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Thanks to the US Federal Reserve ('the Fed'), bullish sentiment has returned to markets. However, we think investors should re-focus on ways of diversifying away from equities. We argue the supposed 'Powell Put', the idea the Fed Chair will step in to prevent the equity market from falling, does not in reality provide insurance for investors. However, perhaps paradoxically, actual options1 do provide a useful solution for investors at this juncture.
There are many ways to diversify risk, including, of course, a shift to government bonds. However, if late cycle worries about inflation resurface, bonds could do badly. We therefore explore two liquid diversifiers:
- Retaining equity exposure but adding an option strategy known as a 'put-spread collar'
- Shifting to funds which systematically sell options on equity indices to capture what we call an 'equity insurance risk premium' (EIRP)
The first idea is a tactical move. It involves both buying and selling options and is based on our view that the risks to the S&P 500 are asymmetric with negative to flat price returns more likely than high returns. The latter is a strategic shift to take advantage of an alternative source of return. Although this is positively correlated to equity returns at shorter horizons, it has a different long term driver. Our team of derivative experts can advise on the appropriate level of hedge, if any, depending on the client’s specific circumstances. For the structure we’re suggesting, a hedge of around 20% of the US exposure and shifting 10% to an EIRP strategy might be appropriate for a plan with no intention to change its strategic allocation to equities in the future.2
To learn more, download the full article above.
1 Options give their owner the right but not the obligation to buy (a call) or sell (a put) on the underlying index at a given price (the strike) up to a certain date (expiry).
2 Why only have a limited switch if we think these ideas will add value? We don't know with certainty that we will remain in a rangebound market environment. A S&P 500 of 3100, or higher, at the end of 2021 when the hedge expires is perfectly possible if valuations remain elevated and profits continue to grow. A 20% hedge on a 20% exposure would be 4% of the portfolio. This will create risk relative to the strategic benchmark but not as high if a larger hedge was implemented. However, a client who envisages that the strategic allocation to equities is likely to come down may wish to consider a much bigger hedge. Alternatively, our experts may advise that the structure of the hedge should be focused more on retaining upside potential with a corresponding lower level of protection, in which case a much higher notional may be appropriate. We don't think the relatively high level of hedge is as appropriate for outside the US – again our experts can advise.
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Diversification – does not ensure a profit nor does it protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility.
Appendix: Index Definitions and General Disclosures
S&P 500 – The Standard & Poor's 500, often abbreviated as the S&P 500, or just the S&P, is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.
VIX Index – Represents a 'risk-neutral' measure of the expectation of volatility of the price of the Standard & Poor's 500 Index, over the next 30 calendar days, by investors in S&P 500 index options. It is constructed by the Chicago Board of Options Exchange (CBOE) using the implied volatilities of a wide range of S&P 500 index options which have a maturity of between 23 and 37 days.
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Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances.