Portfolio Manager Prefers Option, Bond Overlays To Hedge Big Uncertainty Facing Markets

Preferred measures for gauging the strength potential of today's market are unclear, explains Michael Green, a Simplify portfolio manager and strategist.

“The traditional adjustments ranging from seasonality to the birth-death models used in smoothing employment reports are in question,” he says. “Response rates on surveys have deteriorated, too, and this creates conditions such that developed market data sets are approaching emerging market data sets in terms of quality.”

Green is currently spending an inordinate amount of time trying to make sense of updates to the economic data he develops investment theses around.

Green, who manages Simplify portfolios mimicking constructions such as 60/40 (albeit with potentially less volatility and more upside), traditionally expresses his firm’s views using macroeconomic signals. The reduced volatility and amplified profit potential come from overlays that include derivatives.

“I’m looking for opportunities to trade in a manner that reflects an underlying point of view while using cheapness within the derivative markets to risk less capital, but, at the same time, generate the setup for fairly outsized returns,” he said. This means responding to Federal Reserve statements in real-time by trading options on the CME Group Inc’s CME Eurodollar future, a tool to express views on future interest rates.

Survival Of The Fittest

Last year was all about adaptation, Green says. It was survival of the fittest. Investors expecting sharper declines had demanded exposure to commodities and options in a big way. The volatility components, however, underperformed.

“One-year variance swaps or implied volatility on an at-the-money S&P 500 put option would trade somewhere in the neighborhood of 25 to 30%,” he says. “That implies a level of daily price movement that is difficult to achieve.”

Having learned their lesson in 2022, investors have since swapped long-dated volatility exposures for ones with bounded risk and less time to expiry.

Graphic: Retrieved from Goldman Sachs Group Inc GS.

Though both may leave counterparties with less risk within a certain range, if news shocks the market one way, market movements may become exaggerated when investors, and counterparties accordingly, scramble to adjust their risk. For now, the activity has manifested a push-and-pull, mean-reverting-type action; investors lean short volatility in the morning and long volatility in the afternoon. Combined, this tends to mute price action.

Graphic: Retrieved from Bank of America Corporation BAC.

Say one morning an “investor sells call options and a dealer receives them,” Green puts forth as an example. “The dealer will hedge their long call position by selling futures which will pressure the market and result in the options prices collapsing in value.”

To re-hedge falling options prices, “dealers have to buy back their futures exposure and this pushes the markets upward. This is the pattern that’s been playing out over and over again. It’s weakness in the morning followed by strength in the afternoon.”

Though this is a very smart exposure to have, Green says volatility that’s longer-dated is cheap and, when an eventual shock occurs, its payout may more than justify its cost, particularly as the outlook for equities, bonds, and commodities further blurs.

“It’s the Wile E. Coyote moment where we’re off of the cliff, suspended in midair, wondering whether the gravity was shut off,” he responds in a statement drawing parallels between the dot-com bust and the strength of financial markets in 2023. “There are very clear signs the economy is starting to deteriorate and we’re seeing cracks in bubbles like commercial real estate” and risk assets including crypto, presently maintained by a lack of inventory or supply that’s tied up in the bankruptcy proceedings of FTX and Voyager Digital, of all things.

“The question is whether higher interest rates ultimately drive a fraction of the market into distress with forced transactions,” Green wonders, pointing to the likes of Blackstone Inc BX and Brookfield Corp BN handing in keys to properties. “It takes one person being in distress to set a new clearing price which, in turn, changes valuations for everybody, and makes it more difficult to qualify for things like mortgages.”

Looking forward, over the short-term at least, Green says inflation is likely to trend higher, particularly with monetary policy inspiring fiscal action and sparking off geopolitics.

“The world’s growing materially slower and manufacturing capacity, which is spreading around the world, requires labor and investment, which could be inflationary in the short-run,” Green puts forth. Traditionally, “lower rates and costs enable added capacity and a predictable rebound in consumption. However, we’re driving a stake through the vampire’s heart, now, and … there’s the multiplier effect driving fiscal policy, too.”

In response to uncertainty, Green says investors can park cash in short-term near-risk-free bonds yielding 5% or more, as well as allocate some capital to volatility “to introduce a degree of convexity,” risking only the premium paid. Alternatively, investors can take a more optimistic long view and position in innovations like artificial intelligence or next-generation energy production.

“I’m optimistic about human innovation and the rise of AI, as well as higher energy prices creating the impetus for tremendous innovations in energy generation that have the potential to lift us out of this period of perceived scarcity if we allow ourselves to embrace it.”