As of November 23, the S&P 500 was down for the year, with sharp slides in February and March – then again in October and November – bookending a period of strong growth. Similar bouts of volatility have been seen in markets around the world.
In conditions like these, what clients want from their dealers is reliability. They got it from JP Morgan.
“When it comes to consistency, JP Morgan is definitely the best in all market conditions and never retrenched,” says a portfolio manager at a large European asset manager. “They don’t show ridiculous prices just to gain market share. They know their business and they know pricing.”
That doesn’t just apply to the market-making desks. In the fourth quarter of 2017, JP Morgan reported a $143 million loss on an ill-fated margin loan to South Africa’s Steinhoff. Other lenders, including Bank of America Merrill Lynch, Citi and Nomura lost a combined $1 billion on the name.
Some banks pulled back from the business in the aftermath of those losses, clients say, but JP Morgan remained steadfast.
“I was worried a one-in-50-year event could kill the business, and although we had some banks pulling back commitments and not renewing, there has been no impact with JP Morgan. It was smooth sailing,” says one margin loan client.
Another client praises the bank’s commitment: “If they’d wanted to wriggle out they could have used a clause to get all their money back, but they didn’t. We retained full flexibility and even managed to increase the loan-to-value ratio.”
The bank offers its view via a statement: “Our margin lending business is part of the wider financing business in equities and continues to grow steadily. While we are mindful of current market conditions and potential late-cycle dynamics, this business remains a key priority for our equities franchise and we will continue to service clients globally.”
A hefty jump
JP Morgan more than made up for the episode, recording an 18% jump in equity trading revenue for the 12 months starting October 2017.
The foundations for that performance were laid in the last quarter of 2017. As volatility languished at multi-year lows and US indexes sat on 20% annual gains, JP Morgan’s derivatives and quant strategy team, led by Marko Kolanovic, predicted a doubling in the Vix index of implied volatility on the S&P 500, suggesting the surge would be amplified by end-of-day rebalancing in popular exchange-traded volatility notes.
JP Morgan responded by pushing a risk-off theme in early January. The bank cushioned its own books by adopting a long-volatility bias, and began showing a range of defensive strategies to its clients.
The call was spot-on, of course. On February 5, the Vix more than doubled from 17.31 to close at 37.32, with ETNs heaping fuel on the fire.
“We don’t have a crystal ball and can’t guess the timing of market events. What we can do is try to develop products across the full spectrum of client views, so we are ready when things happen and able to engage with clients actively in whatever is most relevant to them,” says Rui Fernandes, head of global equity derivatives structuring at JP Morgan.
The way JP Morgan executes meant it went long much earlier than other long-vol peers, so it was the best performing of our long-vol strategiesMulti-asset portfolio manager
The defensive theme was not an easy sell during January – a month when the S&P 500 gained 6% – but some clients were won over by innovative intraday strategies that aim to maximise exposure to a volatility spike while minimising the cost of running traditional long volatility positions.
“It actually saved the day,” says a multi-asset portfolio manager at a global investment firm who jumped into JP Morgan’s US volatility QES Momentum Index (QES Vix) – part of the bank’s quantitative execution and strategies platform – before volatility erupted. “Our entire portfolio would have been down on the day, but this – along with other vol strategies, which didn’t perform as well as the JP Morgan one – meant we were actually up.”
QES, the cornerstone of the bank’s risk-off toolbox, offers intraday execution on indexes that would typically price off crowded end-of-day fixes. Created in 2011, with direct connection to US futures and options exchanges so it can process live tick-by-tick data on S&P 500 contracts, the platform was extended to Vix futures in late 2017.
JP Morgan’s banner long-volatility strategy, QES Vix, monetises positive intraday momentum stemming from end-of-day rebalancing of Vix exchange-traded notes. The magic dust is an algorithm that executes the long-volatility position according to positive momentum signals, ensuring there is sufficient liquidity to dampen any impact the strategy has on the market price.
The bank – and some of its clients – argues the approach is superior to competing intraday offerings that use volume- or time-weighted average prices to execute – these approaches can result in trades being executed during periods of thin liquidity. Positions are only taken when the Vix futures curve is in backwardation and sold at the close, thereby locking in gains and reducing the cost of carry as no exposure is held overnight.
The proof of any hedging product lies in its performance in a stress scenario, and QES Vix passed the test with flying colours, gaining 14.5% on February 5.
Intraday can be a very foggy word and people can hide many things behind it, but we don’tFater Belbachir, JP Morgan
“The way JP Morgan executes meant it went long much earlier than other long-vol peers, so it was the best performing of our long-vol strategies. When you invest earlier, you can ride the whole spike,” says the multi-asset portfolio manager.
Not all investors were so quick off the mark. Demand for the bank’s defensive intraday strategies surged in the days and weeks that followed the Vix surge, making QES Vix the fastest-growing product within the bank’s investable index suite.
“Intraday is not an isolated product but a theme that permeates the entire offering across our structured volatility complex,” says Fater Belbachir, the bank’s global head of equities volatility trading. “Intraday can be a very foggy word and people can hide many things behind it, but we don’t. The key differentiator is that clients get a full look-through, and sometimes work with us in designing the product to best suit their needs.”
Intraday execution was also introduced to variance swaps, allowing hedge funds and other sophisticated investors to risk manage existing short-volatility exposures by diversifying fixings away from the close. A popular hedge fund strategy – in which firms seek to monetise intraday momentum in realised volatility through a daily flow of index futures – was repackaged into an index, enabling clients to access the cumbersome strategy via a single total return swap.
“The infrastructure underpinning this innovation is unique,” says a volatility hedge fund manager. “You can fully tailor the swap and pick any time of day where the magic happens. That’s on the back of their technology advantage. They have a huge database of tick-by-tick data and are able to index the swap on any slice of that data,”
As part of the bank’s focus on hedging peak equity valuations, JP Morgan developed a suite of defensive strategies that aim to reduce the cost of carry. For example, the bank’s short-term risk-off portfolio delivered almost 5% of positive performance through February compared with just 1.3% for a systematic put spread strategy.
One alternative asset manager constructing its own tail hedge fund selected JP Morgan to provide half of the strategies that make up the new fund.
“JP Morgan are a bit more thorough in their research and the way they put things together,” says the alternative asset manager. “Most of the strategies we looked at have a left tail but not a right tail. We’re interested in the right tail, and JP Morgan had more of those than anyone else and they’re very well constructed. They put a lot of effort into testing before they go live.”
In volatile times, the first line of defence for a market-maker is to recycle outsize risk positions. For JP Morgan, with its strong corporate equity derivatives franchise, that can mean hefty single-stock vega exposures.
In January, the bank sold $350 million of synthetic convertible bonds in its own name, offering exposure to the performance of Swiss duty free retailer Dufry. The cash-settled bond recycles risk associated with a volatility position stemming from a corporate equity derivatives transaction.
Strategic stakeholders often gain financing and leverage through large options strategies on their corporate holdings, leaving the dealer with long volatility exposure to the stock. Through a synthetic convertible, which combines the bank’s credit with an option to redeem into cash at a fixed premium to the underlying stock price, the dealer can pass volatility exposure to convertible bond investors who have been starved of supply in recent years.
A similar $350 million transaction was sold later that month, linked to the performance of Voya Financial – the US arm of ING Group that was spun off in 2013. The bond recycles risk stemming from warrants issued alongside Voya’s initial public offer. The Voya trade was subsequently repeated with similar synthetic convertibles from Deutsche Bank and Bank of America Merrill Lynch. JP Morgan repeated its success just weeks later with a $600 million trade linked to the stock.
One stand-out corporate mandate saw JP Morgan acting as sole structuring and hedging counterparty for Intesa Sanpaolo’s long-term incentive plan. The deal, which incorporated a €1.1 billion capital increase, came amid extreme volatility as the spread between Italian and German government bonds hit multi-year highs.
And the bank’s partnership approach was evident in its fixed index annuity business. The JP Morgan Mozaic index, developed in 2009 and adopted by Nationwide for its New Heights FIA suite in 2015, was beginning to face capacity constraints. A second iteration, Mozaic II, offers greater diversification and comprises more liquid underliers. Refinements to the volatility targeting mechanism, to better reflect correlation, increased the amount of vega risk associated with the index that can be recycled to hedge funds and other sophisticated investors.
A Nationwide spokesperson claims Mozaic has been critical in transforming the provider from a $300 million a year distributor to a $5 billion-plus distributor.
“A major driver behind this success has been the strong partnership with JP Morgan, in particular the ongoing marketing and distribution support, and its market-leading Investable Indices and Insurance franchise,” says the Nationwide spokesperson.
JP Morgan sent a team of experts on marketing roadshows with wholesalers to describe the index and its performance. The bank also hosts a dedicated website and telephone line where end-users and advisers can understand and track the performance of the index.
“We own the performance of our product in good times and bad times, We want to make sure we’re there when there are tough performance periods to explain, potentially restructure, change what needs to be changed and absolutely not hide,” says Fernandes.