Alternatives, mispricing and convexity

investment viewpoints

Alternatives, mispricing and convexity

Christophe Khaw - Chief Investment Strategist 1798 Platform

Christophe Khaw

Chief Investment Strategist 1798 Platform

When it comes to sports analogies for convexity, none is better than baseball. The batting average describes an investment manager’s ability to get calls right through positions that create positive P&L or outperformance. Slugging percentage, on the other hand, measures the batting productivity of the hitter. This accounts for the number of hits as well as how far they travel. As such, slugging percentage aptly illustrates how well gaining positions perform versus how poorly losing positions behave.

The only way to achieve a high slugging percentage is to have convexity in the portfolio, in our opinion. Our Alternatives team constructs highly-bespoke strategies that are naturally, structurally convex while also featuring limited or no negative cost of carry. Such opportunities seek to exploit mispricing in the market in order to maximize the positive convexity of investors’ exposure.

Structurally convex strategies with limited or no negative carry rely on the ability to find mispricing between various instruments that also exhibit convex dependence on one another over time. This dependence must show more than a correlation that could be merely statistical.

In fact, the mispricing must be sufficiently significant to implement a strategy that offers a convex payout with limited or no time decay.

 

Exploring mispricing 

Why do mispricings exist? One reason is that although credit and equity markets are linked, traders and investors in these markets may have different priorities and emphases at various times. The derivative markets (equity, credit, structured credit, volatility) add an additional layer of complexity and thus another potential source of mispricing.

Mispricing has proliferated amid increasingly fractured liquidity in the market since the 2008 global financial crisis. One regulatory offshoot of the financial crisis was to reduce the role of banks as warehousers of risk. This has meant mispricing in the market is not necessarily smoothed out or rectified as it was in the past.

From a timing perspective, market trends indicate that certain convex strategies can be positioned for very favourable outcomes in the event of particular dislocations, with the cost of running these strategies being very low. There are fewer players presently in the market such as proprietary desks, while bond dealer inventory has plummeted and weaker competitors exited after 2008.

In addition, the market structure is also biased. Many participants are tilted heavily towards a long bias, and yield investors tend to distort prices when rates are very low. As a result it is possible to build strategies that seek to benefit from potential liquidity traps in the credit market, or outsized returns in market sell-offs while paying very little to run them.

 

Decompression trades

Decompression trades are a simple example of a cheap convexity strategy that can be put in place as a result of risk premiums compressing and overall complacency in markets. The idea of decompression is that at times, an issuer’s low-quality assets are priced too close to its high-quality assets. In these situations, being long high-quality assets and shorting low-quality assets creates an attractive, convex trade.

The downside is limited because the high-quality assets are unlikely to trade through low-quality assets, yet as the market sells off, the low-quality assets will likely underperform the high-quality assets significantly. This creates a positively convex profile that stands to gain more than it stands to lose.

 

Overcoming barriers to entry

Harvesting such opportunities requires specialists to overcome the ample barriers to entry. Requirements include a flexible investment mandate, broad investment expertise both across asset classes and within asset classes, expensive systems, and somewhat nimble capital.

Such requirements complement perfectly some of the mandates of our 1798 Alternatives platform. Our team is focused on managers who are deeply proficient in convexity-driven investing and we have the infrastructure and governance in place. The platform prioritizes an institutional framework, with the ability to onboard strategies that face little competition but rife opportunities for specialists.

A bespoke approach to exploiting mispricing, we believe, is one way to achieve a high slugging percentage.

 

Please find key terms in the glossary.

 

important information.

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