Option replication: an innovative approach to face a non-performing market environment Presentation for Mondo Hedge November 2010
Contents 1 Motivation to option replication 2 Illustrations of option replication strategies 3 Option replication in a CTA world 4 Summary 2
1 Motivation to option replication
Advantages of option replication Robustness (not fitted to historical data, no data mining) Parsimonious (few parameters) Transparent (strategy costs ex ante quantifiable) Consistent framework for improving the model (e.g. for reducing strategy costs) Easy to incorporate investor s objective One-step process ( signal generation and portfolio construction are merged) 4
Why do we replicate options? We replicate the option payoff profile by dynamically trading the underlying assets (exchange traded futures) We replicate option profiles that are physically not available We are able to incorporate additional features to reduce path dependency High flexibility and liquidity (add new instruments during the course of a year, handle flows into and out of the fund, etc.) 5
2 Illustrations of option replication strategies
A portfolio insurance strategy is implemented by the replication of a Protective Put Strategy performance 1. Portfolio insurance with fixed risk budget 2. Participation in upward trending equity markets Costs of the principal protection Payoff profile of the option (Protective Put) Price of the underlying Underlying 7
In 2008 exposure to stocks was reduced dynamically over time 110 100 90 80 70 60 50 100 80 60 40 Relative performance stocks vs. bonds Allocation in % Cash Portfolio insurance strategy Stocks 20 Stocks 0 Jan Feb March Apr May Jun Jul Aug Sep Oct Nov Dec 8 Sources: Thomson Reuters Datastream, Bloomberg, Metzler calculations. Historical simulation, based on market data Past returns are not a guarantee, warranty or a liable indicator for future results
Option replication strategies are easily expandable to the world of exotic options (e.g. rainbow options) Initial allocation End-of-year allocation Bonds 50 100 Stocks Stocks 50 100 Bonds 9
Replicating a rainbow option 20 Relative performance stocks vs. bonds 10 0-10 -20 100 80 60 Allocation in % Bonds 40 20 Stocks 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 10 Sources: Thomson Reuters Datastream, Bloomberg, Metzler calculations. Historical simulation, based on market data Past returns are not a guarantee, warranty or a liable indicator for future results
Replicating a rainbow option 0-10 -20-30 -40-50 -60 100 80 Relative performance stocks vs. bonds Allocation in % Bonds 60 40 20 Stocks 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 11 Sources: Thomson Reuters Datastream, Bloomberg, Metzler calculations. Historical simulation, based on market data Past returns are not a guarantee, warranty or a liable indicator for future results
3 Option replication in a CTA world
Investment approach 1. Broad diversification: the investment universe comprises 50 international equity, bond and currency markets Reduces dependency on single markets' development 2. Long/Short: declining markets result in short positions. Rising markets generate long positions respectively Reduces dependency on the direction of markets 3. Option replication model: target return is explicitly built into the algorithm. Maximizes the likelihood of achieving the excess return target 13
Single strategy in a bear market environment DAX futures 2002 110 90 70 Performance DAX futures 50 5 Allocation in % 0-5 -10-15 3 2 1 0-1 Performance DAX strategy Procyclical Jan Feb March Apr May June July Aug Sep Oct Nov Dec 14 Sources: Thomson Reuters Datastream, Bloomberg, Metzler calculations. Historical simulation, based on market data Past returns are not a guarantee, warranty or a liable indicator for future results
Single strategy in a bear market environment continued 1 DAX futures 2002 110 90 70 Performance DAX futures 50 5 0-5 -10-15 3 Anticyclical 2 1 0-1 Allocation in % Target performance contribution Performance DAX strategy Jan Feb March Apr May June July Aug Sep Oct Nov Dec 15 Sources: Thomson Reuters Datastream, Bloomberg, Metzler calculations. Historical simulation, based on market data Past returns are not a guarantee, warranty or a liable indicator for future results
Single strategy in a bear market environment continued 2 DAX futures 2002 110 90 70 Performance DAX futures 50 5 Allocation in % 0-5 -10-15 3 2 1 0-1 Performance DAX strategy Target performance contribution Jan Feb March Apr May June July Aug Sep Oct Nov Dec 16 Sources: Thomson Reuters Datastream, Bloomberg, Metzler calculations. Historical simulation, based on market data Past returns are not a guarantee, warranty or a liable indicator for future results
Each market strategy is divided into 12 rolling sub-strategies (DAX future) 125 DAX performance in January 2008 DAX future allocation in January 2009 100 75 DAX strategy January 50 Cumulated DAX future allocation 25 11/07 12/07 1/08 2/08 3/08 4/08 5/08 6/08 7/08 8/08 9/08 10/08 11/08 12/08 1/09 2/09 3/09 11/2007 1/2008 3/2008 5/2008 7/2008 9/2008 11/2008 1/2009 3/2009 17 Sources: Thomson Reuters Datastream, Bloomberg, Metzler calculations. For the period to March 11, 2008: historical simulation based on market data Past returns are not a guarantee, warranty or a liable indicator for future results
Metzler s option replication and its peers performance since inception Performance March 2008 to September 2010 116 114 Nordea1 Heracles LS strategy, return 13.68% 112 110 108 106 104 102 100 98 96 CS Tremont Managed Futures index*, return 8.06% 94 3/2008 9/2008 3/2009 9/2009 3/2010 9/2010 18 * EUR return Sources: Thomson Reuters Datastream, Bloomberg, Metzler calculations. The quoted performance is net of fees (15% outperformance fee; until March 2009 1% management fee, since April 2009 1.2% management fee) and regardless of other charges (i.e. sales load) Past returns are not a guarantee, warranty or a liable indicator for future results
4 Summary
Heracles Long/Short the unique selling propositions No return forecasts involved in alpha-generating process replication of option strategies Daily liquidity, no lock-up period, no redemption fee Target return is explicitly taken into account by the strategy maximizes the likelihood of attaining the excess return target High multi-dimensional diversification along asset classes regions timeline The strategy is uncorrelated to common investment strategies 20
Nordea 1 Heracles Long/Short MI Fund Fund facts: BI-EUR share class (institutional investors) Fund category ISIN code Dividend type Management fee Performance fee Umbrella Custodian Investment manager Recommended holding period Absolute return LU0375726162 (BI-EUR) Accumulating 1.2% p.a.* 15%** of annual outperformance vs. Euribor ("High Watermark" and "Hurdle Rate") Nordea 1, SICAV Nordea Investment Funds S.A. Metzler Asset Management GmbH Mid- and long-term * Valid from 23 rd of March 2009 **Percentage of the annual outperformance in comparison to the Euribor (High watermark and hurdle rate method). Criteria for the calculation of the performance fee are the so-called hurdle 21 rate, a benchmark for the performance of the fund, and the so-called high watermark, that is the highest fund price achieved so far at the end of the year. The Euribor is used as the hurdle rate for the Nordea 1 Heracles Long/Short MI Fund. If the performance of the fund is greater than this at the end of the year, the first criterion for payment of a performance fee is fulfilled. If the fund price is, moreover, higher than the highest annual end-of-year value ( high watermark ) ever reached by that point in time, the portfolio management has fulfilled both criteria for the payment of a performance fee.
Important note This document contains information obtained from public sources, which we deem to be reliable. However, we cannot guarantee the accuracy or completeness of such information. Metzler reserves the right to make changes to the opinions, projections, estimates and forecasts given in this document without notice and shall have no obligation to update this document or inform the recipient in any other way if any of the statements contained herein should be altered or prove incorrect, incomplete or misleading. This document is provided for information only and is not geared to the specific investment objectives, financial situation or needs of individual recipients. Before acting on the basis of the information or recommendations contained in this document, the recipient should consider whether the decision is suitable for his or her personal circumstances and should take independent investment decisions on the basis of his or her financial situation and investment objectives, where necessary with the assistance of an independent financial advisor. This document does not constitute an offer or any part of an offer to buy or sell financial instruments, nor does it form the basis for any contract or any obligations. Neither Metzler nor the author accepts any liability for this document or the use of their contents. Past performance cannot be regarded as an indicator of future performance and thus cannot be regarded as a basis for decisions on investing in financial instruments. Investment income is subject to fluctuation; the price or value of any financial instruments described in this document may rise or fall. The model calculations contained in this document are examples showing the possible performance of a portfolio and are based on various assumptions (e.g. on earnings and volatility). The actual performance may be higher or lower, depending on market trends and whether or not the assumptions underlying the model calculations prove correct. Accordingly, actual performance cannot be guaranteed, warranted or assured. Moreover, the actual performance of a portfolio depends on the volume of the portfolio and the agreed fees and other expenses. This document or parts thereof may not be copied, reproduced or distributed without Metzler s prior written consent. By accepting this document, you declare that you agree to the above conditions. 22