Equity protection is cheaper than you think
Buy What You Need, and Buy Smart
Comprehensive car insurance may not be an absolute necessity, but the peace-of-mind it provides is desired by most people. Such insurance can be expensive if you don’t shop around and if you end up purchasing more insurance than you need.
Investing in equities, like driving a car, comes with inherent risk. Managing this risk can be done through asset allocation and also through the use of customized equity hedging, which we call Structured Equity.
Many people believe that equity hedging is “too expensive”, but we believe that it can be a highly cost effective way to customize equity exposure.
What is structured equity?
Structured equity changes the shape of the return we receive from equities. A standard equity investment will increase (or decrease) $1 for every $1 increase (or decrease) in the equity markets. Many investors do not wish to have 100% exposure to the equity markets, so they diversify with bonds, cash and other alternative assets. While asset diversification will work to dampen equity volatility under most conditions, it does not do so under all. Equity returns can be shaped more explicitly using structured equity.
The precise manner in which an investor shapes their equity exposure is determined by a number of factors…
- Downside Protection: What market falls do you want protection against – the first 30%, the first 40%, the first 50%?
- Exposure: How much return do you want to earn if the equity market rises? Structured equity can help a portfolio obtain a given return through a more than one-for-one exposure to equity market gains. Leverage effectively allows returns to accelerate over a particular range.
- Upside Participation: If the equity market rises by a certain amount, how much more return is required? Can an investor afford to give up all returns above this level, or a proportion of them in order to purchase some downside protection?
The diagram below illustrates the way these factors determine the shape of the payoff:
What are the costs of structured equity?
There are three types of costs to consider:
- Transaction costs: The implementation, or bid-ask spread, cost for a structured equity strategy, are not explicitly seen but they are real. Properly structured and executed, the implementation costs for structured equity need not be significantly higher than for buying and selling many physical equities or bonds.
- Investment management fees: River and Mercantile structured equity management fees are similar to those charged by passive equity managers, and typically lower than those charged by active managers.
- Returns over time compared to traditional investments: While not an explicit cost, investors may perceive they have received good or bad value depending on the returns structured equity generates relative to, say, holding a dedicated equity position over time. Some structured equity strategies, such as buying put options outright, are expected to be a drag on expected returns over the long term. However, with many of the strategies incorporated by our clients this need not be the case as the next section describes.
Building Cost-Effective Structured Equity Strategies
The strategies we implement for clients typically have the following features which allow structured equity to offer comparable expected returns to traditional equity investing:
- Protection against equity falls is limited to a certain levelYou don’t buy insurance coverage where you don’t need it. If you can tolerate some degree of loss at a time when the overall equity market is significantly down (e.g. over 30%) then this can materially improve your risk return profile.The reason for this is that there are other investors who are effectively forced to buy full protection, even to protect against very extreme market falls. Protection at this more extreme level can be expensive so we limit how much we buy.
- Strategies are left in place for at least 6-12 months and sometimes up to 5 years
Other funds in the market place incorporate short term structures and often try to gain alpha through trading. These can be with expiry of a month or less and are constantly rolled into new structures, with transaction costs. The pricing of these structures will be less attractive for an investor with a 5-year view, for example, because you are effectively paying for certainty and reduced risk over the next month, and each month thereafter. Some investors want this, but there will be drag on returns to pay for that certainty.If the primary goal is to improve the outcomes over medium-to-longer time horizons, then using longer term structured equity will lead to a more attractive risk return profile.
What drives the structured equity shape available?
Equity markets move through periods of relative calm and volatility and, when volatility rises, the market price for buying protection increases. While individual put option pricing can vary significantly under different market conditions, the overall shape of a typical structure our clients use is surprisingly stable. This means that the level of market volatility itself should not be the primary driver when deciding if or when to use structured equity.
As an example, consider a structure where the upside potential is capped at 20% and downside protection is purchased for the first 30% of losses. Selling the upside over 20% and purchasing the downside protection results in no upfront cost:
The chart below shows the required level of the upside cap over the past 4 years that would be required to purchase the -30% downside protection, all other aspects of the structure above remaining the same:
Over the past four years, you would have needed to forego total returns above 15%-23% over the following three-year time horizon to pay for downside protection down to -30% over the same period of time.
This is a relatively stable level, given the periods of volatility seen over the past four years. The chart below plots the S&P level and the ‘VIX’ index, a measure of market volatility, over this period:
The conclusion of this data is that pricing structured equity can be relatively insensitive to market volatility. It is primarily the equity market level when you implement (or don’t implement) equity protection that will drive the returns of your strategy going forward.
Customized equity exposure as we’ve described can be a highly cost effective, efficient, and transparent way to manage equity risk.