Teach-In Presentation: Protect Your Assets - Equity Downside Hedging, 16 Sep 2014

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


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


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


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 (

%)



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



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

http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html?_r=0








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


Why?


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


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


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


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


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%


What?


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


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


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


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


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


How


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


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


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


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


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


28

When we look at possible protection strategies, three distinct objectives emerge…

28


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


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)


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%)


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


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


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


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


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


One approach in detail – Volatility Controlled Equity + Put

Driving to the conditions – with fully comprehensive insurance

37


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


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


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 Hedging for UK Pension Funds.aspx


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


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











http://redington.co.uk/getattachment/eea3dd74-37c8-446e-afa9-fd8d1973f295/Taming The Beast.aspx











http://blog.redington.co.uk/Articles/Dan-Mikulskis/September-2012/VOLATILITY-CONTROL.aspx








http://www.indexuniverse.com/publications/journalofindexes/joi-articles/12932-optimal-design-of-risk-control-strategy-indexes.html


















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.

Registered Office: Austin Friars House, 2-6 Austin Friars, London EC2N 2HD. Redington Limited (reg no 6660006) is registered in England and Wales. ©Redington Limited 2014. All rights reserved.

Contact

Dan Mikulskis FIA Director Direct Line: 020 3326 7129 [email protected] @danmikulskis

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Teach-In Presentation: Protect Your Assets - Equity Downside Hedging, 16 Sep 2014

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Transcript of Teach-In Presentation: Protect Your Assets - Equity Downside Hedging, 16 Sep 2014