The lazy or intelligent fund manager



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In funds management, we can find as many strategies as drops in the ocean. If we told you about one which had practically zero costs and allowed us to limit the maximum spread loss, would you say it’s a clever move, or a lazy workaround?

Fund managers follow the same logic that Darwin put forward in his theory of evolution: consistency, diversification and adaptability are crucial for survival.

Focusing on survival, the stress to which the manager is subjected comes from keeping up with the high quality expected of those who suggest active management, and never being outperformed by passive management products.

Let’s turn now to the following hypothesis, in which our YTD management, in a fund that aims to beat the EuroStoxx50, at the end of the year has been excellent, with a spread of 15%! So far everything is perfect, but now we face the problem that we need to maintain that spread until the end of the year without too much risk, immunizing our position in regards to changes in benchmark behaviour. Talk about pressure!

When shuffling through the proposals, it’s clear that there’s a lot of literature on diversification and hedging, but we should also mention that we have a lack of liquidity, and a number of rotation restrictions (phew, this is complicated…) so we discard the use of futures and basket remodeling.

Wait, wait! Sell your entire portfolio and buy the ETF associated with the index! I’ve already mentioned that I have certain restrictions, and some morals…

… But what do you think about the following proposal of using European options?

Benchmarking with options

  1. Sell N PUTs to strike K1
  2. Sell 2*N CALLs to strike K1
  3. Buy 3*N CALLs to strike K2

Obviously the above all expire at the end of the year, and underlie the EuroStoxx50.

In reality, there’s no such perfect symmetry, due to both the valuation of implicit volatility and the fact that current dividend rates are usually higher than the interest rates – obtaining a negative drift that would displace the payoff.

The straightforward nature of this basic strategy does not exceed any psychological tolerance or explicability that any client would require. And if we plan the payoff on the index’s profitability, we can see that if the market falls we are guarded against it, if the market goes up we arrive slightly late but in the same trend, and if the market barely suffers any movement, we enter an area of uncertainty that doesn’t worry us too much.

One of the advantages of this strategy is that, due to usual market situations, its cost is practically zero. Indeed, sometimes we would even receive money for its implementation!

Another advantage is that it allows us to limit the maximum spread loss that we’re willing to assume, playing with the distance between the different strikes used.

In the real case of using our purchased shares (which we don’t want to sell), and the beta in relation to the market, the third leg of the strategy would be equivalent to buying PUTs with the same characteristics as the CALLs, and taking a slightly more dynamic control of possible deviations.

This is one of many strategies, but since someone once told me ‘Sell in May and go away’

Will I be lazy or intelligent?

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