Is it an outdated Investment Strategy? If so, what should you do? Tail Risk Hedging?

Those saving for retirement face the reality that fixed income may no longer serve as an effective portfolio diversifier and source of meaningful returns.

In future fixed income is unlikely to provide the same level of offset in a portfolio as has transpired historically when the inevitable sharp decline in sharemarkets occur – which tend to happen more often than anticipated.

The expected reduced diversification benefit of fixed income is a growing view among many investment professionals.  In addition, forecast returns from fixed income, and cash, are extremely low.  Both are likely to deliver returns around, if not below, the rate of inflation over the next 5 – 10 years.

Notwithstanding this, there is still a role for fixed income within a portfolio.

However, there is still a very important portfolio construction issue to address.  It is a major challenge for retirement savings portfolios, particularly those portfolios with high allocations to cash and fixed income. 

In effect, this challenge is about exploring alternatives to traditional portfolio diversification, as expressed by the Balanced Portfolio of 60% Equities / 40% Fixed Income. I have covered this issue in previous Posts, here and here.

Outdated Investment Strategy

There are many ways to approach the current challenge, which investment committees, Trustees, and Plan Sponsors world-wide must surely be considering, at the very least analysing and reviewing, and hopefully addressing.

One way to approach this issue, and the focus of this Post, is Tail Risk Hedging. (I comment on other approaches below.)

The case for Tail Risk Hedging is well presented in this opinion piece, Investors Are Clinging to an Outdated Strategy At the Worst Possible Time, which appeared in Institutional Investor.com

The article is written by Ron Lagnado, who is a director at Universa Investments.  Universa Investments is an investment management firm that specialises in risk mitigation e.g. tail risk hedging.

The article makes several interesting observations and lays out the case for Tail Risk Hedging in the context of the underfunding of US Pension Plans.  Albeit, there are other situations in which the consideration of Tail Risk Hedging would also be applicable.

The framework for Equity Tail Risk Hedging, recognises “that management of portfolio risk and equity tail risk, in particular, was the key driver of long-term compound returns.”

By way of positioning, the article argues that a reduction in Portfolio volatility leads to better investment outcomes overtime, as measured by the Compound Annual Growth Return (CAGR).  There is validity to this argument, the reduction in portfolio volatility is paramount to successful investment outcomes over the longer-term.

The traditional Balance Portfolio, 60/40 mix of equities and fixed income, is supposed to mitigate the effects of extreme market volatility and deliver on return expectations.

Nevertheless, it is argued in the article that the Balanced Portfolio “limits portfolio volatility in benign market environments over the short term while making huge sacrifices in long-run performance.”

In other words, “It offers scant protection against tail risk and, at the same time, achieves an under-allocation to riskier assets with higher returns in long periods of economic expansion, such as the past decade.”

The article provides some evidence of this, highlighting that “large allocation to bonds still failed to provide enough protection to add value over the cycle — reducing the CAGR by 170 basis points.” 

Essentially, the argument is made that the Balanced Portfolio has not delivered on its promise historically and is an outdated strategy, particularly considering the current market environment and the outlook for investment returns.

Meeting the Challenge – Tail Risk Hedging

The article calls for the consideration of different approaches to the traditional Balance Portfolio.  Naturally, they call for Tail Risk Hedging.

In effect, the strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge (protection of large equity loses).

It is argued that this will result in a higher CAGR over the longer term given a higher allocation to equities and without the drag on performance from fixed income.

The Tail Risk Hedge strategy is implemented via an options strategy.

As they note, there is no free lunch with this strategy, an “options strategies trade small losses over extended periods when equities are rising for extremely large gains during the less frequent but devastating drawdowns.”

This is the inverse to some investment strategies, which provide incremental gains over extended periods and then short sharp losses.  There is indeed no free lunch.

My View

The article concludes, “diversification for its own sake is not a strategy for success.”

I would have to disagree.  True portfolio diversification is the closest thing to a free lunch in Portfolio Management. 

However, this does not discount the use of Tail Risk Hedging.

The implementation of any investment strategy needs to be consistent with client’s investment philosophy, objectives, fee budgets, ability to implement, and risk appetite, including the level of comfort with strategies employed. 

Broad portfolio diversification versus Tail Risk Hedging has been an area of hot debate recently.  It is good to take in and consider a wide range of views.

The debate between providing portfolio protection (Tail Risk Hedging vs greater Portfolio Diversification) hit colossal proportions earlier in the year with a twitter spat between Nassim Nicholas Taleb, author of Black Swan and involved in Universa Investments, and Cliff Asness, a pioneer in quant investing and founder of AQR.

I provide a summary of their contrasting perspectives to portfolio protection as outlined in a Bloomberg article in this Post.  There are certainly some important learnings and insights in contrasting their different approaches.

The Post also covered a PIMCO article, Hedging for Different Market Environments.

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

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

They provide the following Table, which outlines an array of “Portfolio Protection” strategies.

In Short, and in general, Asness is supportive of correlation based like hedging strategies (Trend and Alternative Risk Premia) and Taleb the Direct Hedging approach.

From the Table above we can see in what type of market environment each “hedging” strategy is Most Effective and Least Effective.

For balance, more on the AQR perspective can be found here.

You could say I have a foot in both camps and are pleased I do not have a twitter account, as I would likely be in the firing line from both Asness and Taleb!

To conclude

I think we can all agree that fixed income is going to be less of a portfolio diversifier in future and produce lower returns in the future relative to the last 10-20 years. 

This is an investment portfolio challenge that must be addressed.

We should also agree that avoiding large market losses is vital in accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement, ongoing and uninterrupted endowment, or meeting future Pension liabilities.

In my mind, staying still is not going to work over the next 5-10 years and the issues raised by the Institutional Investor.com article do need to be addressed. The path taken is likely to be determined by individual circumstances.

Happy investing.

Please see my Disclosure Statement

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

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.

Global Equity Markets Meltdown – Don’t Panic Sell

Worried About Your Retirement Investments? Don’t Panic Sell was published prior to the big drop in the markets on Tuesday.

Nevertheless its messages are still very relevant given further market weakness over the last week.

I like how the article starts with the behaviour economics aspect of market volatility. Unfortunately we feel the pain of losses much more than the pleasure of market gains.  The 24 hour cycle of news headlines does not make the feeling of portfolio loses any better!

As the article highlights, equity markets are back to levels they were at a couple of months ago. Unless you have a portfolio of 100% equities (which is unwise in most circumstances – particularly if you are saving for a house deposit) your portfolio loses are unlikely to be as great as those posted by the equity market indices. The benefits of diversification.

Diversification does work. Having said this, the recent daily market activity has witnessed loses in both fixed interest (bonds) and equities on the same day. This is where allocations outside of equities and fixed interest such as alternative strategies adds another layer of true portfolio diversification.

The article makes the very valid point of having an Investment Policy Statement (IPS). This is a critical and important document. At times like this it is worth referencing this document, accessing appropriateness of goals, objectives, and long term strategic asset (risk) allocations. Of course this exercise should be undertaken formally and frequently (yearly) irrespective of market conditions. The continued focus should be on what needs to be done to reach longer term investment objectives. Outcomes should be measured against these objectives not market indices.

 

Rebalancing Policy

An essential component to adding value over time and increasing the chances of meeting investment objectives is to have a well-articulated and documented Rebalancing Policy. This assists in managing the risks that build up within portfolios over time, such that market movements like the recent one do not have an outsized impact relative to expectations and risk tolerance levels.

 

There are lots of other points to consider in the article, namely don’t try and time markets.

 

Please see my Disclosure Statement