The ART of Risk Transfer (Part Two): The hedger

The trades fit into the risk transfer bucket and are made possible by the structural imbalances that follow the creation of structured products. Banks carry out the hedging so, as a simple example, if they are buying a lot of volatility from retail investors in certain products, they need to sell some volatility against this as a hedge.

If they can sell that in a packaged format to a new investor buying risk transfer products and spreading it against another risk transfer, they are passing along the risk, turning it into relative-value investment products. If there is one risk you may not want to hold outright, you can spread its relative value to another risk being held: you are long and short two things that are relatively correlated, so your net risk is smaller. Investors could lose here, but that loss would be mitigated by what they could make, so they are not simply betting one way on just a single exposure. It is more stable.

For the bank, the sale of structured products to retail investors makes for second- and third-order derivative risks – volatility, correlation, skew, convexity, volatility of volatility and so forth. At Societe Generale, we look for smart solutions and ways for investors to be ‘risk-off’ wherever possible, while generating carry. For example, if we are looking to buy skew from investors, we will look for a smart and structurally cheap way for them to buy volatility against this. Or if we are selling correlation on a basket of assets, we would explore methods for investors to own some convexity against this. There are premia to be extracted this way: setting up relative-value trades, being long one parameter that is structurally depressed, while being short another that is structurally rich.

Over the past 10 years, assuming clients traded at the current levels, the P&L has been asymmetric: the timing of such trades is appealing due to these entry points. Societe Generale has invested a lot of time in understanding the complementary nature of the various products within this family. Clients who have agreed and set up a portfolio of such complementary strategies are doing so to optimise their expected return for the lowest possible volatility, in a manner that is robust irrespective of the economic regime. This is the primary objective of setting up such a portfolio and taking a risk premia approach.

Robust strategy

The latest boost for these ART trades came in 2018 when more liquid alternative risk premia portfolios suffered a poor year, defying their promise of non-correlation and losing some of their most ardent advocates, most notably a handful of pioneering investors from northern Europe. Those invested in ART trades, however, were relatively unaffected and, on the whole, showed a good performance, with the rationale for why these trades moved a certain way remaining intact.

Another factor in favour of risk transfer comes in the guise of the many geopolitical risks that make it so difficult to invest with any degree of certainty. If you had been long equities early this year, you will have enjoyed moderate success. The same is true if you have been long duration recently but, generally, it is hard to have conviction.

Many investors have been caught out this year: those who wanted to be underweight duration and equities, as well as the many who started the year saying volatility was a definite ‘outright own’ here. Meanwhile, the family of ‘risk-off’ risk transfer products has performed consistently, doing what it said it would in terms of mark-to-market behaviour and realised P&L. When products made little money in some periods, investors did not lose. They just made less money than the year before.

The next step is to introduce investors that have followed one form of strategy to a portfolio of complementary types. If there are positive expected returns from holding a trade to expiry, the lowest volatility you can have going through the lifecycle, the better. Societe Generale has also been spending a lot of time on the road, educating global allocators that have neither looked at nor considered ART transfer, but have invested in hedge funds. This has led to some natural introductions between hedge funds looking to raise seed or additional capital for risk transfer-related funds, and allocators interested in what we have to say on the topic.

Part One of this story ('The ART of Risk Transfer (Part One): A flood of autocallables') was published on this site yesterday.