Expert Feed

Products that zag when markets zig

BY JOHN DYALL | FRIDAY, 19 NOV 2021   11:25AM

Being pessimistic by nature, I was somewhat surprised to receive a message from abrdn Australia (the new iteration of Aberdeen Standard) in response to a previous column on the importance of long volatility strategies in protecting equities portfolios.

The message was they had the solution to my problems. But before we get to that let us review the problem. "Long vol" strategies are designed specifically to protect investment portfolios during periods of high volatility.

We know that equities is a volatile asset class and that equities exposure is the biggest risk in your typical investment portfolio.

But its volatility is neither consistent nor stable. It is lowest when returns are positive and highest when markets are on a losing streak. Most of the time equities make steady gains and everybody's happy.

Occasionally, though, they embarrass themselves and volatility goes through the roof.

The statistical term that describes this behaviour is skewness. You won't hear many funds managers or consultants talk about this. Personally, I'm a bit obsessed with it.

Negative skewness is when there are many small gains and a few large losses. Equities have negative skewness, which is why they are sometimes referred to as being a "short vol" strategy.

Positive skewness is when there are many small losses and a few large gains. Strategies that have positive skewness are called "long vol" strategies. They love it when market volatility spikes since this is when they make the most money. Most of the time they just sit there doing nothing (or slowly losing money). But every now and again, just when equities are freaking out, long vol strategies make out like bandits.

Neither of these types of skewness - on their own - is ideal for investors, particularly when there are cashflows involved.

When a portfolio has positive cashflows, such as a superannuation account when the member is contributing year after year with many years to go, they should favour negative skew as a portfolio characteristic. After all, when the market falls they continue buying assets at lower prices using their contributions. Dramatic falls early in their investment journey (when the portfolio is relatively small) are in fact positive for the end goal of wealth creation.

Positive skew is relatively bad for wealth creation at the beginning of the investment journey. When the portfolio is small in dollar terms large gains make relatively small impact on the portfolio compared with sudden high returns when the portfolio is bigger.

When the positive cash flows stop (this means when the investor is no longer adding fresh money to the portfolio), negative skew becomes much more dangerous. A big correction (when it's not followed by an immediate recovery like we saw in 2020) could see the owner drawing down when market prices are less than what they originally paid. Once you sell an asset at a loss this is equivalent to a permanent loss of capital.

There's no opportunity to buy back assets at lower prices. The investor becomes a net seller at lower prices.

This is where positive skew/long vol strategies come in handy. When combined with short vol assets (ie, equities) long vol strategies balance the skew and make it neutral for the total portfolio. During a market correction, the short vol strategy (ie equities) lose money while the long vol strategy makes money. End result: Neutrality.

For many years this was the role of long duration government bonds. This is more difficult with low yields (although with the inflation threat yields are rising).

Bonds can still be of benefit, and the longer the maturity the more effective they are for the same investment dollar. There is, in fact, a long duration bond product from BetaShares in the ETP market that should be checked out.

The other solution is abdrn's just launched Global Risk Mitigation strategy. It has positive skew! Who knew that's what you wanted?