Australian equities - seeking simplicity in a complex world
If applied systematically, derivatives can deliver a consistent return outcome. However, client confusion and operational risks can add complexity to the process, as Rudi Minbatiwala explains.
The path dependency of investment returns is critically important in order to address both the short – and long-term objectives of near-retirement and post-retirement investors.
In response to this, Australian equity strategies designed to better address the needs of these investors have an added focus towards achieving a greater return consistency than traditional strategies.
Derivatives have commonly been used to change the return path of traditional equities portfolio to deliver smoother return outcome.
Derivatives provide a simple way to alter the return path of an investment, either through the purchasing of options to protect against downside risk or through the selling of options to generate option premium income, or a combination of both.
Using derivatives, however, can create additional complexities, including operational risks and client understanding.
One approach seeking to simplify this more complicated concept, particularly to address the need for appropriate client understanding of the strategy, has been via systematic implementation of derivative strategies.
Investors must be diligent in understanding whether an investment strategy uses derivatives rationally to achieve its target outcome, rather than systematically.
Selling call options to generate income
The buy-write strategy is a common derivatives strategy comprising simultaneously buying shares and selling call options on those shares to alter the return path and return composition of the investment.
The strategy generates income through the receipt of option premiums from the sold call options. This additional income cushions losses during adverse market conditions and thus produces a level of volatility that is lower than the broader equity market.
When implemented appropriately, the equity strategy is an effective method for balancing the differing investment objectives of near-retirement and post-retirement investors.
The use of this strategy has been fairly modest in the Australian equities market for a long time and was historically limited to more sophisticated investors.
Use of this strategy has only increased more significantly in recent years as the industry has sought to introduce more outcomes-based investment solutions.
As a result, the investment management industry has yet to develop a mature understanding of certain issues regarding the strategy, which is essential when assessing the suitability and sustainability of the strategy for addressing investor requirements.
Most people focus on the attractive level of income that can potentially be generated by this strategy.
The amount of income generated can be increased simply by giving away more of the potential upside in the share price (through selling call options closer to the current share price) or by selling more options over the shares held.
It is this trade-off concept that is often overlooked or misunderstood when implementing the buy-write strategy.
To best understand how the attractive outcomes from selling call options are achieved, the strategy can be considered as an asset-liability concept.
The option premium income received is an ‘asset’ that is obtained when the call option is sold. The size of this asset is fixed and known at the time of implementation.
This makes targeting a desired level of income (cashflow) relatively straightforward.
However, the option premium income that is generated is not free – the capped share price upside represents an unknown ‘liability’ that changes in value with the passage of time and market movements.
While the investor does generate an immediate cashflow on the day a call option is sold, the investor does not create net wealth at the time of implementation.
This is because the option premium income ‘asset’ that is generated is equal to, and offset by, the present value of the upside participation ‘liability’ that is simultaneously created.
If the share price remains below the level of the option cap at the time of expiry of the option position, the ‘liability’ will decay to zero and the investor will generate a gain.
If however, the share price has increased above the level of the option cap at the time of expiry of the option position, the value of the final ‘liability’ may exceed the upfront, fixed ‘asset’ income received. In this event, the final outcome is that the investor may incur a net loss.
Why is this liability often ignored?
When implementing the buy-write strategy, the liability is considered an opportunity cost rather than an explicit loss because the underlying share is also held. This does not mean, however, that the impact of the liability can be ignored.
The opportunity cost becomes an explicit cost when the investor re-implements the strategy, as they do so at a higher price point. Like all liabilities, this call option liability needs to be managed properly.
Liabilities need to be actively managed and the key drivers of the liability need to be understood. The relevant risk factors impacting the value of the call option liability are the same stock-specific risks and market risks impacting the underlying share price.
Understanding the distinction between generating an additional distributable income stream and managing investment returns is critical.
Therefore, a sole focus on income generation from using derivatives is an over-simplification that should be avoided by outcomes-focused investors.
Downside protection
The purchase of put options, which reduce downside risk, is a common investment technique used when seeking a smoother return path from equities. On the surface, this appears to be an intuitive strategy – the payoff profile of a put option provides a floor for the investment value.
However, there are aspects of using put options that need to be considered.
First, the purchase of put options requires the payment of an option premium, which entails a cost (and reduces cash flow).
This directly impacts the return of the strategy. While using put options does protect investors against short, sharp downward price movements, the cost of purchasing the put options can accumulate over time and, in the long run, may outweigh the benefits of the short-term protection they offer.
Second, all put options have a maturity date. As each put option expires, a new position needs to be established. If markets fall significantly, the level at which the new protection is established is also lower.
Third, the asset-liability concept also applies to systematic put buying. The put option premium payment represents a fixed ‘liability’ and the floor provided by the put option is a variable ‘asset’.
This ‘asset’ needs to be actively managed since its value is predominantly driven by the share price of the underlying security or market.
In part, investors can be misguided by the textbook payoff diagram, which only represents the end point outcome at the expiry date of the put option.
Risk assessment based simply on the end points of an investment period is not appropriate when developing outcomes-based investment strategies for near-retirement and post-retirement investors.
The payoff profiles do not clearly incorporate the ongoing implementation cost through the cycle or the path dependency of such investors.
The cost of purchasing the put option varies, depending on the market perception of risk at point in time.
Because of this, the time at which investors most desire protection would generally be when options are at their most expensive and most prohibitive to implement.
Graph 1 shows quarterly market returns from the Australian share market since 1997. It highlights that the cost of protection can accumulate over long periods of time when the floor was not used.
In addition, it can be seen that during periods in which the market is most stressed, the cost of protection increases.
In particular during the Global Financial Crisis, to protect the portfolio to a 95 per cent level for three months would have cost 4 per cent of the value of the portfolio.
Over the course of a year, this can be a very significant cost imposition.
This consideration of cost is particularly important for outcomes-based investors in a low-return environment.
Systematic purchasing of put options to provide through-the-cycle downside protection can be prohibitively expensive and, in effect, reduces exposure to the equity market that was obtained from a discretionary asset allocation decision.
Rudi Minbatiwala is a senior portfolio manager, Australian Equities, Core at Colonial First State Global Asset Management.
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