I-2 Hedging Tail Risk - Board of...
Transcript of I-2 Hedging Tail Risk - Board of...
I-2Hedging Tail Risk
Committee on Investments/
Investment Advisory Group
December 13, 2011
University of California
Office of the Treasurer of The Regents
Hedging Tail Risk
December 13, 2011 | 2University of California
Office of the Treasurer of The Regents
Agenda
• Introduction to Tail Risk
• Approaches to Tail Risk Hedging
– Direct
– Indirect
• Implementation Choices
– Strategic
– Tactical
• Recommendation
• Appendix
Hedging Tail Risk
December 13, 2011 | 3University of California
Office of the Treasurer of The Regents
Introduction to Tail Risk
• What is Tail Risk?
• Why do “Tails” Occur?
• Can Tail Risk be “Hedged”?
I A S B B I S & P 5 0 0 T R U S D : D e c e m b e r 1 9 2 6 - S e p t e m b e r 2 0 1 1
R e t u r n s H i s t o g r a m
R e t u r n
N u m b e rI A S B B I S & P 5 0 0 T R U S D : D e c e m b e r 1 9 2 6 - S e p t e m b e r 2 0 1 1
R e t u r n s H i s t o g r a m
- 4 0 . 0 % 4 0 . 0 %- 3 6 . 0 % - 3 2 . 0 % - 2 8 . 0 % - 2 4 . 0 % - 2 0 . 0 % - 1 6 . 0 % - 1 2 . 0 % - 8 . 0 % - 4 . 0 % 0 . 0 % 4 . 0 % 8 . 0 % 1 2 . 0 % 1 6 . 0 % 2 0 . 0 % 2 4 . 0 % 2 8 . 0 % 3 2 . 0 % 3 6 . 0 %
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M e a n S t a n d a r d D e v ia t i o n s
Histogram of
quarterly S&P 500
returns 1926-2011
The (left) “Tail”
Hedging Tail Risk
December 13, 2011 | 4University of California
Office of the Treasurer of The Regents
Introduction to Tail Risk
• What is Tail Risk?
– A large loss
– An “unexpected” large loss
– A loss outside the bounds of what normally
occurs in the markets
– A loss greater than 2 (3?) standard deviations
– A sudden and severe increase in risk aversion
– Unexpected large losses in multiple asset classes
and across the globe
– Losses beyond what can be mitigated by
diversification alone
Hedging Tail Risk
December 13, 2011 | 5University of California
Office of the Treasurer of The Regents
Introduction to Tail Risk
• Why do “Tails” Occur?
– The other side of the business cycle (cyclical)
– Market liquidity “dries up” (1987, 2007-8)
• Liquidity is inversely proportional to perceived
uncertainty
• The other side of a credit bubble (secular)
• In extreme (bad) events, risk asset markets move
together (down) as fear gathers momentum
– Since equity risk dominates most institutional
portfolios, diversification does not protect against
extreme events
– Regime change (but these cannot be “hedged”)
Hedging Tail Risk
December 13, 2011 | 6University of California
Office of the Treasurer of The Regents
Introduction to Tail Risk
• Can Tail Risk be “Hedged”?
– Yes: many liquid assets have derivatives markets
– No: contractual hedges are expensive; not
recommended as a static strategy
– Maybe
•Risk is not eliminated (counterparty,
operational, basis, regulatory,…)
• Terms of insurance may not correspond to
actual events (e.g., slow decline in market)
Hedging Tail Risk
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Approaches to Tail Risk Hedging
• Direct / Exact Approaches
– Buying portfolio protection, e.g., options
– Know what will be hedged and by how much over
what period
– Costly, especially if used as strategic policy
– All strategies have better performance when
applied selectively
Hedging Tail Risk
December 13, 2011 | 8University of California
Office of the Treasurer of The Regents
Approaches to Tail Risk Hedging - Direct
• Equity Options
– Buying volatility: Puts
– Buying / Selling volatility
•Put-Call Collars
•Put-Spread Collars
– Selling Tail Insurance
• Dynamic Rebalancing
– Use futures to increase / decrease risk exposures,
always maintaining a “floor” value in safe assets
Hedging Tail Risk
December 13, 2011 | 9University of California
Office of the Treasurer of The Regents
Put Options
• If one expects a positive equity risk premium over time, then
most options will expire out of the money (worthless)
• Chart below shows cumulative cost (P/L) of buying and exercising put options
• Source: Bridgewater Asset Management
Hedging Tail Risk
December 13, 2011 | 10University of California
Office of the Treasurer of The Regents
Passive Put Options = Reduce Equity Exposure
• A passive program of always buying 7% OTM puts
has the same impact as a reduction in equity
exposure of 22%!
– US conventional balanced portfolio has same
return, volatility, and drawdowns• Source: Bridgewater Asset Management
Hedging Tail Risk
December 13, 2011 | 11University of California
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How Much Protection Does 1% Buy?
• Suppose we have $600 Equity, $1,000 total (60/40) portfolio
• The bar graph below shows the percent of equity notional value which
could have hedged by buying 10% out of the money puts, using no
more than 1% of the total portfolio value to buy hedges
• On most days – but not when the VIX gapped up - a 1% risk budget
would have been more than adequate• Source: Bloomberg, Treasurer’s Office
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Notional Percent of 60/40 Portfolio Hedged with 1% of total
capital, 10% OTM Puts
Notional Percent VIX Index
Hedging Tail Risk
December 13, 2011 | 12University of California
Office of the Treasurer of The Regents
What Risk Budget is Required for 100% Hedge?
• Suppose we have $600 Equity, $1,000 total (60/40) portfolio
• The bar graph below shows the percent of Total Fund value which
would have been used to hedge 100% of equity by buying 10% out of
the money puts
• The average cost was 63 bp / median cost was 41 bp. For days where
the cost was over 1.0%, the average cost was 1.88%• Source: Bloomberg, Treasurer’s Office
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Percent of total fund required to hedge equity portion of 60/40 Portfolio with 10% OTM Puts
option cost / total fund VIX Index
Hedging Tail Risk
December 13, 2011 | 13University of California
Office of the Treasurer of The Regents
Approaches to Tail Risk Hedging 2
• Indirect / Approximate Approaches
– More efficient diversification, or
– Indirect (i.e., cross) hedges
– “Actual results may vary” from what was intended
– Opportunity cost and/or cost of hedges usually
less than direct approaches
Hedging Tail Risk
December 13, 2011 | 14University of California
Office of the Treasurer of The Regents
Approaches to Tail Risk Hedging - Indirect
• Diversification – by asset class
– Reduce equity allocation (de-risk)
– Gold, Treasuries, Cash
• Diversification – by risk factor
– Risk Parity / Risk Balanced
– “Exotic Beta:” risk factors other than equity
• Cross-Asset Hedges
– Volatility Products (e.g., VIX-based)
– Credit Default Swaps (CDS)
• Active Management
– Dedicated Tail Risk Hedging Funds
Hedging Tail Risk
December 13, 2011 | 15University of California
Office of the Treasurer of The Regents
Balanced Risk Portfolio Strategies (“Risk-Parity”)
• Risk Parity is a portfolio construction method that
provides superior diversification potential
• Most institutional portfolios are heavily weighted to
equity risk (even if “diversified”)
• A “risk balanced” portfolio buys assets so the
contribution to risk from different risk sources is
roughly equal
– Scaled to the same overall volatility as the
conventional portfolio
• Result: better diversification, but with leverage
• This is approach used by Treasurer on a limited
basis for portfolio protection during past 2 years
Hedging Tail Risk
December 13, 2011 | 16University of California
Office of the Treasurer of The Regents
Implementation Choices
• First: what is the goal?
– Avoid loss greater than X or reduce impact of
specific event(s)?
– Level of protection, cost / budget, horizon?
• Second: strategic or tactical?
– Strategic
•E.g., always buy puts, zero cost collars, etc.
•Not necessarily static, but less discretion
– Tactical
•Use discretion (signals) to decide when, what,
and how much insurance to buy
Hedging Tail Risk
December 13, 2011 | 17University of California
Office of the Treasurer of The Regents
Implementation Challenges
• Investors are used to being paid to take risk
• Investors need to pay to avoid risk
– Directly (by buying insurance)
– Indirectly (by reducing risk assets)
• Fiduciaries
– Willingness to occasionally underperform peers
• For Investment Staff / Investment Managers
– Hard to buy protection only when needed
– Hard to buy the right protection for uncertain
outcomes
Hedging Tail Risk
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Office of the Treasurer of The Regents
Recommendation
• Establish pilot “Tail Hedging” program for TRIP
• Recommend use of dedicated “tail risk”
manager(s) to purchase an optimal portfolio of tail
hedges
• Recommend revising fund Policy/Guidelines to
permit investing in tail risk hedging strategies on an
opportunistic basis
– Range of 0-2% (capital used to buy hedges)
– No change to policy benchmark
• Tail risk hedging program becomes part of the
asset allocation decision
Hedging Tail Risk
December 13, 2011 | 19University of California
Office of the Treasurer of The Regents
APPENDIX
• What is hedging?
• Options and Insurance
• Risk disclosure
• Direct Approaches
– Put Options
– Zero Cost Collars
– Put Spread Collars
• Indirect Approaches
– Gold, Treasuries, Cash
– Risk balanced diversification (risk-parity)
– Exotic Beta
– Cross Asset Hedges (VIX, CDS)
– Active Management
Hedging Tail Risk
December 13, 2011 | 20University of California
Office of the Treasurer of The Regents
What is Hedging?
• Hedging = taking an opposite or offsetting position
to temporarily neutralize the fluctuation in value of a
risky portfolio
– Futures
• A short futures position + the underlying index = no
gains (losses) if the index rises (falls)
• Minimal trading cost only
– Options
• An option’s payout is contingent on the market index
exceeding a given level by a given time
• Premium (cost to purchase contract) can be material
Hedging Tail Risk
December 13, 2011 | 21University of California
Office of the Treasurer of The Regents
Options and Insurance
• Buying put options on an equity portfolio is like
buying fire insurance on a primary home
• Option premium is like insurance premium
– If the fire doesn’t occur, the premium is “lost”
– On average, buying insurance is a bad
“investment”
– Yet for most people, the certain loss of a small
premium is worth avoiding the catastrophic loss
of a home
– Do you feel the same way about your
investments?
Hedging Tail Risk
December 13, 2011 | 22University of California
Office of the Treasurer of The Regents
Options and Insurance - 2
• The level of loss protection of an equity option is like
the deductible in an insurance contract
• Differences
– Fires are random events, distributed over space
– Equity market losses, like hurricanes, happen at
the same time to everyone
Hedging Tail Risk
December 13, 2011 | 23University of California
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Risk Disclosure
• Static Strategic Policy Allocation
– Simple to manage and understand
– Ignores changing environment; no longer “best
practice”
• Dynamic Strategic Policy Allocation
– May include Tail Risk Hedging component
– More complex to manage and evaluate
•Counterparty risk for OTC instruments
• Timing / Manager risk (investment decisions)
•Regret risk
Hedging Tail Risk
December 13, 2011 | 24University of California
Office of the Treasurer of The Regents
Put Options
• Cost of insurance (buying puts) is a significant drag on
performance
– 7% OTM: average cost 2.4% of portfolio value
• 15% OTM: average cost 1.5% of portfolio value
• Insurance costs more after market has fallen• Source: Bridgewater Asset Management
Hedging Tail Risk
December 13, 2011 | 25University of California
Office of the Treasurer of The Regents
Zero Cost Collars: Limit Downside + Cap Upside
• Example shows naïve use of zero cost collars on a 60/40
portfolio
• Two different floors: 5% loss and 10% loss, quarterly
• Strategy underperforms unhedged portfolio• Source: State Street Associates
Hedging Tail Risk
December 13, 2011 | 26University of California
Office of the Treasurer of The Regents
Application of Market Timing
• Use of a risk aversion index can be profitable in determining
when to use protection strategies
• This filter is based on a “Systemic Risk Index” which indicates increased likelihood of potential losses when market indexes
begin to move together• Source: State Street Associates
Hedging Tail Risk
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Office of the Treasurer of The Regents
Zero Cost Collars with Timing
• Selective use of insurance strategies outperforms an
unhedged portfolio• Source: State Street Associates
Hedging Tail Risk
December 13, 2011 | 28University of California
Office of the Treasurer of The Regents
Put Spread Collars
• A Put Spread Collar (PSC) is an option strategy in which one
purchases an out of the money and sells a call (like a zero-cost
collar) but then also sells another put further out of the money
• Like a collar, it limits upside and protects on the downside. Unlike a
collar, the downside protection is limited to the range between the
two put strikes
• The investor collects a volatility premium and “self-insures” beyond
the second put strike
• Source: State Street Associates
Hedging Tail Risk
December 13, 2011 | 29University of California
Office of the Treasurer of The Regents
Put Spread Collars
• A Put Spread Collar (PSC) is a Zero Cost Collar plus the sale of
an out of the money put. This strategy provides premium
income (from the short put) and effectively “self-insures”
below its strike
• It thus loses less than a collar in rising markets, while protecting
against moderate losses
• When applied selectively, the results are even better
• Source: State Street Associates
Hedging Tail Risk
December 13, 2011 | 30University of California
Office of the Treasurer of The Regents
Dynamic Hedging (Portfolio Insurance)
• Another approach to portfolio protection is Dynamic Hedging,
also called Constant Proportion Portfolio Insurance (CPPI)
• This is successful at avoiding losses but at the cost of losing most of the upside
• Source: State Street Associates
Hedging Tail Risk
December 13, 2011 | 31University of California
Office of the Treasurer of The Regents
Dynamic Hedging, with Timing
• Selective use of insurance strategies outperforms an
unhedged portfolio• Source: State Street Associates
Hedging Tail Risk
December 13, 2011 | 32University of California
Office of the Treasurer of The Regents
Gold: Not a Consistent Hedge
• Gold has provided a hedge
against equities during select
periods
– 7/1972 thru 8/1974
– 3/2000 thru 12/2002
– 7/2007 thru 2/2009
• But Gold had a negative
return from 6/1980 thru
3/2000 (20 years!)
• For monthly equity losses of
- 10% or more, the value of
holding gold is questionable• Source: Bloomberg
Hedging Tail Risk
December 13, 2011 | 33University of California
Office of the Treasurer of The Regents
Treasuries: Benefit from “Flight to Quality”
• When the S&P 500 had a negative return, its mean monthly return was
-3.44% versus 0.36% for a 10 year US Treasury Bond
• The correlation of negative equity periods with Treasuries was -0.10
• Most importantly, Treasuries never had significant losses during large
equity drawdowns
• Hence sovereign debt has historically been the “hedge” component
of institutional portfolios
Hedging Tail Risk
December 13, 2011 | 34University of California
Office of the Treasurer of The Regents
Cash: the Ultimate Tail Hedge
• Cash always has a positive return, and almost always a
positive real return (but not now)
• It has value as a tail hedge only given superior market timing ability
• Except for the inflationary 1970’s and early 80’s, it has failed to
keep up with equities, so it can only be used tactically• Source: Bloomberg, Morningstar
Negative
real cash
return
Hedging Tail Risk
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Office of the Treasurer of The Regents
-50%
-45%
-40%
-35%
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-25%
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-15%
-10%
-5%
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Drawdown
Conventional Portfolio Risk Balanced Portfolio
Balanced Risk portfolio strategies - example
-50%
0%
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100%
150%
200%
250%
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Cumulative Return
Conventional Portfolio Risk Balanced Portfolio
• Annualized return is 2.4%
higher in the risk balanced
portfolio
• The Return to Risk ratio
(Sharpe ratio) of the risk
balanced portfolio is 0.64
versus 0.37 for the
conventional portfolio
• Leverage of about 2:1 is used
in this example
• Drawdowns were
substantially reduced
during 1973-74 and 2000-
2002, and somewhat
mitigated during 2008-09
• The strategy suffered
during the interest rate
spikes of 1980 and 1981-82
Hedging Tail Risk
December 13, 2011 | 36University of California
Office of the Treasurer of The Regents
“Exotic” Beta = Risk Factors other than Equity
• There are many risk factors uncorrelated with equity
• A portfolio of these strategies can be an efficient return source, while
lowering overall volatility
• Not a direct hedge, but a more efficient use of risk
• Examples: Value, Momentum, Carry, Volatility, Liquidity• Source: Kepos Capital
Hedging Tail Risk
December 13, 2011 | 37University of California
Office of the Treasurer of The Regents
Cross-Asset Hedges
• Some assets are strongly related to equity on the downside, and thus can be
effective as indirect - and potentially inexpensive - hedges
• The two most widely used are VIX derivatives and corporate Credit Default
Swaps (CDS)
• As shown below, when protection is most needed, these markets move
opposite to equity
• Source: Bloomberg
Hedging Tail Risk
December 13, 2011 | 38University of California
Office of the Treasurer of The Regents
Active Tail Risk Management
• Passive use of equity puts has been a poor long run strategy
• Even naïve active strategies would have produced superior results
• Both strategies shown below spend 1% of fund value per year to buy
tail hedges
• Rather than just buy and roll” puts, the active strategy monetizes (i.e.,
exercises) the puts when they increase in value, generating liquidity
during equity drawdowns• Source: PIMCO
82.79
64.3254.18
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1950 1955 1960 1966 1971 1977 1982 1987 1993 1998 2004 2009
Cum
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rns (
Unit V
alu
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S&P Index + Tail Hedging Potential Payoffs
Since Jan 19501
Active 5x Strategy (Model)
No Tail Hedge
Passive Expire/Roll Strategy (Model)
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