As traditional income options shrink, volatility offers an alternative
Chad Padowitz
Investors’ instinct to treat volatility as something to avoid rather than a potential source of return could mean they are overlooking valuable income opportunities, according to Talaria Capital co-CIO Chad Padowitz.
At a time when traditional sources of income are changing, Padowitz says investors should look beyond yield alone, with liquidity, transparency and the source of return all important considerations.
“Investors spend enormous energy trying to avoid volatility, when they could be focusing on how to get paid for it,” Padowitz says.
The opportunity lies in the difference between the volatility investors expect in equities and the volatility those equities ultimately experience. This difference, known as the volatility risk premium (VRP), can be accessed through listed equity options markets.
Put options provide investors with protection against falling share prices. The buyer pays a premium for that protection, much like an insurance premium. Historically, the volatility implied in the prices of equity options has tended to exceed the volatility subsequently realised by the underlying shares. Investors willing to provide that protection can seek to capture the difference as an additional source of return.
“People are willing to pay to make uncertainty go away, even when the price of that certainty is high,” Padowitz says.
“With APRA’s phase-out of bank hybrids and some of the challenges emerging in private market strategies, investors are looking for alternative sources of income that retain liquidity and transparency.
“Volatility strategies won’t replace every source of income that is disappearing, but they can help fill the gap while providing a source of return that is differentiated from traditional equities, bonds and many alternatives.”
Rather than trying to predict which direction markets will move, Talaria seeks to capture the volatility risk premium by selling fully cash-backed put options over high-quality companies its investment team is prepared to own.
Periods of elevated volatility can make this opportunity more attractive. As uncertainty rises, investors are typically willing to pay more for downside protection, increasing the premiums available to those prepared to provide it.
Talaria’s strategy also combines the volatility risk premium with the equity risk premium — the long-term return available from owning equities — giving investors access to two distinct sources of return.
“When markets are uncertain, investors naturally feel most uneasy. But that is also when the opportunity to earn income from providing protection can become most attractive,” Padowitz says.
Importantly, volatility at the individual company level can behave very differently from volatility across the broader market. Talaria believes the ability to identify and exploit these differences is an important advantage of active management.
That distinction may be becoming increasingly important. The environment that rewarded investors for simply maximising exposure to rising markets may be giving way to one in which security selection — what you own, and the price you pay for it — matters more.
“Getting paid for volatility only works as a long-term strategy if you are equally disciplined about the quality of what you own and how much risk you are taking on to earn that premium,” Padowitz says.
“Retirees and income-focused investors are increasingly being asked to take on more risk in the search for income. Volatility, treated carefully and within a disciplined investment process, is one area we think deserves much more attention.”
