How can investors benefit from volatility as an asset class?
In 2024, the S&P 500 has seen many new highs, but in the past week, it had its worst day of performance since 2022. While global equities were re-valued lower, bonds were re-valued higher. This change in the perception of value occurred suddenly and created a spike in volatility. Instances like these pose the question: how can investors benefit from volatility as an asset class?
Market turbulence creates an informative picture of the risks and opportunities of using volatility as an asset class. Our protected equity strategy has evolved from option-based portfolio insurance and involves purchasing equity puts and selectively writing calls to mitigate the cost of implementation. Effectively, we can reduce the level of equity volatility by 40%, which can substantially reduce the impact of corrections after the first 5-10%.
An absolute return investment strategy imposes different demands on the portfolio management team compared to an index relative strategy. A constant commitment to diversification is valuable to managing the investor experience. Although the discipline to capture the growth from a performing market is also fundamentally important. During a transition period of market leadership, equity volatility can jump with a shift into the bond market. This is when options can be critically important to a smoother journey.
When an equity market achieves gains in excess of double digits over the course of a year, we expect volatility to recede, and the cost of protective equity puts to cheapen meaningfully (who needs a raincoat on a sunny day?). This can be a good time to add protective measures and ratchet up the floor for our protected equity strategy.
All-weather investing is a mindset that embodies the portfolio management of absolute return investing. How can I go up more and down less as the market ebbs and flows? How can I spend the least amount of premium and get the most amount of protection? When can I capture excess premium as income? These questions frame the decisions of an active manager. Like sector rotation in equities or duration management in bonds, active management in the options market means taking a view of the market direction and extracting the best risk-adjusted return.
Takeaways
Systematic strategies create opportunities for active managers. Many managers spend considerable time differentiating between stocks and bonds they like or not. The same is true in the option market where volatility can be bought or sold at implied levels that can differ substantially from realized levels. The depth of liquidity across sectors and markets has grown tremendously and has developed into a fabulous risk mitigation tool. When market volatility spikes, it’s important to consider the drivers of these actions but more importantly, how we can use the situation to our advantage to deliver a smoother experience.
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