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LONDON, June 20 (Reuters) - Investors are seeking new defences against possible falls in European stocks as indexes plateau near multi-year highs and traditional hedges prove ineffective in a market anaesthetised by near-zero interest rates.
These alternative tools range from option strategies aimed at minimising the cost of holding a hedge to investing in funds which aim to generate some returns irrespective of the stock market's direction, such as arbitrage hedge funds.
A 50 percent rally in European shares over the past two years has left investors fretting about high valuations and seeking to protect their gains against a possible selloff.
However, hedging tactics which worked during the jittery days of 2008 and 2011, such as straight bets on rising volatility, have proved inadequate in the current, becalmed market conditions, leading fund managers to look for alternatives.
"A direct exposure to volatility may hurt investors because volatility can still fall or stay at a low level for a long period of time," said Bruno Pannetier, chief investment officer of London-based hedge fund Old Park Capital. "Investors have to find new ways of hedging."
Hedging equity positions via futures on the Euro STOXX Volatility index <0#FVS:> (VSTOXX), which gauges the prices of options on euro zone blue-chips and tends to move inversely to cash equities, has cost investors dearly over the past two years.
Firstly, the VSTOXX has fallen roughly 65 percent since the Federal Reserve and the European Central Bank made plain in 2012 that they were prepared to pursue radical measures. The index has shown no sign of revival because the magnitude of swings in the Euro STOXX 50 index has been even lower than option prices imply.
Furthermore, since futures with longer-dated maturities tend be more expensive than shorter-dated ones at times of low volatility, investors would often have to stump up when selling an expiring contract to buy a new one.
To reduce this cost, some investors are buying a cheaper volatility future and selling a more expensive one, betting the latter will lose value as time passes.
"We have observed a trend for people to look for solutions that provide exposure to long volatility but minimise or reduce the cost of carrying that position," said Ryan Rogowski, head of asset manager solutions at Societe Generale.
"Of course there's no free lunch so ... investors must take a view."
Similar strategies can be implemented via put options, bets the market will fall.
Some investors are taking out "put spreads", or financing a put by selling another put with a lower strike price on the same stock, effectively betting that any fall in the share would be small.
More bearish investors are opting for financing their puts by selling a call, or bet the price will rise, on the same security, a strategy known as a "cashless collar".
"Investors are taking down their risk positions and a cashless collar or a put spread are a way to do this without paying too much premium out of the portfolio," said Lorne Baring, managing director of wealth management firm B Capital.
Demand for cross-asset protection has also been on the rise, with investors fearing any hint at a tightening of monetary policy would puncture the recent, twin rally in bond and stocks.
An example of these hedges, designed to protect investors against a rise in interest rates, is an option giving the holder the right to swap a fixed rate for one that tracks market prices.
While buying options, however cheaply, erodes returns if stocks rise and volatility remains low, investing in strategies which are altogether uncorrelated with the market's direction can boost a portfolio's performance.
Such strategies include buying equity funds in which long and short positions cancel each other out, leaving the fund "market-neutral", and arbitrage strategies, which seek to exploit unusual price moves, often using algorithms.
These strategies can, in theory, outperform at times of high volatility, where wild swings throw up buying opportunities.
"We're looking for protection and market-neutral strategies tend to offer that," said Oliver Wallin, investment director at Octopus Investments, a fund of funds. "I think they've got a really good place in well-constructed portfolios." (Reporting by Francesco Canepa; Editing by Ruth Pitchford)