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No ‘dirty word’: Derivatives offer downside protection in volatility

Derivatives should not be a "dirty word" for investors looking for better returns, capital protection and diversification at a time when volatility and higher inflation appear here to stay, according to Atlantic House Group's Andrew Lakeman and Global X's Evan Metcalf.

The past year of volatility has many market participants shaken, but by embracing derivatives and other options products – and appreciating the difference between volatility and true risk – investors can improve their chances of seizing opportunity from what sometimes looks like chaos, according to two specialists.

“Derivatives shouldn’t be a dirty word,” Global X CEO Evan Metcalf (pictured, left) told The Inside Network’s Income & Defensive Assets Symposium in Sydney earlier this month, in a session with Atlantic House Group founder Andrew Lakeman (pictured) titled “Factoring for resilience”. For investors looking for smoother returns as volatility increasingly becomes the norm, they said, these instruments can provide capital protection and needed diversification.

According to Metcalf, Global X is focussed on offering investors innovative products aimed at helping them meet their investment objectives, whether that be building an income portfolio or providing capital protection. Quite often, that involves adding derivatives and other options strategies to the mix, he said.

  • “We’ve seen a lot of different products over the years – some good and some bad – and there are definitely some overly complex and dangerous products in the market,” he said. “But there’s also a very large cohort of devices we use time and time again, which are very effective in achieving outcomes for investors.”

    Against the current economic backdrop of rising cash rates and sticky inflation, Australian investors are dealing with negative real rates of return and increased risk. “There’s a range of risks that is really making people question whether strategies like stepping up their credit to try and get that additional yield are really the right way of going about it,” Metcalf said.

    “The Australian ETF market itself is a bit of a microcosm of that over the last 12 to 18 months,” he added, with money moving into floating-rate bonds, short-term debt and government debt but otherwise “quite muted on the credit side” and particularly in high yield.

    “Similarly, on the equity side, we’ve got some high dividends to provide a decent amount of income, but we’ve also got that undefined risk. And whilst volatility is relatively low at the moment, there have been enough bouts of high volatility over the last 12 months to keep people questioning whether a sustained downturn or recession response is likely to play out in the future.”

    While there has been a lot of talk about risk-return trade-off, it’s also helpful to think about risk versus income, he added. “When you put derivatives into the mix, you can turn around that philosophy and make risk and volatility work for you rather than against you.”

    Investors are generally facing three problems, Metcalf said: how to generate higher income to keep pace with inflation, how to navigate uncertainty and protect against asset price volatility, and how to remain diversified when major asset classes are moving in tandem. “You have this tendency for correlations to spike at the same time that volatility is driving markets and where people are putting assets,” he noted.

    One way to solve these three problems simultaneously, he said, is through a covered-call strategy – “probably one of the simplest derivative overlays and commonly used revenue strategies out there”. Covered calls – call options written on a basket of stocks representing an equity index – are simple and effective, provide a “reasonably high level of income and a bit of volatility buffer, and potentially turn around some of that correlation”, according to Metcalf.

    Essentially, this strategy involves “forfeiting the upside on your equity holdings and receiving a fixed, up-front, cash premium to do that.” And as for downside risk, Metcalf explained, “the bigger premium you receive, the more buffer you have.”

    Lakeman agreed that derivatives offer a more predictable way of getting healthier returns even in volatile markets – “having a better chance of getting it right”. For retirees and those planning to retire soon, he said, “knowing what to do in this slow-motion trainwreck is impossible,” and the temptation to simply sell is strong.

    Atlantic House, which specialises in derivative-based investing, has a clear strategy, according to Lakeman, offering “long-run equity-type returns with more clarity on how, through simply giving up some upside”, an investor can ensure higher returns in a rising-rate environment.

    But the education piece is important, as these instruments are more complex than regular equity investments, he added. “The only problem investors have using derivatives is when they don’t know what they’re buying and how it’s going to pan out.”

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