Negative sentiment is usually hard to shake and reputations hard to recover. The fear and skepticism linger, and it’s no surprise that these instruments have become associated with speculation, high risk and, ultimately, losses. But, as we face the uncertainty of 2023, amidst threats of a global economic recession, one could benefit from some assistance when navigating these markets. Enter: derivatives. 

What we don’t see in the headlines is all the times that derivatives were successfully used to protect investors from downside risk during uncertain times. The market is notoriously difficult to predict and during periods of market volatility, as we are currently experiencing, it becomes more likely that we could suffer a sudden downturn. It is in these instances where derivatives can be used as a powerful tool in the investment world. Instead of being used for leverage or gearing, which, as history has shown, adds risk to your portfolio, they can be used as a form of “insurance.” If a portfolio manager is concerned about a possible market decline, they can invest in a hedging structure that is set up to limit losses in the event that this happens. 

So, what is a derivative? A derivative is a product that derives its value from an underlying asset. This underlying asset could be shares, bonds, currency, or commodities, to name a few. The most common derivatives used in investment management are Options, Futures, Forwards and Swaps. There are nuances to each but in any of these derivative structures, you enter a contract that either gives you the option or the obligation to buy or sell the underlying asset at a future point in time, and importantly, at a predetermined price. 

Here is an example of an Options contract and how it works: if you hold a particular share, and you think the price may decline in the near future, you could enter an options contract which would give you the option to sell the share if the price started declining. There may be a certain price where, any price lower than this, you would deem the losses to be too great, or you may just want to lock in profits that you have already made. This is the price you would set as the sell price in the contract. If the share price does decline, you can sell your share for this price and limit your losses. Remember, if you didn’t have the options contract, you would need to sell your shares in the open market at whatever price it is currently trading at. It is important to note that the contract gives you the option to sell and limit your losses, but you are not required to do anything if the price doesn’t move, or even goes up! The contract merely expires after a specified period. 

The catch is that this “insurance” is not free. You need to pay a premium which forms as compensation for the counterparty to your contract. In conclusion, you pay a fee (and lose some upside profits) to gain the option to limit losses in potentially negative scenarios.  

Investment managers use derivatives in a myriad of ways to add value to the portfolios they manage. One way, as mentioned, is for risk management – when risk is an important consideration in a portfolio, measures need to be put in place to ensure that they are able to deliver on the capital preservation targets. As in the example above, derivatives assist the portfolio manager to hedge against sudden, negative market movements by paying away a portion of upside potential to limit losses. 

In addition to risk management, derivatives can be used to enhance efficient portfolio management. They can be used to gain exposure to an underlying asset, without actually owning it, which has its own benefits. For example, buying Futures on an Equity Index gives you exposure to the market movements of the underlying shares but is more cost effective than buying the physical shares as this method incurs lower brokerage fees. Futures are also more liquid and thus more easily traded than the physical asset. 

Derivatives can also be used to apply tactical tilts to a portfolio, which are short-term deviations from the strategic asset allocation, to express a portfolio manager’s views. Instead of buying and selling physical assets, which, again, incurs fees and can be affected by liquidity constraints, a derivative structure that overlays the portfolio can change its composition in a cheap and efficient manner. Another example would be taking the full 45% offshore exposure in a balanced portfolio, as per the new changes in Regulation 28, and using derivatives to strip out a portion of the currency risk. This gives the investor exposure to the offshore assets, and the resultant diversification, without adding any undue volatility from fluctuations in the rand. 

It’s clear from the advantages highlighted above that derivatives are not the problem – it’s how they are used. They are certainly complex and can be risky if they are being used for speculative purposes or without a deep understanding, but investment managers with expertise in this area can exploit these skills to reduce risk and enhance returns in their portfolios. At Prescient we have extensive experience in using derivatives for these purposes and have a successful track record of doing so.

Managing the downside risk may come at a marginal cost, but the power of compounding positive returns through time is priceless and leads to consistent outperformance. We cannot predict the market, and we don’t try to. What we can do is give our clients the best possible investment outcomes by using all the tools available in our toolbox. Derivatives can help create a degree of certainty in these increasingly uncertain markets, something that we, at Prescient, consistently strive to do for our clients. DM/BM

Author: Natalie Anderson, Investment Specialist at Prescient Investment Management

DISCLAIMER:

• Prescient Investment Management (Pty) Ltd is an authorised financial services provider (FSP 612).
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