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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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    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 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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    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

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    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

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    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%

    Dailyretu

    rn(%)

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    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

    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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    Teach-in Equity Downside Hedging September 2014

    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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    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

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    Teach-in Equity Downside Hedging September 2014 10

    Why?

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    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

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    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

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    Teach-in Equity Downside Hedging September 2014

    How can downside risk affect the objectives (1)

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    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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    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

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    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%

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    Teach-in Equity Downside Hedging September 2014 16

    What?

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    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

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    Teach-in Equity Downside Hedging September 2014

    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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    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

    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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    Teach-in Equity Downside Hedging September 2014

    Diversification is by itself a powerful way of reducing draw