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Alternative View: Time to Consider your Options

Summary

Thanks to the US Federal Reserve ('the Fed'), bullish sentiment has returned to markets. However, we think investors should re-focus on ways of diversifying away from equities. We argue the supposed 'Powell Put', the idea the Fed Chair will step in to prevent the equity market from falling, does not in reality provide insurance for investors. However, perhaps paradoxically, actual options1 do provide a useful solution for investors at this juncture.

There are many ways to diversify risk, including, of course, a shift to government bonds. However, if late cycle worries about inflation resurface, bonds could do badly. We therefore explore two liquid diversifiers:

  • Retaining equity exposure but adding an option strategy known as a 'put-spread collar'
  • Shifting to funds which systematically sell options on equity indices to capture what we call an 'equity insurance risk premium' (EIRP)

The first idea is a tactical move. It involves both buying and selling options and is based on our view that the risks to the S&P 500 are asymmetric with negative to flat price returns more likely than high returns. The latter is a strategic shift to take advantage of an alternative source of return. Although this is positively correlated to equity returns at shorter horizons, it has a different long term driver. Our team of derivative experts can advise on the appropriate level of hedge, if any, depending on the client’s specific circumstances. For the structure we’re suggesting, a hedge of around 20% of the US exposure and shifting 10% to an EIRP strategy might be appropriate for a plan with no intention to change its strategic allocation to equities in the future.2

To learn more, download the full article above. 


1 Options give their owner the right but not the obligation to buy (a call) or sell (a put) on the underlying index at a given price (the strike) up to a certain date (expiry).
2 Why only have a limited switch if we think these ideas will add value? We don't know with certainty that we will remain in a rangebound market environment. A S&P 500 of 3100, or higher, at the end of 2021 when the hedge expires is perfectly possible if valuations remain elevated and profits continue to grow. A 20% hedge on a 20% exposure would be 4% of the portfolio. This will create risk relative to the strategic benchmark but not as high if a larger hedge was implemented. However, a client who envisages that the strategic allocation to equities is likely to come down may wish to consider a much bigger hedge. Alternatively, our experts may advise that the structure of the hedge should be focused more on retaining upside potential with a corresponding lower level of protection, in which case a much higher notional may be appropriate. We don't think the relatively high level of hedge is as appropriate for outside the US – again our experts can advise.


The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Diversification – does not ensure a profit nor does it protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility.


Appendix: Index Definitions and General Disclosures

S&P 500 – The Standard & Poor's 500, often abbreviated as the S&P 500, or just the S&P, is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.

VIX Index – Represents a 'risk-neutral' measure of the expectation of volatility of the price of the Standard & Poor's 500 Index, over the next 30 calendar days, by investors in S&P 500 index options. It is constructed by the Chicago Board of Options Exchange (CBOE) using the implied volatilities of a wide range of S&P 500 index options which have a maturity of between 23 and 37 days.


Legal Disclosures and Disclaimers

This document has been produced by Aon Hewitt’s Global Asset Allocation Team, a division of Aon plc and is appropriate solely for institutional investors. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. The information and opinions contained herein is given as of the date hereof and does not purport to give information as of any other date and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. The information contained herein is derived from proprietary and non-proprietary sources deemed by Aon Hewitt to be reliable and are not necessarily all inclusive. Aon Hewitt does not guarantee the accuracy or completeness of this information and cannot be held accountable for inaccurate data provided by third parties. Reliance upon information in this material is at the sole discretion of the reader.

This document does not constitute an offer of securities or solicitation of any kind and may not be treated as such, i) in any jurisdiction where such an offer or solicitation is against the law; ii) to anyone to whom it is unlawful to make such an offer or solicitation; or iii) if the person making the offer or solicitation is not qualified to do so. If you are unsure as to whether the investment products and services described within this document are suitable for you, we strongly recommend that you seek professional advice from a financial adviser registered in the jurisdiction in which you reside. We have not considered the suitability and/or appropriateness of any investment you may wish to make with us. It is your responsibility to be aware of and to observe all applicable laws and regulations of any relevant jurisdiction, including the one in which you reside.

Aon Hewitt Limited is authorized and regulated by the Financial Conduct Authority. Registered in England & Wales No. 4396810. When distributed in the US, Aon Hewitt Investment Consulting, Inc. (“AHIC”) is a registered investment adviser with the Securities and Exchange Commission (“SEC”). AHIC is a wholly owned, indirect subsidiary of Aon plc. In Canada, Aon Hewitt Inc. and Aon Hewitt Investment Management Inc. (“AHIM”) are indirect subsidiaries of Aon plc, a public company trading on the NYSE. Investment advice to Canadian investors is provided through AHIM, a portfolio manager, investment fund manager and exempt market dealer registered under applicable Canadian securities laws. Regional distribution and contact information is provided below. Contact your local Aon representative for contact information relevant to your local country if not included below.

Aon plc/Aon Hewitt Limited
Registered office
The Aon Center The Leadenhall Building
122 Leadenhall Street
London
EC3V 4AN

Aon Hewitt Investment Consulting, Inc.
200 E. Randolph Street
Suite 1500
Chicago, IL 60601
USA

Aon Hewitt Inc./Aon Hewitt Investment Management Inc.
225 King Street West, Suite 1600
Toronto, ON
M5V 3M2
Canada

Copyright © 2019 Aon plc


About Aon

Aon plc (NYSE:AON) is a leading global professional services firm providing a broad range of risk, retirement and health solutions. Our 50,000 colleagues in 120 countries empower results for clients by using proprietary data and analytics to deliver insights that reduce volatility and improve performance.

Aon Hewitt Limited
Registered in England & Wales No. 4396810
Registered office: The Aon Centre | The Leadenhall Building | 122 Leadenhall Street | London | EC3V 4AN

Copyright © 2019 Aon Hewitt Limited. All rights reserved.

Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances.

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