Industry Voice: For Warren Buffett, derivatives were once "financial weapons of mass destruction", but for Insight Investment portfolio manager Colin Bennett they enable access to investment opportunities that can generate returns through different market conditions.
How do derivatives fit into a wider portfolio? In a low-yield world where volatility appears to be on the rise, that's a key question for investors - and one that Insight portfolio manager Colin Bennett considered at BNY Mellon's recent global investment conference.
Bennett, a portfolio manager on Insight's Global Absolute Return strategy, explained the long history behind derivatives. The first known forward contract, for example, appears in the Sumerian civilisation around 4,000BC. The Sumerians used tokens (to represent different commodities such as sheep or goats) baked into a globular clay envelope. The tokens held inside the globe represented transactions to be completed in the future as well as ones that had just been transacted. In case of dispute the clay globe could be broken open and the tokens inside accurately tallied.
Fast forward five millennia and forward contracts have become a part of everyday life - even if at times that goes unrecognised. Home ownership is an obvious example: at its heart, every mortgage is a promise to pay a defined sum by a defined date for a defined good.
Options, likewise, have been around for thousands of years. Here an early example comes from Greece where Aristotle relates how in around the 6th century BC the Milesian philosopher Thales used his superior knowledge of mathematics and astronomy to forecast a bumper olive harvest.  As an impoverished philosopher Thales lacked the capital to buy up olive presses in the surrounding area outright but he was able to secure a deposit granting him the option on their use. When harvest time came he was then able to lease out the presses to the highest bidder - thus reaping a healthy profit.
Given their longevity, says Bennett, it's no exaggeration to describe derivatives as having something important to say about the human condition - almost as if they reflect a fundamental desire to find upside in uncertainty or to create security in chaos. Investing today is no different - and derivatives remain among the most useful tools for those seeking above-average returns, particularly during episodes of volatility.
Of course, like any investment, using derivatives requires care and skill to manage both the investment opportunities they present and the unique risks that derivatives might introduce to a portfolio. But checks and balances, including stop-loss reviews to limit potential losses and extensive due diligence of derivative counterparties, can help safeguard the potential benefits that derivatives can present.
Bennett highlights how derivatives support one of the key characteristics of Insight's Global Absolute Return strategy: its ability to switch between traditional directional sources of return and alternative, less-directional sources (see Figure 1). When markets are trending up, the investment team tends to focus on traditional, directional sources of return such as equities, commodities and fixed income. However, when markets are falling or volatility comes to the fore, the team has the ability to deploy alternative, less-directional sources of return. These include relative value and range-bound strategies that employ derivatives alongside more ‘orthodox' areas such as infrastructure or dividend investing.
Figure 1: Directional versus less directional returns: aiming for long-term positive performance through different market conditions
Source: Insight Investment, April 2018.
Relative-value strategy: a case study
One recent example of a relative-value strategy executed within Insight's Global Absolute Return strategy, according to Bennett, was centred on improving growth momentum in the US and globally. The investment team believed the market would price in further US interest rate rises and that short-term bond yields would move higher in consequence. The team also expected structural forces and appropriate policy tightening to keep longer-term inflation expectations well anchored - meaning longer-term rates would remain low. In other words, they expected the US Treasury yield curve to flatten.
To capitalise on the opportunity, the team opened a position that would profit if the US yield curve flattened over the second half of 2017. They opened a long position in 30-year US Treasury futures coupled with a short position in 5-year futures. By the end of 2017, the yield curve had flattened, and the position generated a profit.
Figure 2: A relative value strategy in practice - the US yield curve flattened in H2 2017
Source: Insight Investment, Bloomberg as at April 2018
Range-bound strategy: a case study
An example of a recent range-bound strategy came in early October 2017 when credit spreads had fallen close to the low point in 2014. The team believed it was unlikely that credit spreads would fall much further, or that they would rise materially given the strength of prevailing economic data.
The team therefore opened a strategy that would profit if spreads traded within a range over the following six months. It would only lose money if spreads fell or rose materially. Credit spreads traded within the expected range over the period, and the strategy was closed in March 2018 at a profit.
Figure 3: A range-bound strategy in practice - credit spreads traded within a range
Directional strategy: a case study
A strategy reflecting the team's views on market direction was executed in late 2017, when the White House was trying to jump-start work on its plan to cut taxes. The team believed that if the tax plan was approved, the S&P 500 Index would rise; if it failed, they expected a small decline. The team therefore implemented a strategy that would record a profit up to a certain point if the Index rose, and that would not record a loss unless the Index fell materially.
In late December the US Senate approved the tax plan, paving the way for the most radical reworking of the US tax code in more than 30 years. Markets greeted the news with euphoria and the S&P 500 Index initially rose well above the maximum profit level of the strategy. This meant that despite a market sell-off in February, the strategy still comfortably generated the maximum possible profit by the time it expired at the end of March 2018.
Figure 4: A directional strategy in practice - US equities rose after the tax plan was approved
Source: Insight Investment, Bloomberg as at April 2018.
Source: Lipper as at 30 April 2018. Fund performance for the Institutional W (Accumulation) calculated as total return, including reinvested income net of UK tax and charges, based on net asset value. All figures are in GBP terms. The impact of an initial charge (currently not applied) can be material on the performance of your investment. Further information is available upon request.
 Sumer, located in modern-day southern Iraq between the rivers Tigris and Euphrates, was arguably the world's first civilisation.
 Miletus was an ancient Greek city on the western coast of Anatolia in modern-day Turkey.
 Aristotle: ‘Politics, Book 1', c.4th century BC
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Past performance is not a guide to future performance.
The value of investments can fall. Investors may not get back the amount invested.
Currency Risk: This Strategy invests in international markets which means it is exposed to changes in currency rates which could affect the value of the Fund.
Derivatives Risk: Derivatives are highly sensitive to changes in the value of the asset from which their value is derived. A small movement in the value of the underlying asset can cause a large movement in the value of the derivative. This can increase the sizes of losses and gains, causing the value of your investment to fluctuate. When using derivatives, the Strategy can lose significantly more than the amount it has invested in derivatives.
Changes in Interest Rates & Inflation Risk: Investments in bonds/money market securities are affected by interest rates and inflation trends which may negatively affect the value of the Strategy.
Credit Risk: The issues of a security held by the Strategy may not pay income or repay capital to the Strategy when due.
For Professional Clients only. This is a financial promotion and is not investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations. Any views and opinions are those of the investment manager, unless otherwise noted.
For further information visit the BNY Mellon Investment Management website. INV01288-004 Exp 15 Nov 2018.