The strategy in brief
Consider a multi-asset strategy that aims to capture risk premia across all major asset classes in a diversified portfolio: structurally long bonds, equities, and commodities, with an options overlay that makes it short volatility. Allocations across asset classes would be adjusted tactically as the macro backdrop evolves.
Rationale and asset allocation
Traditional portfolio construction relies on an allocation split between equities and bonds, benefiting from their negative correlation: equities do well with growth, bonds do well when growth weakens and rates fall. But since the start of 2022, that relationship broke down. The return of high inflation pushed interest rates sharply higher, hurting both bonds and equities simultaneously. The asset class at the heart of that inflationary spike was commodities. Adding them to a bonds-equities mix is therefore a natural way to restore the benefit of negative correlation, since commodities tend to do well in exactly the environment that hurts both bonds and equities.
There is a second observation worth making: each of these asset classes has strong offsetting forces keeping it in check. Higher rates bring bond prices down, but in doing so they weaken demand, which adds to deflationary forces that ultimately support bonds. Higher inflation drives rates up and pressures equity valuations, but equities are real assets that benefit from nominal price increases. Supply shocks cause commodity spikes, but those spikes bring demand destruction that reverses much of the move.
While a portfolio wants long exposure to all three asset classes to capture the negative correlation, there is a strong case for further optimising returns by selling options against those positions, treating extreme moves in either direction as inherently short-lived.
This is especially compelling when implied volatility spikes on macro or geopolitical uncertainty, since that is when the options being sold are most overpriced relative to the likely persistence of the move. Within that overall framework, positioning in each asset class can then be optimised individually based on the prevailing macro and volatility conditions.
Macro environment: US fiscal dominance
After the fear of runaway inflation that dominated most of 2022, market focus shifted to fearing a sharp economic slowdown or outright recession. While inflation was no longer considered runaway, with central banks hesitant to ease and willing to keep rates higher for longer, there was a widespread expectation that the economy would not be able to cope.
A different view is that, particularly since Covid, the dominant force in the economy is not monetary policy but fiscal. The substantial stimulus deployed in response to Covid never really went away, and continued to support the economy. As monetary policy tightened aggressively, fiscal policy picked up the slack. Unlike the Eurozone crisis a decade earlier, where fiscal authorities were constrained by real and imagined fears of market discipline, the US government faces no such constraint on its spending capacity. To be clear, limits do exist, even for a monetary sovereign, even for the issuer of the global reserve currency. But they show up in the form of inflation rather than a market-imposed borrowing ceiling.
If anything, higher-for-longer rates, rather than limiting the US government's fiscal capacity, provide an additional buffer: protection against undesired high inflation, and room for the Fed to cut if and when the economy shows signs of weakness. That is a considerably healthier, and arguably more sustainable, equilibrium than the zero-rate policy that characterised most of the post-GFC era.
Equities and volatility
This looks like a genuinely healthy environment, not a bubble or euphoric market like 2021, and not an economy on life support via zero rates at risk of deflation, but a healthily expanding economy with interest rates comfortably above inflation. The repricing that followed higher rates had understandably weighed on equities, which traded in a wide range for an extended stretch, with mid- and small-cap stocks sitting well below levels from a couple of years earlier.
This is the kind of environment that favours expressing mild bullishness through bets against a collapse rather than bets on a strong rally. Selling puts instead of buying calls, or selling VIX futures to capture the volatility risk premium and, in particular, the futures roll premium. A short-volatility approach along these lines tends to work well as long as the term structure remains elevated and in contango; it becomes less attractive once the curve flattens out at lower levels.
Geopolitics, commodities, and oil
Ongoing geopolitical turmoil has direct implications for an oil strategy within this framework. A natural approach is to hold long exposure to far-dated Brent oil futures while overwriting nearer-dated contracts with calls, capturing the term structure backwardation plus an additional volatility premium by choosing the tenor with the richest skew.
At times the front of the curve sees heavy selling flows, making it more attractive to write calls a bit further out, in 3–6 month tenors. At other times, for instance during a sudden geopolitical shock that spikes both price and short-end volatility and shifts the skew toward calls, the short end becomes the more attractive place to sell again. The general principle is to keep rolling the maturity being sold toward wherever the curve currently offers the richest combination of skew and term structure, while maintaining a modestly positive net delta, a position that benefits most if the price simply stays close to or slightly above current levels, while collecting carry along the way.