protect your assets-equity downside hedging- redington teach-in-15 sep 2014
TRANSCRIPT
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Protect Your Assets:
Equity Downside Hedging
Tuesday 16
th
September 2014
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Teach-in Equity Downside Hedging September 2014 2
Background
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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 backstopremoving 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
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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
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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
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The downside risk of equities
6
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
Dailyretu
rn(%)
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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
exDrawdownfrompriorpeak(%)
Equities tend to experience infrequent large drawdowns (>30% +) Even ignoring the early part
of the 20thcentury this still happens frequently enough to be a problem in a portfolio context
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The downside risk of equities
8
Equity performance, even overlong 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
http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html?_r=0http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html?_r=0http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html?_r=0http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html?_r=0http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html?_r=0http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html?_r=0http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html?_r=0http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html?_r=0http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html?_r=0 -
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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
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Teach-in Equity Downside Hedging September 2014 10
Why?
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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
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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
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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
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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
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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%
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Teach-in Equity Downside Hedging September 2014 16
What?
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Tail risk hedges?
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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
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The three layers of portfolio risk management
18
Risk anagement should be put in place in the good times to have most effect in the bad times
Diversification
Downside protection
Risk Control
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Improving risk adjusted returns
19
We use the Sharpe ratio* as the basis for assessing risk adjusted return. It
isnt a perfect measure, but is a reasonable starting point for assessingassets 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
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Diversification is by itself a powerful way of reducing drawdowns but it isnt protection
20
Source: What a CAIA Member Should Know Understanding Drawdowns Galen Burkhard Senior Advisor, Newedge USA, LLC.Ryan DuncanGlobal Co-Head, Newedge Alternative Investment Solutions Advisory
Group Lianyan LiuQuantitative 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 3.5volatility units
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Tail risk hedges?
21
Put options
Options collar
Put spread
US treasuries
ommodities Gold
CTA Managers
mart Beta
Low volatility stocks
isk control
VIXariance
Cash
DGF
Gilts
CDS
Short index futures
Tail risk funds
Explicit protection
Implicit protection
Risk Control
Diversifiers
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Teach-in Equity Downside Hedging September 2014 22
How
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Basic option strategies
23
The simplest direct downside protection strategy is to buy a put option on theunderlying 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 skewin the market, meaning
that premiums for downside protection can optically look expensive when
compared to the expected level of volatility
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Basic option strategies
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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 optionsslife)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
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Relevant anecdotes from the DGF universe
25
We reviewed the Diversified Growth Fund (DGF) market in December 2013 (workupdated 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
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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 agiven 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
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Insurance but at what price ?Carry costs of the basic approaches
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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
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When we look at possible protection strategies, three distinct objectives emerge
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Protection strategies classified according to objectivesKEY
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
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Carry costs
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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
OptionSlightly 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)
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How does the performance of Volatility Control with and without a Put compare?
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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
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Not only is equity risk high, it is also very variable
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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
AnnualizedVolatility(%)
Passive MSCI World Roll ing Volat il ity Long-term volat il ity
Annualized Rolling and Long-Term Volatility of MSCI World
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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
llocationofvolatilitycontrolledap
proach
% Allocation of Volatility Controlled Index
Allocation to Equities in Volatility Controlled Index
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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
AnnualPercentageReturn
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
AnnualizedVolatility(%)
S&P 500 S&P 500 Volati lity Controlled Index
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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
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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
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Recap & Conclusions what weve 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 thats 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
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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
http://redington.co.uk/getattachment/cce30fdf-f359-4630-b605-ba6c9c76d8e3/Equity%20Hedging%20for%20UK%20Pension%20Funds.aspx -
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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
AnnualPerce
ntageReturn
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
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T h i E it D id H dgi g S t b 2014
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