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Investors look for inexpensive protection as nervousness rises
(pictured: Paul Bouchey)
There’s growing evidence that investors large and small are increasingly nervous about the short-medium-term future for both equities and bonds. For Australians, this nervousness probably extends to property, as well. So, what do they do about it?
Tumbling oil prices and the slowing Chinese economy are said to have been the main causes of the big January sell-off in equities markets. There are also other fundamental reasons, such as a potential exit from the Eurozone by the UK and rising geopolitical risks. The State Street Investor Confidence Index fell 1.7 points to 110.5 in January, because of declining confidence in the three main regions of North America, Europe and Asia.
Meanwhile, according to Paul Bouchey, the chief investment officer of Parametric, the premiums for his firm’s “defensive equities” strategy will rise in February through to at least April, due to the January market falls.
The strategy involves combining partial de-risking of a portfolio with an overlay strategy that positions funds on the sell-side of the equity protection that other funds are buying.
According to Parametric, this avoids the cost (income drag) and flexibility issues with buying protection, plus it generates option writing (premium) income and allows the fund to harvest a consistently observed ‘volatility risk premium’ in the market.
Seattle-based Bouchey says that the firm has raised about US$2 billion in the strategy over the past year or so as investors have become more nervous about equity markets.
He was visiting Australia last week to speak with clients about defensive equities and also the firm’s smart-beta strategies. In Australia, Parametric is best known for its after-tax investing services but the other two business offerings have also attracted interest from super funds in recent months.
For Australian investors, the Parametric defensive equities strategy involves de-risking a portion of an MSCI ACWI portfolio into bonds and selling options over the resulting portfolio, for which it has simulated positive excess returns as well as downside protection. For actual client experience in the US, over the S&P 500 for which the firm has a four-year track record, the annualised premium is 2.8 per cent on top of the protection element.
Bouchey points out that traditional defensive strategies using derivatives, typically implemented by an investment bank, are very expensive. “If this insurance is expensive, why not be a seller of it, rather than a buyer?” he says. Also, as an investment manager, Parametric is a fiduciary acting as an agent of the client. Investment banks may not be – they may act as principals in the transaction.
Parametric is also a little different from many fund managers because it focuses on implementation efficiencies across its strategies and funds. It does not take a view on the direction of individual stocks or whole asset classes and, with its after-tax strategies for instance, often works in tandem with other managers in the best interests of the clients.
“With our protected equities strategy we use listed options, which are transparent and liquid and have low fees,” Bouchey says, “compared with the illiquid, non-transparent strategies of the traditional providers who have hedge-fund-like fees.”
One of Parametric’s largest clients in the US is Research Affiliates, the renowned inventor of the “fundamental index” (Research Affiliates Fundamental Index or RAFI), which saw demand for its products take off after the global financial crisis.
Bouchey says that Parametric started off in the space implementing any smart beta which it could, as requested by such clients and then evolved into greater customisation. Last year, it also introduced its own factor strategies.
“We wanted to have more control over the end result,” Bouchey says, so that we can be sure we are providing ‘pure factors’, rather than exposing our clients to various potential sector imbalances. And we also build the portfolios with the taxable investor in mind [making them after-tax efficient].”
He says that it is a commonly held myth that smart-beta products are tax efficient. Anything that involves a lot of transactions, such as smart beta, active strategies and, even, index funds, will benefit a lot from the application of after-tax processes, such as Parametric’s centralised portfolio management.
