Institutional investors are increasingly turning to options for downside protection because cash and bonds currently offer weaker diversification benefits.
“We think they give you portfolio flexibility to maintain a reasonable allocation to equities when bonds and cash aren’t going to play that defensive role that they have historically,” Justine O’Connell, Frontier Principal Consultant, Head of Debt, Alternatives and Innovation Research, said at the annual Frontier Conference.
Options can provide a flexible tool for portfolio hedging and add another defensive lever to the traditional mix of core bonds, cash, and foreign currency.
“We think considering options should really be considered within a dynamic framework and not a strategic allocation unless you have particular characteristics in your portfolio that you’re trying to hedge over the long term.”
Michael Sommers, Senior Consultant at Frontier Advisors said many investors were surprised to learn that the S&P 500 regularly posts falls of 5-15 per cent. Historically, this has occurred 28 times in a 12-month period since 1970.
Frontier advises clients to focus on protecting against these types of mid-range market falls, which initially entails making an assessment of the portfolio’s inherent equity risk and the diversifying benefits of other asset classes such as infrastructure and property.
“They dampen the loss as it starts but not many asset classes dampen that much when equity falls start gathering pace,” Sommers said.
The explicit cost of option protection is an ongoing concern for investors, but the opportunity cost of shifting a portfolio from equities to cash or bonds is less visible when markets rally.
For many typical Frontier clients, a 0.5 per cent option budget is roughly equivalent to a 5 per cent portfolio tilt from equities to cash and bonds.
Frontier analysed various portfolio protection strategies across a number of scenarios including deep and shallow equity market falls.
“If you want to protect against big market falls, puts will be better than the others, but for those shallower falls if you’re a defined contribution fund… then put spreads are better,” Sommers said.
Frontier also suggests clients increase their foreign currency exposure as another downside protection strategy against equity market falls. It typically advocates that international assets are 60 per cent hedged and 40 per cent unhedged.
“Overall we think it helps with the volatility of the portfolio,” Sommers said.[Download the presentation]