager to identify specific investments to trade within the context of the broader portfolio, which can take time and effort and thus create additional costs for the portfolio – both expenses and opportunity costs. The costs and complexities associated with direct equity trading may not always justify the precision it provides, especially if it is important to adjust equity exposure quickly.
Equity index options: Equity index options provide another potential approach to managing portfolio volatility. When using equity index options to de-risk, a portfolio manager does not have to identify specific securities or funds to sell. Instead, he or she can identify a broad-based index (or indexes) representing a portfolio’s overall equity exposure and then implement an option trade on the selected underlying index.
This strategy may consist of buying put options and/or selling call options. The potential benefit of this approach over selling individual equity securities is its broad-based nature. Rather than identify a large number of securities or funds to sell, the portfolio manager need only identify an index or a small number of indexes. Additionally, under most market conditions, liquidity should be greater for index options than for individual securities.
However, buying put options as a portfolio hedge can be expensive, especially during times of market stress when implied volatility and volatility skew are elevated. This cost may materially impact portfolio returns over time. The strategy has other drawbacks as well. While it may be simpler to execute a few option trades rather than to sell many individual securities or funds, it is still difficult to determine which strikes and expirations to trade. Moreover, the portfolio manager may need to constantly monitor the option positions in order to determine their evolving impact on portfolio risk. Finally, options entail risks, such as the potential for rapid changes in value and the possibility of expiring worthless.
Equity index futures: The third approach to managing volatility involves transacting in equity index futures. This approach has several potential advantages over trading physical equity securities or options. Generally, costs are lower because index futures require no upfront premium and are liquid in most market conditions. Liquidity is a particularly important consideration in a volatility management strategy as the portfolio may de-risk and re-risk within short periods of time.
Another potential advantage of using futures is simplicity: the portfolio manager does not need to choose specific securities, sectors, or option strikes; only the notional value of the contract must be determined. This process helps save portfolio managers much of the time and effort associated with traditional asset selection and allocation and allows them to focus on other aspects of managing the portfolio.
Finally, futures allow a portfolio manager to leave the portfolio fully invested in its existing active equity positions while simultaneously hedging the overall equity risk. This maintains the portfolio’s alpha opportunities while adjusting the beta, or broad equity market risk, which is the primary driver of equity volatility in most portfolios.
The primary disadvantage of using futures is less precision – trading equity index futures doesn’t offer the level of granularity that trading individual securities or funds typically offers. However, this may not be a material consideration, particularly in a de-risking environment. During times of market stress, risky assets tend to move together more closely, with correlationsapproaching one. As a result, equity futures should achieve exposure similar to the portfolio’s equity securities while allowing a portfolio manager to manage cost and reduce complexity. While futures can also entail risk – notably the potential for sizable losses on unhedged positions – they are a useful tool for dynamically adjusting portfolio equity exposure.
Equity index futures: choosing an indexSelection of the equity index that underlies the futures contract is critical to the success of a volatility management strategy. Utilizing several indexes may provide a better match to an overall portfolio’s equity exposure in a manner similar to trading a large cross-section of securities or funds. However, this approach does come at a cost. Not only is it more complex to manage several underlying indexes, but also the cost of trading futures on more illiquid indexes can meaningfully impact performance. This fact highlights the importance of trading liquid futures contracts with large regular volume and broad appeal among a variety of market participants. The S&P 500 futures contract currently meets this definition: it is the largest contract available by volume (see Figure 2), is used by a broad investor base and can be traded virtually around the clock. Its liquidity may also allow investors to trade quickly in and out of contracts, and take either long or short positions, often at lower bid-ask spreads than other index futures.
Although the S&P 500 represents large cap stocks in the U.S., it is often viewed by many investment managers as a reasonable proxy for equities around the globe. This is especially true during times of market stress, when equity indexes have been highly correlated, as Figure 3 shows. This is precisely the time investors typically need portfolio equity exposure quickly reduced.
ConclusionBecause equity risk tends to dominate overall volatility in most balanced or traditional portfolios, it is important to manage its impact. In our view, managing portfolio volatility with S&P 500 Index futures can provide several potential advantages over other approaches, as indicated in Figure 4: lower costs, higher liquidity, more efficient and dynamic rebalancing and low complexity. Finally – and importantly – portfolio managers can maintain alpha opportunities in the active portion of the portfolio while seeking to reduce beta, or overall market risk.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in futures and options involves a high degree of risk and is not suitable for all investors. 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.
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. Investors should consult their financial advisor prior to making investment decisions.
The Barclays Investment Grade Corporate Index is an unmanaged index that is the Corporate component of the U.S. Credit Index. The index includes both corporate and non-corporate sectors and are publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. The corporate sectors are Industrial, Utility, and Finance, which include both U.S. and non-U.S. corporations. The non-corporate sectors are Sovereign, Supranational, Foreign Agency, and Foreign Local Government. 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 EURO STOXX 50 Index covers 50 stocks from 12 Eurozone countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The DAX 100 Index is a total rate of return index of the 100 most highly capitalized stocks traded on the Frankfurt Stock Exchange. The FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. The equities use an investibility weighting in the index calculation. The index was developed with a base level of 1000 as of January 3, 1984. The Nikkei Stock Average is an index of 225 leading stocks traded on the Tokyo Stock Exchange. Similar to the Dow Jones Industrial Average, it is composed of representative “blue chip” companies (termed first-section companies in Japan) and is a price-weighted index, whereby the movement of each stock, in yen or dollars respectively, is weighed equally regardless of its market capitalization. The Morgan Stanley Capital International World Free Index is an unmanaged market-weighted index that consists of over 1,200 securities traded in 21 of the world’s most developed countries. Securities are listed on exchanges in the US, Europe, Canada, Australia, New Zealand, and the Far East. The index excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The index is calculated separately; without dividends, with gross dividends reinvested and estimated tax withheld, and with gross dividends reinvested, in both U.S. Dollars and local currency. It is not possible to invest directly in an unmanaged index. The correlation of various indexes or securities against one another is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is 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.
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