Managing equity downside riskBy: WFAM Systematic Investment Group1

In an environment of low interest rates and tight credit spreads, some investors seeking return have allocated away from bonds to equities.

Downside risk is a concern, but investors are putting off protection because of the cost trade-off.

We strive to avoid unnecessary costs typically associated with protecting downside with futures-based and options-based strategies that seek the most efficient way to protect and deliver resilient portfolios.

As investors make greater use of equities to pursue real returns, they are naturally wary of their portfolio’s increasing exposure to equity market risk. One way to improve investor confidence in the face of expected volatility is to shape their portfolio’s expected return profile with a hedging program that is effective and cost-efficient. The use of futures, options, and dynamic allocation can be valuable components in an intelligently constructed hedge. This paper outlines the holistic considerations in designing and implementing an overlay that can be tailored to an investor’s underlying portfolio and unique circumstances.

Background Many investors are feeling pinched. They need to generate real returns, but real yields are low. Their fixed-income portfolios have become concentrated and riskier in the search for yield. Equities offer the allure of greater long-term returns but may be viewed as expensive in the current environment. They certainly come with the risk of significant drawdowns.

Downside risk management overlays can provide an alternative to just buying equities. When efficiently designed and managed, overlays that use futures or options may reduce the drawdowns associated with equity investing in a cost-effective way.

1. This paper incorporates investment insight and expertise from Analytic Investors and the Multi-Asset Solutions team, who together with Golden Capital and the Systematic Fixed Income team represent the WFAM Systematic Investment Group. The WFAM Systematic Investment Group delivers systematic investment solutions and expertise across equities, fixed income, and multi-asset.

FOR INVESTMENT PROFESSIONAL USE ONLY – NOT FOR USE WITH THE RETAIL PUBLIC April 2020

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Downside risk management Wells Fargo Asset Management (WFAM) has three preferred tools for managing downside risk: portfolio diversification (at the overall strategy level), futures-based strategies, and options-based strategies.

The most appropriate approach depends upon the desired outcome for the portfolio and its constraints. Many investors have already embraced the benefits of diversification. We see new and more cost-effective ways of improving diversification, as highlighted in our recent paper, “Getting More for Less: An Integrated Approach to Factor Investing.” 2 However, low interest rates and tight credit spreads have caused some investors to look for ways to generate return by shifting some of their bond allocation into equities.

For investors who are unable to bear the increase in the risk of drawdowns created by selling bonds and buying equities, pairing their new equity investment with a downside risk management strategy is an alternative. We use both futures-based and options-based strategies, depending upon the investor’s sensitivities and objectives.

We follow a four-step process for designing and managing downside risk management strategies.

1. Define theoutcome

2. Consider theunderlying

exposureCombination

Dynamic

Options

3. Design thesolution

4. Enhance implementation

1. Define the outcomeThe first step in designing our option overlay strategy is to define the desired outcome. This could be an insured floor for an investment to assist with capital requirements or a desire to cushion the portfolio against small and medium-size drops in asset prices. An investor may be willing to exchange some upside potential in order to fund the overlay or may prefer to pay an explicit premium. With this information, we set about designing the investor’s desired payoff profile.

2. Consider the underlying exposureThe solution may need to provide the underlying equity exposure to offset the risk of a portfolio held elsewhere. We don’t want to leave all of the work to the overlay. By providing the underlying equity portfolio, we can access active, passive, or factor-based strategies that can be tailored to suit the investment need, such as incorporating environmental, social, and governance screens or objectives. Once the underlying equity portfolio has been identified, we optimize the investor’s exposure to seek minimal basis risk and tracking error to the underlying portfolio.

3. Design the solutionDepending on the investor’s desired outcome, preferences, and constraints, we may suggest a futures-based, options-based, or blended approach to the overlay design.

Futures-based strategies

Our dynamic risk hedging program uses liquid futures contract strategies in an effort to improve portfolio outcomes. These strategies are dynamic and reactive and seek to reduce drawdowns while mitigating the explicit costs of risk management.

The trade-off is that they tend to reduce portfolio risk reactively rather than continuously mitigate risk. This means the overlay may not protect investors against sudden downturns or large gaps in the market.

Futures-based strategies could be a good approach for investors willing to bear this risk in order to reduce explicit costs.

Other investors may prefer to pay some level of explicit cost to better manage this gap risk. For them, we often propose options-based risk management strategies.

2. Source: WFAM, October 2019. Please see our piece, “Getting more for less with an integrated approach to factor investing,” February 2019, available upon request.

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Our approach to equity protection

Always-on protection

Efficient financing

Enhanced implementation

Protection in practice: U.K. pension fund case study WFAM was appointed in 2019 to manage a customized risk management framework. We worked closely with the fund and its investment consultant to understand their unique needs and design a strategy seeking to provide significant protection at a reasonable cost. We achieved this using our four-step approach:

1. Define the outcome“We need an equity protection strategy to provide a minimum protectionlevel of 90% for our equity portfolio. We need to reduce our risk but we areconcerned about the costs involved. We require our manager to manage theunderlying single collateral pool and hedge currency risk as well.”

2. Consider the underlying exposureThe underlying equity portfolio in this case is managed externally. Our focuswas to meet the objective of having significant protection and a close matchbetween the hedge and the underlying equity exposure. Any flexibility in thechoice of protection is therefore bound by clear guardrails.

3. Design the solutionThe preference was for an options-based strategy. Key features of thedesign were:

• Always-on protection: an intelligently designed options strategydelivering self-refreshing protection that’s “always on” rather thanreactive, in line with the 90% target

• Efficient financing: seeking to achieve the best risk-adjusted outcome,while balancing the objective of sacrificing less upside and managingdrawdowns

4. Enhance implementationWe use our proprietary option valuation models to determine the best valuefor the investor by seeking to purchase the most cost-effective protectionavailable—and similarly, where we sell some upside to fund the protection, welike to sell this at a premium! This approach is supported by our strong andlong track record in actively managing option overlays. Implementation usesthe most liquid instruments available to further reduce cost while achievingthe desired level of protection.

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Options-based strategies

Options-based strategies give investors a lot of flexibility to seek specific outcomes and have defined payoffs. Also, they can be designed to address capital charges under a variety of regulatory regimes. These benefits do come at a cost. The costs are both explicit and implicit, but they are manageable. Through thoughtful design and active management, we seek to harvest the benefits of these programs while minimizing the cost to the overall portfolio.

The WFAM approach

By working with investors to understand their goals and sensitivities, we can recommend an approach (or blend of approaches) specifically designed to efficiently target their investment outcome.

4. Enhance implementation

Finally, we actively manage the investor’s overlay. We believe that even the smartest rules-based strategies can be improved with active management to take advantage of market opportunities and inefficiencies in valuations. The goal of active management is to reduce the overall cost of mitigating risk in the portfolio and to ensure the overlays take advantage of market dislocations or mispricing.

On the futures side, our portfolio managers are able to take profits on the hedge when the market is oversold. This can help get portfolios back in the market after large market corrections.

On the options side, a proprietary volatility-forecasting model seeks to identify mispriced options. This allows the selection of the best-priced options available, subject to maintaining the desired aggregate protection for the solution.

Importantly, adjustments we make through active management (whether on futures or options) are always made within well-defined guidelines and in a way that aims for the desired level of protection at the solution level.

Delivering the outcome Investors who have traditionally invested in fixed income securities are increasingly looking for different ways to generate return. Many sources are available, but few have sufficiently defensive risk profiles to suit their needs. We believe downside risk management overlays can be added to equity portfolios to provide some of the advantage of equity investing while mitigating some of the inherent risk.

We want to help clients build for successful outcomes, defend portfolios against uncertainty, and create long-term financial well-being. To learn more, investment professionals can contact us:

l To reach our U.S.-based investment professionals, contact your existing client relations director, or contactus at WFAMInstitutional@wellsfargo.com.

l To reach our U.S.-based intermediary sales professionals, contact your dedicated regional director, or callus at 1-888-877-9275.

l To reach our U.S.-based retirement professionals, contact Nathaniel Miles, head of Retirement at Wells FargoAsset Management, at nathaniel.s.miles@wellsfargo.com.

l To discuss environmental, social, and governance (ESG) investing solutions, contact Hannah Skeates, globalhead of ESG at Wells Fargo Asset Management, at hannah.skeates@wellsfargo.com.

The views expressed and any forward-looking statements are as of September 25, 2019, and are those of Wells Fargo Asset Management. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author(s) and are not intended to be used as investment advice. Discussions of individual securities, or the markets generally, or any Wells Fargo Fund are not intended as individual recommendations. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Asset Management disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

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Wells Fargo Asset Management (WFAM) is the trade name for certain investment advisory/management firms owned by Wells Fargo & Company. These firms include but are not limited to Wells Capital Management Incorporated and Wells Fargo Funds Management, LLC. Certain products managed by WFAM entities are distributed by Wells Fargo Funds Distributor, LLC (a broker-dealer and Member FINRA).

FOR INVESTMENT PROFESSIONAL USE ONLY – NOT FOR USE WITH THE RETAIL PUBLIC

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