Traders need to insure against the downside

 
Steve Sedgwick
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EXCUSES, excuses followed by more excuses. When is the broader asset management industry going to put its hands up and say; “We were wrong,” or “I’m going to fall on my sword, sell my five houses on the Wentworth Estate and distribute the proceeds amongst those foolhardy enough to believe I could make them money?” The answer of course is “never”.

We’ve just had a dreadful quarter for stocks and the long equity brigade will be putting on their tin hats waiting for the redemptions.

In this very column a month or so ago I bemoaned a whole raft of excuses touted for underperformance.

One of the oldest excuses in the book which is going round again is about mandate.

“If you look at our mandate,” they say, “we aren’t actually allowed to hedge our long portfolio.”

“We have to hold a minimum exposure in stocks,” they say, “and the investors get very worried whenever we start talking about protection, overlays and options.”

Hmm, are these managers sure that it’s the investors who are worried about overlays? Or is it the fact that after all these years of hugely volatile stock markets the broader asset management industry still hasn’t bothered to learn what an option is?

Let’s be clear here. No-one is talking about adding complicated OTC products to a portfolio. What I am suggesting is really basic – go and open the Derivative Book for Idiots on page one, read what a long put is. Turn to page two to learn how a long put added to a long underlying stock portfolio creates a hedged downside with only a slightly diminished upside. Then close the book.

Then the asset manager has to find out which exchange offers a put on the index or stocks that he or she is most exposed to and wait for the rally to buy some protection. That last bit is perhaps the most challenging.

You see people only talk about protection when the VIX, or whatever the European at-the-money volatility equivalent measure is, is trading sky high and accompanying plummeting markets.

This is where, I suggest, the problems lie. Downside protection isn’t sexy. In fact for many European regulators it’s downright heresy to want to own downside products.

Until managers gain a little bit more knowledge about listed products available and perhaps are willing to give up on a minimal amount of upside gains when the times are good, then we are doomed to repeat the same old mistakes and come up with the same old tired excuses.

Steve Sedgwick is a CNBC anchor