teach-in presentation: protect your assets - equity downside hedging, 16 sep 2014
DESCRIPTION
Protect Your Assets - Equity Downside Hedging: presentation from the teach-in covering why tail risk hedging may be useful for institutional investors, types of strategies available and important things for investors to consider.TRANSCRIPT
Protect Your Assets:
Equity Downside Hedging
Tuesday 16th September 2014
Teach-in Equity Downside Hedging September 2014 2
Background
Teach-in Equity Downside Hedging September 2014
Introduction
3
“Frankly, we have just taken a very important decision with a view to tackling the crisis. As I have said, this is a fully effective backstop removing tail risk for Europe, and I would not want to speculate on other measures for the time being at least.”
Mario Draghi ECB Press Conference September 2012
Teach-in Equity Downside Hedging September 2014
Introduction
4
• Equities continue to rally, but investors remain wary of risks
• Opportunities have decreased in other asset classes (notably credit)
• Driven an interest in tail risk hedging approaches (although in some ways this is
nothing new)
• One illustration is the growth in VIX futures contracts volume (below)
Growth in VIX futures volume (total open interest in number of contracts)
Source: CBOE
Teach-in Equity Downside Hedging September 2014
Contents
5
• Background
• Equity risk
• Why
• As a pension fund, why does tail risk matter
• What
• What are the products/strategies that are useful
• How
• How can the available approaches be employed in practice
Teach-in Equity Downside Hedging September 2014
The downside risk of equities
6
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
Dai
ly r
etu
rn (
%)
Teach-in Equity Downside Hedging September 2014
The downside risk of equities
7
-100%
-90%
-80%
-70%
-60%
-50%
-40%
-30%
-20%
-10%
0%
1927 1940 1954 1968 1981 1995 2009
Ind
ex D
raw
do
wn
fro
m p
rio
r p
eak
(%)
Equities tend to experience infrequent large drawdowns (>30% +) Even ignoring the early part
of the 20th century this still happens frequently enough to be a problem in a portfolio context
Teach-in Equity Downside Hedging September 2014
The downside risk of equities
8
Equity performance, even over
long periods of time can be
influenced by large falls
http://www.nytimes.com/interactive/2011/01/02/business/2011
0102-metrics-graphic.html?_r=0
Teach-in Equity Downside Hedging September 2014
Why invest in equities?
9
• Very long term (100yrs+) evidence of a positive risk premium
• Can experience significant falls in value (30%+ over multi-year periods)
• Liquid
Teach-in Equity Downside Hedging September 2014 10
Why?
Teach-in Equity Downside Hedging September 2014
Why does downside risk matter? A definition of Tail Risk
11
An event outside the confidence interval
used by an institution …..
That makes the investment objectives of
the institution unlikely to be achieved
Teach-in Equity Downside Hedging September 2014
Example Pension Schemes and their objectives (1)
12
Objective
Primary Funding Objective
Expected return Gilts + 2.0%p.a.
Required return to 2037 Gilts + 2.0%p.a.
Risk
1 Year 95% VaR £122m
1 Year Required Return at Risk 0.8%
0
200
400
600
800
1,000
1,200
1,400
£mm
Assets Liabilities
Teach-in Equity Downside Hedging September 2014
How can downside risk affect the objectives (1)
13
Strategy Starting Position Required Return % p.a. (Over Gilts) Full Funding Date Funding Level
Current Base 2.0 31/03/2037 71%
-10% fall in assets 2.7 31/03/2037 64%
-15% fall in assets 3.2 31/03/2037 60%
-20% fall in assets 3.6 31/03/2037 56%
0
200
400
600
800
1,000
1,200
1,400
£mm Assets Liabilities Assets realised
In this example, a fall in assets of any more than 10% throws the scheme off its flightplan,
meaning a revised full funding date or increased contributions
Teach-in Equity Downside Hedging September 2014
Example Investor and their objectives (2)
14
• Pension fund or SWF
• Targeting real return of +3-4% over long term (rolling 5 year periods)
100%
120%
140%
160%
180%
200%
220%
240%
2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034
Teach-in Equity Downside Hedging September 2014
How can downside risk affect the objectives (2)
15
• A 15% capital loss can make a 5 year excess return target start to look pretty
unachievable
• Even rolling the time period back to 20 years the returns required to meet the same
objective are c1%p.a. higher
100%
120%
140%
160%
180%
200%
220%
240%
2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034
5 year periods Excess Return Target >> 3.0% 4.0% 5.0%
-10% 5.3% 6.3% 7.3%
Capital Drawdown >> -15% 6.5% 7.5% 8.6%
-20% 7.8% 8.9% 9.9%
-25% 9.3% 10.3% 11.4%
20 year periods Excess Return Target >> 3.0% 4.0% 5.0%
-10% 3.6% 4.6% 5.6%
Capital Drawdown >> -15% 3.9% 4.9% 5.9%
-20% 4.2% 5.2% 6.2%
-25% 4.5% 5.6% 6.6%
Teach-in Equity Downside Hedging September 2014 16
What?
Teach-in Equity Downside Hedging September 2014
Tail risk hedges?
17
Put options
Options collar
Put spread
US treasuries
Commodities
Gold
CTA Managers
Smart Beta
Low volatility stocks
Risk control
VIX
Variance Gilts
Cash
DGF Gilts
CDS
Short index futures
Tail risk funds
Teach-in Equity Downside Hedging September 2014
The three layers of portfolio risk management
18
“Risk Management should be put in place in the good times to have most effect in the bad times”
Diversification
Downside protection
Risk Control
Teach-in Equity Downside Hedging September 2014
Improving risk adjusted returns
19
We use the Sharpe ratio* as the basis for assessing risk adjusted return. It
isn’t a perfect measure, but is a reasonable starting point for assessing
assets on a risk adjusted basis
Effect on Sharpe ratio
Sharpe Ratio
Single Asset Class or Risk Premia 0.1-0.2
Diversified Portfolio
Risk Control
Downside Protection
0.2-0.25
0.25-0.35
0.3-0.4
* Sharpe ratio is equal to the excess return (over cash) divided by the volatility
Teach-in Equity Downside Hedging September 2014
Diversification is by itself a powerful way of reducing drawdowns – but it isn’t protection
20
Source: “What a CAIA Member Should Know” Understanding Drawdowns Galen Burkhard Senior Advisor, Newedge USA, LLC.Ryan Duncan Global Co-Head, Newedge Alternative Investment Solutions’ Advisory Group Lianyan Liu Quantitative Analyst, Newedge Alternative Investment Solutions’ Advisory Group
For a 0.5 sharpe ratio strategy the
expected max 10 year drawdown is 2.5x
volatility (ie, 25% for a 10% volatility
strategy)
For a more basic 0.15 sharpe strategy –
perhaps a single asset class, the max
drawdown is greater at around 3.5
volatility units
Teach-in Equity Downside Hedging September 2014
Tail risk hedges?
21
Put options
Options collar
Put spread
US treasuries Commodities Gold
CTA Managers Smart Beta
Low volatility stocks Risk control
VIX Variance
Cash
DGF Gilts
CDS
Short index futures
Tail risk funds
Explicit protection
Implicit protection
Risk Control
Diversifiers
Teach-in Equity Downside Hedging September 2014 22
How
Teach-in Equity Downside Hedging September 2014
Basic option strategies
23
• The simplest direct downside protection strategy is to buy a put option on the
underlying equity holding
• The strike and maturity can be chosen/varied
• Typically most liquidity is in the 3 month maturity, but pension funds tend to look
at periods of 1 year of longer
• The premium of these options will vary with the market level of implied volatility,
making them quite variable through time
• The price of the option will also reflect the level of skew in the market, meaning
that premiums for downside protection can optically “look” expensive when
compared to the expected level of volatility
Teach-in Equity Downside Hedging September 2014
Basic option strategies
24
• Obvious enhancements to basic option strategies
1. Split the maturities such that the “regret-risk” of having the payout
determined on a particular day is minimized
2. Have a rolling program to maintain the split of maturities through time
3. Trade longer maturity options and have a framework to sell these options
before expiry (avoiding the decay in the final few months of the options’s life)
4. Adopt a program of call selling (as well as put buying) – a popular strategy is
to sell 2-4 week calls and buy 12 month puts
• More sophistication can reduce carry costs, but starts to look more like a
quantitative trading strategy
Teach-in Equity Downside Hedging September 2014
Relevant anecdotes from the DGF universe
25
• We reviewed the Diversified Growth Fund (“DGF”) market in December 2013 (work
updated in June 2014)
• DGF managers generally have a brief to generate equity like returns of 3-5% above
LIBOR (or inflation) with half the volatility of equities
• We reviewed around 15 managers with around £100bn total aum
• 13 of 15 were using variants of the above options structures, variants included:
• Rolling put protection
• Rolling collars on low volatility indices
• Relative value trades using call options (call vs call)
• Variance swaps relative value (China vs US)
• VIX
Teach-in Equity Downside Hedging September 2014
Insurance – but at what price ? Carry costs of the basic approaches
26
• It is important to try and evaluate the impact on portfolio expected return of a
given protection strategy, although it is hard to be precise about this
• Two possible approaches
• Use historical backtesting/simulation (limited data, accusations of data-
mining)
• Re-price options using real-world (as opposed to risk neutral) variables
• We can draw some general conclusions around carry costs
Teach-in Equity Downside Hedging September 2014
Insurance – but at what price ? Carry costs of the basic approaches
27
Option Premium (%) September 2014
Historic Carry p.a. [min/max]
Approx Calculated Carry
(% p.a.)
Buy 3m 90% put options
0.7% -2.7%1 -2.2%
Buy 1yr 90% put options
3.5% -1.4%2
[-10% / +23% ] -2%
Buy 2yr 90% put options
6.4% +0.3%3 -1.8%
Calendar collar n/a +6%4
1. Source: SocGen Engineering. Calculated since 2000 using Eurostoxx 50 data
2. Source Bloomberg using S&P 500 data. Average of negative years is -4.6%. Using Eurostoxx data since 2000 the equivalent result is
+0.06%
3. Source SocGen Eurostoxx 50 data since 2000
4. Source SocGen, strategy consists of buying 1/12 of 1 year 90% put per month and selling 2 week 102% calls
5. Calculated by Redington based on option pricing using real-world equity expected excess return of 3% and realised volatility
Teach-in Equity Downside Hedging September 2014
28
When we look at possible protection strategies, three distinct objectives emerge…
28
Teach-in Equity Downside Hedging September 2014
Protection strategies classified according to objectives
KEY
Single Static Put Option Strategy
Multiple Static Put Option Strategy
Dynamic Option Strategy
Systematic Option Strategy
VIX
Variance
Volatility Control
Low Volatility Stocks
Volatility Control + Annual Put
Option
29
Teach-in Equity Downside Hedging September 2014
Carry costs
30
Historic Carry p.a. [min/max]
Approx Calculated Carry (% p.a.)1
Buy 1yr 90% put options -1.4%2
[-10% / +23% ] -2%
VIX -5% p.a. [since 2009] c-1% longer term estimate
-1/-2%4
Volatility Control with Put Option
Slightly positive since 19993 -0.5%
1. Calculated by Redington based on re-pricing option using real world expected equity excess return of 3%p.a. and volatility
2. Source Bloomberg using S&P 500 data. Average of negative years is -4.6%. Using Eurostoxx data since 2000 the equivalent result is
+0.06%
3. Calculated by Redington
4. Carry cost for VIX calculated by looking at the average level of contango in the futures curve (the extent to which the futures price tends
to be higher than the “spot” VIX price)
Teach-in Equity Downside Hedging September 2014
One approach in detail – Volatility Controlled Equity + Put
31
• The purpose of today’s session is to contrast various approaches to hedging equity
tail risk and protecting equity portfolios
• There is one approach that we favour for our clients, based on our own research
and experiences and it has formed one of our high-conviction strategic asset
allocation views for the last year
• 7 clients have implemented or signed off the allocation, accounting for more than
$1bn in allocation
• It can be summarised as follows:
• Implement a benchmark for the equity allocation based on a volatility-
controlled index (this can be achieved through a futures overlay program or
TRS, we have favoured TRS)
• Adopt a program of buying 1 year 90% put options on the volatility controlled
index to protect downside
• Volatility control cheapens the carry cost of a put option strategy substantially
(carry cost is reduced by c75%)
Teach-in Equity Downside Hedging September 2014
How does the performance of Volatility Control with and without a Put compare?
32
0
50
100
150
200
1999 2002 2005 2008 2010 2013
MSCI World Index
MSCI World Vol Control (10% Vol) Index
MSCI World Vol Control (10% Vol) with Put (90% strike)
Performance MSCI World vs MSCI World 10% Vol
Control with and without Put
Teach-in Equity Downside Hedging September 2014
Not only is equity risk high, it is also very variable
33
Passive MSCI World Nov 1998 – Dec 2013
Whole Period Average Volatility (% p.a.) 15%
Maximum Volatility (% p.a.) 63% (December 2008)
Minimum Volatility (% p.a.) 6% (February 2007)
0%
10%
20%
30%
40%
50%
60%
70%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
An
nu
aliz
ed
Vo
lati
lity
(%)
Passive MSCI World Rolling Volatility Long-term volatility
Annualized Rolling and Long-Term Volatility of MSCI World
Teach-in Equity Downside Hedging September 2014
Volatility Control invests to target a lower and constant level of risk
34
• By “driving to the conditions”, the scheme experiences a smoother ride
• The objective is not to “outperform” passive equities, but to control risk
0%
20%
40%
60%
80%
100%
120%
140%
160%
1999 2000 2000 2001 2001 2002 2002 2003 2004 2004 2005 2005 2006 2007 2007 2008 2008 2009 2009 2010 2011 2011 2012 2012 2013
% A
lloca
tio
n o
f vo
lati
lity
con
tro
lled
ap
pro
ach
% Allocation of Volatility Controlled Index
Allocation to Equities in Volatility Controlled Index
Teach-in Equity Downside Hedging September 2014
By driving to the conditions the investor experiences a smoother ride
35
Source: Bloomberg; Calculations: Redington
32%
-3%
30%
8% 10%
1%
38%
23%
33% 29%
21%
-9% -12%
-22%
29%
11%
5%
16%
5%
-37%
26%
15%
2%
16%
32%
26%
0%
20%
8% 11%
1%
46%
19% 19% 14% 13%
-5% -7% -12%
18%
9%
2%
16%
4%
-12%
12% 10%
-1%
8%
25%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
An
nu
al P
erce
nta
ge R
etu
rn
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
An
nu
aliz
ed
Vo
lati
lity
(%)
S&P 500 S&P 500 Volatility Controlled Index
Teach-in Equity Downside Hedging September 2014
What is the cost of a put option?
36
Cost of equity downside protection with
maturity of 1 year
Source: Bloomberg, Investment Banks; Calculations: Redington. Pricing is indicative and subject to change
1 Year Protection level
Current cost of
protection on Global
Equity Index (%) over 1
year
Stressed market
conditions cost of
protection on Global
Equity Index (%) over 1
year
Cost to protect 10%
Volatility Control
portfolio (%) over 1 year
90% 3.5% 6.5% 1.0%
85% 1.6% 4.8% 0.5%
80% 1.3% 3.5% 0.2%
The above figures are the approximate premium for the option. Very roughly the annual carry
cost (expected return drag) is roughly half that
Teach-in Equity Downside Hedging September 2014
One approach in detail – Volatility Controlled Equity + Put
Driving to the conditions – with fully comprehensive insurance
37
Teach-in Equity Downside Hedging September 2014
Extensions of downside protection
38
• Strategies which access risk premia with volatility control in liquid markets are in
theory reasonable candidates for downside protection
• Three obvious examples of this include
• Risk Parity
• Style Premia
• CTAs
• Implementation challenges are more significant than for equity as a standalone,
and carry costs are likely to be higher, but we still believe that it can make sense
from a strategic perspective
Teach-in Equity Downside Hedging September 2014
Recap & Conclusions – what we’ve covered
39
• Equities can experience large, infrequent drawdowns which can dominate portfolio
risk even when equities are held at lower levels
• Equity drawdowns can challenge the investment objectives of a pension fund or
institution, and that’s what really matters in terms of tail risk
• Direct hedges using options has several benefits:
• Help safeguard objectives
• Provide ability to add value by moving into distressed assets following sell-off
• Safeguard liquidity position, particularly if in negative cashflow
Teach-in Equity Downside Hedging September 2014
Recap & Conclusions
40
• Diversification and risk control are powerful portfolio
building blocks that help reduce drawdowns
• But they do not by themselves provide downside
protection. This can only be achieved by direct
hedges using options
• Option strategies likely to bear a carry cost (equal to
roughly 50% of premium per year)
• Volatility controlled benchmarks reduce the cost of
downside protection considerably
Click image to access paper
Teach-in Equity Downside Hedging September 2014
The returns of a downside protection strategy are not evenly distributed
41
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
An
nu
al P
erce
nta
ge R
etu
rn
Relative returns of S&P500 strategy with 1yr 90% put strategy vs S&P 500
• Making it hard to evaluate even using datasets of 15 years or more
Teach-in Equity Downside Hedging September 2014
Downside Risk Management in the Press and Media
42
Further Reading
The Actuary Magazine
http://www.theactuary.com/features/2012/12/volatility-control-taming-the-beast/
RedViews
http://redington.co.uk/getattachment/eea3dd74-37c8-446e-afa9-
fd8d1973f295/Taming%20The%20Beast.aspx
RedBlogs
http://blog.redington.co.uk/Articles/Dan-Mikulskis/September-2012/VOLATILITY-
CONTROL.aspx
The Journal of Indexes
http://www.indexuniverse.com/publications/journalofindexes/joi-articles/12932-optimal-
design-of-risk-control-strategy-indexes.html
Teach-in Equity Downside Hedging September 2014 43
Disclaimer
For professional investors only. Not suitable for private customers.
The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference
rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this document is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence. This presentation may not be copied, modified or provided by you , the Recipient, to any other party without Redington Limited’s prior written permission. It may also not be disclosed by the Recipient to any other party without
Redington Limited’s prior written permission except as may be required by law. Redington Limited is an investment consultant company regulated by the Financial Conduct Authority. The company does not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional, tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate.
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Contact
Dan Mikulskis FIA Director Direct Line: 020 3326 7129 [email protected] @danmikulskis
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