Use of derivatives to provide capital protection
Background
Prescient has successfully used derivatives to provide capital protection in our Prescient Positive Return Quantplus mandate since inception in 1999. This fund is similar to a normal balanced fund in that it has exposure to a combination of equities, bonds and cash. However, It differs from a normal balanced fund in that it strives to deliver inflation beating returns over the long term without losing capital. To prevent capital loss derivatives are used to protect the value of the equities in the fund.
What is a derivative?
A derivative is a financial instrument, the price of which is linked to the movement of the price of an underlying asset. A multitude of different derivatives and derivative strategies are available to fund managers to either protect capital or to attempt to earn higher returns by taking on more risk.
Prescient normally uses a type of derivative called a put option to protect the value of equities. The most common put option used is the option on the FTSE/JSE Africa Top 40 index (index of 40 largest shares traded on the JSE) as it is the most liquid option listed on SAFEX (the SA futures exchange).
A put option is bought at a cost (called a premium) and is valid for a fixed period (for example one year). The end of the period is called expiry of the option. At expiry, the owner of a put option on the Top 40 Index has the right to sell the shares in the Top 40 index to another investor at a pre-determined price called the strike price.
How does put options provide protection?
Let’s assume you own the individual shares comprising the Top 40 index and to protect yourself you buy a one year put option on the Top 40 Index, with the strike price of the option equal to the current value of the TOP 40 index.
If the value of the Top 40 Index falls over the next year you can make a profit at expiry of the put option by buying the shares in the Top 40 Index at the then lower level and selling the Top 40 Index shares at the higher strike price. The profit you make in this way will offset the lost you suffered on the Top 40 shares you owned.
The protection does not only work at the end of the period. A SAFEX option is priced daily and any move in the Index value will be reflected in the price of the option, with negative moves in the Top 40 Index associated with an increase in value of the put option. However, if the Index value drops by say 10%, the value of the put option will not increase with the full 10%. The sensitivity of the option price to moves in the TOP 40 index price is called the “delta”. The portfolio will be protected in a market fall equal to the delta of the options. Should the value of the Top 40 Index remain below the strike price until the end of the period, the delta increases to a point where the fund is fully protected. In other words, should the Index declined over a 12 month period, the option acts to convert the equity exposure into cash at the strike price, effectively preventing any capital loss.
Conversely, should the Index continue to rise, the portfolio will participate in the upside via the equity exposure.
The cost of options depends on the volatility in the market, the higher the equity volatility the more the options will cost. This cost or premium will reflect as a reduction in the performance of the portfolio as it is paid to the seller of the option.
At times when the cost of the put options is high Prescient can sell a call option at a much higher strike price than the current market level. By selling such a call option Prescient earns income that offsets the premium required to purchase the put options. The effect of selling a call option is to place a limit (a cap) on the positive performance that the fund may experience over the period. By selling a call option the cost of buying the put option is reduced at the expense of giving some potential positive performance away.
Protection in practice
The investment process in the Prescient Positive Return Quantplus mandate starts by deciding how much exposure is required to each of the asset classes (equities, bonds and cash). This is done by comparing the growth potential and risk of each of the asset classes with each other and with their respective long term histories. The equity exposure is obtained through investing in the FTSE/JSE Africa Top 40 Index shares. Once the equity, bonds and cash positions are filled, Prescient buys Top 40 Index put options that (typically) expires in March of the next year to fully protect the equity position.
Over the next year, until expiry of the options, Prescient continuously monitor factors such as the sensitivity of the put options (effectiveness of protection), the cost of buying more protection, the attractiveness of selling a call option (a cap) to reduce cost of put options, etc. As the market is dynamic, the level of protection (the strike price or floor) must be raised as the market moves up. If this is not done, the gain in the portfolio is at risk down to the level of the protection.
The graph below illustrates the protection strategy followed in the Prescient Positive Return Quantplus fund. It shows the actual level of the FTSE/JSE Africa Top 40 Index (black line) and also the floor (green line) and cap (blue line) in the portfolio.
Dynamic strategy followed:
Consider the period from October 2001 to March 2003. At the start the protection in the fund was at 8 350 on the ALSI 40, the market then rose to 11 000 and then fell back all the way to 7 000. If the original protection level had stayed in place, i.e. 8 350, all the gains made to 11 000 would have been given back in the subsequent fall. However, following the green line, it is evident that the floor was lifted 4 times to 10 650. This ensured that gains made from 8 350 to 10 650 was locked in. Lifting the floor does cost the portfolio and the decision to lift the floor is a trade-off between extra return locked in and the cost of the additional protection. This will change from each move to the next depending on volatility and the prevailing interest rate. As a rule of thumb, normally the floor is lifted for every 10% move in the underlying market and the cost will range between 2% and 3% on the equity exposure.
Similarly, just as the floor must be lifted, it must also be lowered when the market falls. In the same example above, if the floor remained at 10 650 during the subsequent fall and also when it started to rise again (Sept 2003 onward), the portfolio would only have meaningful exposure once it has moved above the floor of 10 650. Therefore it is just as important to lower the floor to ensure that the portfolio participate in any upside from the new lower levels.
Following this process rigorously will result in inflation beating returns over time and also reduced volatility. It offers investors a way to invest in a portfolio with a meaningful return target, but where volatility is also addressed.
Performance of the Prescient Positive Return Quantplus Fund
From the tables below it follows that since inception, the Prescient Positive Return Quantplus Fund marginally underperformed a Balanced Fund with 65% exposure to the JSE Top 40. This was however achieved with a maximum drawdown 10 times lower than that of the balance fund and volatility half that of the balanced fund. On a risk–adjusted basis the Prescient Positive Return Quantplus Fund outperformed the Balanced Fund handsomely.
Return statistics for period ending May 2006*
Prescient Positive Return Fund / Balanced Fund** / JSE Top 40 Index / Inflation1 Year / 29.5% / 36.4% / 52.9% / 3.9%
2 Years / 22.6% / 31.9% / 43.7% / 3.9%
3 Years / 18.7% / 27.3% / 36.7% / 4.1%
5 Years / 16.1% / 17.4% / 19.4% / 5.7%
Since Inception
(1 Jan. 1999) / 18.5% / 20.9% / 23.7% / 6.3%
* All performance gross of fees.
** Simulated by combing 65% of ALSI 40 (JSE Top 40 index), 20% of ALBI (all bond index) and 15% of STEFI (cash index).
Risk Statistics for period 1 Jan 1999 to 31 May 2006
Prescient Positive Return Fund / Balanced Fund** / JSE Top 40 IndexMaximum drawdown*** / -3.9% / -22.9% / -34%
% Months with negative return / 19% / 38% / 39%
Standard deviation / 6.2% / 13.5% / 20.7%
Return per unit of risk / 2.9 / 1.5 / 1.1
Sharpe Ratio^ / 1.4 / 0.84 / 0.69
** Simulated by combing 65% of ALSI 40 (JSE Top 40 index), 20% of ALBI (all bond index) and 15% of STEFI (cash index).
***Maximum percentage decline
^Sharpe ratio is the excess return earned per unit of risk, where excess return is the fund return minus money market return. A higher number indicates better risk/return characterstics.