Derivatives. Colin Bennett

Transcription

1 For Professional Clients and, in Switzerland, for Qualified Investors only. Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA or the BNY Mellon funds. Any views and opinions are those of the investment manager, unless otherwise noted. Derivatives Colin Bennett

2 Contents INTRODUCTION TO DERIVATIVES Are derivatives good or bad? History of derivatives Uses of derivatives HOW DERIVATIVES CHANGED MODERN INVESTING Managing positions Relative value Range trading Directional trading HOW DERIVATIVES RELATE TO FUND MANAGEMENT Directional vs less directional returns Changing asset allocation Performance 2

3 Are derivatives good or bad? Warren Buffett is not a fan of derivatives. Or is he? derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. Berkshire Hathaway shareholder letter 2002 Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the US, the FTSE 100 in the UK, the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future. When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Berkshire Hathaway shareholder letter 2008 Berkshire Hathaway shareholder letter

4 History of derivatives: forwards A derivative is a contract that derives its value from the performance of an underlying entity Forwards are the simplest derivative A forward is an agreement to sell a certain asset at a specified date and a price agreed today First forward was traded around 8,000 BC using clay tokens (to represent sheep or goats) baked into a clay envelope Clay envelope had details of trade, but in case of dispute it could be broken to allow contents to be recounted Forwards are part of everyday transactions Agreeing to buy a house is a forward transaction Forward transactions can provide certainty to investment decisions An oil company can sell forwards on oil to lock in revenues to ensure drilling is profitable. Similarly an airline can buy forwards on oil to ensure tickets sold on future flights are profitable Source: Insight Investment. 4

5 History of derivatives: options An option is a contract with the right, but not the obligation, to buy or sell an underlying asset at a specified date and price agreed today Options give exposure to volatility Oldest option trade was around 600 BC when Thales paid a deposit for olivepresses as his knowledge of astronomy predicted a large crop Options give asymmetric payoff and can limit losses if investment view is incorrect The more volatile the underlying, the more an option is worth Deposits could be considered the premium paid for option A deposit paid for room in hotel, gives the right to that room for a fixed price. If the booking is cancelled the deposit is lost Deposit is effectively the same as a premium for an option If price of room is volatile, then the price could fall below the effective strike price (price agreed deposit) and a saving made through buying cheaper room at current lower price and losing the deposit Source: Insight Investment. 5

6 History of derivatives: timeline Introduction to derivatives 8000 BC Globular envelope (first forward) 1990 TIPS listed (first ETF) 600 BC First option trade 1998 VOLAX (first volatility futures) 1650 Yodoya rice market (first future) 2004 VIX futures 1730 Dojima Rice Exchange open (first future exchange) 2006 Options on VIX (first listed options on volatility) 1973 Black-Scholes model & CBOE (first standardized option exchange) 2008 SX5E dividend futures Post Lehman bankruptcy there has been a trend away from OTC towards listed products Source: Insight Investment. 6

7 Uses of derivatives Derivatives offer diversification, and can offer more attractive risk reward profiles Delta 1 (forwards, ETF etc) have many advantages over owning underlying asset Delta 1 products can offer cost saving through economies of scale (trading costs, exchange fees, maintenance of positions / corporate actions etc) Some delta 1 products can offer leverage and the ability to go short Delta 1 products can allow efficient access to difficult to access markets offering diversification Options offer buyer asymmetry, and above average returns to seller Long option positions offer exposure to rising and falling asset prices with limited capital downside As options are on average expensive and loss making, they can be sold to earn a risk premium (like selling car insurance) Different markets had different imbalances, offering opportunity European and Asian markets have significant structured product issuance, depressing implied dividends USA has significant variable annuity issuance, lifting implied volatility Source: Insight Investment. 7

8 How derivatives changed modern investing Managing derivative positions throughout life of trade Derivatives allow different positions to be taken Relative value earn profits while not being exposed to overall direction of market Range trading benefit even if markets do not move significantly up or down Directional trading gain directional exposure but with better risk reward profile than vanilla long or short Establishing and maintaining derivative positions Relative benefit of delta 1 positions vs options needs to be established pre trade For options positions appropriate maturity needs to be chosen As options approach expiry decision needs to be taken to roll, cut or hold position Risk management Positions with unlimited downside need to have a stop loss Overall risk of portfolio to geography and asset class needs to be considered Source: Insight Investment. 8

9 % % % Relative value trading: equity How derivatives changed modern investing Relative value trade of Europe outperforming US Long Europe vs short USA Using index instruments Buy long exposure to Europe and sell exposure to US Equal sizes ensure the trade s overall (or net) exposure to the broad equity asset class is zero Trade will generate a profit if European equities perform better than US equities, irrespective of whether markets rise or fall Trade design: Exposure as % of fund % -2% +0% +4% Europe US Net exposure Gross exposure Scenario 1: Both markets rise 15 Trade profit for 2% position size +10% 2% x 5% = 0.1% % +5% Europe US Difference Scenario 2: Both markets fall -5% Trade profit for 2% position size 2% x 5% = 0.1% -10% +5% Europe US Difference Source: Insight Investment. For illustrative purposes only. 9

10 Yield Yield Relative value trading: fixed income How derivatives changed modern investing Term structure trades are a relative value trade Directional view Relative value Directional view = Yield curve moves up or down Curve shape view = Shape of yield curve changes Time Time Source: Insight Investment. For illustrative purposes only. 10

11 Yield (%) Relative value trading: fixed income example How derivatives changed modern investing Relative value position: US Treasuries 30yr vs. 5yr (1:2) Rationale Improving growth momentum in the US and around the world Market likely to price-in further US interest rate rises: short term bond yields expected to move higher Structural forces, together with appropriate policy tightening, expected to keep longer-term inflation expectations well anchored hence longer term rates expected to remain low US yield curve expected to flatten Yield Price Yield Price 1M 3M 6M 1Y 3Y 5Y 7Y 10Y 30Y 30-Jun Dec-17 Implementation Exchange traded US Treasury futures Position size: 2% long exposure to 30yr vs 4% short exposure to 5yr (manage down duration) Profit target: 10bps of fund NAV, Stop-loss review level: -8bps Profit target Stop-loss Jun-14 Jun-15 Jun-16 Jun-17 Historic tracking index P&L position since inception Source: Insight Investment, Bloomberg as at January For illustrative purposes only. 11

12 Range trading How derivatives changed modern investing Range-bound position: Short straddle when underlying asset expected to range trade Rationale Specific market expected to trade within a specific range for a specific period of time Ideally underlying market would have not traded outside the range for a significant period of time Implementation Sell put and call options of same strike (usually at the money) Where option pricing provides attractive pay-off range, range is greatest when implied volatility is highest Stop loss trigger set at inception of trade (at c75% of maximum potential profit) Trade profit/loss + - Trade makes money if market trades within ±5% range Current market level Trade loses money if market moves outside ±5% range Trade profit/loss Source: Insight Investment. For illustrative purposes only. 12

13 Market index level Market index level Range trading: impact of volatility How derivatives changed modern investing Only profitable in narrow 10% range with low volatility Wider 20% profitability range when implied volatility is high 10% 20% Time Market level Profit zone Loss zone Time Source: Insight Investment. For illustrative purposes only. 13

14 Range trading: fixed income example How derivatives changed modern investing Range trading position: Short US High Yield spread Straddle Mar18 Rationale Credit spreads in early October 2017 had fallen to bp, just above the post credit crunch low of the index of 291bp (in 2014) A short six month straddle at a spread of 338bp had a lower breakeven of 281bp and upper breakeven of 394bp To be unprofitable spreads would have to have fall more than 10bp below their lows since the financial crisis, or rise c100bp in an environment of strong economic data Implementation Short receiver and short payer swaptions at an index strike of (equivalent to 338bp spread) Position size: 3.9% of AUM Profit target: 9bps, Stop-loss review level: -7bps Index history and pay-off levels (spread) Pay-off profile (spreads) Inception of trade Oct 17 Source: Insight Investment, Bloomberg as at April

15 Directional trading How derivatives changed modern investing Call spread collar (long call spread, short put) offers upside exposure with downside buffer - Rationale Specific market expected to rise but not rise more than a certain level (e.g. 10%). Due to positive view on underlying asset, significant declines are not expected Premium (cost) of long call spread is funded by sale of a put (as two options are sold and only one bought structure is more attractive when volatility is high) Useful structure during later stages of cycle Implementation Strikes are chosen such that the structure is zero cost For example, fund buys call at 105 strike, sells call at 110 strike and sells put at 90 strike Stop loss trigger set at inception of trade (at c75% of maximum potential profit of call spread) Source: Insight Investment. For illustrative purposes only. Trade profit/loss + Trade makes money if market breaks out of trading range to the upside between 5 10% Current market level Trade loses money only if market falls by 10% giving some downside protection Trade profit/loss 15

16 Market index level Market index level Directional trading: impact of volatility How derivatives changed modern investing Pre volatility spike (short put is only 6% out of the money) Post volatility spike (short put is 12% out of the money) +2% -6% +2% -12% Time Time Market level Profit zone Loss zone Source: Insight Investment. For illustrative purposes only. 16

17 P&L at expiration Directional trading: equity example How derivatives changed modern investing Assymetric, upside position: S&P500 Mar18 call spread vs put Rationale In September 2017 the White House was trying to jump start work on a tax cut plan. If this succeeded the S&P500 was likely to rise, if it failed there could be a small decline A Mar18 call spread funded by a short put outperforms a vanilla long delta 1 strategy for levels between a c10% decline and c15% gain While the S&P500 initially rose well above the short call strike, it remained in the range that the structure outperforms a traditional exposure of just owning the market (delta 1) Implementation Long call spread funded through short 2300 put End of month Mar18 expiry (6 months) chosen Position size: 2.5% of AUM Profit target: 9bps, Stop-loss review level: -7bps Source: Insight Investment, Bloomberg as at April Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 SPX Index Start losing money Start making money Max Profit Expiry Inception -10 2,200 2,400 2,600 2,800 3,000 Expiry Payoff Delta One (inc Carry) 17

18 Directional vs less directional returns Using derivatives within fund management Equity US equity European equity UK equity Japanese equity Asian equity Emerging market equity Fixed income Government bonds Investment grade bonds High yield bonds Emerging market bonds Insight Global Absolute Return Strategy Cash¹ Real assets Real estate and securitised credit Infrastructure Commodities Total return strategies Dividends Relative value Range-bound strategies Breakout strategies Source: Insight, January For illustrative purposes only and subject to change. ¹ Cash: Includes cash at bank, FX forwards and money market instruments. 18

19 Directional vs less directional returns: traditional vs alternative Using derivatives within fund management Traditional (directional) return sources Alternative (less directional) return sources Equities Commodities Real estate Absolute return Dividend EMD Directional High yield Infrastructure Less directional Relative value Government bonds Investment grade Breakout Range bound Opportunities for alternative less directional strategies increases when markets are falling and more volatile Directional trades are attractive when markets are trending up 19

20 Directional vs less directional returns: our approach Using derivatives within fund management Blending traditional with alternative sources of return provides Broader opportunity-set from which to generate return Greater diversification than being reliant on either one on its own More dynamic approach to asset allocation Improves consistency of return through typical economic / market cycles Diversified market based sources of return Insight A dynamic blend Alternative, less-directional sources of return 20

21 Portfolio weight % Changing asset allocation Using derivatives within fund management Insight Global Absolute Return representative portfolio Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 Aug-15 Feb-16 Aug-16 Feb-17 Aug-17 Feb-18 Net cash Dev Gov Bonds Non-Govt Bonds Equity Real assets (inc infrastructure) Relative value Absolute return funds Dividend futures Range bound strategies Breakout Strategies: Upside Breakout Strategies: Downside Source: Insight. As at 31 March Cash: Includes cash at bank, FX forwards and money market instruments. Positions are shown on a gross basis and adjusted to total 100%. Allocations are subject to review and may change without notice. The representative portfolio adheres to the same investment approach as Insight s Global Absolute Return Strategy. 21

22 Insight Global Absolute Return Strategy principles Using derivatives within fund management Access a broad set of return sources Blending two sources of returns: asset class performance (rising markets) strategies less reliant on broad asset class performance Dynamic asset allocation (within a risk framework) Wide flexibility to steer towards investments where we believe the environment is conducive to good performance and away from those where it is not Risk management: Emphasis on keeping losses within tolerable bounds A smoother return path Aiming for more consistent returns via diversification across a range of return sources that offer opportunities in different market environments 22

23 Returns, rebased to 100 Annualised performance since 31-Dec-2004 (GBP) Performance: Insight multi-asset strategy vs benchmark Using derivatives within fund management Strategy performance against benchmark since inception Drawdown risk/return comparison since inception 8% 4% 0% -4% 3.47% 5.21% 3.84% 1.49% 0.28% 0.35% 0.37% 0.93% 1 year 3 years (pa) 5 years (pa) Insight's multi-asset strategy (Net, GBP proxy) Strategy performance since inception 10 years (pa) 5.96% 1.94% Since inception of the strategy¹ (pa) 3 Month GBP Libid Dec 2004 Dec 2006 Dec 2008 Dec 2010 Dec 2012 Dec 2014 Dec 2016 Insight s multiasset strategy Global Gov Bonds Macro Hedge Fund Return Index Global Hedge Fund Return Index Static asset allocation 60/40 Global Equities Source: Insight as at 31 March Performance calculated as total return, income reinvested, net of annual charges (including AMC of 0.5%), in GBP. ¹ Strategy initiated 31 December The long term track record of the Insight's multi-asset strategy has a base currency of USD. This performance record has been adjusted by interest rate differentials to derive an GBP proxy. No currency adjustments have been made to the underlying investments. Cash represents 3 Month GBP Libid. Static asset allocation is based on a 60% global equities and 40% global government bonds allocation. Global Equities represents MSCI World index, net, hedged into GBP. Global Gov Bonds represents JP Morgan GBI index hedged into GBP. Global Hedge Fund Return Index represents HFRX Global Hedge Fund (GBP) index. Macro Hedge Fund Return Index represents HFRX Macro/CTA (GBP) index. Drawdown is calculated as the largest peak-to-trough change in the period. This investment strategy shown is used to illustrate Insight's skills and experience. Performance of the Insight s Global Absolute Return Strategy may differ. 10% 8% 6% 4% 2% 0% -2% 0% -10% -20% -30% -40% Downside risk/drawdown -50% -60% 23

24 Returns, rebased to 100 Performance: Insight Global Absolute Return strategy Using derivatives within fund management Representative portfolio performance since inception¹ 8% 6% 4% 2% 0% -2% -4% 4.62% 2.66% 2.85% 2.95% 0.40% 0.42% 0.93% 0.47% 0.50% 0.50% 1 year 2 years (pa) 3 years (pa) Insight Global Absolute Return Fund RP (Net, GBP) 5 years (pa) Representative portfolio performance since inception² Since inception (pa) 3 Month GBP Libor Representative portfolio rolling 1-year volatility³ 25% 20% 15% 10% % Jan 2013 Jan 2014 Jan 2015 Jan 2016 Jan 2017 Jan % Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16 Aug-17 Global Equities Insight's Multi-Asset underlying strategy Insight Global Absolute Return RP Fund ¹ Source: Bloomberg as at 31 March Performance calculated as total return, income reinvested, net of annual charges (including AMC of 0.625%), in GBP. Since inception February ² Performance calculated as total return, income reinvested, gross of fees, in GBP. Fees and charges apply and can have a material effect on the performance of your investment. ³ Source: Bloomberg as at 31 March Rolling 1yr volatility. Performance calculated as total return, income reinvested, net of annual charges (including AMC of 0.625% for Insight Global Absolute Return Representative portfolio and 0.5% for Insight Multi-Asset Strategy), in GBP. Global equities is based on the MSCI World TR index in local currency terms. Comparisons are made to demonstrate volatility only and are for illustrative purposes only.the representative portfolio adheres to the same investment approach as Insight s Global Absolute Return Strategy. 24

25 Performance: Insight Global Absolute Return representative portfolio attribution Using derivatives within fund management Fixed income Government bonds High yield Emerging markets Investment grade Equity UK US Europe Japan Asia Emerging markets Real assets Commodities Infrastructure Real estate & securitised credit Range-bound Total return strategies Relative value Absolute return Dividends Breakout Upside Breakout Downside -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% Source: Insight. This attribution is a desk estimate for the period 8 February 2013 (inception of the representative portfolio) to 31 March This reflects a proportion of the overall portfolio return. The representative portfolio adheres to the same investment approach as Insight s Global Absolute Return Strategy. Performance calculated as total return, income reinvested, gross of fees in GBP. Fees and charges apply and can have a material effect on the performance of your investment. 25

26 Any questions? INTRODUCTION TO DERIVATIVES Are derivatives good or bad? History of derivatives Uses of derivatives HOW DERIVATIVES CHANGED MODERN INVESTING Managing positions Relative value Range trading Directional trading HOW DERIVATIVES RELATE TO FUND MANAGEMENT Directional vs less directional returns Changing asset allocation Performance 26

27 Appendix

28 Colin Bennett Portfolio Manager, Multi-Asset Group Colin Bennett joined Insight in July 2017 as a portfolio manager within our Multi-Asset Strategy Group. Prior to joining Insight Colin was a synthetic equity and derivative strategist at Deutsche Bank. He has also worked at Eurex as Head of Equity and Index Product Development, Banco Santander as Head of Quantitative and Derivative Strategy, Barclays Capital as Head of Delta 1 Research and at Dresdner Kleinwort as Head of Convertible and Derivative Research. Colin started his career in convertible bond research at Merrill Lynch. He studied Mathematics and Electrical Engineering at Cambridge University and is also the author of a highly regarded derivative text book, Trading Volatility. 28

29 Insight s multi-asset strategy Performance as at 31 March 2018 Strategy performance 12.00% 9.70% 10.00% 7.71% 8.00% 6.00% 5.29% 4.00% 3.47% 2.00% 0.28% 0.32% 0.46% 0.43% 0.39% 0.00% -2.00% -4.00% -6.00% -8.00% -6.21% Mar 17 - Mar 18 Mar 16 - Mar 17 Mar 15 - Mar 16 Mar 14 - Mar 15 Mar 13 - Mar 14 Insight s multi-asset strategy (Net, GBP Proxy) 3 Month Sterling LIBID Source: Insight as at 31 March Performance calculated as total return, income reinvested, net of annual charges (including AMC of 0.5%) in GBP. Strategy initiated 31 December The long term track record of the Insight's multi-asset strategy has a base currency of USD. This performance record has been adjusted by interest rate differentials to derive an GBP proxy. No currency adjustments have been made to the underlying investments. 29

30 Insight Global Absolute Return Strategy Representative portfolio performance as at 31 March 2018 Performance 10% 8.88% 8% 6.58% 6% 4% 2.66% 2.78% 2% 0.41% 0.44% 0.58% 0.55% 0.52% 0% -2% -4% -6% -8% -6.03% Mar 17 - Mar 18 Mar 16 - Mar 17 Mar 15 - Mar 16 Mar 14 - Mar 15 Mar 13 - Mar 14 Insight Global Absolute Return RP Cash (3 month GBP Libor) Source: Lipper IM as at 31 March The representative portfolio adheres to the same investment approach as Insight s Global Absolute Return Strategy. Performance calculated as total return, income reinvested, net of annual charges (including AMC of 0.625%), in GBP. 30

31 Risk disclosures Past performance is not a guide to future performance. The value of investments can fall. Investors may not get back the amount invested. Currency Risk: This Strategy invests in international markets which means it is exposed to changes in currency rates which could affect the value of the portfolio. Derivatives Risk: Derivatives are highly sensitive to changes in the value of the asset from which their value is derived. A small movement in the value of the underlying asset can cause a large movement in the value of the derivative. This can increase the sizes of losses and gains, causing the value of your investment to fluctuate. When using derivatives, the portfolio can lose significantly more than the amount it has invested in derivatives. Changes in Interest Rates & Inflation Risk: Investments in bonds/money market securities are affected by interest rates and inflation trends which may negatively affect the value of the portfolio. Credit Risk: The issuer of a security held by the Strategy may not pay income or repay capital to the portfolio when due. Counterparty Risk: The insolvency of any institutions providing services such as custody of assets or acting as a counterparty to derivatives or other contractual arrangements, may expose the portfolio to financial loss. 31

32 Important information For Professional Clients and, in Switzerland, for Qualified Investors only. This is a financial promotion and is not investment advice. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and its subsidiaries. BNY Mellon Investment Management EMEA Limited and any other BNY Mellon entity mentioned are all ultimately owned by The Bank of New York Mellon Corporation. Issued in UK and Europe (excluding Switzerland) by BNY Mellon Investment Management EMEA Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No Authorised and regulated by the Financial Conduct Authority. Issued in Switzerland by BNY Mellon Investments Switzerland GmbH, Talacker 29, CH-8001 Zürich, Switzerland. Authorised and regulated by the FINMA. PRE Exp. 19 July

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