New Era of Stock Supremacy Turns Tail-Risk Hedging Upside Down
(Bloomberg) -- Just months after the pandemic broke out, Dennis Davitt was busy pitching his bearish investment fund to panic-stricken clients prepping for the next market crash.
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These days though, the former Credit Suisse derivatives chief is on a different capital-raising mission altogether: Selling amped-up bullish options strategies to institutional investors fearful of missing out on the next stock boom.
“It’s primarily client-driven,” said Davitt, who heads up Millbank Dartmoor Portsmouth, a volatility firm in Asheville, North Carolina. “Their worry is — as the market continues to move forward as it has been — all the performance in the investing universe is going to be coming from public equities. My feeling is nobody owns enough of them.”
It’s the latest sign of the stock mania on Wall Street, where owning too few shares is the new risk for a cohort of bulled-up investors. The S&P 500 has already posted more than 30 records this year alone in a melt-up that has defied everything from delayed monetary easing from the Federal Reserve to geopolitical turmoil.
Now volatility managers like Davitt, who typically design defensive portfolios, are structuring strategies to amplify equity returns, by buying and selling options that pay off when the market lurches upward. It’s a speculative pastime typically enjoyed by the retail crowd.
Responding to demand initially expressed by a pension-fund client, his firm in December launched an $85 million portfolio that actively manages derivative positions based on volatility signals and the relative cost of options. By employing leverage, the fund aims to outperform the market on the way up, while providing a buffer on the way down.
The MDP team has secured over $40 million to back another fund that deploys bullish-call spreads on the S&P 500 to ride rallies, by buying a call contract while simultaneously selling another at a higher strike price. The trade is funded by selling puts and includes a long-put position to protect against sudden meltdowns.
“When I started the firm in 2020, there was a need for a hedged-equity product. There was clearly a demand for people wanting to be long the market, if anything, overly long the market, but to have some sort of hedge,” said Davitt, who began trading stock options in 1990. “What has changed is people’s allocations.”
Investors, particularly those who have boosted exposure to fixed income and private assets, may live to regret not going all-in on equities as the tech-powered market advance continues. Broadly, the average institutional investor, including pensions, endowments and insurance companies, has kept their equity exposure unchanged at 38% over the last four years, according to a recent study by Preqin. During that period, the S&P 500 is up 12% a year, compared with a loss for fixed income.
That relentless equity rally has dealt a harsh blow to investment funds that hedge against market crashes. Those set up to profit from unexpected calamities, or so-called tail risks, have suffered closures and giant outflows in recent years.
Unlike those focusing on negative outcomes, or left tail, Davitt’s new funds put an emphasis on positive outcomes, or right tail.
From big money managers to day traders, investors of all stripes are trying to catch up with the market advance — and options are their go-to investing tool. The evidence is most pronounced in technology megacaps whose 187% share surge since 2023 has crushed almost everything else. Trading volume in their bullish call options last week outstripped that of bearish puts by a record amount, data compiled by Deutsche Bank AG show.
Typically, puts cost more than calls, leading to a so-called positive skew, as traders hedge the risk of losing money. This year, however, more stocks saw calls in their favor. In March, for instance, 12 members in the S&P 100 experienced skew inversion, the most since the 2021 meme craze.
At the same time, the fear of missing out may have fueled a breakdown in the relationship between equity prices and volatility. Usually when stocks fall, expectations rise that equity prices will post bigger swings ahead. That’s because traders turn to put options for protection, leading to the inverse relationship between the S&P 500 and the Cboe Volatility Index, a cost gauge for options and commonly known as the VIX.
This year, the two have spent 27% of the time moving together — a frequency not seen in nearly three decades.
“When the market has been going up more than it’s been going down — and the up days have been larger than the down days — you could see this sort of reach or grab for upside that’s pushing the VIX higher,” said Danny Kirsch, head of options at Piper Sandler & Co.
That’s not to say stock hedging has vanished on Wall Street, and the likes of Davitt at MDP are still designing portfolios for clients playing defense. Yet the newfound demand to maximize returns is a notable shift for his typically conservative cohort of clients that include pensions and endowments.
“My clients who use me for hedged equity are saying that is not as much of a concern of theirs anymore,” the money manager said. “Winds change,” he added. “We change the sails.”
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