Active management and active managers often get highlighted for their discretionary abilities when stock picking, particularly in a volatile market. That said, the active umbrella is much larger and can look a whole lot of different ways, from simply being index-agnostic to blending in options and having control over when to exercise them.
Garrett Paolella, managing director and a portfolio manager at Harvest Volatility Management, recently sat down with VettaFi to discuss what active management looks like regarding collar strategies and risk management and the benefits of utilizing options when it comes to equity investing. HVM currently provides portfolio management for Nationwide’s ETF lineup.
Active management within risk management strategies isn’t discussed often, and Paolella observed how an active strategy differs from a passive one within this arena. In the case of Harvest Volatility Management’s approach, it isn’t about individual discretion but instead the inclusion of factors and data beyond just the index.
“We like to embed what we call active risk management within our investment strategy,” Paolella explained. “These aren’t just a static index; we are looking at a number of underlying data sets and a number of different factors to give us what we think our rules-based approach should be.”
Collar Strategy Breakdown
A collar strategy entails holding the shares of an underlying security while buying protective puts and writing covered calls for the securities. A put allows but does not force the owner to sell the underlying security at an agreed-upon price by an agreed-upon day. At the same time, a call gives the owner the right to buy the security at an agreed-upon price by an agreed-upon day but does not obligate them to do so.
Collar strategies aren’t new by any means, but they can be a particularly appealing strategy in challenging times due to their ability to provide income from writing calls while offering the potential to reduce volatility and offer a measure of downside protection through puts.
The way that Paolella and the portfolio managers at Harvest Volatility Management — pioneers of some of the first options-based ETFs in 2013 — are utilizing collar strategies goes beyond just the ordinary, however.
“We wanted to take it a step further and basically create a net credit collar that allows us to not only generate a net credit that can be used as an income source for investors, but take a portion of that and buy an out of the money put, which could do two things: reduce volatility in the overall fund, and then also offer a measure of downside protection,” Paolella explained.
Within this strategy, the portfolio managers at HVM can exit a call early within the month window between resets if markets look to be moving strongly to the upside, and that upward movement could continue. By leaving the call position, more of the portfolio’s underlying securities can be engaged in the upside movement, capturing more of the price action. It can also leave the portfolio open to more volatility should markets abruptly reverse, but the protective put always remains.
The other time that exiting a call position makes sense for the fund is when the market is falling precipitously.
“If the market has a pretty significant sell-off and we’ve earned the majority of our opportunity out of the call option and the income we could generate, we’ll close that,” said Paolella.
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Breaking It Down Further
Modeling this kind of data-driven approach to risk management involves a host of factors, including looking at the price movement of a broad index and comparing that to the volatility index for that underlying index, the rate of change over rolling periods, what the options market looks like, and much more. All the data gets collated into a model that then works to predict what the next month will look like and how to position the collar.
The portfolio managers then look at the model and decide what optimal positioning is, toggling between slightly more risk-averse or slightly more risk-on.
“Part of our model is trying to assess the overall probability of what the expected outcome can be and then where we want to set our collar; slightly more risk on or slightly more risk-off, but not definitely not a binary,” Paolella said. “It’s a very subtle, subtle change, but we do want to have the ability to capture a little bit more upside. The other products out in the marketplace are not doing that.”
The Challenges of 2022 Markets
“This year has been more challenging for the strategy because when you look at the model as a whole, what we’re trying to do is play to probability; we want to play to the highest probability of the market historical data,” explained Paolella.
From a probability perspective, this gradual fall of markets over multiple months has rarely happened historically. It has created a perfect storm for many collar strategies, with markets never falling precipitously enough within a month to engage the protective puts. However, the system can still capture income from the covered calls and any dividends earned from the underlying securities.
“You want to look at this as long-term because we’re going to consistently deliver you your monthly distributions because we built a strategy that we feel is right in rising equity markets; we can deliver you your distribution in a flat market, we generate a net credit plus dividends in a down market. In a down market, we do the same, and we still might generate value out of the put as well,” Paolella said.
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