How Do SynAs Fit into the Picture?
As structured securities, SynAs start by creating a flexible framework. As part of the framework, options create new design possibilities and help to bridge the gap between mean-variance portfolios and quantitatively managed portfolios. The options, together with management rules, act by:
- Increasing yield
- Adding hedging
- Adding insurance
- Adding a mechanism for risk budgeting
- Allowing for separate alpha and beta applications
With stocks, bonds, and cash, there are three sources of investment returns: interest, dividends, and capital gains. Adding options to a security structure creates a fourth source: theta. Compared to interest and dividends, theta, the time decay of options, is by far the most powerful source of yield. It is perhaps the most promising building block of new products.
Adding Hedging to Risk Management
A SynA adds hedging through an options wrapper on individual securities, normally short call options and long put options. The options create a market or delta hedge, making the security less volatile. This means that, in addition to the normal portfolio diversification (accomplished by asset allocation and security selection), the security itself has a new element of diversification.
The long underlying position has an almost perfect negative correlation with the options. So regardless of how the security behaves with regard to the other securities in the portfolio, the security is diversified against itself. Even under extreme conditions, this element of diversification will not break down. The idea is to strengthen the diversification features of MVO without interfering with the equilibrium features responsible for risk premiums unless it is necessary. At the portfolio level (described in Chapter 10), a volatility asset class SynA adds another effective diversifier, again within the framework of MVO.
Hedging can be used as a strategic (long-term) element of the position or for tactical (short-term) trading opportunities. When hedging is used strategically, it lowers the volatility of the position—and low-volatility investing is more efficient, often generating 40 to 60 basis points of improved return without a corresponding increase in risk.11
Adding Insurance to Risk Management
A typical SynA reinvests a portion of call option proceeds to purchase puts. Puts are a simple and effective way to add insurance protection to an investment position. The initial setup of a SynA specifies a minimum number of puts. Going forward, the long-term management rules encourage opportunistic financing of additional put protection so that, over time, net principle is fully protected.
Adding Risk Budgeting or Risk Allocations
Risk budgeting, or risk allocations, is an extra layer of risk control. A risk budget might be set at 5% to 20% of the amount invested. In traditional portfolios in which the only decisions are buy, sell, or hold, if the risk budget is exceeded, it means that the position is sold to prevent further loss. In the case of SynAs, risk budgets are used to trigger a reduction in the net cost basis rather than a sell of the position itself. This softer form of risk budgeting adds a stronger risk-management mechanism than available with MVO, but also helps to preserve long-term holdings and cut down on portfolio turnover.
Allowing for Separate Alpha and Beta Applications
Many institutional portfolios are separated into alpha and beta. Individuals often do the same, treating retirement accounts (beta) and trading accounts (alpha) differently. The beta portion of the portfolio usually contains broad asset class exposures, intended to produce income and capture risk premiums. The alpha portion represents more targeted investments to take advantage of perceived market inefficiency, or trades based by fundamental or technical analysis.
SynAs can be used in the alpha portion or the beta portion of a portfolio, or both. And they can be customized for each position depending on your views of mean-reversion or minimum values.
In the beta portion of the portfolio, you have the choice of when and by how much to apply risk budgets. Hopefully, the additional diversifiers within the MVO framework make it unnecessary to apply absolute risk controls to the beta portion of the portfolio in most market conditions. In the alpha portion, all the risk-control elements, including risk budgeting, are appropriate. As mentioned earlier, in the pursuit for alpha, there is no theoretical reason to expect risk premiums, so it is important to have the ability to dynamically adjust market exposure. Risk budgeting controls single-security idiosyncratic risk more tightly.
In summary, a SynA works across all three dimensions of risk management: diversification, hedging and insurance. It starts by creating a level of delta hedging on an investment position that makes it less volatile. It also uses a minimum level of insurance to slow down losses during price declines. Then, if necessary, management rules call for adjustments to invested capital to maintain risk budgets. The idea is to let the SynA operate within the Markowitz diversification framework as much as possible by adding diversification features that stand up under stress, and when necessary, beyond it, by adding dynamic hedging.