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US investors bank on derivatives to guard against stocks slowdown

US equities updates

Investors are increasingly turning to derivatives strategies to guard against a slowdown in the $51tn US equity market, suspecting that the white-hot rally this year is starting to run out of steam.

Large institutional money managers have already shown a nervy tilt in recent weeks, opting for funds likely to do well in tougher economic or market environments.

Now they are trying to protect some of their double-digit gains this year while still staying invested in the market, as concerns over the spread of the Delta coronavirus variant and slowing global growth have tempered expectations for further stellar returns from stocks.

“Investors need and want equity market exposure and yet don’t want to take full-on risk with markets already at all-time highs,” said Paul Stewart, a portfolio manager at Gateway Investment Advisers.

Gateway runs one of the largest call overwriting funds, a term used to describe a strategy of selling options linked to the S&P 500 index or individual stocks to bolster an equity portfolio.

The derivatives give the buyer on the other side of the trade the right to buy a stock or the index at a pre-agreed price above where the market is currently trading. If the market price simply trundles along or even declines, the call overwriting fund will face no payout, but still collect a premium for selling the option, boosting returns.

This year, the strategy has trailed behind the overall stock market. While the S&P 500 has returned more than 20 per cent, the Cboe’s S&P 500 buy-write index, which tracks the call selling strategy, has gained a smaller 14.5 per cent.

But brisk demand for some funds suggests the strategy’s fortunes are expected to change.

Chart showing showing call overwriting strategies lagging behind the S&P 500

Call overwriting funds recorded their largest monthly inflows in July since 2012, according to investment bank Barclays, even excluding shifts made by pension funds and endowments in separately managed accounts, outside of the eye of public mutual funds. JPMorgan Asset Management earlier this year closed one of its hedged equity funds to new investors given its strong inflows.

“The stock market is up 20 per cent year to date,” said Michael Purves, founder of Tallbacken Capital. “People are saying they still like the story but that it’s just not going to be as good going forward.”

Bankers also say they are fielding more requests for these types of trades.

James Masserio, co-head of equities and equity derivatives for the Americas at Société Générale, said his bank’s trading desk had seen an increase in interest from investors looking to overwrite call selling on existing and new stock positions. 

“It’s still a bullish strategy,” he said. “You hope the market goes up, just that it goes up in a controlled manner.”

Rish Bhandari, a senior portfolio manager at hedge fund Capstone, said the demand was particularly pronounced from public and corporate pension plans as their assets have swelled in size alongside the stock market rally. That has prompted some to shift to these call overwriting strategies, given they are at their best funding levels since the start of the financial crisis in 2008, according to data from actuarial group Milliman.

If the market rises above the strike prices on the call options and the pensions are forced to sell the stocks they own, they are content capping their gains and reducing their equity holdings, Bhandari added.

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