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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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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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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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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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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)

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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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What?


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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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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

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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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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

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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

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


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28

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

28


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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

29


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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

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?

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


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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

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?

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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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customers.

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We do not guarantee every aspect of its accuracy. The

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