Generating performance in choppy markets

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Market-neutral strategies such as dispersion trades have proved very effective amid the financial turmoil wrought by the Covid‑19 pandemic. With market direction now so difficult to call, they look set to remain popular – as do systematic hedging strategies

When the US technology stock rally came to a juddering halt in September, Asia’s family investors were given a stark reminder that what goes up must eventually come down. 

Even the mighty Faangs – Facebook, Amazon, Apple, Netflix and Google – have been known to have their wings clipped in a stock market selloff every once in a while. 

After rallying 58% following its Covid‑19 trough between March 23 and September 2,1 the Nasdaq Composite index shed roughly 10% over the course of one week. However, the US tech benchmark does remain well above its pre-pandemic high – and many family investors have done reasonably well from the turnaround in the second quarter.

Even so, against today’s prevailing market uncertainty, a growing number of family offices in Asia have been starting to seek out more balanced investment strategies. 

Dispersion trades, market-neutral strategies where the goal is to exploit differences between implied and realised correlation, are one type of strategy that have been popular with clients of late, says Conrad Huber, head of Asia-Pacific capital markets at UBS Wealth Management. 

These are participation strategies, where clients paying a premium are exposed to the absolute relative performance of a basket of stocks versus each stock. 

The idea is that in volatile markets individual non-correlated securities perform in different ways, and if the investor’s anticipated scenario plays out they can gain some upside. 

Going market neutral

UBS first saw some pick-up in client demand for market-neutral strategies last year, as a sentiment that the top for US tech stocks was nearing began to spread. 

Nobody could have predicted what happened next, of course. The outbreak and subsequent global spread of a novel coronavirus at the beginning of the year quickly went from being a public health crisis to an economic crisis and, ultimately, a market crisis. 

“Even before that, we didn’t know how much higher the markets could go,” says Huber. “So we needed to take a more market-neutral view, and that’s where dispersion trades came in.”

Assessing the economic outlook, a long position on tech stocks appeared to make a lot of sense at that point – especially if relatively compared with cyclical stocks, he adds. 

“If markets are totally disrupted, as long as a number of stocks does better than the others, the client is still going to make some money.”

Eric Pong, founder of Avenue Family Office, a Hong Kong-based asset manager, says that the best time for participation products is when market direction is “up and down”.

Shifting strategies

In the not so distant past, family offices in Asia were by and large reluctant to fork out a premium for some participation, Huber says. But in recent years this has been changing. He sees participation strategies starting to gain real traction as an investment tool for clients across the region, as they have long been in the US, Europe and the Middle East. 

Wealth management clients in Asia have historically preferred to keep things simple, with outright stock or bond purchases. Now they are becoming gradually more amenable to the use of derivatives. 

“More and more – especially in the past few years – clients in Asia have been willing to pay a premium to get alternative alpha,” he says. “Clients use these strategies in many forms: via over-the-counter structures, put options or accumulators, or as notes, with the assets in securitised form.”

The global stock rout in the middle of the first quarter did nothing to diminish this growing enthusiasm for participation strategies among UBS clients. When the bank advised clients earlier this year that the time was right for dispersion trades, there was a strong response. 

“This year we’ve had the highest volumes we have ever seen [for these trades],” he says. 

Downside protection

To protect against downside risk, investors can also put in place conditional capital protection, using products with an embedded down-and-in put option. This works to ensure that principal is only at risk should the underlying fall towards a level where the put would be activated. 

Huber offers an example of an equity-linked note. In the wake of the pandemic-driven market selloffs in March a client that invested in an equity-linked note with an embedded put option with 50% down-and-in barrier would have to see a drop of the same magnitude before the option would be activated. 

However, over recent months this product would have achieved a return upwards of 20% – depending on the underlying – while continuing to provide investors with downside protection. 

“We need to ensure that the client does not have excessive concentration risk, in terms of having too much invested into a certain underlying sector or geography,” he says. “If the view is very bullish, then [this] should not be the main strategy – but it can be complementary.”

With volatility remaining at elevated levels across many market sectors, UBS says market-neutral strategies continue to look appealing, especially with investors who are currently keen to avoid putting all their eggs in one basket.  

“We are running a very diversified book right now because governments have used different policy responses, with different market outcomes,” says Manish Bhargava, chief executive of Singapore-based Straits Investment Management, which manages portfolios for Straits Trading Company. “So we’re not taking any concentrated bets at this point.”

Hedging with quantitative investment strategies (QIS)

Reflecting family investors’ growing comfort with the inclusion of derivatives-based investment solutions in their portfolios, demand for systematic strategies has also been growing this year.   

A systematic strategy that provides enhanced hedging solutions through QIS and one that generates income from gold have been especially popular.

UBS believes QIS that apply systematic hedging have a lot to offer for investors worried about the toll another downturn might have on their portfolios. 

Interest in QIS for hedging risk first begun to pick up when US equity markets were reaching record highs last year, says Felix Maratier, UBS head of global markets structuring, Asia‑Pacific. But this year the bank has seen demand for systematic hedging QIS explode.  

“More and more – especially in the past few years – clients in Asia have been willing to pay a premium to get alternative alpha. Clients use these strategies in many forms: via over-the-counter structures, put options or accumulators, or as notes, with the assets in securitised form”
Conrad Huber, UBS

Unlike alternative risk premia, hedging QIS is not intended for yield enhancement nor as a means to diversify an investor’s sources of return. The simple idea is to use programmatic methodologies that respond to market signals by rebalancing asset allocations in a way that protects investors from risks such as that of the stock market crash at the start of the year.

Huber says the utility of systematic hedging is that it eliminates complex considerations around timing: the right time to enter a hedge in terms of spot and a price, and right time to exit.

This is what has drawn the interest of investors such as the region’s family offices, some of which will lack the time or resources to be continually making such calculations. For these clients, UBS can offer QIS geared towards putting an ‘evergreen hedge’ on their portfolios. 

One such QIS that has performed particularly well over the course of this year’s whipsaw markets is the UBS S&P Intraday Trend, a systematic strategy applying implicit hedges to trade on patterns of intraday behaviour in stress market scenarios.  

The S&P 500 has seen historically large moves this year, hitting a fresh record closing high above 3,300 points in February, sinking towards 2,200 in March, then rallying for five months.1 Throughout all these ups and downs, the strategy fully performed. 

“The future is always uncertain, and what happened was a reminder that – even after years of favourable markets – one must keep in mind the need for hedging,” says Maratier. “We’ve received a lot of positive feedback on hedging QIS, from institutional clients to global family office clients,” he adds. 

UBS also uses a systematic approach in the bank’s Gold Income Strategy – a solution launched this year that generates regular income from gold, a non-income generating asset. The strategy is operationally burdensome to execute, involving the daily selling of call options on gold to smooth out entry and exit points in the overwriting strategy to generate income when markets are rallying or range bound and work as a hedge when there is a selloff. 

Just as with hedging QIS, a key attraction of this solution for resource-constrained family offices is its elimination of all the heavy lifting involved in implementing such strategy in-house.

“We feel there is more and more of a need for clients to use investment banks as an agent, as someone able to take on the operational tasks they are not able to do themselves,” says Maratier. “Some hedge funds that have their own traders don’t need us. But for certain types of asset owners, such as wealthy individuals or family offices, this is very helpful for them.”

 

Notes

1. Bloomberg, 2020

 

Family office investing – Special report 2020
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