Convexity but not at all costs

investment viewpoints

Convexity but not at all costs

Jonathan Clenshaw - Head of Institutional Sales Europe

Jonathan Clenshaw

Head of Institutional Sales Europe

Positive convexity1 tends to be a highly desirable feature for institutional investors, yet the means to this end can differ vastly. Indeed, the many paths leading to convexity vary both in terms of method and cost. 

While our solutions approach convexity from different angles, they are united in their goal of maximizing positive convexity for good value. Our solutions focus on delivering asymmetric returns, ranging from instruments such as convertible bonds, to structural construction with derivatives in our alternatives portfolios, and downside protection techniques2 in our multi-asset portfolios. Our fixed income approach looks to moderate the negative convexity inherent in corporate credit.

Fruitful, long-term investing requires successfully achieving two objectives. Firstly, it means taking the right (or profitable) investment decisions more often than taking the wrong ones. Secondly, and equally importantly, it means earning more on profitable investments than what is lost on unprofitable ones.3

The concept of convexity - a non-linear relationship between the prices of two assets/strategies - is a key focus for almost all portfolio managers. At its most basic level, we define convexity as an investment that has upside potential while mitigating downside potential, and helps build better asymmetry of returns into a portfolio.

While our solutions approach convexity from different angles, they are united in their goal of maximizing positive convexity for good value.

We believe this is a key element of value-added and long-term outperformance, and especially suits institutional investors looking to offset a negatively convex profile emanating from their liabilities. For instance, insurance companies have negative convexity woven into the fabric of their business.  To compensate, they need a systematic approach that adds convexity and asymmetry, as well as helping to safeguard their capital position.

 

Fundamental drawbacks

Convexity can stem from deep and differentiated fundamental work that aims to find truly misunderstood and undervalued opportunities. Investing in those and building an efficient portfolio around them would result in exposure that should be naturally convex, even if there is no guarantee that this fundamental convexity will hold true in all market situations.

Furthermore, while proper due diligence can help put a floor on the value of a stock, the instrument is not intrinsically convex, and even the worst case scenarios which analysts build will hinge on their view of economic cycles and industry characteristics, and historical perspective.

Ultimately, this hypothetical view can be incorrect due to unforeseen events. Moreover, there is a risk that the fundamental analyst underestimates how bad things can actually get.

Turning to the value angle, one popular approach is to buy convexity through optionality. Options can have shortcomings, however, because they come at a price and can have implications for time decay and carry.4

For instance, one consequence of the standard option is that time value is embedded in the position that naturally bleeds away with the passing of time. In other words, an investor in an option has to pay on a continuous basis for the right to hold the convex instrument.

Ideally, the prudent investor will look to pay as little as possible for this.

 

Ingrained complexity

We believe that the more complex and hard to price an instrument, the more likely it is to be positively convex with potentially cheap carry. A convertible bond, for instance, combines various instruments and options, and its longer-dated nature means the underlying instrument is more likely to be mispriced and thus potentially cheap.

Indeed, convertible bonds have positive convexity built into their core because of their asymmetric return profile. That means convexity is an innate outcome that is not readily available for purchase in the market and gives a typical 3-5 year profile. The equity option embedded in the bonds gives the investor unlimited potential to invest in the upside of equities. Conversely, the bond element provides something of a buffer should the underlying equity fail to increase in value. Combining participation in rising equities but defence when equity markets are declining, convertibles naturally offer long-term, positive convexity.

Convexity can also be built structurally, whereby the consequence of positioning is convexity with limited or no negative cost of carry. This involves a highly bespoke approach that filters through the market for mispriced trades that, once they are combined, provide a convex return profile. Such trades can result from complacency in the market for instance, or from illiquidity. Broad investment expertise and bespoke systems are needed to construct a truly convex profile in this manner, as well as a flexible investment mandate. In such a capacity-constrained strategy, implementation is key.

Our strategies seek to optimise asymmetry in the most cost-effective way possible.

Our multi-asset strategy is oriented to reducing downside risk at a reasonable cost. Our proprietary dynamic drawdown management (DDM) process looks at four key components – realized drawdowns, risk appetite, robustness and relative drawdown – to determine how to best deploy risk. We believe taking into account these components improves portfolio efficiency, while addressing some of the pitfalls of option-based strategies. Careful design is crucial, however, to optimise cost efficiency.

Because fixed income as an asset class is inherently negatively convex, our fundamental fixed income team seeks to improve convexity in credit. We believe that the crossover area of bonds – rated BBB to BB – could help investors reduce their negative convexity exposure. Our way of building portfolios based on quality further enhances convexity characteristics. We believe the combination of these two factors better positions investors to withstand the risk of adverse outcomes. And it does so at no additional cost.

Many roads can lead to positive convexity. Our strategies seek to optimise asymmetry in the most cost-effective way possible.

 

Please find key terms in glossary.

 

Sources

1 We refer to convexity in this context as providing more upside than downside.

2 Downside protection represents a portfolio construction goal and cannot be guaranteed.

We note that some successful strategies, such as trend-following strategies, do not require being right more often than being wrong. In fact, they may be wrong more often. But the gains made from being right outweigh the losses from being wrong, meaning the overall strategy is profitable.

Negative carry occurs when the cost of holding an investment exceeds the income earned while holding it. Any investment that costs more to hold than it returns in payments can result in negative carry.

important information.

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