Atlantic House CEO: The secret maths of derivatives

This article and the graphs mentioned can be seen here: Citywire Wealth Manager

With inflation and rates among investors' biggest concerns, Tom May outlines how derivatives can unlock powerful market signals in 2023.

It is a truism of investment management that at the start of each year we spend our time making predictions that we know full well are almost certain to be proved wrong.

The world is too complex, events too unpredictable, to believe we really know the future. It is an exercise, like making long-term weather forecasts, which seems to offer some comfort despite no real record of proving true.

The task for professional asset allocators is in reality much less about predicting the future and much more about building portfolios that have the resilience to survive an inherently unpredictable world.

In accomplishing this goal I believe every serious investor should consider the role of derivatives to achieve two key goals.

Firstly, well-used derivatives can reduce risk and increase the probability of a good outcome for a multi-asset portfolio even if this requires sacrificing the potential for an exceptional outcome.

Secondly, by carefully studying the derivatives market - and the real-time data it produces - we can gain clearer signals about how the world is changing.

We believe that UK private client portfolios can benefit from having investment managers who are engaged in the process of understanding these signals, even if they do not end up buying a derivative-based product or instrument as a consequence. They provide an important complement to the real world data points that form the bedrock of analysis for investment committees across the country.

Structural changes

In 2023 this is more true than ever because derivatives can open the door to understanding how the market is responding to a number of the most crucial structural changes taking place.

Foremost amongst these is what they tell us about the path of inflation and interest rates. If anyone doubted that the sorts of funds that thrive at any given time are those which are supported by a helpful tailwind from the monetary policy environment, then the last six months has removed this doubt.

The rapid rise in US interest rates utterly changed the leadership amongst equities, bonds and the funds that hang off them.

For many investors it is the decisions of the Federal Reserve that will be a key input to decisions this year as it contends with a slowdown in inflation, but one which must prove decisive before policy can be loosened.

Most investors are familiar with inflation-linked bonds which make up almost 15% of all G7 government bonds. These ‘linkers’ allow us to derive break-even inflation as a crude measure of inflation expectations, using the difference between nominal and real yields.

However, we believe deriving future expectations from inflation-linked derivatives is a more reliable and precise approach. Our weapon of choice here is the inflation swaps market. We can decompose zero coupon inflation swaps into implied future inflation rates for each major market.

These forward inflation rates of UK RPI shown in the chart below have been as predictive of future inflation as the Bank of England’s own model used in its famous inflation fanchart. The Old Lady’s projections are only available quarterly though, while the inflation swap market allows us to monitor future inflation expectations in real time.

The Fed Pivot

As well as understanding the future path of inflation the derivatives market provides us with a real-time signals for probably the most crucial question it presents: when will the Fed pivot its policy?

Whilst it’s tempting to base investment decisions on our own judgement around a question like this, and for example our own reading of every nuanced word in a Fed statement, the wider market itself will have more precisely analysed this problem and presented us its answer in data-form.

We consider this problem by looking at the swaption market.

The derivatives enable investors to swap the current interest rate for the interest rate that exists at a future date for example in three months time. Investors can choose to either buy the current rate and sell the future rate or vice versa.

The price that investors are willing to pay for this insurance can offer us important signals about whether they believe the risk is skewed to higher interest rates or lower interest rates than the consensus suggests.

Over recent months we have seen this skew change. In December investors were more cautious about the risk that interest rates could fall faster than anticipated.

However the derivatives market now tells us that as a result of the change in monetary policy stance and incoming data since then investors now see the risk as skewed towards rates staying higher than the general market assumes.

Finally, perhaps one of the best-known sources of data from the derivatives market could be particularly useful in 2023.

The market to buy volatility tells us much about whether it is wise to buy dips created by market falls. Many investors focus on the Vix index as a simple measure of market volatility.

However, derivative investors focus on the more esoteric area of the Vix futures strip market. This enables investors to bet on the shape of market volatility up to six months into the future. This future curve showing the market’s expectations of volatility can either shape upwards, indicating that further volatility is more likely in the future than the present or downwards suggesting a broad view that conditions will ease.

At the current time the curve slopes relatively steeply upwards. This tells us that whilst investors are quite sanguine in the very short term, they don’t believe we are necessarily completely out of the woods yet – a view that will not surprise many readers.

The exact application of the wide range of derivative instruments now available within private client portfolios, both within open-ended investment funds and through structured notes, must be judged by the individual asset allocator.

However, our conviction is that the signs the derivative market produces should be used as a valuable input to almost every investment process.

Tom May is chief executive & CIO of Atlantic House Investments, and manager of the Atlantic House Defined Returns fund