Preparing Portfolios for the Return of Volatility: Advisors’ Questions Answered
April 30, 2019
Several hundred financial advisors joined us for a Monetizing Volatility: A Deep Dive webcast on April 2. The first quarter had just closed with the S&P 500 up double digits, equity valuations were elevated, and the VIX (CBOE volatility index) was low and on its way to dropping further—all conditions that have continued into the second quarter.
While low volatility and rising stocks make for an attractive environment, many advisors are cautious. When we polled our webcast participants, eight of 10 expect a return of volatility, such as was experienced last year (see this post on 2018’s three drawdowns).
To help advisors navigate these crosscurrents, our webcast focused on the opportunities of equity and fixed income liquid alternatives as strategic allocations, including in times of turbulence. The webcast featured equity alternative Calamos Hedged Equity Fund (CIHEX) and income alternative Calamos Market Neutral Income Fund (CMNIX).
Advisors, to learn how these strategies can capitalize on market volatility and generate diversifying alpha, we invite you to watch the on-demand replay.
Below, we excerpt some highlights of the webcast’s extended Q&A, edited for clarity. Moderated by Calamos Senior Vice President Tim Brand, Head of U.S. Intermediary Distribution, the discussion featured Eli Pars, CFA, Co-CIO, Head of Alternative Strategies and Co-Head of Convertible Strategies, Sr. Co-PM; Jason Hill, Senior Vice President, Co-Portfolio Manager; David O’Donohue, Senior Vice President, Co-Portfolio Manager; and Jimmy Young, CFA, Vice President, Co-Portfolio Manager.
Q. Please compare the two funds and how the hedged strategy is used in Market Neutral Income versus in the Hedged Equity Fund.
A. They have comparable equity portfolios, and our philosophy in constructing the hedge is similar in that we're using SPX options in both funds to build the hedge that the team believes will have the best risk/reward tradeoff.
But, the two funds do have different risk profiles and different investor bases. The exact hedge profile between the two funds can be quite different at times.
While Hedged Equity is positioned as a more defensive equity fund or equity substitute, the Market Neutral Income Fund aims for a more stable, consistent, fixed income-like return stream over time.
We generally have an eye on maintaining greater downside protection in the Market Neutral Income Fund. In the Hedged Equity Fund, we are focused on achieving more upside participation. The graphs on this chart compare the delta hedge and general option positioning for the two funds at each quarter-end in 2018.
Generally, with a delta hedge, the higher the number, the more likely the fund has greater opportunity for potential downside protection. As you can see, throughout the year, Market Neutral consistently had a higher delta hedge than Hedged Equity.
It’s important to note that these numbers are just a snapshot in time and looking at one number in isolation doesn't tell the whole story.
For example, in the fourth quarter of 2018, the delta hedge for Market Neutral looks relatively low compared to earlier in the year. However, the fund had a relatively high put notional (81%), giving the fund good skew to the downside. In the event of a large market selloff, the hedge would quickly increase, giving the fund greater opportunity for potential downside protection.
Market Neutral maintained a higher call write and as much or more put notional throughout the year than Hedged Equity, which illustrates the different positioning of the two funds. Hedged Equity had a lower delta hedge during the year, which we achieved with a lower call write. And through the use of call spreads, Hedged Equity often had more long calls, giving the fund the opportunity for more additional upside participation.
Q. From your perspective, how would the two funds fit in an asset allocation?
A. In our experience, many advisors use Market Neutral Income Fund as a fixed income alternative. It has a similar return profile to what intermediate-term fixed income used to have. To date, it hasn’t had a lot of interest rate sensitivity.
When people were concerned about the downside of fixed income, particularly the Treasury market with rates being as low as they were, we didn't really have a lot of that downside interest rate risk. When the bond market is rallying like it has been over the last couple of months, we don't have that opportunity either. We're just not correlated that closely to the bond market.
We think Market Neutral Income is especially compelling as a fixed income substitute when the risk reward profile for bonds is less attractive, particularly for Treasuries or higher investment-grade credits. From a risk/reward basis, we believe there's a pretty strong argument for many investors to move some money out of traditional fixed income and into alternatives like Market Neutral Income.
The fund is also often used by sophisticated advisors who have big allocations to alternatives already. Market Neutral serves as a great anchor to that part of the portfolio. It has been a steady-return, lower-risk fund you can allocate to that allows you, at the edges of that alternative portfolio, to maybe take on some more high flyers with higher return—and higher risk—potential.
Hedged Equity Fund is an equity alternative. We're trying to find equity returns with lower volatility to help manage investors’ instincts to get out of the market at the wrong time.
Our hedged equity approach could be a good choice for those who have missed out on some of the post-2008 bull market and are reluctant to put money into equities now. This is a way to dip your toe in with potentially less risk. It could be for those who had a nice equity allocation for a while and want to take some risk off the table but don't necessarily want to take it all the way to fixed income or cash.
A lower-volatility equity strategy like Hedged Equity Fund fits very well for that. We think we can do more than what a blend of fixed income and equities would give you in your portfolio. Our ability to manage that option book on an active basis has proven its ability to generate alpha.
Q. What is the market environment that would present the most headwinds for the strategy?
A. Some of our competitors tend to be systematic and dogmatic about how they construct their hedge, which can work well in some market environments and not well in others. We are more active in trying to take advantage of what the market gives us, which means that in a lower vol environment like 2017: a) we’re probably going to have more of a long vol approach to our hedge than we would in other market environments; and b) we're not presented with as many opportunities to monetize that volatility.
Often, people are focused on some of our options competitors that have blown up in different manners over the last few years, and they're concerned about what market environment could blow up the Hedged Equity Fund.
We just don't run it that way. We don't want to oversell calls, overwrite puts or take those tails on. If anything, we’d want to get long those tails rather than short them. We just don't want that risk.
We did lag a few of our more systematic competitors in 2017 when volatility was at historically low levels. We think that's probably the worst-case scenario market environment for the fund. For an equity alternative, that's maybe not the worst thing in the world, because if you're deciding where you're going to place your risk, what you don't want to do is underperform in a down market.
Our worst-case market isn't some crazy spike that blows up the fund, it’s more of a drifting up market when we’re earning a decent return but lagging a bit more than we'd like.
Q. Do the funds use leverage?
A. We've never used leverage in either fund. Although it is common for hedged funds to use convertible arbitrage on a levered basis, we run Market Neutral Income’s convertible arbitrage sleeve on an unlevered basis. We think it provides greater balance to a portfolio without introducing too much risk.
Q. How do you construct the underlying equity basket that's a foundation for the option strategy of both funds?
A. In our Hedged Equity Fund and hedged equity strategy in the Market Neutral Income Fund, we are buying about 250 to 275 stocks to replicate and ideally beat the S&P 500. We aren’t taking large sector or factor bets. Our goal is to add alpha in our equity books. But foremost we want to have a minimal tracking error to the S&P because we trade S&P 500 Index options.
Q. Please explain Hedged Equity Fund’s increase in turnover in 2018.
A. It’s important to note and understand that turnover is not inherent to the core strategy. The strategy itself actually has had a reasonably low turnover.
The turnover in 2018 was really a function of our rapid AUM growth, and more specifically how we manage and invest those inflows. As the fund grows and we reach more of a steady state, you should see that turnover come back down.
To elaborate: as we get inflows, we have to invest them. Sometimes that can be tricky for managers. One benefit to the structure of our fund is we actually have some flexibility in how we do that. When we get an inflow, normally that would involve us going out and buying that portfolio of 250 to 270 stocks. But due to the nature of our strategy and the low tracking error we maintain, another option available to us is to purchase an ETF that closely tracks the index.
As we build up that ETF position over a couple of days, we can sell the ETF and simultaneously roll that into a portfolio of equities.
We like this for two reasons. One, it reduces our slippage versus the index. It's quick. It's efficient. We can match up the ETF sale with those single-name buys. But it also gives us some greater flexibility on timing, which allows us to be a bit more opportunistic.
Take for example, if we have a larger inflow. We come in that morning and S&P futures are down. It's not realistic for us to purchase all 270 equities pre-open. We can't do it very efficiently. But we can purchase an ETF that tracks the S&P 500, which allows us to take advantage of that discount.
One of the core strengths of the strategy is its liquidity. We’ve been able to handle the inflows fairly seamlessly. Unfortunately, the drawback is that it does affect the turnover calculation. But this is a somewhat temporary problem that will ultimately fix itself.
As the AUM of the fund grows, the denominator in the calculation grows, the impact of each subsequent inflow diminishes, and that turnover will come down naturally.
Q. How do you account for the fact that puts might get more expensive as volatility spikes? Would you ever go unhedged because of the cost of the puts or the cost of the options that you're trying to implement?
A. Generally, our base or model trade is an 80% call over write matched with a minimum 40% put protection and a 40 delta to the downside. While these are the guardrails that we will typically stick to, we are continuously trying to improve this baseline trade based on the market environment.
We have gone either close or completely unwritten on the call side. For example, if you think about it mathematically, we might go out and sell a call for $25. And the market breaks meaningfully—10%-15%. A little time passes. All of a sudden that call that we sold for $25 is now $4. Well, it can only go to $0. It's not going to be negative. And at some point, we may buy that back.
If the sell-off in December had continued a couple more days, we might have reached a point there where we were zero call written, because we were reaching the point where the value of our calls was dropping relatively quickly. We had the advantage of having a lot of puts—more than the 40% notional guardrail—to lean on in that environment.
We will do that on the call side, but we won't on the put side. We're always going to make sure we have some potential downside protection.
This is an example of how we dynamically manage our options positions. We like having either put spreads or incremental puts on top of the 40% notional, so we have something to monetize, to roll out, to maintain that put hedge even as the vol environment gets trickier. And we'll do some things with playing around with expiries. Generally, if put vol is expensive, call vols usually get at least a better bid, so there's something we can do on the call side as well.
As managers, it’s important to understand the core nature of your investor. For both of these strategies, we always have to be cognizant of the downside and of making sure that we do flatten out that downside tail. The goal is to have left ourselves in a position where we can trade out of a position of strength in those markets and have the ability to monetize a little bit of that and take out some of the upside. But we also remain focused on the fact that we need to continue to manage and protect capital when the market really gets ugly.
We are mindful of our guardrails, but there are times when puts are expensive and times when they are relatively affordable. There are times when selling calls makes a lot of sense. And there are times when it's tougher when you're selling low implied volatility calls.
We really want to have flexibility. There will be times when we need to dampen down the risk of our equity books. But how we do that is going to be determined by what the opportunity set in the market is. We step back and ask what's unique to this market environment today and how can we use that to build up a better hedge?
Q. Isn’t the put spread an aggressive trade? How does it fit into the overall profile of the Hedged Equity Fund?
A. Put spreads are risk-reducing positions. We're buying one put and we're selling a lower strike put. So, the only amount we can lose on that is what we paid for that put spread. They don't inherently increase risk, they diminish risk. The downside is that they pay off only for a certain distribution—in between the two strikes but not all the way down.
It’s the same for call spreads. If we sell a call spread, it's a little less risky because it caps us only for a certain move in the market. So, it offers less cap than just a pure call sell. And once again, we're not going to overwrite that. We'll never oversell 100%, even if we have long calls. So, our call spreads will be included in that. We want to make sure that we're not short a tail at the upside as well.
For More Information
The webcast tapped into growing interest—and increasing asset flows—in the options-based alternative category over the past two years. For more information, also see our options-based explainer).
Calamos was #1 in flows to funds in the Morningstar Alternatives Category in 2018, and ranks fourth on the list of alternative fund managers by assets under management as of 3/31/19 (Morningstar data).
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
Active management does not guarantee investment returns or eliminate the risk of loss. It should not be assumed that any securities mentioned in this recording will be profitable or experience equal performance in the future.
Alternative investments may not be suitable for all investors, and the risks of alternative investments vary based on the underlying strategies used. Many alternative investments are highly illiquid, meaning that you may not be able to sell your investment when you wish to.
Some of the risks associated with investing in alternatives may include hedging risk – hedging activities can reduce investment performance through added costs; derivative risk – derivatives may experience greater price volatility than the underlying securities; short sale risk – investments may incur a loss without limit as a result of a short sale if the market value of the security increases; interest rate risk – loss of value for income securities as interest rates rise; credit risk – risk of the borrower to miss payments; liquidity risk – low trading volume may lead to increased volatility in certain securities; non-U.S. government obligation risk – non-U.S. government obligations may be subject to increased credit risk; portfolio selection risk – investment managers may select securities that fare worse than the overall market.
As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility and difficulty obtaining information. In addition, emerging markets may present additional risk due to potential for greater economic and political instability in less developed countries.
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