After enduring the Global Financial Crisis (GFC), investors around the world reflected on the lessons learnt and started asking how they could better protect their portfolio should such a catastrophic event reoccur.

It is commonly accepted that any time out of the market will likely reduce portfolio returns. This is partly true as the market tends to go up in the long run, and an allocation to cash erodes the portfolio performance in a rising market. The age-old adage of “time in” versus “timing” the market still rings true today. But avoiding downturns and preserving capital will always create a better long term investment outcome, due to the effects of compounding.

The rising need for both portfolio protection and maintaining market participation has prompted investors to look at different types of protective portfolio overlays. Here, we compare two main types of overlays – futures or options based. We look at how they perform in different market scenarios, and which one suits investors’ needs best.

Why the type of overlay is important: Options or Futures?

Futures definition: Agreement to buy or sell a specified asset, at a future date, at an agreed price. Futures are a type of derivative.

Options definition: A contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date. Options are a type of derivative.

The goals for both futures and options overlay strategies are often similar:

• To maximise the return of your portfolio in all market scenarios;
• To limit portfolio losses in falling markets; and
• To reduce the volatility of the overall portfolio.

Before selecting a particular overlay strategy, investors must understand the pay off profile of the overlay, and how the overlay performs under different market scenarios. Options and futures overlays differ significantly in terms of the extent of protection, as well as the flexibility of protection.

Cost is another major differentiating factor when selecting between options-based and futures-based overlay. An option has an initial cost, whilst a futures contract has an opportunity cost.

What is an options overlay?

Specifically, a protective options overlay is a dynamic strategy that aims to reduce the impact of market falls on portfolio value. Strategies that utilise options act much like an insurance policy. The purchaser pays a premium to protect against a potential loss. A portfolio manager can employ different combinations of options to construct a bespoke protective overlay that suits each investment fund’s risk profile.

A put option pay off profile is asymmetric. This is the key difference between options and futures; protecting the downside and preserving the upside at the same time. Below is a simple put option payoff diagram.

In constructing an option portfolio, using either index or single stock options, a portfolio manager can create a payoff profile to suit an investors’ desire for upside participation and downside protection.

What is a futures overlay?

A futures overlay is a protection strategy that aims to reduce the impact of market drawdowns on investor capital.

The most important attribute of a futures strategy is that it has a symmetric payoff profile, as demonstrated in the diagram below.

Being symmetric in nature, it means that futures only offer investors a binary outcome i.e. equal amount of upside and downside risk. This is in contrast to a long options position, where downside risk is limited to the option premium paid, like an insurance policy.

It can be argued that a futures overlay is essentially an asset allocation tool. A futures overlay is managed in either a “risk-on” or “risk off” fashion, where the manager will move away from the risky asset and effectively increase cash exposure by selling futures.

One type of futures overlay acts as a volatility-targeting strategy. In a volatility-targeting strategy, as market volatility rises to around its long run average level, the futures overlay algorithm signals this as stress building in the system and decreases exposure to the market by selling futures. This sell decision will end up being either correct, or incorrect; i.e. if markets fall, the protection decision is correct. However if markets continue to rise, this decision is incorrect and costs any additional portfolio performance that would have been gained.

What is the difference between the overlays?

A futures overlay is a market timing device, while an option overlay is a risk management tool.

There are times where both options and futures overlays work similarly. In falling markets, both strategies will limit the effect of a falling market to varying degrees.

However, the main difference is that options have convexity (i.e. gamma) whereas futures do not. As markets fall, options increase in their effectiveness of cushioning downturns, whereas a futures exposure will remain constant. In a rising market, a put option will become less impactful on a portfolio exposure, such that the portfolio can increasingly participate; a futures contract will retain the effective short weighting. An options overlay will not penalise investors to the same extent for misjudging the market direction. The most investors can lose is the option premium.

Further, a futures overlay should not be treated as a hedge. While the strategy can provide an offset in dislocated markets, on the whole they are non-correlated. A futures overlay also requires a certain amount of time to sell futures. This makes them vulnerable to rapid reversals or the sudden onset of volatility. An options overlay is strongly negatively correlated to the underlying asset. It does not rely on market timing, thereby providing constant, definable protection. It is therefore a better hedge.

Effective exposure

The effective exposure of a portfolio is the amount of the portfolio exposed to the risky asset (in this example the ASX 200).

Below is an example of the differences between the effective exposure of a futures and options overlay strategy between 2008 and 2014. The ASX 200 is the green line and indicates its total return over this time period. The red line shows the option overlay’s effective exposure and the blue line the futures overlay effective exposure with a volatility target.

Negative market: e.g. January 2008 – March 2009: The ASX 200 is falling rapidly. Both futures and options overlay strategies are decreasing their effective exposure as the market falls. The key here is that the effective exposure change of the options is happening organically. That is to say, the delta of the put options is increasing as the market falls. The futures overlay effective exposure is decreasing because the strategy is selling futures. Most of the time the futures strategy is selling low when volatility spikes, and buying high as volatility subsides. Intuitively, this is not the ideal way to enhance portfolio return.

Positive market: e.g. March 2009 – March 2010: The ASX 200 line is moving upwards throughout this period. We can see a volatility targeted futures overlay (blue line) is not as quick to increase its effective exposure.

Flat/Sideways market: e.g. March 2010 – December 2012. The ASX 200 is flat but relatively volatile over the time period. Futures effective exposure (blue line) is more volatile than that of the options overlay (red line). The options strategy is adding more value as the overshoots are less frequent and effective exposure is changing without the buying or selling of assets.

Expected return profile

The chart below outlines the differences between the futures and options strategies against market returns. You can see what the volatility in the futures strategy (blue line) can do to a portfolio’s returns over time – by design it does not participate fully in market rallies. This erodes any positive performance during market declines and tends to limit your portfolio to a market like return over the long run.

In contrast, the options overlay (red line) provides a more stable return on your portfolio, enabling you to lock in the gains achieved in down markets and utilise these in a compounding effect when markets are positive.

Risk adjusted return

The table below shows the options overlay has the highest risk-adjusted return (i.e. information ratio), compared to the futures overlay and ASX 200 with no overlay.

The overall portfolio volatility of the options overlay is slightly higher than the futures overlay, however the return per annum is more than 1.5 times as much, therefore the information ratio is significantly higher than the futures overlay, and is twice that of the ASX 200.

Conclusion

The goal of both options and futures overlay strategies is to protect a portfolio in a falling market. This can be achieved using both approaches. However, we have found that a futures overlay pays for this protection by sacrificing participation in a rally, and long term returns tend to revert to market returns. Further, the futures overlay strategy is not correlated to the market, so its protection is uncertain and cannot safely be considered a hedge.
On the other hand, due to its asymmetric payoff profile and convexity, an options overlay strategy gives investors the ability to add value through active and dynamic hedging. The risk profile over time is improved significantly by reducing the downside volatility, and the upside returns can be preserved.
In conclusion, we believe constructing a protective overlay using liquid, exchange-traded options is the safer and more efficient way to manage portfolio risk.

Dan Bosscher, Portfolio Manager, Perennial Value Management

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Disclaimer: Issued by the Investment Manager, Perennial Value Management Limited, ABN 22 090 879 904, AFSL: 247293. Responsible Entity: IOOF Investment Management Limited ABN 53 006 695 021, AFSL: 230524. This promotional statement is provided for information purposes only. Accordingly, reliance should not be placed on this promotional statement as the basis for making an investment, financial or other decision. This promotional statement does not take into account your investment objectives, particular needs or financial situation. While every effort has been made to ensure the information in this promotional statement is accurate; its accuracy, reliability or completeness is not guaranteed. Past performance is not a reliable indicator of future performance.

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We upgraded two funds, the Latrobe Australian Mortgage Fund-Pooled Mortgage Option to four stars and the Australian Unity Mortgage Income Trust to three stars. We removed from ‘On Hold’ and assigned a three-star rating to the Challenger Howard Mortgage fund.

We only rate one fund as two stars, the OnePath OA IP-OnePath Mortgage Tr No. 2 fund, which OnePath Funds Management has decided to compulsorily return capital to investors over the next three to five years.
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S&P Fund Services analyst Peter Ward said: “We have not seen a uniform approach among mortgage fund managers or consistent timing in resolving liquidity issues. We consider this to be a reflection of the different underlying investor base, underlying investments, and different managers’ mortgage fund sector outlook.”
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“Three funds, managed by Australian Unity, Challenger, and OnePath have changed their redemption mechanisms. Each solution has provided improved certainty, but outcomes differ. The changes have contributed to our decisions to upgrade the Australian Unity fund to three stars from two stars and to resolve the long-standing ‘On Hold’ ratings on the Challenger and OnePath funds,” added Mr. Ward.
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Key areas of focus during this review included fund managers’ product strategies, investment team continuity, liquidity and redemption provisions, lending competition and margins, portfolio credit quality/arrears and defaults, and fees.

Click for a full list of funds rated in the S & P Australian Fixed Interest – Mortgages Peer Groups

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The value of daily cash market trading in April was down slightly on the previous month’s strong performance, with an average traded value of $5.8 billion a day.

Activity in interest rate futures contracts continued its upward trend, although well down on the strong March expiry month, with trading during April in the four main contracts (3 and 10 year bonds, 90 day bank bills, and the 30 day cash rate) recording a daily average of 268,770 contracts traded.

AUSTRALIAN SECURITIES EXCHANGE

Listings and capital raisings

• In April 2011 there were 11 new listings, 57% higher than the 7 in the previous corresponding period (pcp).
• Total listed entities at the end of April 2011 were 2,238, up 3% on the 2,181 a year ago.
• There was $330 million of initial capital raised in April 2011, compared to $2.5 billion in the pcp.
• Secondary capital raisings in April 2011 increased significantly, with $6.1 billion raised, compared to $3.6 billion in the pcp. There was also $3.0 billion of other capital raised including scrip-for-scrip in April 2011.
• Total capital raised in April 2011 amounted to $6.4 billion, up 7% on the $6.0 billion raised in the pcp.
• For the financial year-to-date, total capital raised is down 26%, with capital raised from IPOs $23.5 billion and from secondary raisings $29.9 billion.

Trading – Cash markets (including equities, interest rates and warrants trades)

The All Ordinaries Index closed at the end of April at 4899.0 points, a fall of 0.6% over the course of the month. The index has risen 1.1% in the calendar year-to-date.

• Total cash market trades for April 2011 were 11.2 million, up 16% on the pcp.
• Average daily trades for April 2011 of 620,473 were 22% higher than the pcp.
• Total cash market traded value was $103.8 billion in April 2011, down 7% on the pcp mainly due to one less trading day. The daily average value traded was $5.8 billion in April 2011, down 2% on the pcp.
• In April 2011 the average value per trade was $9,296, down 19% on the pcp of $11,540. The percentage of traded value crossed was 28% (28% pcp).

Trading – Financial derivatives markets

• Strong turnover was seen in all benchmark interest rate futures contracts in April, even though volatility in markets declined compared to March where heightened volatility accompanied a number of major natural disasters.
• The RBA left the official cash rate unchanged at its April meeting. Market expectations of future policy changes were also largely unchanged over the month leading to narrower daily trading ranges across all contracts. Most key economic data was in line with expectations, with the exception of the stronger than anticipated CPI which created some volatility on the day of release.
• Commodity markets and the Australian dollar rallied throughout the month, with the dollar hitting a new post-float closing high of $US1.09.
• Equity derivatives volume (excluding the ASX SPI 200) for April 2011 was 1.9 million contracts, up 3% on the pcp, with a daily average of 103,067 contracts, up 8% on pcp.
• Total futures and options on futures contracts volume (excluding equity derivatives and CFDs) for April 2011 was 6.1 million, up 12% on the pcp, with a notional value of $3.1 trillion. Average daily contracts volume during April 2011 of 323,304 was up 18% on the pcp.       Page 3 of 6
• A total of 5,778 ASX CFD trades were transacted in April 2011, comprising a volume of 14.1 million contracts. The total notional value of all CFD trades for April was $218.4 million, a decrease of 8% on the pcp, while the value of CFD open interest at the end of April was $77.6 million, a decrease of 34% on the pcp.

Trading – Energy and agricultural derivatives markets

• A total of 12,587 Australian electricity futures and options contracts were traded in April 2011, a decrease of 22% on the pcp. Total open interest was 40,905 contracts at the end of April 2011.
• The ASX grain futures and options market traded 20,868 contracts (417,360 tonnes) during the month, down 21% on the pcp. Open interest at the end of April 2011 of 87,784 futures contracts represents 1.75 million tonnes of Australian grain and oilseed.

ASX CLEARING CORPORATION

Clearing

All on-market trades (equities and derivatives markets) are novated by ASX’s two central counterparty clearing subsidiaries, ASX Clear and ASX Clear (Futures), which act as counterparties to those trades and replace bilateral counterparty exposures.

• Total margins (including additional margins held against stress testing exposures and concentrated large positions) averaged $2.8 billion during April 2011 (including excess cash collateral but excluding equity securities lodged in excess of the margin requirement), with cash margins lodged averaging $2.2 billion.
• There were intraday margin calls made on two separate days in April 2011 totalling $8.0 million compared to intra-day margin calls in March 2011 totalling $75.8 million.

ASX SETTLEMENT CORPORATION

ASX Settlement

There were no delays to the completion of batch settlement in the equities market during April 2011.

• Total equity settlement delivery fail rates averaged 0.7% per day during April 2011 (no change from March 2011).

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CMC Markets and optionsXpress Australia, a leading online derivatives trading firm, today announced a new partnership for CFDs and share trading that is set to transform the education and broking experience for investors.

The partnership includes the entire optionsXpress Australia family: HUBB Financial, Safety in the Market, optionsXpress and Optionetics.

optionsXpress has chosen to partner with CMC Markets because of the advanced and flexible nature of CMC Market’s Application Programming Interface (API) and wide range of investment tools and products. CMC Markets will provide optionsXpress with the flexibility to offer multiple front ends based on the needs of the individual client.

The partnership means that all optionsXpress Australia clients will automatically have access to trading solutions such as CFDs and shares, and can act on whatever trading signals are generated by optionsXpress’ state of the art Profit Source and Integrated Investor platforms encompassing signals based trading.

“This partnership expands the relationship between the Australian subsidiaries of both firms, which have been delivering unique investment opportunities for traders in Australia for several years now. The agreement we now have in place delivers on optionsXpress’ goal of making it easy for everyday investors to trade derivative products,” said John-Paul Drysdale, Managing Director of optionsXpress Australia.

“We are proud to offer CFDs to optionsXpress Australia’s traders and investors, and to be able to give our clients an important asset class as part of their plans to grow their wealth,” said Mr Drysdale.

“The appeal of working with optionsXpress is that they have a large and loyal client base, both domestically (with HUBB Financial) and overseas. The fact that optionsXpress’ clients were clearly dedicated to the company, across several continents, was a very positive sign to CMC Markets,” said Jamie Clinnick, Head of Partners (Wholesale) Australia and New Zealand at CMC Markets.

“CMC Markets is a strong advocate of trading and investment education and this partnership gives CMC Markets even stronger education options to potentially offer to its own clients, that optionsXpress can support,” said Mr Clinnick.

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Distinction between Warrants and Options

Option contracts are standardised, but there is a wide range of warrant types. Offerings from the different issuers vary significantly, and each warrant has its own distinct terms and conditions. The issuers of warrants must produce a disclosure document (PDS) for each warrant it offers. It is essential for investors to read and fully understand these documents before investing. Of course it is equally important for an adviser to do the same before advising a client to acquire any particular security, to satisfy the “know your product” requirement.

Warrants may be either call warrants, where the holder has the right to buy an asset at a predetermined price by or at a predetermined date, or put warrants where the holder has the right to sell an asset. Unlike options, investors are unable to write (short sell) warrants.

Underlying Assets

Warrants are issued over a variety of underlying assets. These include:

• individual shares
• baskets of shares
• share market indices
• commodities
• currencies

Trading and Investment Warrants

Warrants are generally classified as either “trading warrants”, designed for investors with shorter term investment horizons, or “investment warrants” for investors looking to gain longer term exposure to an underlying asset. Trading warrants tend to be higher risk/return than investment warrants. The distinction between the two categories is not always clear-cut, and some warrants may have features of both types.

Trading warrants include:

• equity put and call warrants
• equity barrier warrants
• currency warrants
• index warrants
• commodity warrants

Investment warrants include:

• instalments
• capped warrants
• basket warrants
• endowments
• structured investment products (ALPS, YIELDS)
• premium income warrants (PIES)

The diversity of structures, underlying assets and payoff profiles is one of the features of warrants that make them attractive to investors. However, as a result of this diversity they also present a fairly complex mix of risk/return profiles and strengths and weaknesses. Whether a particular warrant instrument is appropriate for a particular investor will depend upon the structure and terms of the instrument and the profile and investment goals of the investor.

Warrant Terms and Pricing Variables

Unlike options, warrants do not have standardised contract terms. However, depending on the type of warrant, the warrant price is influenced by many of the factors that affect option premiums, including:

• spot price of the underlying instrument
• strike price
• volatility of the underlying investment
• interest rates
• dividends

These variables may have different effects on different warrant types. For example, some warrants, such as instalments, entitle the holder to the dividends paid on the underlying investment. A dividend payment will therefore affect an instalment differently from a trading warrant, where the holder is not entitled to the dividend.

Other Warrant Variables

While the variables listed above are common to both options and warrants, there are a number of others that may be unique to warrants. These include:

• settlement terms—warrants may be deliverable by transfer of the underlying instrument or they may be cash settled
• conversion ratio—the number of warrants that must be exercised to enable delivery of one unit of the underlying instrument. All else being equal, the higher the conversion ratio, the lower the warrant price. To calculate the warrant price on a per share basis, multiply the price by the conversion ratio. For example, a warrant with a conversion ratio of 4:1, that is trading at $0.10, is worth $0.40 on a per share basis
• covering—a covered warrant is one offered by an issuer who holds the underlying instrument in a legal structure on behalf of the holder. The existence of physical cover reduces the counterparty risk faced by the investor
• index multiplier—this is applied in the case of index warrants to determine the amount to be paid to the investor at expiry
• cap levels—this refers to the upside cap placed on some warrant series that limit the investor’s return. Essentially, this represents an option written back to the issuer by the investor that is embedded in the structure. All else being equal, a capped warrant will trade at a lower price than an uncapped warrant
• barrier levels—these are defined levels, the breach of which causes some event to occur. Some barriers may cause a warrant to terminate before the original expiry date while others may cause an adjustment to the exercise price
• assessed value payment (AVP)—unlike options where the failure to exercise an in-the-money option at expiry results in the complete loss of the option’s value, the warrant issuer will make a payment to the holder if an in-the-money warrant expires unexercised. If the warrant is deliverable, the issuer must pay the holder an AVP, which is the warrant’s intrinsic value less reasonable costs. If the warrant is cash-settled, 100 percent of the intrinsic value must be paid to the holder.

Advantages and Disadvantages

Advantages of using warrants include:

• convenient gearing—there is no need to arrange a credit facility
• a wide variety of instruments to meet a range of both speculative and longer term investment objectives
• depending on the terms set out by the issuer, a holder of a warrant may be entitled to receive dividends and franking credits
• the ability to extract cash from physical share portfolios by transferring them into instalment warrant instruments
• innovative structures that allow the targeting of high-income yields
• tradeable on ASX
• ASX oversight of market
• tax benefits, depending upon the type of warrant and the investor’s individual circumstances
• time to decide for the buyer of the warrant, until expiry, whether or not to take delivery of the underlying securities (or if cash settled, await expiry)

Disadvantages and risks of using warrants include:

• the diversity of non-standardised structures can make it difficult for investors to compare offerings over the same underlying assets
• some warrant structures are quite complicated and require a high level of investment sophistication to fully understand the payoffs and costs
• the absence of a central counterparty means that investors face higher credit risk than with other exchange-traded instruments
• depending upon the popularity of particular issues, liquidity may be quite low
• the inability of investors to write warrants may inhibit the arbitrage mechanism that generally acts to ensure fair pricing in derivatives markets
• warrants entail significant costs for issuers, including the maintenance of an investor register, client services function, regular issue of new instruments, provision of finance, compliance with ASX Market Rules and managing and hedging their market exposures. These costs must be passed on to investors and may make them expensive when compared to other structures
• limited life of warrants may mean that the expected price movement does not occur before expiry

Warrants versus Options

While options and warrants share many characteristics, there are significant differences. The following table sets out the main differences.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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