FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY NOT FOR RETAIL USE OR DISTRIBUTION Getting the best from your beta exposure AUTHORS Hamilton Reiner Head of US Equity Derivatives Rick Singh Portfolio Manager US Equity Group IN BRIEF As macroeconomic woes continue to unnerve global investors, August saw sharp spikes in volatility. Against this challenging market backdrop, investors are searching for strategies that can take advantage of volatility, and deliver more consistent and higher risk-adjusted returns. There are several alternative equity strategies long/short, options overlays and covered call writing designed to reduce portfolio risk through the use of shorting and options. Determining the appropriate strategy depends on the investor s strategic objectives, risk profile and desired beta exposure. This paper provides a broad overview of some of these strategies, with a particular focus on equity long-short and equity hedged approaches, as well as an analysis of their roles in asset allocation and investor portfolios. Long-short equity strategies can provide a liquid alternative to hedge funds, delivering attractive risk-adjusted returns by generating alpha from both long and short positions with a flexible net market exposure range. Alternative equity strategies that use hedging can make sense as part of a longterm strategic asset allocation plan. Because these actively managed hedges aim to provide higher risk-adjusted returns over long-only strategies, investors can use them to meet a variety of investment objectives, from de-risking and re-risking. VOLATILITY: CAN T LIVE WITH IT, CAN T LIVE WITHOUT IT Slowing growth and market uncertainties from China continue to put pressure on global equities, commodities, emerging market currencies, and high yield credit. As a result, developed market and emerging market equities have experienced their biggest drawdowns since the European debt crisis. Meanwhile, the CBOE/S&P 500 Volatility Index (the VIX), aptly known as the fear index, hit a four-year high in August 2015, with Exhibit 1 showing how volatility can hit the markets without warning.
As market turbulence rattled investors, the VIX hit a four-year high in August 2015 EXHIBIT 1: CBOE/S&P 500 VOLATILITY INDEX (VIX) S&P 500 Volatility Index (VIX) 60 50 40 30 20 10 By skilfully combining derivative-based approaches alongside fundamental research and sophisticated portfolio construction techniques, these strategies target higher riskadjusted returns relative to broad-based equity indices, capturing gains when the markets are rallying and cushioning the falls when the markets are dropping. The asymmetric risk profile provided by many alternative equity investing strategies can help investors stay invested in equities and participate in the stock market s growth rather than waiting for a break in market conditions. Let s take a closer look at six of the main strategies that make up the alternative equity investing world (Exhibit 3). 0 Aug 10 Feb 11 Aug 11 Feb 12 Aug 12 Feb 13 Aug 13 Feb 14 Aug 14 Feb 15 Aug 15 Source: CBOE/S&P 500 VIX; data as of 31 August 2015. Over a long-term horizon, markets rise more often than they decline. But intra-year drawdowns are an ever-present feature of the market, so investors who wait for a pullback in market conditions could see crucial return potential pass them by (Exhibit 2). Other than retreating to cash, there is no easy way for investors to protect their portfolios from every volatilityrelated eventuality. As a result, some investors are looking for opportunities provided by alternative equity strategies based on shorting and options to manage portfolio risk without significantly reducing equity exposure. TACTICAL BETA STRATEGIES In tactical beta approaches, managers use derivatives to tactically raise or reduce equity market exposure. This offers the greatest level of flexibility in market exposures, with some strategies having net exposure over 100%. While these strategies are built to benefit from price gains on stocks, they also strive to protect capital during volatile periods by using hedging strategies to vary the exposure to general market fluctuations. It usually pays to stay invested through volatile market periods EXHIBIT 2: S&P 500 INTRA-YEAR DECLINES VS. CALENDAR-YEAR RETURNS 40% 30% 20% 10% % -10% -20% -30% -40% 26 15-10 -17-18 -17 17-7 1-13 26 27 26 15 12 7 4 2-2 -8-9 -8-8 -7-6 -6-5 -9-20 -34 34-3 20 31 27 20-8 -10-8 -7-8 -11-12 -13-10 -14-17 -19-23 -30-34 26 9 3 14 4-38 23-28 13 0 13 30 11 YTD 0.2-4 -6-7 -10-16 -19-50% -60% '80 '85 '90 '95 '00 '05 '10 '15-49 Source: FactSet, Standard & Poor s, J.P. Morgan Asset Management; data as of 31 December 2014. Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 2014. 2 GETTING THE BEST FROM YOUR BETA EXPOSURE
Exploring the spectrum of alternative equity investing strategies EXHIBIT 3: CHARACTERISTICS OF EQUITY STRATEGIES ALONG THE BETA CONTINUUM STRATEGIC APPROACH TACTICAL BETA COVERED CALLS/ BUY-WRITE LONG/SHORT HEDGED EQUITY/ OPTIONS OVERLAY MARKET NEUTRAL Benchmark Equity index Equity index Equity index Equity index Cash Cash Objective Use active management to adjust the beta exposure as the market changes General income or partial cushion against losses, or both Provide attractive risk-adjusted returns by creating alpha on long and short positions Provide downside protection by applying an options based hedging strategy Neturalise equity beta exposure and deliver total returns solely from stock selection alpha Risk profile high Moderate Moderate Moderate Low Low Advantages Limitations Offers the greatest flexibility in market exposure Returns may be less predictable than other equity strategies Provides potential premium income and dampens volatility Tends to underperform in sharply rising markets May offer some downside protection by reducing overall market exposure Does not fully participate in up markets; may also introduce incremental idiosyncratic risk into the portfolio May provide systematic downside protection by using options to protect capital, while providing long exposure through underlying equities Forgoes some upside participation in return for downside protection Can provide uncorrelated market returns Can be difficult for managers to maintain beta of zero; limited upside in bull markets. May introduce incremental idiosyncratic risk into the portfolio Beta exposure Flexible 0.0 to 1.0 Flexible 0.6 to 0.9 Flexible 0.3 to 0.7 Flexible average 0.9 0.0-1.0 TAIL RISK/ NEGATIVE CORRELATION Provide hedge to volatility or left-tail events May provide shortterm hedges against sharp market deadlines Can be less reliable as a hedge if correlations break down; can be expensive Source: J.P. Morgan Asset Management; data as of 31 August 2015. Managers look at factors including valuation and market action to decide how much to vary the market expo-sure. Because the strategy s exposure to market fluctuations will vary depending on the manager s assessment of current stock market conditions, investment returns can fluctuate or deviate from the overall market returns to a greater degree than other funds that do not employ this strategy. But if the strategy has put a high degree of leverage in place and stock prices fall, losses could be bigger than anticipated. During the trough of the financial crisis, for example, many tactically orientated hedge funds reduced their equity market exposure and, as a result, missed out on the market s subsequent rebound. COVERED CALLS/BUY-WRITE STRATEGIES In a covered call, or buy-write, strategy, managers sell call options on stocks in a portfolio. The manager of the strategy sells options to generate cash, thereby guaranteeing a modest return from them. In essence, the investor is essentially selling other investors the right to buy these stocks at a certain price. Pros: The potential to help generate income and reduce portfolio volatility. Cons: The chance of missing out on big market gains, and losing money from losses on the underlying stock. The option premium received from selling the options can help reduce portfolio volatility and enhance income. But the trade-off is that the strategy reins in the potential for big gains. And investors are still exposed to the downside risk from owning the underlying stock, which may potentially lose its value. J.P. MORGAN ASSET MANAGEMENT 3
The approach typically outperforms equities in bear markets, as the option premium helps to offset losses, and underperforms in sharply rising markets. Depending on the strike prices of the calls strike prices, covered calls may also outperform when markets rise more modestly, as the premium income enhances less-than-strike-price gains. This can make it a useful option for conservative investors looking for added returns in a sideways market. Pros: Maximum flexibility in adjusting market exposure. Cons: Less predictable and more volatile returns than other equity hedging strategies. MARKET-NEUTRAL STRATEGIES Market-neutral strategies aim to deliver positive return across market conditions. This approach to capturing noncorrelated performance has the potential to increase returns, reduce risk and expand diversification when added to a portfolio of traditional assets. Professionally managed market-neutral portfolios use short and long positions in an effort to eliminate exposure to beta, or market risk. This can produce positive returns independent of the broad market if the portfolio s long positions outperform its short positions. For example, returns would be positive in rising markets if longs rise more than shorts. In declining markets, returns would be positive if longs fall less than shorts. In a market neutral strategy, therefore, the manager needs to maintain zero beta exposure to the overall market to avoid introducing any added risk or volatility into the portfolio. Pros: Aims to reduce overall portfolio risk and enhance return potential by neutralising exposure to broad market movements. Cons: Heavily reliant on manager skill in neutralising market movements. TAIL RISK/NEGATIVE CORRELATION Sometimes, market shocks are so extreme and unexpected that they trigger widespread declines in portfolios. Hedging the tails the end portions of distribution curves can help investors protect portfolios against outsized losses. Investors can use tail risk hedging in four key ways. First, they can limit asset allocation risk by weighting portfolios to less volatile sectors. Second, they can complement their asset allocation with option strategies or strategies that introduce asymmetric return patterns. Third, they can buy put options on indices such as the S&P 500. This is the most explicit and predictable way of hedging against tail risk and can work effectively as an insurance con-tract against any dramatic event. Fourth, they can invest in strategies or securities that are negatively correlated with equities, for example, by leveraging the negative correlation between the VIX and the S&P 500. Since the VIX tends to spike when equities sell off and fall when equity markets rally, in theory, buying VIX call options can offset losses in an equity portfolio. Since investors cannot invest in the VIX itself, these strategies invest in derivatives (futures or options) linked to the VIX. The VIX tracks the prices investors pay for options to protect themselves against swings in the S&P 500. An increase in those prices suggests an increase in investor anxiety and is also used as a short-term predictor of investor behaviour. However, historical correlations can break down, making the hedge less reliable. While the S&P 500 and the VIX usually swing in opposite directions about 80% of the time, this is not always the case. In addition, it can be difficult to make long-term gains when betting on volatility, making these investments more appropriate for short-term traders. Pros: Can provide short-term hedges against sharp declines in the stock market. Cons: Can be expensive for long-term investors; the hedge tends to be less reliable when correlations break down. 4 GETTING THE BEST FROM YOUR BETA EXPOSURE
LONG/SHORT EQUITY STRATEGIES Long/short equity strategies are designed to limit losses and protect assets during declining markets, while still capturing much of the market s upside potential. They use short positions to offset much, but not all, of their long holdings to reduce exposure to market risk. The idea is that the net long exposure helps capture part of the positive stock performance when the market is moving higher, while the short positions helps lower market risk and offer protection during difficult equity periods. Short positions give portfolio managers much more scope to add value by profiting from stocks that they don t like than in traditional long-only equity portfolios, where the ability to underweight stocks is constrained by benchmark weightings. More active money can therefore be focused on the portfolio manager s insights. In rising markets, long/short equity strategies are typically expected to deliver slightly less upside potential than longonly portfolios, but are likely to outperform long-only portfolios in difficult market environments. Pros: Can deliver higher risk-adjusted returns with lower volatility than long-only equity strategies. Managers can adjust to changing market conditions by varying their short exposures. Cons: In rising markets, long/short equity strategies could deliver less upside than long-only portfolios. JPMORGAN FUNDS - US OPPORTUNISTIC LONG-SHORT EQUITY FUND An equity alternative solution that complements traditional equity offerings. This opportunistically managed fund is designed to deliver strong uncorrelated risk-adjusted returns and lower volatility than traditional long-only equity portfolios, along with greater transparency and liquidity than traditional hedge fund vehicles. Combining a fundamental, bottom-up approach with highconviction stock selection, the fund enables the manager to actively manage the portfolio s gross and net exposure based on bottom-up portfolio construction and top-down macro considerations. Some managers rely on fundamental bottom-up research to make long and short directional bets. When a portfolio uses short positions to hedge its long exposure, stock selection can become a greater factor behind performance. Success depends on selecting long positions that are likely to appreciate more rapidly in rising markets and short positions that are likely to increase less than the long positions. As a result, long/short equity managers rely heavily on an intensive research effort to gather insights into stocks and generate sound investment ideas. HEDGED EQUITY/OPTIONS OVERLAY STRATEGIES Hedged equity, or options overlay, strategies aim to reduce risk by trading put and call options around an underlying stock index. These strategies are designed to produce higher risk-adjusted returns than long-only equity strategies, while minimising the impact of market disruptions or downturns. Some hedged equity strategies also give investors full exposure to alpha from an underlying actively managed equity index strategy, as well as dividends. But in return for providing significant downside protection, investors sacrifice some upside potential. Applying a hedged equity strategy can give investors precious peace of mind by providing consistent downside protection, especially during large, negative market moves. Because its limits are defined by the exercise price of the put and call options, it comes with a more defined and predictable range of investment outcomes than other long/ short strategies. Meanwhile, investors can benefit from lower exposure to the idiosyncratic risks that can come from shorting securities, as option positions act as a hedge to reduce the portfolio s exposure to beta. It s also a more cost-effective way to hedge an equity portfolio than shorting borrowed securities, with the costs of buying put options on the underlying equities to provide downside protection offset by income from the sale of call options. By smoothing out the bumpy ride during periods of market volatility, these strategies help investors stay invested, allowing their assets to growth over the long term. This is key given that the stock market, on average, goes up. Since 1928, the S&P 500 has gone up about two-thirds of the time, according to analysis by J.P. Morgan. But it s worth remembering that stocks generally take an escalator up and an elevator down. J.P. MORGAN ASSET MANAGEMENT 5
Crucially, the strategy can protect capital during market troughs so investors have less ground to make up. A 40% portfolio loss, for example, will require a 67% gain to get back to breakeven. And by minimising the impact of market volatility, the strategy helps investors stay invested, allowing their assets to grow over the long term. Pros: Potential for higher risk-adjusted returns relative to broad-based equity indices, plus capital protection in volatile markets. Cons: Significant downside protection can mean sacrificing some returns in rising markets. Stocks take an escalator up and an elevator down. Hedged equity strategies are designed to help investors stay invested during market volatility, capturing the gains they would otherwise have missed. Hamilton Reiner, Head of US Equity Derivatives JPMORGAN FUNDS - US HEDGED EQUITY FUND A liquid alternative solution bridging the gap between stocks and bonds J.P. Morgan s US Hedged Equity strategy typically has half the beta and volatility of the S&P. Since the strategy is expected to capture around two-thirds of the market s gains, mathematically speaking, it should result in higher risk-adjusted returns against a broad-based equity index. This gives more conservative investors a more controlled and disciplined way to participate in today s volatile markets. PORTFOLIO CONSTRUCTION: KEY CONSIDERATIONS Depending on investors objectives, equity strategies that use hedging techniques can be incorporated into portfolios in many ways. After the market gains in recent years, for example, many corporate pensions are looking to de-risk after an improvement in their plans funding status. These investors could move money out of traditional equities and into equity hedging strategies to limit potential drawdowns. Other investors, still scarred by recent market events and the global financial crisis, may be looking to ease back into the stock market. These investors could potentially move into lower volatility strategies by funding equity hedging positions out of other asset classes, such as fixed income. As a result, investors can gain greater equity exposure while maintaining a similar risk profile. Finally, investors looking to further diversify their investment line-up and reduce volatility could position equity hedging solutions as a fixed income substitute or as a liquid alternative by funding an allocation from their current fixed income investments. The caveat is that in times of severe market stress, investors may flee to fixed income for short periods as a defensive investment. 6 GETTING THE BEST FROM YOUR BETA EXPOSURE
CONCLUSION If the past few years have taught us anything, it s that volatility is set to remain a feature of the financial markets for some time to come. This has served as a timely reminder to investors that risk is as much a part of investing as reward. It has also refined the tools that enable investors to take a calculated risk one that is either acceptable for the returns they seek or tolerable for the returns they can live with. With multiple approaches to alternative equity investing available, investors need to carefully consider their objectives, risk profile and desired beta exposure when selecting an appropriate strategy. Successful alternative equity investing strategies start with an effective stock valuation and investment process. In addition, the complexities of managing options and short positions also require a set of unique and robust operational capabilities, as well as a portfolio team with the skills and experience in shorting and managing derivatives- and options-based strategies. By any measure, publicly traded equities have delivered a greater return than any other asset class over the long run. But as the markets have shown repeatedly, the difficulty for investors doesn t lie in the long run itself. It lies in the many short runs along the way. Rather than simply being swept along by the changing tides of market movements, face volatility head on with intelligent alternative equity investing strategies designed to optimise exposure to markets as conditions change and maximise risk-adjusted returns over the long term. Equities have outperformed other asset classes over the long run. But it s not the long run that matters; it s the short runs along the way. This is where alternative equity strategies can really prove their worth. Hamilton Reiner, Head of US Equity Derivatives J.P. MORGAN ASSET MANAGEMENT 7
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