INVESTMENT FOCUS-Stock investors seek new hedges in unnatural market calm

Reuters - UK Focus

By Francesco Canepa

LONDON, June 20 (Reuters) - Investors are seeking newdefences against possible falls in European stocks as indexesplateau near multi-year highs and traditional hedges proveineffective in a market anaesthetised by near-zero interestrates.

These alternative tools range from option strategies aimedat minimising the cost of holding a hedge to investing in fundswhich aim to generate some returns irrespective of the stockmarket's direction, such as arbitrage hedge funds.

A 50 percent rally in European shares over the past twoyears has left investors fretting about high valuations andseeking to protect their gains against a possible selloff.

However, hedging tactics which worked during the jitterydays of 2008 and 2011, such as straight bets on risingvolatility, have proved inadequate in the current, becalmedmarket conditions, leading fund managers to look foralternatives.

"A direct exposure to volatility may hurt investors becausevolatility can still fall or stay at a low level for a longperiod of time," said Bruno Pannetier, chief investment officerof London-based hedge fund Old Park Capital. "Investors have tofind new ways of hedging."

Hedging equity positions via futures on the Euro STOXXVolatility index (VSTOXX), which gauges theprices of options on euro zone blue-chips and tends to moveinversely to cash equities, has cost investors dearly over thepast two years.

Firstly, the VSTOXX has fallen roughly 65 percent since theFederal Reserve and the European Central Bank made plain in 2012that they were prepared to pursue radical measures. The indexhas shown no sign of revival because the magnitude of swings inthe Euro STOXX 50 index has been even lower than option pricesimply.

Furthermore, since futures with longer-dated maturities tendbe more expensive than shorter-dated ones at times of lowvolatility, investors would often have to stump up when sellingan expiring contract to buy a new one.

To reduce this cost, some investors are buying a cheapervolatility future and selling a more expensive one, betting thelatter will lose value as time passes.

"We have observed a trend for people to look for solutionsthat provide exposure to long volatility but minimise or reducethe cost of carrying that position," said Ryan Rogowski, head ofasset manager solutions at Societe Generale (Paris: FR0000130809 - news) .

"Of course there's no free lunch so ... investors must takea view."


Similar strategies can be implemented via put options, betsthe market will fall.

Some investors are taking out "put spreads", or financing aput by selling another put with a lower strike price on the samestock, effectively betting that any fall in the share would besmall.

More bearish investors are opting for financing their putsby selling a call, or bet the price will rise, on the samesecurity, a strategy known as a "cashless collar".

"Investors are taking down their risk positions and acashless collar or a put spread are a way to do this withoutpaying too much premium out of the portfolio," said LorneBaring, managing director of wealth management firm B Capital.

Demand for cross-asset protection has also been on the rise,with investors fearing any hint at a tightening of monetarypolicy would puncture the recent, twin rally in bond and stocks.

An example of these hedges, designed to protect investorsagainst a rise in interest rates, is an option giving the holderthe right to swap a fixed rate for one that tracks marketprices.

While buying options, however cheaply, erodes returns ifstocks rise and volatility remains low, investing in strategieswhich are altogether uncorrelated with the market's directioncan boost a portfolio's performance.

Such strategies include buying equity funds in which longand short positions cancel each other out, leaving the fund"market-neutral", and arbitrage strategies, which seek toexploit unusual price moves, often using algorithms.

These strategies can, in theory, outperform at times of highvolatility, where wild swings throw up buying opportunities.

"We're looking for protection and market-neutral strategiestend to offer that," said Oliver Wallin, investment director atOctopus Investments, a fund of funds. "I think they've got areally good place in well-constructed portfolios." (Reporting by Francesco Canepa; Editing by Ruth Pitchford)

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