Protect Your Assets-Equity Downside Hedging - Redington Teach-In-15 Sep 2014

Protect Your Assets:
Equity Downside Hedging

Tuesday 16th September 2014
Background
Teach-in
September 2014
Introduction
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
Teach-in
September 2014
Introduction
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
Teach-in
September 2014
Contents
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
Teach-in
September 2014
The downside risk of equities
15.00%
10.00%
Daily return (%)
5.00%
0.00%
-5.00%
-10.00%
-15.00%
-20.00%
-25.00%
Teach-in
September 2014

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
Index Drawdown from prior peak (%)
0%
-10%
-20%
-30%
-40%
-50%
-60%
-70%
-80%
-90%
-100%
1927
1940
Teach-in
1954
1968
1981
1995
2009
September 2014
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
Teach-in
September 2014
Why invest in equities?

Very long term (100yrs+) evidence of a positive risk premium
Can experience significant falls in value (30%+ over multi-year periods)
Liquid
Teach-in
September 2014
Why?
Teach-in
September 2014
10
Why does downside risk matter? A definition of Tail Risk
An event outside the confidence interval

used by an institution ..
That makes the investment objectives of

the institution unlikely to be achieved
Teach-in
September 2014
11
Example Pension Schemes and their objectives (1)

mm
1,400
1,200
1,000
800
600
400
200
0
Assets
Liabilities
Objective
Expected return Gilts + 2.0%p.a.

Primary Funding Objective
Required return to 2037 Gilts + 2.0%p.a.

1 Year 95% VaR 122m
Risk
1 Year Required Return at Risk 0.8%

Teach-in
September 2014
12
How can downside risk affect the objectives (1)

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
mm
1,400
Assets
Liabilities
Assets realised
1,200
1,000
800
600
400
200
0
Strategy
Starting Position
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%
Teach-in
Required Return % p.a. (Over Gilts)
Full Funding Date
Funding Level
September 2014
13
Example Investor and their objectives (2)

Pension fund or SWF
Targeting real return of +3-4% over long term (rolling 5 year periods)
240%
220%
200%
180%
160%
140%
120%
100%
2014
Teach-in
2016
2018
2020
2022
2024
2026
2028
2030
2032
2034
September 2014
14
How can downside risk affect the objectives (2)

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
240%
220%
200%
180%
160%
Excess Return Target >>

-10%
Capital Drawdown >>
-15%
-20%
-25%
3.0%
5.3%
6.5%
7.8%
9.3%
4.0%
6.3%
7.5%
8.9%
10.3%
5.0%
7.3%
8.6%
9.9%
11.4%
20 year periods
3.0%
3.6%
3.9%
4.2%
4.5%
4.0%
4.6%
4.9%
5.2%
5.6%
5.0%
5.6%
5.9%
6.2%
6.6%
Excess Return Target >>

-10%
Capital Drawdown >>
-15%
-20%
-25%
140%
120%
100%
2014
5 year periods
2016
2018
2020
2022
Teach-in
2024
2026
2028
2030
2032
2034
September 2014
15
What?
Teach-in
September 2014
16
Tail risk hedges?

Put options
Variance
Gilts
Put spread
CDS
Cash
VIX
Gold
Options collar
US treasuries
Commodities
Short index futures
Low volatility stocks
CTA Managers
Smart Beta
DGF
Teach-in
Risk control
Gilts
Tail risk funds
September 2014
17
The three layers of portfolio risk management
Risk Management should be put in place in the good times to have most effect in the bad times
Downside protection
Risk Control
Diversification
Teach-in
September 2014
18
Improving risk adjusted returns
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 assessing
assets on a risk adjusted basis
Effect on Sharpe
ratio
Sharpe Ratio
Downside Protection
0.25-0.35
Risk Control
0.3-0.4
Diversified Portfolio
0.2-0.25
Single Asset Class or Risk Premia
0.1-0.2
* Sharpe ratio is equal to the excess return (over cash) divided by the volatility
Teach-in
September 2014
19
Diversification is by itself a powerful way of reducing drawdowns but it isnt protection
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
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
Teach-in
September 2014
20
Tail risk hedges?

Put options
Explicit protection
Put spread
Options collar
Implicit protection
Risk Control
Variance
Tail risk funds
Risk control
Low volatility stocks
Commodities
VIX
Short index futures
Gold
US treasuries
Gilts
Smart Beta
CDS
Cash
Diversifiers
DGF
Teach-in
CTA Managers
September 2014
21
How
Teach-in
September 2014
22
Basic option strategies
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
Teach-in
September 2014
23
Basic option strategies
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 optionss 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
Teach-in
September 2014
24
Relevant anecdotes from the DGF universe
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
Teach-in
September 2014
25
Insurance but at what price ?

Carry costs of the basic approaches
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 datamining)
Re-price options using real-world (as opposed to risk neutral) variables
We can draw some general conclusions around carry costs
Teach-in
September 2014
26
Insurance but at what price ?

Carry costs of the basic approaches
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
Teach-in
September 2014
27
When we look at possible protection strategies, three distinct objectives emerge
Teach-in
September 2014
28
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
Teach-in
September 2014
29
Carry costs
Historic Carry p.a.

[min/max]
Buy 1yr 90% put options
VIX
Volatility Control with Put
Option
Approx Calculated Carry

(% p.a.)1
-1.4%2
[-10% / +23% ]
-2%
-5% p.a. [since 2009]

c-1% longer term estimate
-1/-2%4
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)
Teach-in
September 2014
30
One approach in detail Volatility Controlled Equity + Put

The purpose of todays 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 volatilitycontrolled 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%)
Teach-in
September 2014
31
How does the performance of Volatility Control with and without a Put compare?
Performance MSCI World vs MSCI World 10% Vol

Control with and without Put
200
150
100
50
MSCI World Index
MSCI World Vol Control (10% Vol) Index
0
1999
MSCI World Vol Control (10% Vol) with Put (90% strike)
2002
Teach-in
2005
2008
2010
2013
September 2014
32
Not only is equity risk high, it is also very variable

Annualized Rolling and Long-Term Volatility of MSCI World
70%
Annualized Volatility (%)
60%
50%
40%
30%
20%
10%
0%
1999
2000
2001
2002
2003
2004
2005
2006
2007
Passive MSCI World Rolling Volatility
2008
2009
2010
2011
2012
2013
Long-term volatility
Passive MSCI World Nov 1998 Dec 2013

Whole Period Average Volatility (% p.a.)
Teach-in
15%
Maximum Volatility (% p.a.)
63% (December 2008)
Minimum Volatility (% p.a.)
6% (February 2007)
September 2014
33
Volatility Control invests to target a lower and constant level of risk
By driving to the conditions, the scheme experiences a smoother ride
The objective is not to outperform passive equities, but to control risk
Allocation to Equities in Volatility Controlled Index
% Allocation of volatility controlled approach
160%
140%
% Allocation of Volatility Controlled Index
120%
100%
80%
60%
40%
20%
0%
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
Teach-in
September 2014
34
By driving to the conditions the investor experiences a smoother ride

90%
Annualized Volatility (%)
80%
70%
60%
50%
40%
30%
20%
10%
0%
S&P 500
Annual Percentage Return
40%
30%
S&P 500 Volatility Controlled Index
46%
50%
38%
32%
26%
33%
30%
23%
19%
20%
20%
8%8%
10%
21%
19%
14%
11%
10%
32%
29%
29%
26%
18%
13%
16%
16%
11%
9%
1%1%
0%
12%
25%
5%4%
5%
2%
16%
15%
10%
8%
2%
0%
1989
-10%
1990
-3%
1991
1992
-20%
1993
1994
1995
1996
1997
1998
1999
2000 2001 2002 2003

-5%
-7%
-9%
-12%
-12%
2004
2005
2006
2007
2008
2009
2010
2011
-1% 2012
2013
-12%
-22%
-30%
-40%
-37%
Source: Bloomberg; Calculations: Redington
Teach-in
September 2014
35
What is the cost of a put option?
Cost of equity downside protection with

maturity of 1 year
Stressed market
Current cost of
conditions cost of
Cost to protect 10%
protection on Global
1 Year Protection level
protection on Global
Volatility Control
Equity Index (%) over 1
Equity Index (%) over 1 portfolio (%) over 1 year
year
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
Source: Bloomberg, Investment Banks; Calculations: Redington. Pricing is indicative and subject to change
Teach-in
September 2014
36
One approach in detail Volatility Controlled Equity + Put

Driving to the conditions with fully comprehensive insurance
Teach-in
September 2014
37
Extensions of downside protection

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
Teach-in
September 2014
38
Recap & Conclusions what weve covered

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
Teach-in
September 2014
39
Recap & Conclusions
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
Teach-in
September 2014
40
The returns of a downside protection strategy are not evenly distributed

Making it hard to evaluate even using datasets of 15 years or more
30%
Relative returns of S&P500 strategy with 1yr 90% put strategy vs S&P 500
25%
Annual Percentage Return
20%
15%
10%
5%
0%
-5%
-10%
-15%
2001
2002
Teach-in
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
September 2014
41
Downside Risk Management in the Press and Media
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-afa9fd8d1973f295/Taming%20The%20Beast.aspx
RedBlogs
http://blog.redington.co.uk/Articles/Dan-Mikulskis/September-2012/VOLATILITYCONTROL.aspx
The Journal of Indexes
http://www.indexuniverse.com/publications/journalofindexes/joi-articles/12932-optimaldesign-of-risk-control-strategy-indexes.html
Teach-in
September 2014
42
Contact
Please connect on LinkedIn, Twitter

Dan Mikulskis FIA
Director
Direct Line: 020 3326 7129
dan.mikulskis@redington.co.uk
@danmikulskis
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
Teach-in
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
Limiteds prior written permission. It may also not be
disclosed by the Recipient to any other party without
Redington Limiteds prior written permission except as may

be required by law.
Registered Office: Austin Friars House, 2-6 Austin Friars,

London EC2N 2HD.
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.
Redington Limited (reg no 6660006) is registered in England

and Wales.
Redington Limited 2014. All rights reserved.
September 2014
43

Protect Your Assets-Equity Downside Hedging - Redington Teach-In-15 Sep 2014

Загружено:

Сведения о документе

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Protect Your Assets-Equity Downside Hedging - Redington Teach-In-15 Sep 2014

Загружено:

Авторское право:

Доступные форматы

Protect Your Assets:

Equity Downside Hedging

Equity Downside Hedging

Frankly, we have just taken a very important decision with a view

Equity Downside Hedging

Equities continue to rally, but investors remain wary of risks

One illustration is the growth in VIX futures contracts volume (below)

Equity Downside Hedging

Equity Downside Hedging

The downside risk of equities

Daily return (%)

Equity Downside Hedging

The downside risk of equities

Equity Downside Hedging

The downside risk of equities

Equity performance, even over

Equity Downside Hedging

Why invest in equities?

Equity Downside Hedging

Equity Downside Hedging

Why does downside risk matter? A definition of Tail Risk

An event outside the confidence interval

That makes the investment objectives of

Equity Downside Hedging

Example Pension Schemes and their objectives (1)

Expected return Gilts + 2.0%p.a.

Required return to 2037 Gilts + 2.0%p.a.

1 Year Required Return at Risk 0.8%

Equity Downside Hedging

How can downside risk affect the objectives (1)

-10% fall in assets

-15% fall in assets

-20% fall in assets

Required Return % p.a. (Over Gilts)

Equity Downside Hedging

Full Funding Date

Example Investor and their objectives (2)

Equity Downside Hedging

How can downside risk affect the objectives (2)

Excess Return Target >>

Excess Return Target >>

Equity Downside Hedging

Equity Downside Hedging

Tail risk hedges?

Tail risk funds

Equity Downside Hedging

The three layers of portfolio risk management

Equity Downside Hedging

Improving risk adjusted returns

Single Asset Class or Risk Premia

Equity Downside Hedging

Diversification is by itself a powerful way of reducing drawdowns but it isnt protection

For a 0.5 sharpe ratio strategy the

For a more basic 0.15 sharpe strategy

Equity Downside Hedging

Tail risk hedges?

Tail risk funds

Low volatility stocks

Short index futures

Equity Downside Hedging

Equity Downside Hedging

Basic option strategies

Equity Downside Hedging