The recent performance of tail hedges raises the issue of sustainability of hedging and monetisation.
After 2018, investors may be forgiven for questioning tail strategies.
Even with declines in more than 90% of asset classes1, the Eurekahedge Tail Risk Index finished with a 6% decline.2 Its sister index, the Eurekahedge Long Volatility index, mustered a mere 1% gain.3 This lacklustre performance was realised despite 2018 being the most volatile year since 2011 in equities and, as Figure 1 shows, the realised volatility of 60/40 portfolios hitting the highest since the financial crisis (nearly triple the average of 2017).
The volatility highlight of 2018 may well have been the collapse of the XIV, a 2x levered note short the VIX Index, which managed an 80% decline in one day in February. This led to a year in which volatility buyers made much less than one would expect based on losses incurred by volatility sellers.
With the dramatic reversal in markets in 2019, tail hedges have lost as much, or more, than they gained in the final quarter of last year. While that performance may be forgivable given the sharp recovery of markets, it raises the issue of sustainability of hedging and monetisation, and when to take some profits in the face of large equity moves.
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Source: Bloomberg; as of 13 February, 2019. Realised volatility of a portfolio consisting of 60% S&P 500 Index and 40% allocation to the ICE U.S Treasury 20+ Year Bond Index.
The High Cost of Owning Protection
Tail hedging has always been a difficult proposition given the relatively high cost of owning protection over time. Probably too much attention is paid to the losses of hedges rather than considering them in the context of overall portfolio returns. Investors seeking cheap hedges rather than risk-targeted ones may wind up with hedges that fail to perform, while ad hoc implementation and monetisation plans may result in further risk to the sustainability of hedge programs. Fees for investments in tail funds result in even less protection as a projected max loss of, say, 5% may well need to incorporate annual cost of fees which may reduce the available budget to allocate to hedging. Further, any incentive paid to managers means even less protection when hedges pay off. Based on fees alone, investors may find themselves considering taking on the project themselves.
However, we believe that they are best served relying on an asset manager to implement these programs, but maybe for different reasons than commonly pitched by the tail hedge community. We believe finding the best hedges does require going beyond simply targeting the lowest cost hedge alternative or looking for lottery ticket type option hedges.
The trade-off between cost and efficacy is an important one and may be better made in the context of portfolio risk, not in the context of a generic tail fund with little visibility on client risks. The more complex the hedge, the greater the potential risk to the hedge failing in a market correction. Finally, implementation and monetisation may be as important as hedge selection and require planning at the commencement of the hedge program, not on the fly.
Why Does Anyone Tail Hedge At All?
It is a sad fact that most tail funds, hedge strategies and products have lost money since 2009. The aforementioned Eureka Tail Risk Index has lost 50% since the end of the financial crisis. Further, as shown in Figure 2, the drag from simply buying S&P 500 Index puts to hedge appears expensive, with a hedged portfolio underperforming by more than 80% between1 August, 2006, to 31 March, 2019.
However, an investor’s motivation for hedging is worth analysing before determining whether, in fact, hedges have failed. For example, if hedging is undertaken for the purpose of maintaining a long exposure to equities, it may not be true that hedging failed. If the choice is cutting risk in equities versus maintaining risk using a hedge, the hypothetical portfolio (shown in Figure 3) of the S&P 500 hedged with 1-year 90% puts has simulated returns of nearly 6% per year. Those returns would be above an investment in cash yielding an average of 60 basis points a year over the same period. Thus, while the hedge was costly, the impact on the portfolio was beneficial.
Similarly, investors may wish to reduce their reliance on bonds as diversifiers/protection to their equity portfolio given current yields. With properly designed hedges, investors may be able to reduce downside risk of the portfolio from equities and thus, potentially reduce the need to own duration as a hedge.
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Source: Bloomberg; as of 31 March, 2019. The performance data is synthetic and is not based on the actual performance of a representative fund or strategy. It is shown for information purposes only and should not be used as a guide to the future. Investment product charges have not been applied. Performance is represented by the retrospective performance of an underlying hypothetical portfolio that has been constructed in accordance with the methodology detailed. Portfolio is made of S&P 500 index hedged with either the purchase of rolling 1-month 95% puts or the purchase of rolling 1-year 90% puts. One-year options are monetised and replaced annually on a quarterly rolling basis (1/4 rolled per quarter), while 1-month options are replaced at expiry. New option prices based on market values at the time of each roll. Calculation data is available upon request. The start and end dates of such events are subjective and different sources may suggest different date ranges, leading to different performance figures. Simulated past performance is not indicative of future results.
Figure 3. Underperformance in Numbers
|Hedge Strategy||Cumulative Return||
|S&P 500 Total Return||197%||8.00%||19.50%||
|S&P 500 Hedged: 1-Month 95% Put||74%||4.51%||13.50%||
|S&P 500 Hedged: 12-Month 90% Put||109%||5.97%||11.50%||
Source: Bloomberg; as of March 31, 2019. The performance data is synthetic and is not based on the actual performance of a representative fund or strategy. It is shown for information purposes only and should not be used as a guide to the future. Investment product charges have not been applied. Performance is represented by the retrospective performance of an underlying hypothetical portfolio that has been constructed in accordance with the methodology detailed. Portfolio is made of S&P 500 index hedged with either the purchase of rolling 1-month 95% puts or the purchase of rolling 1-year 90% puts. One-year options are monetised and replaced annually on a quarterly rolling basis (1/4 rolled per quarter), while 1-month options are replaced at expiry. New option prices based on market values at the time of each roll. Calculation data is available upon request. The start and end dates of such events are subjective and different sources may suggest different date ranges, leading to different performance figures. Simulated past performance is not indicative of future results.
We believe that the notion of efficiency, while intellectually intriguing, may sometimes need to give way to common sense on risk and the difficulty of achieving return objectives. Casting efficiency aside allows us to begin to look at the exercise through the prism of the 60/40 portfolio. A generic 60/40 allocation by capital may be more akin to 90/10 in terms of risk with equities forming the bulk of risk. With many CIOs tied to mandated returns in the range of 6-8% and 10-year notes yielding only 2.5%, there is little choice but to be heavily overweight in risk terms in equities to be able to achieve return objectives. We believe this leaves the portfolio with considerable tail and drawdown risks to manage.
Knowing this, managers continue to hunt for hedges, but saddled with high return objectives, they may need hedges to be low cost or even carry neutral; in short, taking outsize risk to generate returns, but looking for the least expensive possible way to hedge it. The flaws of this approach to hedging may be exposed fairly quickly if hedges fail. There is a temptation to search for the lowest cost hedges first and then, once found, look for portfolio risks that those hedges may address.
Yet, investors do need risk-management tools in place to protect the portfolio from impairments that come with large equity declines. For funds that move slowly to adjust risk in large declines, tail hedging becomes much more relevant. While index puts are among the highest cost hedges, at a minimum, they increase in short exposure during market declines, resulting in risk reduction, and a portfolio that we feel is in a better position than the static or occasionally repositioned portfolio.
If You Have to Hedge, What Should It Look Like?
In designing hedge programs, a starting point is to target portfolio risks that you cannot live with and then search for hedges that you can live with that address those risks. Once found, buy with the size and the scope to actually make a difference. As a guide, Figure 4 shows the framework we apply to the exercise, with an eye toward sustainability and reliability of hedges.
Figure 4. The Framework
Source: Man Solutions. For illustrative purposes.
In a previous paper, we argued that hedges should target risk and not returns. What we meant was to avoid highly complex hedges that may prove less likely to pay off in declines than traditional hedges. This race to cheapen hedges has led to investors trying to find low cost hedges first and then looking for risk in their portfolios that these hedges might protect.
We believe a further mistake is putting only a small amount of capital to work in hedging. We frequently find ourselves pondering why a large-scale pension fund might choose to allocate trivial amounts of capital to a tail hedge fund given the minimal impact on portfolio risk. The time worn phrase of “being in motion” on hedging more or less sums up the approach.
If small allocations to tail funds cannot meaningfully impact risk, and large allocations to complex carry-neutral or low-cost strategies could have adverse outcomes, what does that leave? We say target risk, but what we mean is target risks which may leave the portfolio exposed to significant drawdowns. By adding valuation principles to the process, hedges can be designed that may better fit within both risk and return constraints.
Determining fundamental and macro data based upside targets may allow investors to sell upside calls to fund puts via an equity collar structure. By giving away upside that may be above investor return objectives, the portfolio gains potentially meaningful protection in market declines. The alternative is also worth analysing. When stocks appear inexpensive, selling upside calls may not make much sense. In order to keep the upside, the better premium reducing strategy may be to cap the amount of protection by converting the put into a put spread through the sale of a far out of the money put. While this means the portfolio has less protection in a crash, it offers the potential benefit of removing the upside cap. The lower put strike should target levels in the market at which the investor may be comfortable getting longer on equities again. In short, by adding valuation tools to the hedging conversation, we put on hedges that we believe align with portfolio views, have scalability and protect against risks.
Implementation: Avoiding Randomness
Tail hedge managers are often telling investors that the sky is imminently going to begin falling; however, we believe attempting to guess the timing of the next market crisis misses the point.
We believe that one root cause of hedge failure comes from ineffective and/or ad hoc implementation. Because hedges are felt to be high cost, often little capital and thus little effort seems to be applied in designing them and managing them. Attempts to time markets may result in chasing hedges into declines just as volatility shoots higher or other inefficiencies. By not having a core implementation plan, investors may be unprepared for changing market regimes that dramatically alter the best hedge profiles.
As Figure 5 shows, the variation of gains or losses in a backtest of hedges based solely on implementation date selection can be significant. A simple 1-year collar strategy struck on the S&P 500 on a constant number of shares implemented on 1 January, 2005, loses about 6.84% a year versus 4.33% if implemented a month later. This is based on an annual expiration and rolling at 10 months into the year.
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Source: Bloomberg; as of 31 March, 2019. *Simulations showing profit or loss on hedges through 31 March, 2019. The performance data is synthetic and is not based on the actual performance of a representative fund or strategy. It is shown for information purposes only and should not be used as a guide to the future. Investment product charges have not been applied. Performance is represented by the retrospective performance of an underlying hypothetical portfolio that has been constructed in accordance with the methodology detailed. Hedges based on using 1-year collar on the S&P 500 Index (sale of 108% call to fund purchase of 90% put), with single annual roll of hedges at 10-month mark. New option prices based on market values at the time of each roll. Calculation data is available upon request. The start and end dates of such events are subjective and different sources may suggest different date ranges, leading to different performance figures. Simulated past performance is not indicative of future results.
While the chart should raise caution flags on any backtests used by marketers, it also goes to the point that gaming hedge timing may do more damage than good. Having a systematic implementation plan prior to commencing on any hedging program is pivotal to success in our view. The design should include all the inputs you might put into asset management programs, including fundamental and quantitative triggers to slow or accelerate hedging pace. Market regimes frequently change and today’s best hedge may not be the same tomorrow. The plan should have flexibility to adapt to those conditions which may well involve changing hedging instruments. Most importantly, we believe the benefit of a plan outweighs any hope of beating the market.
Monetisation: Working Toward Sustainability
One primary goal of any program should be sustainability, which is challenging given losses of the last 10 years. Hedge losses are offset by portfolio gains and thus should not be viewed in isolation; however, for many, the losses have impaired their ability to maintain hedges over the very long run as much attention is paid to negative lines in the portfolio profit and loss statement.
In the rush to commence hedging programs, a frequently overlooked piece is monetisation. Much like implementation, we believe the monetisation piece is pivotal to the long-term viability of the hedging plan. Not every market event is a crash; however, periodic market declines offer some opportunities to take profits on hedges and thus continue to fund the program over a longer time period. As markets decline and volatility increases, the option premium of the hedges necessarily expands and thus, so do risks of the position. While the portfolio is likely experiencing losses, we believe the plan should be designed to contemplate taking some early profits on hedges in order to help maintain the sustainability of the program.
A variety of market-based and quantitative signals may form the basis to inform the timing of a partial monetisation. Market data may include volatility and skew levels, asset managers’ net and gross exposures, excess flows in terms of buying/selling stocks and momentum indicators, just to name a few. None works in isolation, but taken in composite, they may form the basis to reduce hedges and potentially realize some gains around what may be a short-term ‘panic’ low in the markets.
An example may be volatility and flow based. Figure 6 shows the spot level of the VIX volatility index and the ratio of puts being traded in the market to calls on any given day. A high put/call ratio simply means that investors are buying puts in larger quantities than usual and thus, may suggest heightened concern. Often described as a ‘panic’ measure, the ratio is read by contrarians for signs of complacency or fear. Many read the VIX the same way. The put/call ratio can be a volatile series and thus, is best viewed through the prism of implied volatility. In early December 2018, even as markets declined, neither the VIX nor the put/call ratio showed signs of panic; however, in late December, both jumped to among the highest levels of the last 10 years. In conjunction with valuation and other factors, that may have suggested a monetisation point for a portion of the hedge portfolio.
Figure 6. S&P 500 Put/Call Ratio and the VIX Index
Source: Bloomberg; as of 28 March, 2018. Forms of monetisation may include rolling down puts to maintain exposure if the crash worsens or simply harvesting a portion of the gains while maintaining the majority of hedges. After all, few hedge the entire portfolio and as such, tail hedges likely have a much smaller notional exposure than the portfolio being protected.
As we have written before, one of the most important aspects of tail hedging is to simply move from an ad hoc and occasional approach to developing a long-term plan to ensure the sustainability of the program. This means having a process in place to inform hedge selection, implementation and monetisation. It is not enough to find the cheapest hedges that might be available today. As markets change, the ‘best’ hedges may be entirely different from one period to the next. As such, there needs to be some adaptability to the approach to ensure the hedges fit the current market regime.
Implementation may similarly be sped up or slowed down based on a variety of metrics. However, we believe the key to implementation is to have some systematic approach. We do not advocate timing the market; however, when valuations or other factors change, your pace of implementations and for that matter monetisation, should have built in the power to adapt.
By putting in place plans for all of it, investors may be able to create a framework that helps ensure the program survives long enough to be in place for the next crisis.
1. Source: Wall Street Journal.
2. Source: Eurekahedge.
3. Source: Eurekahedge.