Inevitable but unpredictable
Today, the links between risk and new business ventures, trade and economic growth appear self-evident. However, this was not always the case; indeed, this understanding is surprisingly recent.
In ancient times, risk was often seen through the lens of fate and met with acceptance rather than defiance. Protecting against misfortunes was perceived as tantamount to interfering with divine destiny. For millennia, prayers, pilgrimages and donations were seen as the most appropriate methods to manage risks. Over time, acceptable ways of alleviating losses evolved, such as sharing risks within social and business communities. In Europe, risk mitigation, based on solidarity, was widespread among guilds, trade associations and village communities. For example, most craftsmen in the Middle Ages were trained through the guild system. Apprentices spent their childhoods working for masters, for little or no pay. Once they became masters themselves, they paid dues to the guild and trained their own apprentices. The wealthier guilds had large coffers, acting as a pool of cash, to be distributed to members when they fell on hard times. For example, if a master's practice burned down – a common occurrence in the largely wooden cities of medieval Europe – the guild would rebuild it, using money from its own funds. If a master was suddenly disabled or killed, the guild would support them or their surviving family. This safety net encouraged more people to leave farming to develop new skills. As a result, the amount and range of goods and services available for trade increased.
Underwriting risks – the need for insurance
By the 1600s, shipping was just beginning between the New World and the Old, as colonies were being established and exotic goods – exchanged for the products of the guilds – ferried back. In the past, most seafaring nations distributed cargo onto different ships to hedge against storms and pirates. However, this rapid growth in trade required something much more sophisticated to manage risks and marine insurance evolved. Having originated with the Lombardy merchants in 13th century Italy, it spread through the continent and then to England, with London becoming the centre of the sector from that point on.
Upon a voyage being planned, the merchants and ship owners went to the coffee houses of the City – Edward Lloyd’s (precursor to Lloyd’s of London) being one such example – to hand over a copy of the ship's cargo manifest, so investors who gathered there could read it. Those who were interested in taking on the risk signed at the bottom of the manifest, beneath the figure indicating the share of the cargo for which they were taking responsibility (hence, was borne the term ‘underwriting’). Consequently, a single voyage would have multiple underwriters, who looked to diversify their own risk by repeating this process across several ships.
Insurance, in this context, is an economic term, defined as a form of risk management used to prepare against a greater economic loss in the future. By the second half of the 19th century, the rapid growth in trade, industrialisation, urban development, traffic and communication had created an immense need for insurance and by the turn of that century the industry was spanning the globe. Today, most of us fortunate enough to afford insurance, are covered for the main risks of everyday life. Car insurance, home insurance, health insurance and travel insurance are now mainstream policies and, in some countries, mandatory to have by law.
So, how to insure portfolios against losses?
2022 has proved an exceptionally challenging year for managing assets. Rule number one of investing is not to lose money; with rule number two, not to forget rule number one.
The tried and tested approach to achieving this goal has been through asset class diversification, with risks typically ‘balanced’ by allocating to a 60/40 portfolio; the former reflecting the percentage allocation to equities, the latter the allocation to bonds. The chart illustrates how this approach has failed miserably in 2022, for those invested in US assets (and is broadly representative of portfolios diversified across geographies). The return from equities has not been unusually negative – in the context of history, however, bonds have been crushed, delivering their worst return to investors in 150 years.
As an alternative approach, investors could, of course, buy insurance-type instruments – such as options. If we take out insurance on our houses, our cars or ourselves, we do so to be protected against unlikely, but potentially catastrophic, outcomes. We do not expect to make a profit on the transaction. We know that the insurance company should make money, on average, across the policies it writes. But when it comes to investment, many people take a different view. They buy insurance-like instruments, such as put options, which give the owner the right to sell a security at a predetermined price at a set time in the future, potentially enabling them to make money from falls in the market. However, as some learnt to their cost, when losses occur, they do not always pay out in the way a more traditional insurance product would.
Just in the same way the premium for standard building insurance is calculated based on several inputs – age of property, location, state of repair, value etc. – the cost of a put option (the ‘premium’) has several inputs too. These include the value of the portfolio or security being insured, the period it is being insured for, prevailing interest rates and underlying volatility. Research demonstrates the implied volatility priced into options, on the S&P 500 index, is almost always greater than the volatility the market subsequently delivers. In other words, investors end up paying for a level of fluctuation in the market that rarely materialises. For example, this year’s equity market correction was very different to the one we saw in 2020, when Covid emerged. The latter was a violent re-pricing, whereas 2022 was more death by a thousand cuts. In the first scenario option strategies provided protection, but this year many of them failed to kick in, due to the profile of the sell-off. Taking this further, it means the options market – just like the insurance market – generally works for the benefit of sellers, not buyers.
But, like most things in life, timing is everything
Firstly, studies implying it is better to be a seller than a buyer of options, and other forms of investment insurance, tend to exclude extreme events on the grounds these are rare and not typical of normal market conditions. However, the reality is these happen much more frequently than traditional financial theory would suggest.
Secondly, losses from selling investment insurance tend to have particularly unpleasant characteristics: they can be large and clustered, over a short period of time. So, even if selling insurance appears to be profitable, on average, there is an increased risk of the seller being bankrupted by an unfortunate run of losses, or from margin calls caused by a spike in volatility – as the recent FTX collapse attests to.
Investor behaviour drives option pricing: supply and demand dynamics are ever present. As stress in markets rises, participants are especially keen to protect themselves against the ‘tail risk’ of a big crash. As a result, put options tend to be even more expensive when needed most.
On the topic of tail risk – it is important to differentiate between a simple approach of buying S&P puts, versus a complex, actively managed tail-risk strategy. The latter is a very different beast; whereby practitioners use their deep expertise to find pan-asset class, global, long-dated options, which provide cheap convexity and positive asymmetry. These less-liquid solutions are not suitable for most ‘typical’ discretionary strategies, as divesting can take several months. You also need to be selective around the timing of an allocation, as when volatility is expanding and investors are panicking, buying protection will prove very expensive. However, the volatility cycle is mean reverting; therefore, although the tail event cannot be predicted, the cycle does guide when buying a tail risk hedge is cheap. Once again this requires specialist insight and execution. Finally, as options cost money, if there is no payoff, over time their value wastes away (theta bleed/negative carry), delivering a negative contribution to performance.
Implications for portfolios
A natural question to ask is why we have chosen not to hold such dedicated tail risk funds, over recent years. We would counsel they are not suitable for all portfolios, lending themselves to those growthy mandates with long term investment horizons. Even then, sizing and timing the allocation correctly is not straightforward, as we do not have an in-house team of option specialists. That said, we do have clients who we have assisted in investing in such funds, through our advisory service.
Instead, given our cautious stance, we chose to manage downside risk (as opposed to buying insurance), through a combination of increased cash levels; holdings in lower beta, high quality equities; gold and government bonds. Clearly things did not go quite to plan, particularly for fixed income which experienced a 3 standard deviation event (likely to happen only once in 700 years), contrasting with the Global Financial Crisis, where bonds – and cash – provided significant protection. Gold also underwhelmed, given it is typically a go-to asset in a time of war and rising inflation. Real yields kiboshed this, as there was a greater ‘cost’ for holding a non-yielding asset. To top it off, quality equities struggled, as being the most liquid and broadly held, they experienced widespread selling as investors sold that they could, rather than what they wanted.
Portfolios were also buffeted by extraordinary currency moves, as the trade-weighted dollar, strengthened markedly (given interest rate differentials) at the expense of all major currencies – including the traditional safe-haven Yen.
As 2022 demonstrates, markets are generally highly unpredictable, over the near-term. However, inevitably, after extreme price moves, they tend to mean-revert to normal or average values. The speed at which this occurs is another unknown and given we find ourselves amidst a paradigm shift in the cost of capital, this may take more time. Inevitable yes, but predictably unpredictable.
Please do contact us with any questions.
Julia Warrander and Russell Waite
Affinity Private Wealth is a trading name for APW Investors Limited, which is regulated by the Jersey Financial Services Commission. Registered office 27 Esplanade, St Helier, Jersey JE4 9XJ.
