Posted on 08 November, 2010 | 76 Comments
Long-only portfolio managers traditionally manage risk through asset allocation strategies that concentrate on finding a balance between equity, fixed income, and cash. Portfolio managers wanting to minimize volatility generally do so by increasing exposure to fixed income products while simultaneously underweighting equities.
But what happens when demand for seemingly safe fixed income investments, such as government and investment grade bonds, drives prices up to ‘bubble’ territory. Shifting assets out of equities and into an inflated asset class such as bonds does little to minimize risk.
Here, long-only portfolio managers are handcuffed – constrained by the fact that the fixed income alternative is in fact no alternative at all. That leaves cash as the only substitute for equities. Of course, cash tends to be dead weight. And while there may be times that sitting on cash makes sense, investors simply do not need to pay professional money managers to hold onto cash.
This is where option licensed portfolio managers outperform their long-only counterparts – not only in higher returns but in managing the overall risk profile of the investment portfolio. Suitably designed options strategies can add considerable value to a tactical asset allocation program.
Rather than change asset allocations in order to modify risk profiles, option licensed portfolio managers can use puts and calls to preserve capital, enhance income, and reduce market volatility without having to sell equities outright.
Many unsophisticated investors see derivatives and options as instruments used to increase, rather than to reduce risk. Nothing could be further from the truth. Investors interested in prudent risk management strategies should be looking at option instruments including puts and calls.
Buying plain vanilla puts are similar to buying portfolio insurance and protect investors against a market fall. These type of instruments are great for conservative investors who want capital preservation. Not only do puts provide a floor in the event that the market falls, but they allow investors to enjoy all the benefits of a rising market as well as any dividend payouts. In this environment, where fixed income instruments are overpriced and bond yields offer next to nothing, maintaining equity exposures with put protection is the way to go.
In addition to buying puts, income oriented investors can also consider option strategies including covered calls and collars. These strategies are a tad more complicated than simply buying puts. That said, they are not beyond the reach of ordinary investors who have been brainwashed to think that risk profiles are based on asset allocation.
Make no mistake, there’s a real bond bubble forming and unfortunately many conservative investors are on the verge of a rude awakening. Whereas the stock market crash of 2007 punished greedy, risk seeking investors, this time around it will be conservative, risk-averse investors who take the hit. Protect your portfolio with options.
Jeff Kaminker
Frontwater Capital
November 8th, 2010 at 6:47 pm
[...] This post was mentioned on Twitter by Frontwater Capital, Frontwater Capital. Frontwater Capital said: Long-Only Portfolio Managers Just Can't Compete w/ Option Licensed; Read the latest from #Frontwater http://www.fwcapital.ca http://bit.ly/a7Crdr [...]
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