Friday, 28 April 2017
Last updated 5 hours ago
Mar 23 2017 | 5:39pm ET
Editor's note: In late February, FINalternatives' Garrett Baldwin sat down for a Q&A with Rick Selvala, CEO and co-founder of Harvest Volatility Management, LLC (Harvest) to discuss his firm’s strategies, current events and expectations for the markets moving forward. Selvala graduated from the University of Michigan with a BSME in 1985 and received his MBA at Harvard Business School in 1990. His career has taken him from the corporate treasury world to the hedging of commodities, currencies, fixed income and equities. After joining Credit Suisse in 2002, he would become the co-head of Volaris, a wholly owned subsidiary focused mostly on covered call strategies for clients with large concentrated equity positions.
In April of 2008, he left to launch Harvest with Curt Brockelman (formerly of Perch Bay Partners and Smith Barney). Today, Harvest is managing over $9 billion in volatility based strategies that seek to either (a) add incremental yield/returns to existing client portfolios; (b) reduce the risk and volatility of long equity holdings; (c) generate compelling risk-adjusted absolute returns with low correlation to other investments; or (d) outperform the S&P 500 with similar levels of volatility and less risk.
FINalternatives: Tell us about your most popular strategy.
Selvala: Our most popular offering is the Collateral Yield Enhancement Strategy (CYES), which is run as an overlay with no capital commitment or opportunity cost. In the CYES we manage a portfolio of iron condor structures via separately managed accounts using listed SPX index options. This strategy generates option premium by selling overpriced volatility with limited risk (i.e., the CYES sells rich options to collect premium and buys cheap options to limit/define the maximum loss potential).
The CYES seeks to exploit the richness of implied over subsequent realized volatility and the natural time decay of options. It’s effectively a “portable alpha” strategy i.e., clients can add the Harvest CYES overlay to their existing portfolios without changing their asset allocation.
In the nine years since inception, the CYES has added about 1.5% of incremental returns net of fees over and above the returns on each client’s other investments (equities, fixed income, cash etc.,). In other words, if clients are long equities and can add 1.5% per annum, their returns would improve from the middle of the pack to the top decile (or better). If clients can add 1.5% on top of their fixed income, the relative outperformance is even greater.
Because we manage risk and keep the maximum loss contained, clients can dial up their notional up to 3-4x the margin release capacity on their securities (which would have added 4.5-6% of incremental returns per annum since inception). This works particularly well for clients who are running more conservative asset allocations or portfolios.
At the end of the day, in our opinion and experience, if you are not using an overlay strategy like CYES, you are leaving significant return potential on the table.
Who are your typical clients?
The CYES has 800+ separately managed accounts across eight different platforms at firms like Merrill Lynch, Morgan Stanley and UBS – plus Schwab, Fidelity and Pershing via independent RIAs. To date, most of the clients have been ultra-high-net-worth individuals and related entities. That being said, we are starting to see more interest from institutional investors and consultants as well.
What is your elevator pitch?
How do you find yield in a yield starved world? Extremely low interest rates have pushed some investors into equities because their dividend yields are often higher than bonds (plus they have the potential for growth over time). Similarly, fixed income investors with certain return requirements are being forced to extend out the duration curve or to go down the credit curve. In all of these cases, investors may be forced to take on more risk than they would like – with significant implications if we ultimately see a large scale correction in either equities, bonds or credit spreads.
Harvest provides investors with an alternative solution to this fundamental problem i.e., an ability to add incremental yield or returns through the CYES overlay (without taking on more equity, duration or credit risk than they would like).
For those looking for a compelling allocation for their capital, we also have the Harvest Volatility Alpha Fund (HVAF) - a hedge fund LP version that runs CYES on cash at 3-4x. The HVAF targets T-Bills plus 6-12%.
When you said that CYES was within the platforms, does that mean that it's like a turn-key plugin?
The CYES is not really turn-key since it’s offered via separately managed accounts and there is generally more education involved. Although each of our distribution partners and custodians have performed extensive due diligence on Harvest, clients cannot just check a box, get a prospectus and make the investment. The client needs to sign an Investment Management Agreement with Harvest and open a separate margin account at their broker dealer/custodian with the highest level of option approval for their Harvest positions.
In addition to extensive due diligence before approving Harvest on their platforms, our distribution partners and custodians conduct annual check-ups to ensure continued and ongoing compliance. They also see every trade and the corresponding margin capacity utilized and our active risk management. As such, they are very comfortable with the risk and reward inherent in the CYES strategy.
Is there a benchmark or comparable strategy out there?
There are a handful of managers offering iron condor or similar strategies, but they generally take more risk (with the inherent larger draw downs and longer recovery periods). Harvest CYES has become the largest iron condor manager on the street due to the length and quality of our track record and our reputation as the best risk manager on the street (with the smallest drawdowns and quickest recovery periods). The CBOE launched an iron condor index (CNDR) which is helpful to investors and consultants looking to validate the space and to provide a comparison of returns, risk, standard deviation, drawdowns and recovery periods over time.
Give us an example of what a typical trade looks like?
We only trade SPX index options on the S&P 500. We typically go out 1-2 months and stagger and ladder a portfolio of iron condor structures utilizing weekly, monthly and quarterly expiration dates. In simple terms, we generally sell 15-25 delta options to collect premium (i.e., 20 delta calls on the upside and 20 delta puts on the downside) and buy 3-7 delta options to limit our risk and maximum loss potential.
We trade SPX index options (rather than options on ETFs or individual stocks) for several reasons:
First, SPX index options provide the deepest and most liquid of all option instruments. This enables us to trade as efficiently as possible while minimizing frictional and execution costs.
Second, because it's large size, we need fewer SPX index option contracts that we would on smaller indices, ETFs or single stocks. Fewer contracts means smaller commission/execution costs.
Most importantly, SPX index options get Section 1256 tax treatment which provides a more favorable blended rate (60% LTCG / 40% STCG) rather than 100% STCG.
When have you seen challenges to the strategy?
The strategy does best in choppy, side-winding, range-bound markets. In other words, the Harvest CYES does best when other investments aren’t doing much. In that case, the strategy will make money on both sides – with less active management or rolling required. Range trading is best for the strategy but, since we launched in April of 2008, it seems the market has either been free falling or surging – both of which can be a challenge to the strategy. The return of more normal range trading will be very good for the strategy.
While the strategy can make money whether the market goes up or down, the CYES will be most challenged during extreme SPX surges or collapses (we’ve seen plenty of both in our nine years). We have managed through extreme SPX collapses in the fall of 2008, Q1 of 2009, the Flash Crash in May of 2010, the Euro debt and U.S. credit rating crisis in 2011, the Ebola scare in August of 2015, etc. We’ve also managed through extreme surges after each of the collapses above – especially since the lows of March of 2009 – as well as the market surge in 2013, the v-shaped recoveries in 2014, and the post-BREXIT and post-U.S. Presidential election rallies in 2016 and into 2017.
Despite these extremes, we’ve delivered +1.5% annualized returns net of fees since inception with 7/9 years positive; a best year of +3.62% and worst year of -0.68%; a best month of +3.51% and worst month of -2.83; annualized standard deviation of 2.39% (with 5 straight years at 1.58% or less).
With the VIX hovering near 12, what is your outlook moving forward?
We are a perpetual seller of volatility, which may give some clients pause with the VIX around 12. However, even with the VIX at 12, realized volatility has been closer to 5 – which means the richness of implied versus realized remains robust (and good for us). Even if volatility increases, we mitigate the potential impact by staying relatively short dated, only selling spreads, and generally re-selling every week. In other words, we can still make money if volatility increases. If it increases too far too fast, it won’t be good for the positions already in place, but it will be very good for the positions we haven’t yet written.
Do you expect volatility to remain low during Trump’s presidency?
While the extent of the post-election rally has been surprising, the lack of any [meaningful] pullbacks and extremely low levels of volatility has been even more surprising. The market seems to be pricing a powerful combination of deregulation, infrastructure spending and tax cuts. We know, at some point, there could be disappointment and we’ll see a pullback, more two-way range trading and higher volatility once again (which will ultimately be good for us again).
What else has you excited for 2017?
In addition to the continued growth in the CYES, including new platforms and institutional interest, we have launched a suite of yield enhancement strategies to allow clients to choose the overlay that works best for them. In some cases, call writing strategies might be more appealing for those holding concentrated or overweight equity positions (short calls are negatively correlated to the underlying). Similarly, for those who are overweight fixed income or cash (and underweight equities), put writing strategies can give clients some less risky equity exposure while exploiting the richness of implied over realized volatility – and the richness of skew for the downside puts.
We have also launched a suite of investment strategies (allocations rather than overlays) that are building nice track record, momentum and AUM. These include a Long/Short Replacement (LSR) strategy, a Purchasing Power Protection (PPP) strategy, and an Enhanced Equity Strategy (EES) which seeks to outperform the S&P 500 with similar standard deviation but lower risk. The EES in particular seeks to exploit the richness of implied versus realized volatility; the richness of downside skew; the decay characteristics of short versus longer dated options; and the benefits of selling spreads versus buying outright longs. In our opinion, these are a more continuous and perpetual source of alpha than other alternatives.