The recent experience of London-based 7IM has shown that portfolio insurance can still play a role in reducing the impact of downside volatility on portfolio returns.
The opportunistic purchase and sale of a put option on the EuroStoxx 50 index within the past week produced a 60 percent return for 7IM’s balanced portfolios.
Although this has almost certainly not fully mitigated the extent of the damage wreaked by recent market falls - the put option only accounted for 0.1 percent of total net asset value (NAV) - it will have provided a partial cushion. Moreover 7IM has a put position struck further down on the EuroStoxx and another on the S&P 500 to provide protection against any further falls.
“Following the moves seen in markets yesterday, we have taken profits on one of our EuroStoxx 50 put options,” said Ben Kumar, a 7IM investment manager. “The fall in equity markets and the rise in volatility gave us the chance to take a profit on a position that had been implemented to protect against these sorts of events. Admittedly, we hadn’t seen them occurring within five days of purchase.
“We had spent 0.1 percent of our balanced portfolios’ NAVs last Thursday (1 February) with the put struck at 3450, around five percent below the market level at the time. This option was due to expire in December of this year, giving a sense of our expected time horizon. However the violent moves on Monday and Tuesday quickly saw the option become ‘in the money’, so yesterday (6 February) we exited the position. Overall we had spent £6.6 million on premium, and we sold for a total of £10.6 million – a 60 percent return.
“Whilst we are not in the habit of switching in and out of positions in the space of a few days, in this case we felt that taking profits was the sensible approach. We still have two put options in the portfolios, one struck further down on the EuroStoxx and one on the S&P 500. The intention is that these could continue to protect portfolios if we see another sharp move downwards.
“With markets still unsettled we are now looking for opportunities to put some of our cash to work.”
“Portfolio insurance can be a valuable thing – put options can protect value when markets wobble,” added Justin Urquhart Stewart, the co-founder and head of corporate development at 71M. “If you think it could be a bad winter, you might strengthen your home insurance – put options can work in exactly the same way. Market volatility can create opportunities, and is not necessarily any more disconcerting than the eerie calm that we have hitherto seen in markets over the last year or so.”
But insurance is a not free good. The premium paid for portfolio insurance is the price of the put option(s) purchased. And these can expire long before market falls puts (no pun intended) investors “in the money”.