Thursday, 30 June 2016
Last updated 11 min ago
Jun 26 2013 | 2:10pm ET
The words of the Financial Times' James Morgan tell you all you need to know about derivatives, according to V2 Capital founder and chief investment officer Victor Viner: “A derivative is like a razor. You can use it to shave yourself… or you can use it to commit suicide.”
Viner uses the quote when pitching his fund—a strategy that is long equities, short index options. Viner says it's a response to those—like Warren Buffet, who once characterized derivatives as “weapons of mass destruction”—who look at the complex financial tools and see only risk.
“The gist is really good and it kind of sets a tone,” Viner told FINalternatives. “How we use options is all about reducing risk.”
Viner has been in the financial arena for over 25 years, holding senior positions at UBS and Credit Suisse Group. Prior to founding V2 Capital, he co-founded Volaris Advisors, a multi-billion dollar options firm acquired by Credit Suisse in 2003.
His latest venture was launched with partners Brett Novosel, a Bear Stearns vet who serves as co-portfolio manager, and Michael Holleb, a former manager with the accounting firm Michael J. Liccar & Co. and now V2's CFO and COO.
The strategy, which began trading almost three years ago, is based on Viner's earlier work. “For years, going back into the late '90s, I had been in the business of working with institutions as well as private clients, on using derivatives,” he said. “Over the years, I worked with many family offices and large holders of single, concentrated stocks—literally hundreds of millions of single stocks. We saw that these clients took a lot of risk in holding one equity.”
After the collapse of Lehman Brothers and the revelation that “there was a lot more risk inherent in the market than maybe they'd seen before,” Viner proposed to one of his long-term clients that, in addition to providing a portfolio of “solid companies,” they should “create a diversified structure of those stocks that would take away the idiosyncratic risk of one major holding and then use options to enhance that portfolio similar to what we had done on single-stock positions.”
The Options Option
To hedge those long bets, Viner writes index rather than equity options.
“Most managers probably use equity options, and I grew up trading equity options on the floor of the Chicago Board Options Exchange, so I understand them very well," he said. "The problem is, they're not as liquid as index options, they're not mispriced from a volatility risk premium stand point. What we wanted to do with index options was take advantage of the anomaly of the volatility risk premium. And the simple way to define that is, index options, both calls and puts, have been typically overpriced since the stock market crash of 1987.”
In addition, writing individual equity options on strong performing stock is tricky. “Take 2011,” Viner said. “The best performer in our portfolio was VF Corp. VF owns Timberland and the North Face and a lot of the jeans brands. It's a great company, it was up about 51% for the year. If you're writing options on that stock, you're going to get called away. We're very good at it, but nobody's that good—it went up too much, too fast,” said Viner.
V2 uses flexible exchange options, which allow the firm to customize key contract items like strike price and expiration date. Viner said the flex options also serve to eliminate counter-party risk—another post-Lehman Brothers concern for investors—as the Options Clearing Corp. guarantees every listed trade. Writing flex options on the long book allows V2 to create “an efficient portfolio of options very similar to the way people create an efficient portfolio of equities to diversify the risk of a single equity.”
What's more, he said, by writing on the broader portfolio, they allow their holdings to appreciate. “We believe in these holdings, we have a fundamental conviction holdings, so why would I want to cap that upside?”
V2's long portfolio is concentrated, comprising 35 to 40 names that meet the firm's definition of a “solid” company—one that pays a consistent and growing dividend, has a solid balance sheet and demonstrates good return on invested capital relative to its peers.
They want exposure to all 10 sectors in the Standard & Poor's 500 Index, but they also want diversified exposure within each sector, Viner said. For example, V2's current financial sector holdings include an insurance company, a real-estate investment trust, a money-center bank and a wealth management firm.
The risk in their approach, said Viner, is a lack of correlation between the equity portfolio and the index they're writing on, in this case, the S&P 500.
“We have to monitor our correlation of our equity portfolio to the overall broader S&P 500 market. Now, we're not just buying a basket of the S&P 500; we're not using the sector weightings to have similar weightings; we could care less. We do our own portfolio construction where we want exposure to all 10 sectors in the S&P, and then writing index options, giving us collectively a very low-volatility, equity-like product, maximizing upside capture and minimizing downside capture.”
Through the end of April, Viner said their volatility since inception in August 2010 has been 6.7%, compared to overall market volatility of 13.65%. Their Sharpe Ratio is 1.82. “We've gotten 13% annualized returns with a low vol, which is why our risk-adjusted returns are so good.”
V2 currently manages about $250 million—$32 million in the fund—but because they “primarily play in large caps and the options are liquid,” Viner sees capacity of “a couple of billion.”
His target investor is looking for equity exposure with low volatility.
“I think for institutions, pensions, others, that are currently underfunded, that have underperformed with active managers over a long period of time, we're offering a product that is understandable from a risk standpoint, has no leverage, and is...going to have a nice yield component. And by having a lower vol component, we're going to do better over a market cycle because when you do have these market drawdowns, you don't have to recapture as much."