The £1.3bn London Borough of Islington Pension Fund is assessing three equity protection strategies as part of its ongoing investment strategy update.
Total liability-driven investment activity fell in the second quarter of 2017, according to research by BMO Asset Management. Interest rate hedging decreased by 18 per cent and inflation hedging dropped 14 per cent.
The £1.3bn Islington pension fund is considering protecting the downside of an equity market fall by paying a premium and participating in an equity market rise.
It is also weighing up a simple ‘collar’ strategy. This would guard the downside of an equity market decline while sacrificing some equity rise potential, without paying a premium.
How much out-of-the-money you want to go is completely dependent on discussion and what it is you believe is prudent
Aniket Bhaduri, JLT Employee Benefits
Finally, the scheme is assessing a ‘put spread collar’ that would protect against an equity market fall, apart from “large market falls”. It would also give up some equity market rise potential, without paying a premium.
Don’t take out too much protection
Equity protection strategies are designed to allow investors to retain exposure to return-generating assets while managing downside risks.
Adam Lane, investment strategy consultant at Mercer – the consultancy that advises the Islington scheme – likened the derivative strategy to an insurance contract.
“The simplest way of doing it is just to simply pay a premium,” he said. “But equally if you’re a large institutional investor, paying 1, 2, 3 per cent in premiums could potentially be a large pound amount,” he added.
Buying hugely extensive downside protection is unlikely to prove a capital-efficient strategy. Equity protection strategies can be designed against market falls to zero, but at that stage, the total collapse of the economy would negate the benefits of a protective strategy.
When assessing equity protection strategies as risk-takers, investors must decide the level of downside risk they need and the cost of taking this protection. “There’s no free lunch here,” Lane said.
Consider reducing upside to bring down cost
The second option under review, a simple collar strategy, involves buying an “out-of-the-money” put option, while simultaneously issuing an “out-of-the-money” call option.
A put option gives its holder the right to sell an asset. A put option is described as out-of-the-money when the price of the asset is greater than the exercise price of the put written on it.
A call option gives its holder the right to buy an asset, and is out-of-the-money when the price of the asset is less than the exercise price of the call.
Of the second option, Mark Davies, managing director, derivatives at River and Mercantile, said: “What you’re doing by sacrificing gains is you’re effectively selling equity market upside to someone else, so they’re paying you a premium, for selling that upside.”
Lowering the potential upside of the market brings down the cost of the strategy, making it cheaper than the first option under review.
Equity protection strategies are flexible
The final option under review involves a similar approach to the simple collar, in that paying a premium is avoided and some equity rise potential is forgone.
The put spread collar accepts “large market falls”. Aniket Bhaduri, senior investment consultant at JLT Employee Benefits, said these contracts can last for as little as one month, and can be quickly adjusted.
“The important thing is, if you want to capture the upside for the next six months or one year, before you start squeezing out more downside protection but still have the protection in place, you can get into the put spread structure,” he said.
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“How much out-of-the-money you want to go is completely dependent on discussion and what it is you believe is prudent,” Bhaduri said. “At 10 per cent, you will still start getting protected. Up to 10 to 40, you’re protected. Beyond 40, you are selling off any kind of protection.”
Bhaduri added that even at 40 per cent, the investor would still not be exposed to a significant level of risk.
