This week, Caddie's Content and Engagement Manager, Chris Barnett, caught up with the Co-Founder and Chief Investment Officer of PEF Capital, Stephen Arulogun, to get his insights on investment portfolios, options and diversification benefits. Here's what Stephen had to say...

Chris: In your experience what types of investment portfolios see the most benefit from options as a source of protection?

Stephen: For the large proportion of investors, there are two portfolio types that benefit most from options as a source of protection: ones which are concentrated by asset class (towards equities) and more specifically by industry sector; and ones which are leveraged/geared.

The premise is based upon portfolio theory — a portfolio consisting of different asset classes making the same return as a single asset will be more attractive if the variability in returns over time (sometimes quantified using the Sharpe, Sortino, Treynor or Sterling Ratios) is less than the variability of return from the single asset.

Concentrated portfolios are more susceptible to market risk of a particular market as there are no assets outside the particular market to act as a hedge.

For portfolios that are equity-heavy, they can be protected using single equity or index options.

Options are especially useful to retail investors who may not have access to other derivatives used for hedging, like swaps or futures.

Leveraged portfolios benefit from options protection because it minimises the effects of drawdowns on the portfolio.

For example, investors with an Australian equities portfolio geared at LVR 75% on 2 February 2018 would have lost 20% of their capital over the following two days and would have been required to close more than 15% of their positions to meet lending restrictions, right at time they would have wanted to be holding onto those positions.

It was clear in the couple of days before 2 February 2018 that downside risk was likely to materialise.

With options, investors would have been able to ‘ungear’ their portfolio over this period without having to unwind their equity positions, which would have been time consuming, costly and raised tax implications.

Chris: Are there any market situations where options do not provide the diversification benefits that investors would like? Are there any asset classes that can’t be protected via this means?

Options are extremely versatile (probably the most versatile derivative instrument), so they are useful in all markets: upward and downward trending, flat and volatile.

The main issue with using options (and probably a consequence of the way they derive their value) is that investors who do not understand how best to use them can burn through a lot of money quickly.

Two examples come to mind. In late 2016, a friend of mine asked for a couple of ‘stock tips’ so he could trade his own money rather than have me manage it for him.

I mentioned the stocks I was positioned in but not the specific option positions (as he assured me he was confident about executing appropriate positions).

Two weeks later, I found out he’d lost 100% of his capital; meanwhile, I’d traded the same underlying stocks using options profitably.

In mid-2017, a professional investor contact of mine placed about $750,000 with a professional options trader in Germany who subsequently lost about half of his capital over a period of about three months through ‘time decay’.

This issue is further complicated by confusion between the cost of using options to hedge/protect a portfolio with losses incurred from poor trading.

In the first scenario, an investor will consider the cost of the hedge as part of managing a particular market scenario (like buying insurance) using a number of different qualitative or quantitative factor.

In the second scenario, an investor will lose money from poor options trading; this loss will not be offset with a corresponding benefit (whether risk management or proven income/growth strategy).

Chris: As option-based funds become increasingly popular with investors, how do you see the industry changing with these types of funds and do you think financial advisers will start recommending these funds to their clients?

Stephen: I think there are two hurdles Australian investors must overcome before we see further significant investment in options/derivative based funds: education and acceptance.

Australian retail (and the majority of ‘sophisticated/wholesale’) investors do not understand how options can be used effectively.

The ‘supply’ reason for this hurdle, the education, is that brokers and investment managers in Australia are significantly more risk averse to overseas advisers — the regulatory risk associated with providing derivatives advice to an Australian investor who heavily scrutinises fees when he or she makes a profit but also threatens to sue when he or she makes a lost means advising on derivatives is not as attractive in Australia as in other countries.

It’s not uncommon for highly successful funds overseas to charge performance fees of over 20%; I know an American fund manager that charges 45% and I have been offered up to 55% from a European investor.

Such fees are not accepted by Australian investors – even on the basis their net return far exceeds their current returns.

Because Australian fund managers can’t offset regulatory and legal risk with a proportionately higher fee stream, they tend to pivot to management fee based, low-risk low-return equity-only investment strategies.

The ‘demand’ reason for this hurdle, the acceptance, is that Australia investors associate the use of options/derivatives with ‘high risk’.

This association is no truer than the belief that buying a residential property with an LVR of 50% is safer than an LVR of 75%. Such a belief fails to consider the investment risk of choosing an asset in a poor performing area geographically, market risk of high vacancy rates, credit risk of which financier they source debt through (case in point being ANZ evicting 162 farmers from their property after acquiring Landmark’s lending book in 2009).

Collectively, these risks could sink an LVR 50% property purchase. Conversely, managed properly, an LVR 75% property investment could be very profitable.

If financial advisers begin to better understand option/derivative investment strategies and gain confidence in these more dynamic investment strategies (and are remunerated accordingly in ways which conform with regulation), they will begin to start recommending these funds over low performing funds.

The key is high risk-adjusted returns, not fee minimisation.

Chris: Do you believe the options market suffers from a lack of liquidity as the VIX increases, and how would you recommend Financial Advisers structure their clients’ portfolios moving forward?

Stephen: Australia’s options market is relatively liquid. Most of the exchange traded equity options have four or more market markers with the significant number of option series being subject to mandatory market marker obligations.

Options traded over the index (XJO) are more liquid again, with ASX reporting about 60,000 index options traded daily in May 2018.

As at May 2018, there were more than 1 million index option contracts open with a notional value of about $7 billion.

Significant moves (think Santos rising 20% on 3 April or Metcash falling 18% on 28 May) will result in a skew of the offer and bid prices quoted by market makers intraday, these tend to recover quickly (within one day) even with the underlying stock remaining at the new ‘dislocated’ price.

With many investors instructing their wealth manager out of hours/overnight, this temporary skew on options/derivative prices does not practically affect investors.

Illiquidity risk can usually be managed between an experienced investment manager and his or her counter-party (broker/prime broker) as they negotiate execution timing of the underlying and option/derivative, and collateral obligations.

Chris: PEF Capital utilises options to find value in the market, do you see the effectiveness of this model diminishing if more options-based funds are established which seek the same opportunities?

Stephen: I believe the effectiveness of our choice to use options will increase. For example, Thomson Reuters reported that in January 2018, there were over $400 billion of foreign exchange contracts traded on its platforms – each day.

Yet many investment managers return greater than 30% annually in the foreign exchange market.

However, I believe PEF Capital’s investment strategy would adapt.

As an investment manager, my role is not to execute a trade at a particular price; it is to execute a trade when an asset with a particular value reaches a particular price.

The value of an asset (either the underlying stock or its derivatives) is comprised of many quantitative and qualitative factors, including asset quality, management acumen, current and potential earnings, growth potential, competitive moats.

Additionally, factors which are rarely fully appreciated but probably more important that the foregoing factors, are cognitive biases exhibited by investors (often collectively studied as ‘behavioural finance’).

Much of PEF Capital’s alpha is derived from analysis around these biases.

As more funds and investors begin to trade options, the mix/prevalence of cognitive biases will change, and PEF Capital’s investment strategy will adapt to capture this change.

Chris: Final question for today – you have been involved in the Derivatives world for over 15 years, if you could go back in time to when you first started out and give yourself once piece of advice, what would that advice be?

Stephen: Either by luck, good fortune or personality, I cycled trading a range of different derivative products relatively quickly early on in my trading career: foreign exchange, futures, CFDs then to options.

I preferred to follow the path of least resistance and find the right products and strategies that suited my personality.

A couple of other traders I know persisted with trying to master certain products or strategies even though it didn’t suit their personality or thought processes and continued until they walked away from trading broke.

So, I wouldn’t change that.

However, as I didn’t go through the institutional banking route, it took me a little longer to appreciate the need for back and mid office processes, especially since these can be mundane and not usually front of mind (until something goes wrong).

If I had my time again, I would have either pursued institutional banking at a younger age, or at least directed my efforts earlier to developing sound operational systems (front/mid/back office processes) as over time I’ve learnt that these are invaluable for quality control irrespective of fund size or structure.

About PEF Capital

PEF Capital is a Brisbane-based investment fund manager focussed on achieving absolute returns for investors in the Australian equities market. Stephen co-founded PEF Capital in 2017 as Director and Chief Investment Officer. Bringing over 15 years of experience in financial markets in various research, analyst and management roles, Stephen is responsible for the development and execution of fund’s strategies and oversees its strategic direction and evolution.