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For today’s soundbites, we speak with Shane Murphy, senior portfolio manager with Irish Life Investment Managers about derivatives to manage volatility. We talked about what derivatives he favours, and how he accommodates the cost of risk management… and we started by asking about how prone the current moment is to market volatility.

Shane Murphy (SM): If you look at the S&P index, volatility is running well below its long-run average over the last six months, but the market feels very fragile. You know, the market seems to recover from each dip every time, but every time there is that dip there’s a real nervousness there that it could lead to something a lot worse. So, while there really hasn’t been any market volatility, the market is pricing options as if it were twice as volatile as it is. This makes it a good environment to really be a net seller of options and trying to earn that premium rather than just be a buyer of those options.

What asset classes are most susceptible to volatility?

SM: We’ve got this constant fight between growth-inclined stocks, these are the kind of the tech, the FANG stocks, Tesla, those types of stocks, which really drove returns up in 2020, and then value stocks that haven’t really gotten the market excited in a while, but as you get interest rates starting to rise, they become a lot more attractive. Those two things are constantly fighting with each other at the moment. And if you were all in growth or all in value, that has the potential to be a much wilder ride.

His philosophy with respect to managing volatility. 

SM: Yeah, well you can’t eliminate volatility, and to be honest I don’t believe you would want to either because that would be like putting all your portfolio in cash. You want to be taking risks that you believe you’ll get rewarded for, and that’s what we in the market will often call a risk premium, where there’s an embedded risk but you feel you’re going to get paid for that risk premium. There’s really two embedded risk premia in that strategy that we’re looking to capture. The first one is equity risk, just the return you get for being long the equity market. And the other is what we call the volatility risk premium — or the premium that is imbedded in options. Options in general trade expensive. There’s loads of natural buyers out there of options. There’s not as many natural sellers and therefore most of the time, it makes sense to be a seller rather than a buyer of options that earn that premium.

What derivatives he prefers?

SM: We are really talking here about very liquid, very straightforward derivatives. We want to be nimble and be able to position that portfolio correctly, and we need liquidity to do that. So, we’re talking about exchange-traded options, nothing over-the-counter. We’re talking about on the S&P 500 which is the deepest, most liquid option market in the world. And we’re talking about vanilla put options and call options. We’re not going out and buying any weird-looking options with knock-ins or digital payouts or weird structures that could end up surprising us in a very big way. Options I suppose are challenging for a lot of people, in and of themselves. We don’t want to be doing anything unnecessarily complicated and we certainly don’t want to be doing anything that we can’t sell pretty quickly if we need to. I still am a firm believer that the best risk-mitigating strategy you will ever find out there is bonds. Good old-fashioned government bonds or very high-grade corporate bonds are probably the most reliable hedge you’ll get out there. When equities have a big fall, when there’s really big selling in the equity market, the capital flows into bonds. You know, I always refer to bonds as the kind of insurance that pays you, that hides in plain sight because they’re, you know, again, one of the biggest, most liquid market in the world and are readily available. Every portfolio should have good sizable allocation of bonds to defend against those situations where equities really, really fall.

How he accommodates the cost of risk management.

SM: This is where we’re trying to be smart with our options portfolio. We called it a calendar colour strategy. So, what we’re doing is, we are buying put options with relatively long maturities, like one-year put options, in the portfolio. And then we’re selling shorter-dated call options. So, we want to be selling call options every month. And by doing that, it actually enables us to earn more money on the call options than we’d get on the put option. We want to be net income generators on the option portfolio. So, managing that cost is really, really important for us because you know fundamentally put options trade expensive and if you were just sitting there buying productions in your portfolio without thinking about how you’re funding those, you know, you might have this nice protective element that feels quite comforting, but it’s not actually that productive for your long-dated return.

And finally, what’s the key takeaway?

SM: Maybe don’t be scared. You know, I think a lot of people are intimidated by derivatives, and options in particular. There’s a lot of lingo that comes with them, that seems designed to intimidate people. But if they use them sensibly and properly and responsibly, you know, they can actually take a bunch of risk off the table.

Well, those are today’s Soundbites, brought to you by Investment Executive, and powered by Canada Life. Our thanks again to Shane Murphy of Irish Life Investment Managers.

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Thanks for listening.

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