How derivatives can lower investment risks
The fear of a market slump and increased volatility can be successfully countered by calculated uses of derivatives. Most fund managers in South Africa use diversification to manage their fund’s risk and lower volatility. But derivatives can offer you an equal – and more certain – strategy to eliminate concerns on market downside.
According to Prescient Investment Management’s Positive Return fund manager, Liang Du, options can be used to hedge a portfolio against potential downside. “The standard way of managing risk is by using diversification. However, when using this strategy, you’re relying on forecasts which are based on numerous assumptions. But through derivatives, the Prescient Positive Return fund eliminates these risks, particularly on equities.”
Prescient uses put options to protect the positive return portfolio against equity weakness – which works like an “insurance contract”, says Du. A put option contract gives Prescient the option to sell an underlying asset (in this case the market in general, or individual stocks) at an agreed price by a certain date. If the market falls, this put option offers a hedge for the portfolio. If the market rises, the equities within the portfolio will benefit. The strategy reduces volatility for clients.
Du says, “We always use SAFEX (The JSE’s Equity Derivatives market) when we trade. A lot of people trade over-the-counter, but we avoid this in order to minimise counterparty risk.” Over-the-counter instruments are not regulated in South Africa. The JSE’s market, however, is regulated, transparent, and protects investors against fraud and counterparty defaults.
The use of derivatives to hedge the portfolio has worked well for the Prescient Positive Return Fund to date. The fund has never made negative returns in any 12-month rolling period, as set out in its mandate. Since the fund was launched in 1999 (until end-May 2011), it returned 15.5 percent per year, versus its benchmark (headline inflation), which returned 6.5 percent. Du says, “The fund is designed to offer real returns to investors, and in spite of the market crashes in 2001 and again in 2008, we’ve never had a down year. That’s vital in preserving real purchasing power.”
The fund invests in local equities (mostly from the JSE Top 40 index), bonds and cash, while making use of derivatives to lower risk. By the end of May, the fund was 50 percent invested in equities, although this was fully protected. The rest of the fund is invested in money market assets and inflation-linked bonds. It is considered a low-risk investment.
The fund’s managers seek value in the stock market, and will invest in cheapest asset class, i.e. stocks and/or bonds. In the Positive Return Fund, derivatives are a permanent feature when the fund holds volatile assets. In other funds, like the Balanced QuantPlus Fund, they only use derivatives when it’s appropriate for the strategy, “When volatility is low, you want to buy put options because they’re cheaper. As volatility rises, options become more expensive, and we manage that closely. Through our quantitative investment strategy, we look for value in the stock market, and we look for value when we’re using derivatives.”
Prescient Investment Management has more than R90-billion of assets under management. The business has grown 50 percent a year since inception in 1998. The group recently won the Overall Asset Manager of the Year at the Imbasa Yegolide Awards for 2011.
