Protecting your Portfolio from different market environments – including tail risk hedging

Avoiding large market losses is vital to accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement or an ongoing and uninterrupted endowment.

 

The complexity and different approaches to providing portfolio protection (tail-risk hedging) has been highlighted by a recent twitter spat between Nassim Nicholas Taleb, author of Black Swan, and Cliff Asness, a pioneer in quant investing.

The differences in perspectives and approaches is very well captured by Bloomberg’s Aaron Brown article, Taleb-Asness Black Swan Spat Is a Teaching Moment.

I provide a summary of the contrasting perspectives in the Table below as outlined by Brown’s article, who considers both men as his friends.

There are certainly some important learnings and insights in contrasting the different approaches.

 

PIMCO recently published an article Hedging for Different Market Scenarios. This provides another perspective.

PIMCO provide a brief summary of different strategies and their trade-offs in diversifying a Portfolio.

They outline four approaches to diversify the risk from investing in sharemarkets (equity risk).

In addition to tail risk hedging, the subject of the twitter spat above between Taleb and Asness, and outlined below, PIMCO consider three other strategies to increase portfolio diversification: Long-term Fixed Income securities (Bonds), managed futures, and alternative risk premia.

PIMCO provide the following Graph to illustrate the effectiveness of the different “hedging” strategies varies by market scenario.PIMCO_Hedging_for_Different_Market_Scenarios_1100_Chart1_58109

As PIMCO note “it’s important for investors to know in what types of environments each strategy is more likely to work and in what environments each are likely to be less effective.”

As they emphasise “not every type of risk-mitigating strategy can be expected to work in every type of market sell-off.”

A brief description of the diversifying strategies is provided below:

  • Long Bonds – holding long term (duration) high quality government bonds (e.g. US and NZ 10-year or long Government Bonds) have been effective when there are sudden declines in sharemarkets. They are less effective when interest rates are rising. (Although not covered in the PIMCO article, there are some questions as to their effectiveness in the future given extremely low interest rates currently.)
  • Managed Futures, or trend following strategies, have historically performed well when markets trend i.e. there is are consistent drawn-out decline in sharemarkets e.g. tech market bust of 2000-2001. These strategies work less well when markets are very volatile, short sharp movements up and down.
  • Alternative risk premia strategies have the potential to add value to a portfolio when sharemarkets are non-trending. Although they generally provide a return outcome independent of broad market movements they struggle to provide effective portfolio diversification benefits when there are major market disruptions. Alternative risk premia is an extension of Factor investing.
  • Tail risk hedging, is often explained as providing a higher degree of reliability at time of significant market declines, this is often at the expense of short-term returns i.e. there is a cost for market protection.

 

A key point from the PIMCO article is that not one strategy can be effective in all market environments.

Therefore, maintaining an array of diversification strategies is preferred “investors should “diversify their diversifiers””.

 

It is well accepted you cannot time markets and the best means to protect portfolios from large market declines is via a well-diversified portfolio, as outlined in this Kiwi Investor Blog Post found here, which coincidentally covers an AQR paper. (The business Cliff Asness is a Founding Partner.)

 

A summary of the key differences in perspectives and approaches between Taleb and Asness as outlined in Aaron Brown’s Bloomberg’s article, Taleb-Asness Black Swan Spat Is a Teaching Moment.

My categorisations Asness Taleb
Defining a tail event Asness refers to the worst events in history for investors, such as the 5% worst one-month returns for the S&P 500 Index.

Research by AQR shows that steep declines that last three months or less do little or no damage to 10-year returns.

It is the long periods of mediocre returns, particularly three years or longer, that damages longer term performance.

Taleb defines “tail events” not by frequency of occurrence in the past, but by unexpectedness. (Black Swan)

Therefore, he is scathing of strategies designed to do well in past disasters, or based on models about likely future scenarios.

 

 

 

Different Emphasis

The emphasis is not only on surviving the tail event but to design portfolios that have the highest probability of generating acceptable long-term returns.   These portfolios will give an unpleasant experience during bad times.

 

Taleb prefers tail-risk hedges that deliver lots of cash in the worst times. Cash provides a more pleasant outcome and greater options at times of a crisis.

Investors are likely facing a host of challenges at the time of market crisis, both financial and nonfinancial, and cash is better.

Different approaches AQR strategies usually involve leverage and unlimited-loss derivatives.

 

Taleb believes this approach just adds new risks to a portfolio. The potential downsides are greater than the upside.
Costs AQR responds that Taleb’s preferred approaches are expensive that they don’t reduce risk.

Also, the more successful the strategy, the more expensive it becomes to implement, that you give up your gains over time e.g. put options on stocks

Taleb argues he has developed methods to deliver cash in crises that are cheap enough that they actually add to long-term returns while reducing risk.

 

 

Investor behaviours Asness argues that investors often adopt Taleb’s like strategies after a severe market decline. Therefore, they pay the high premiums as outlined above. Eventually, they get tire of the paying the premiums during the good times, exit the strategy, and therefore miss the payout on the next crash. Taleb emphasises the bad decisions investors make during a market crisis/panic, in contrast to AQR’s emphasis on bad decisions people make after the market crisis.

 

 

 

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

We will get through this – coronavirus

One of the better discussions available on the coronavirus is the CFA Institute interview between Laurence B. Siegel and Andrew “Drew” Senyei, MD.

The most important point to take away is the concluding remark “the advances in medical knowledge and molecular biology, especially in the last decade, and with the full focus of the world on this one challenge — we will get through this.”

The discussion is wide ranging and will help in providing clarity on several issues e.g. the importance of testing, how the virus impacts on the body, and the trade-off between preventing or slowing the spread of the disease at all costs versus the cost on the economy and people’s mental health, including what testing is required to get people back to work.

 

The interview begins by acknowledging that although our knowledge of the virus is increasing there is still lots to learn about it. It is evident that this coronavirus is different from previous coronaviruses.

One important unknown is how lethal it is. This relates to the case fatality rate (CFR). This is the number of people who die of the disease, expressed as a percentage of the number of people who have it.

As you may be aware, there are a number of problems in measuring this currently:

  • More testing is needed to know how many people who have had it, especially asymptomatic patients – tested positive for the virus but showed no symptoms.
  • The reporting of deaths has also been problematic, did they die because of the virus or was there an underlying ailment e.g. cancer or heart disease. The difference between died with and died from.

The best estimate currently is that the CFR of the coronavirus is higher than the flu, but it is unlikely to be as high as SARS.

Also, the CFR for the coronavirus is likely to fall as further testing is undertaken, this was the experience with SARS.

The experience on the cruise ship, The Diamond Princess, provides an insight into the likely CFR, and interestingly, over half those tested were asymptomatic. This is discussed in more detail in the article.

The issue of incomplete statistics is highlighted in comparing the outcomes between Italy and South Korea. This comes down to the level of testing and the variations in the way different countries are testing.

Social distancing is having a positive impact. Particularly from protecting the health care system. Ideally, we want “the density of new cases presenting in any geographic area at any given time to be as low as possible and over as long a time period as possible to prevent a surge on the health care system.”

There is a great discussion around the issues with testing. There are a lot of variables.  At the risk of sounding repetitive we need lots of testing, “We need to know how much of the disease is out there so we can have the health care resources and physicians to respond to that surge, where and if it occurs.”

 

Economic Trade-off

The latter half of the article covers the issue of the trade-off between preventing or slowing the spread of the disease at all costs versus the cost on the economy and people’s mental health.

The argument being, should we ease up relatively quickly on policies that discourage work and income and social interaction, otherwise we will severely injure the economic life.

Is there an optimum or balance between the two extremes?

 

Initially, given the unknows, erring on the side of caution would appear appropriate.

Nevertheless, there is an argument for considering “a rational middle ground and that is: We have to first understand if this is peaking. And remember when you look at new case rates, you’re actually lagging by two weeks.”

Understanding more about the virus will help in getting the economy back up and running.  More testing is needed.

“I would look at those [new case rates], and then at hospitalizations and intensive care utilization, and see if that’s peaking because that is the most pressing problem. Then I would look at the rates by population density and see where the wave is happening more locally and usher resources there.”

The discussion comes back to more but different testing, to get a better sense of who’s had the infection, who’s over it, and who’s protected at least for a while.

This is an interesting discussion and highlights a likely path to getting people back to work. .

The key is to identify those individuals already immune and not likely to get infected or infect others back to work.

Protecting the elderly is important, therefore it is suggested “to look at the density of the elderly and make sure resources are adequate for that particular region — not just equipment and supplies, but personnel.”

Senyei concludes “I would invest really heavily in the basic biology and in vaccine development which is two years out. I think you’re going to need a vaccine and you’ll probably need a new vaccine like you do for the flu every year. This virus will mutate.”

“Now all that takes money, time, and coordination — but people are working on it and I think, if we did that, we could sort of get back to the economy being an economy.”

As highlighted above, they conclude by acknowledging that we will get through this.

 

Stay safe and healthy.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.