Equity convexity value - Holding positive gamma conditional on the macro environment

 

How do you create an edge in current market environment where monetary policy is being normalized, volatility is rising, and stocks may have a negative bias? It is a good time for stocks that have positive convexity, yet finding positive convex stocks is not a structural characteristic but a matter of empirical testing. Equity convexity is subject to change and needs to be forecast yet finding a positive convex stock portfolio can protect against downside risk and allow for some upside potential. This is the subject of a recent paper, "Equity Convexity and Unconventional Monetary Policy".

The researchers at Amundi Asset Management look at potential drivers of stock convexity and find that there are both bottom-up and top-down factors that will help with sorting stocks to find those that may have the highest gamma. The equity gamma differs by both sectors and factors. 

From a bottom-up perspective, value (price to book) and historical volatility can be used to differentiate between convex and concave stocks. From a top-down perspective, short-term rates, the VIX and oil prices drive the gamma portfolio.

By focusing on long convexity and using macro signals, the researchers found that a portfolio can be developed with higher returns and higher return to risk than holding an index (MSCI world), albeit for a limited period.

Macro equity investing can be used to generate excess return through looking for positive gamma stocks. There is no prediction on the future environment or on the earnings of a given stock, the focus is on finding stocks that will have positive gamma in different environments.