While there are funds that say they use, or may use, derivatives, it can sometimes be difficult to ascertain much about how the asset class is actually used.
Many people think the main purpose of derivatives is to “juice” returns by seeking riskier opportunities than conventional assets can deliver, says Tom May, chief investment officer at derivatives-based investment manager Atlantic House Group. But he says the vast majority of derivatives reduce risk.
“The first tool many portfolio managers reach for is a defined return investment: a derivative structure that offers investors a fixed return, over a defined period of time, in a wide range of market scenarios,” says May.
“But derivatives, including those accessible within regulated funds, can also be built into portfolios to achieve a range of other goals. Two that are particularly pertinent are to provide some level of crash protection and insulation from rising inflation.
“Crash protection strategies are investments that seek to kick in when markets are experiencing particularly large falls. There is no panacea for this, because these derivatives come at a cost.”
Rising inflation is another scenario that derivatives can help protect portfolios from, says May. “Classic approaches, such as owning index-linked bonds, all come with their own risks.
“If inflation rises sharply, this can make longer-duration bonds fall, and some investors have been surprised to discover that their inflation-protected bond holdings fall into that category. However, derivative instruments such as inflation swaps can be owned within bond funds to make money from the rising price of inflation itself.”
An example of this use of derivatives can be found in Atlantic House’s Dynamic Duration Fund, which holds UK and US interest rate and inflation swaps. The latter provide exposure to inflation, without the element of duration that comes with inflation-linked bonds, says co-manager Jack Roberts.
Owning derivatives is ‘almost essential’
With an overall view that the environment is one where inflation is higher and more volatile, where cross-asset correlations will be more unstable and volatile, Ruffer fund manager Duncan MacInnes says owning derivatives as part of a portfolio becomes “almost essential” in this new environment.
“Bonds offered protection by way of negative correlation to risk assets, diversification and income. In the future, we believe these characteristics will be less reliable,” he says.
“2022 was proof of concept, where in a higher-inflation environment bonds and equities fell together, and conventional portfolios were revealed to be insufficiently diversified.
“If investors want to get negative duration or negative correlation into their portfolio, then derivatives are the easiest way to do this. In 2020 and 2022, our derivative protections were the largest contribution to our portfolio returns.”
Portfolio managers at Fidelity also use derivatives to hedge currency exposure, take short positions, or for gearing within a closed-ended fund.
If investors want to get negative duration or negative correlation into their portfolio, then derivatives are the easiest way to do this
The Fidelity Emerging Markets trust, for example, uses derivatives to target the weakest stocks most exposed to competitive threats and financial distress, says Fidelity International head of UK wholesale Dennis Pellerito.
“More broadly, many of our listed investment companies will use contracts for difference to gear, instead of a traditional bank loan,” he says. “CFDs are very cost effective as we only incur a cost when we use them, unlike loans.”
Pellerito also cites the Fidelity Enhanced Income Fund as an example of a fund that uses derivatives extensively.
“[It invests] in an equity portfolio of dividend-paying stocks, but adds an actively managed call option overlay to further boost the yield without having to compromise on the quality of the underlying equity portfolio, as is often the case with a traditional high yield approach.”
At any given time, Pellerito says it is likely that between 40 per cent and 60 per cent of the fund will be overwritten.
“Call options . . . allow the funds to generate additional income from existing investments. The fund will sell to other market participants the right to buy stocks from the fund at a fixed strike price, at a specified point in the future.” he says.
“Purchasers of these options pay the fund a premium for that option and in return, the fund gives up some of the potential capital gains should the stock price be above the strike price at expiry. If the share has failed to achieve that price when the option matures, then the option holder will not take up the right to buy it; yet importantly, the fund will still keep the premium paid.”
‘Spreading the overlay’
Generally, the fund will sell call options that have a maturity of three months at initiation, with approximately a third of the holding overwritten each month.
“This way, we build up an overlay with options of three maturities that expire in one, two and three months for each holding,” Pellerito says. “By spreading the overlay across different maturities, we reduce the likelihood of a large holding being called away in one go.”
Another fund that uses options is the Invesco Global Income Fund, which manager Alexandra Ivanova says aims to deliver diversified and stable income through different cycles.
“We use both equity futures and equity put options to manage our overall equity exposure,” she says. “Given the low-volatility environment, it makes sense to buy put options on major equity markets that would cushion losses if we were to experience large drawdowns in the equity markets.
“We pay a premium to have these options on, but given the yields available from credit, we are happy to pay a little bit of that carry to buy these options, which act as an insurance policy in case the markets sell off meaningfully.”
For the fixed income portion of the fund, Ivanova says interest rates futures are used to change the composition of the duration element.
“Currently, we are more constructive [on] European and UK duration, relative to US Treasuries, hence we will buy rates futures on gilts, bonds or BTPs [Italian government bonds]. We are cautiously positioned on US rates futures,” she says.
Given the low volatility environment, it makes sense to buy put options on major equity markets that would cushion losses if we were to experience large drawdowns in the equity markets
“We also can pick spots on the [yield] curve that have better value in our assessment. Given expected stickiness of inflation and more positive growth outlook in the US, we believe the curve will steepen from here, so we can use interest rates futures to sell the long end, like 10 and 30-year, in favour of the short end of the curve, like two and five-year interest rates futures.”
And while the fund is mostly hedged back to its base currency (sterling), Ivanova adds: “Given reduced volatility in the currency markets, we can buy cheap US dollar/euro upside options that would benefit in case the dollar continues to rally.
“We put euro/dollar downside options that would also cushion a major sell-off in [the euro]; or in other words, we like dollar upside. The euro has been put under a lot of pressure from the results of the US elections, and these positions have worked more recently.”
Chloe Cheung is a senior features writer at FT Adviser
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