Skittish market creates opportunity for active managers

A general sense of nervousness in equities markets is creating opportunities for active portfolio managers, says Shane Murphy, senior alternatives portfolio manager with Irish Life Investment Managers.

Murphy said equities prices remain stable, and volatility on the S&P 500 is running well below its long-term average. Yet many investors consider the equities market to be fragile.

“The market is pricing options as if the market were twice as volatile as it is,” he said. “This makes it a good environment really to be a net seller of options and to try to earn that premium rather than just be a buyer of those options.”

He said a common buzzword in the industry over the last few months has been “fragility.”

“When you know looking at pricing on its own, it doesn’t look particularly volatile, but the market feels very fragile,” he said. “The market seems to recover from each dip, but every time there is a dip there’s real nervousness there that it could lead to something a lot worse.”

Given the hesitancy, there is room to beat expectations. “There is a lot of opportunity for active managers and active strategies at the moment,” he said.

Murphy said growth-oriented tech stocks drove returns in 2020. Conversely, value stocks haven’t excited the market in a while, but are starting to look more attractive as interest rates rise.

Value and growth “are constantly fighting with each other at the moment,” he said. “And if you were in [a] strategy that was heavily invested in one side of those — if you were all in growth or all in value — that has the potential to be a much wilder ride.”

Volatility, both perceived and real, can pave the way to profits, he said, and the best thing portfolio managers can do is identify volatile situations and then try to manage the fluctuations with derivatives.

“You can’t eliminate [volatility], and I don’t believe you would want to do that because that would be like putting all your portfolio in cash,” he said. “My philosophy on this is that you want to be taking risks that you believe you’ll get rewarded for.”

Murphy described two kinds of embedded risk premia — one where you’re rewarded simply for being long the equities market, and another where you use derivatives and options to counteract volatility risk. That second kind can be intimidating, but profitable.

“I think some people find it difficult to understand [options and derivatives]. They’re generally associated with risk-taking. But if you use them sensibly and properly and responsibly, you can actually take a bunch of risk off the table and help improve risk-adjusted returns for customers,” he said.

Murphy prefers to use “vanilla put 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. We want to be doing things in quite a simple way,” he said. “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 in the market.”

He endorses a strategy of buying put options with relatively long maturities, and then selling shorter-dated call options at a profit.

Murphy is also a big believer in bonds, which he describes as the best risk-mitigating products in the market.

“Good old-fashioned government bonds or very high-grade corporate bonds are probably the most reliable hedge you’ll get out there,” he said. “When equities have a big fall, when there’s really big selling in the equities market, the capital flows into bonds.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.