Investment

Family offices need to hedge portfolios against risk…urgently, say traders

Some say soaraway share prices are riding for a fall. Others believe the only way is up as technology, and easy money, create endless ways for us to get rich.

Some years back, family offices would have hedged their equity risk with bonds in a balanced portfolio, but yields are now so low bonds could crash as easily as equities, at the first hint of a rise in interest rates. Disruption has also undermined prospects for real estate, another traditional refuge for family offices. 

A strategy used by Nassim Nicholas Taleb, author of The Black Swan, involves buying out-of-the-money options which cost money to maintain, unless markets crash at which point you clean up

Tom May, chief investment officer at Atlantic House Investments, empathises with their dilemma: “Family offices want to preserve their capital, right?” he says. “I must say if I developed a family office, I wouldn’t want to do it again. It’s tough enough the first time.”

He says it makes sense for investors to spend time in the markets, as opposed to timing the market. It rarely pays to bet against a flood of money. 

But family offices also need to consider ways to hedge their portfolios against risk, as a matter of urgency.  

According to US-based Artemis Capital Management, investors should hedge their bets by raising their weighting in alternative investments which can deal with a sea change in market conditions. They would include gold, volatility positions, commodities, trend and macro. Ruffer Investments has started to put bitcoin in the mix. 

Last August, Family Capital described the way that trend-following hedge funds can protect investors against downturns by moving from long to short positions, when markets turn. 

A strategy used by Nassim Nicholas Taleb, author of The Black Swan, involves buying out-of-the-money options which cost money to maintain, unless markets crash at which point you clean up.

Atlantic House offers a hybrid driven by derivatives in equities, short-dated bonds and gold. Its computer-driven trading systems also makes carefully-timed bets on volatility, designed to protect portfolios from harm during a market crash.  

Atlantic’s Total Return Fund which targets 4% a year generating half the volatility of equities. It has returned 10% over two years, easily beating its peers, coming out of this year’s setbacks well ahead. Its strategy was tweaked in June to take the fullest possible protection against volatility.

Professional investors can buy direct access to volatility hedging through Atlantic’s parent company Catley Lakeman Securities formed by Russell Catley, Andrew Lakeman and Tom May in August 2008, whose products are also available through investment banks. 

All three previously worked in senior positions at Citigroup, with May later becoming head of European equity derivatives and secondary market trading, where he kept a close eye on the bank’s portfolio risk exposures. 

Catley sets out to offer quant tools to portfolio managers to hedge their positions or enhance their index returns. Since inception, Catley has originated instruments worth £10 billion. 

Tony Stenning, former head of UK retail at BlackRock, has bet his career on the success of their strategies by signing up as chief executive. His former BlackRock associate, Dorian Hughes, has become head of distribution. 

Catley advisory arm Albemarle Street Partners agrees it is time to take a new look at asset allocation. 

According to chief strategist Clive Hale: “Long volatility – tail risk hedging in one form or another – is going to be a very important component in portfolios going forward.” 

Atlantic has won business totalling $1.4 billion, mainly invested in its core fund which defines future returns at 7% to 8% a year, although it was hit by this year’s sharp setback and recovery.

At this fund, Tom May uses derivatives to trade indices against each other. He says: “The fund is basically a bunch of puts and calls which crunch together for returns you can forecast from the way the market moves.” 

Atlantic’s total return fund has taken into volatility. It has a 51.2% exposure to equity returns and 39.6% in short-dated bonds which help anchor the fund’s positions. It also has 9.2% in gold, to protect against a rise in inflation. 

Its long positions in volatility hover above the portfolio like a hawk, paying out during a market slump the same way insurance pays out after a car crash. 

But the cost of a volatility insurance premium can be high. According to May: “If you want to go long on volatility using the Vix index, that costs 9% a month, on average, and that’s really expensive.”

So Atlantic only takes out comprehensive volatility insurance when markets are set to turn really rocky. 

To do this, it uses signals which monitor volatility futures.  

If the expected price of one-month volatility is higher than three months, say, this could be the right time to insure against a drop in the market. 

The signal used by Atlantic has worked in most crises although it can sometimes turn off too quickly to be useful. 

Atlantic also uses a systematic route to buy additional insurance. This can involve selling one call, or one put, close to its maturity, then using the money raised by that transaction to buy calls and puts further out. The strategy is relatively cheap to run, so Atlantic keeps it in play the whole time.

May says: “It’s fascinating to compare how the Vix tends to move relative to equity markets. They are very uncorrelated – that is, they tend to move in opposite directions. The Vix, and by implication long volatility strategies, can therefore offer excellent diversification benefits.”

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