UBS: Low implied vol has made options attractive
In the first instalment of a two-part interview with Shane Edwards, global head of equity structuring at UBS, we asked him about what strategies and asset classes are driving product development and how investors can capitalise on the current low volatility environment.
There has been a lot of talk recently about volatility becoming an asset class in its own right. What is your view on this?
Certainly, more and more investors are becoming educated on the instruments that can be used for trading volatility and are keen to express a view. Despite all the uncertainty out there, vol is pressing historical lows for many indices. Sophisticated vol traders will express a view as they see fit whilst directional investors may take a more passive view on vol, but recognise that low implied has made options attractively cheap. For this reason, and to take advantage of historically low interest rates, one of our high conviction investment ideas is buying long-dated Eurostoxx50 call options. Extending the tenor gives the investor considerable Vega and Rho so they have additional upside, beyond spot price increases, if either volatility or rates move toward historical norms. That's why we encourage investors to 'expand their horizons' and consider the attractive features that extending the tenor brings.
Do you think volatility is an asset class in itself?
I don't think there's a generic answer as it really depends on how each investor chooses to segment their portfolio. Irrespective of that, the proliferation of instruments that can be used to trade vol is evidence of its increasing popularity, and versatility, as it may offer a source of tactical or systematic alpha in addition to its well-known use as a risk hedge.
What kind of product would you recommend?
Despite very low levels of implied vol, realised vol is trading even lower. In theory clients could take advantage of this differential by selling options and delta hedging, but many clients would find the operational aspects of re-hedging and re-margining too burdensome. For that reason we have launched a product which systematically sells strangles and automatically uses UBS's infrastructure for the dynamic delta hedging. This is intended to be a passive strategy, but provides a clean solution to profit from implied volatility when it trades rich versus subsequent realised.
Would you recommend investors to buy volatility?
It would really depend on what the investor was trying to achieve. In terms of outlook, UBS Investment Research has the view that vol will remain low and may become even softer in the short term given the absence of a catalyst. We do continue to see a steady flow of regular structured products in which clients are implicitly selling implied volatility in order to earn potential coupons and we have seen some institutional clients buying put options over the summer to protect against the downside; paying what they see as a cheap premium to own this type of insurance. Yet longer term more bullish clients are buyers of calls. There is no one size fits all answer.
Are you using risk control features in your products?
Absolutely. Risk control is popular with a variety of client types and over the past few years it's grown from an interesting niche product to becoming embedded into mainstream investment offerings. For financial advisers the explicit focus on the volatility level encourages an informative dialogue to ascertain end client risk appetite and for larger institutional clients, such as insurance companies and pension funds, risk control products are beneficial in their overall actuarial framework because mark to market fluctuations can be more accurately anticipated.
Risk control is also an excellent tool from a provider perspective. It allows us to offer capital-protected products over a wider variety of assets and to be able to reduce prices in order to fit a client's option budget.
Is this trend here to stay or could we be talking about a new trend after the next market correction?
A market correction could make risk control products even more popular. Equity markets have historically exhibited cyclicality and downturns have been accompanied by elevated vol. Therefore, risk control products have automatically reduced market exposure during bear markets and raised exposure when vol softens - which is typically when investor confidence is returning. This dynamic mechanism may be thought of as an implicit risk mitigating [element], but as with all historical analysis it's impossible to extrapolate exactly how this may perform in the future.
There is also a lot of talk in the market about smart beta. What is your take on these strategies?
These strategies facilitate an interesting dialogue and encourage investors to dissect and manage their portfolios in ever greater detail. Some clients may seek a specific type of beta that they believe is likely to outperform or may seek to hedge a beta that has indirectly arisen as a result of other predominant investment choices. We have a compelling offering in this space which is intrinsically due to the strength of our Research franchise. They actively cover the performance of myriad betas and have an immense database of single stock factors. Clients are well attuned to traditional factors like market cap, value vs growth, momentum etc. and are increasingly looking at either a blend of factors e.g. quality and dividend yield, or overlooked factors like the potential alpha attached to low vol, low beta or low liquidity stocks.
Are you working on any particular strategy that will generate smart beta?
As I mentioned we have broad menu of smart beta products. Quality dividend indices continue to be popular as investors continue seeking income products, but perhaps the most exciting current project relates to the latter factor I mentioned; low liquidity stocks.
Professor Ibbotson is the world authority on that topic. He's not only a highly respected academic, but also the founder and CIO of Zebra Capital. Using his research on the 'popularity premium' we are able to deliver what is potentially the most pure implementation of a behavioural finance smart beta.
Are any of these strategies going to end up being used in proprietary indices? Do you think index providers take advantage of the work investment banks do in developing ideas which are then marketed as independent benchmarks?
Yes, indices continue to be an extremely important format due to the transparency and robustness they provide. For this reason a number of the regulatory frameworks favour this wrapper.
Both investment banks and third-party providers like S&P, Stoxx and FTSE continue to build indices. There is definitely space for both types of providers as this increases choices for end investors. The third-party providers excel at providing independent benchmark products for the broad market. However, they tend to be more generically designed, 'one size fits all', whereas we excel at developing specifically tailored solutions. Furthermore we have the distinct advantage of having a deeper insight into a number of practical topics like liquidity and transaction costs, as well as delivery formats.