Long Story Short: What To Do When Your Hedges Don’t Work

Shanta Puchtler, President at Man Group, talks to Peter van Dooijeweert about the practical ways investors can manage and distribute risk in their portfolio.

Given the volatility in both credit and equity markets, portfolio hedging has never been more important. Peter van Dooijeweert, Managing Director at Man Solutions, joins Long Story Short to discuss the different ways investors can manage their tail risk, from put options to risk distribution strategies.

Shanta Puchtler, President at Man Group, talks to Peter van Dooijeweert about the practical ways investors can manage and distribute risk in their portfolio.

Recording date: May 2022

 

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Shanta Puchtler:

Welcome back to Long Story Short. I want to focus today on what I think is a very timely subject and that is hedging portfolio and hedging risk in beta portfolios more broadly. Given the volatility and drama in equity and credit markets over the last several months, I really want to drill down into this topic. Joining me today, I have Peter Van Dooijeweert, who’s Managing Director at Man Solutions and an expert on this topic to talk to us about hedging more broadly. Thank you for joining us, Peter.

Peter van Dooijeweert:

Yep. Happy to be here.

Shanta Puchtler:

It's great to have you here. You speak with a wide range of global asset owners. What's their sentiment right now, and how is it differing from yours?

Peter van Dooijeweert:

It's funny. There's been a big evolution over the last year and a half. The inflation story started as maybe there's some inflation, then it became transitory, then it became not transitory. Now we're in the, oh my goodness, the Fed is hiking rates, inflation is bad, and my portfolio's doing terribly. Whatever version of 60/40 people own, they're suffering. I don't think people have a clear view what to do. We're in a little bit of, I hope this all works out phase. I know that people want to diversify, and we'll talk about that later, and it's hard. So the sentiment is down and not great.

My sentiment doesn't really matter, because I'm basically a permabear. My job is to help people with hedging and risk mitigation. You don't want to have the most bullish, optimistic guy in the room and telling you, "No, no, that'll be fine. You don't need to do anything about this." For me, it's minus 20% can be minus 50%, minus 50 can be minus 80. All the charts in history tell you, it could be worse than you think. Just because it worked for 20 years, doesn't mean it'll work for 40, so you don't know what's coming. You need to be prepared for it. It's tougher to prepare for a fire when your house is already on fire, and we're kind of there right now. But there are some practical smart things I think people can do. And that's what they're talking to us about.

Shanta Puchtler:

I've heard you use this term outsourcing risk management before. What do you actually mean by outsourcing risk management, in the context of tail hedging?

Peter van Dooijeweert:

Yeah. I say it a lot because when you buy a put option you're basically insuring that your portfolio won't lose money beyond a certain level, so you buy a 5% out of the money put. And the market falls, you're protected by that put option, and you pay a certain premium for that. What you've done, basically, is you've transferred your risk to some third party, a market maker, an investment bank, something like that. Now, they're basically in charge of managing the risk of your portfolio. Not directly, because you've protected yourself.

The thing about outsourcing is, it has a cost. We're used to outsourcing meaning it becomes cheaper, I should do it. I should give people this to do for me because they're going to be better at it. And that's not the case here. You're paying a very high premium for that. You need to make some decisions. Is it worth outsourcing my risk management for this very high cost? It was expensive coming into the year. It was expensive coming out of COVID. I think, in part, it became expensive because bond equity correlation was problematic, and people started to worry about bonds. Will bonds be defensive?

There were a few moves you could make. You could de-risk, which people often don't do in a market rally. You could diversify, which is a little tough to do with an IC that hasn't seen certain products. Or you could start thinking about hedging and buying options. We had huge retail inflow that everyone knows about in terms of call buying. So vol was high to begin with. And since then, it's been nothing but volatile. The whole year has been ups and downs. The Ukrainian war, bond equity correlation. So it's definitely expensive and harder to hedge. A one year put might cost you 6% for a 10% out of the money put. Before COVID, that would've cost you 2.5%. So there's a huge increase in cost.

If you think about that put, to break even on a 10% out of the money put, that you paid 6% for, means down 16% from here. We're already down a lot year to date. That could put you in a 30, 40% down range to break even on a put. That doesn't feel great if you're doing that trade.

Shanta Puchtler:

And so what about non-equity asset owners and the cost of protection? Is the cost high in bonds in other parts of the market as well?

Peter van Dooijeweert:

It's gotten high everywhere else sequentially. Fixed income went first last year in September. And you remember people were saying, "I can't believe that equity markets aren't more volatile when fixed income's gotten this volatile." It took a little while to translate, and it finally showed up. And then the FX markets got a little unglued. There had been some unusual moves. We're used to yen strong in a bad market, and it's moved 15% pretty quickly. FX markets have gotten more expensive.

You can imagine oil markets are expensive to trade volatility. Everything is expensive, and you're now at a point where I don't know which asset class is best if I have to hedge things. Imagine if you have to hedge all of the asset classes, you're really left with no cheap option. Even credit options have become expensive, because credit has suffered under the dual problem of spread widening and rates rising. It's definitely a tough year for all asset classes, and using options isn't necessarily the best option right now.

Shanta Puchtler:

And if outsourcing at this point is top-ticking price wise, and therefore prohibitive, what are the options for protection?

Peter van Dooijeweert:

I think from a hedging perspective, maybe the better question is what can you do with a portfolio? You can make certain decisions right now. You can diversify the risks you have, i.e. 60/40 is difficult and correlations are high, so we should diversify. You could directly manage the risk you have. Or you can find a way to distribute the risk. And distribute the risk, we've talked a little bit about hedging, but it may mean selling. That's the three step way, I guess, to think about it and where to go from here.

Shanta Puchtler:

But given all the correlation spiking we're seeing in the market, diversification seems challenging these days. If 60/40 is vulnerable, what do we do from here?

Peter van Dooijeweert:

Yeah. I think we're used to bonds working, and everybody's talked about 60/40 being challenged. I'm not going to spend a lot of time talking about bond equity correlation. Diversification is tough, because it means going multi-asset into potentially going to commodities. It might mean going into real estate, infrastructure, asset classes you're not familiar with. There's a lot of work that goes into it. It's very easy for me to sit here and say, "In inflationary times, you should buy commodities." It's very easy for [inaudible 00:05:57] to say the same thing. And then the IC member who says, "But I remember in March 2020 that oil went to minus 40," and everyone looks around and thinks, yeah, maybe we shouldn't pay 110 for an asset that went to minus 40. There's a lot that goes into this diversification conversation.

One of the things I find interesting is when we look at what's going wrong with 60/40, if you can't figure out what to do it doesn't hurt to sell a little bit and put some in cash. I think one of the biggest disservices we have in the investment industry is to say cash is trash. Cash this year is flat, right? Flat feels pretty good compared to minus 15, minus 60, whatever asset class you're looking at.

Shanta Puchtler:

Flat and low vol.

Peter van Dooijeweert:

Flat and low vol, easy. And it gives you some optionality to say, you know what? I think this fed story is overdone, or this story is overdone, so I might start reallocating the assets. So if you don't know what's happening and moving to cash to provide yourself free protection, you know that class is going to be safe, I don't think it's a crazy thing to do.

Shanta Puchtler:

But that sounds a little bit crazy in the face of the inflation that we're experiencing. How do you counter that?

Peter van Dooijeweert:

You are, and I'm not trying to sell you a cash only strategy. But it's fair, right? Because some of the conversations you have, well, on a real return basis you can't do this. Fed funds still don't really give you any money. I think that's a reasonable response. And certainly we don't want you holding cash for the next 50 years, unless rates are really high. For sure that's difficult. On the other hand, it's a pretty challenging time. There's a bit of an arrogance in our industry to say you should always be invested, because you should be invested always in things that go up. Making that list of things that go up all the time isn't all that easy. And managing the things when they don't go up all the time isn't all that easy. So I think people need to take the flexibility, use cash as a buffer zone, and make tactical decisions based on that.

If you don't understand the environment well enough when you look at I think so many things can go wrong, valuations might be very high, and we're still probably high on a historic basis valuation wise, there's nothing wrong with putting some in cash and sitting it out. You've still got plenty of risk on. If you go from 50 to 60 to 55 equity, you're not missing that much to the upside.

Shanta Puchtler:

So given the challenges you talk about, how do we fix the 60/40 malady?

Peter van Dooijeweert:

So before I told you commodities are tough. It turns out you still need them. You need something. I think we've been too dependent for a long time on those two asset classes, and rightly so. It's been relatively easy. There probably have been much better mixes. You can make a lot of better versions of 60/40. It just happens to have worked really easily. It's been a decent benchmark. I think it makes sense to be in commodities. It probably makes sense to go beyond that into infrastructure and real assets. That's not really our bag. For me, I focus a bit more on getting exposure to commodities.

Given it's pretty hard to risk manage it, perhaps using something like trend makes a lot of sense, where trend is a decent answer because it'll get long things that are going up like commodities in this type of environment. And when it starts to reverse, it'll get out of the way. Maybe it over trades, maybe it buys and sells it a little too often, but I think it gives you an access to that asset class.

Shanta Puchtler:

Peter, I was waiting for you to play the trend card. Tell me more about how it's really different or diversifying from owning underlying assets permanently.

Peter van Dooijeweert:

I think what's great about trend is it manufactures its own convexity, if you will. It creates exposure to assets. But what it does, it gives you exposure to assets that I wouldn't even put in a 60/40 portfolio. I don't know how you would create a basket of FX and currency crosses for your portfolio. What, 60/40, plus I'll throw in some yen and some Euro, and it doesn't really make any logical sense. But trend will get you exposure to those asset classes. You're getting exposure to things that aren't really even investible in many ways for most asset managers. So you get commodities, we get currencies.

Also it gets you involved in bonds in a way you wouldn't do. You wouldn't be the type of manager who shorts bonds in 60/40. It's one thing to say, I don't want as much duration. It's another thing to go to the IC in the middle of a war and in fed hiking rates and say, I don't think we need bonds. We should be short them. That's a pretty tough thing to do. So trend has this neat tendency to correct the portfolio problems you have. It's not an amazing complicated instrument, it's a bit of a blunt instrument, but it gets you out of some bonds. It gets you out of some equities. It gets you into commodities and moves your portfolio around in a multi-asset way. And in a way that creates convexity to these other asset classes.

Shanta Puchtler:

Let's take a detour for a minute. Help us understand what manufactured convexity is. It sounds like a great feature of trend, but just illuminate there.

Peter van Dooijeweert:

When we talk about options, people often say, "Well, options are convex." You own a put option. The market starts to move, the put option starts getting a lot of Delta market exposure very quickly. And that's what convexity looks like. So you can imagine people have seen the hockey stick version of these put option payoffs. Trend does that in a replicating manner, but it's more like a straddle. So as the market starts to move away from some baseline in some direction, one or two standard deviations, it starts to build exposure.

So just like a straddle might build exposure because you own it, the call option is going up in value, trend is slowly buying that exposure. But instead of buying a straddle, buying a putter, buying options from the market at high price, trend is just doing it dynamically and getting you that exposure, for lack of a better word, for free. Your cost of that, of course, is what if it moves really fast? Then you might have missed some of that first move that a straddle would get. But trend is doing it in a lot of different asset classes. I don't mind if I missed one of them if I've got some of the other ones working. And that's the really key thing for trend as a diversifier. I think people sometimes think trend makes a lot in equities in a crash. It actually makes a lot more in all the other asset classes in an equity crash. And so maybe 80, 85% of returns come from non equities during market dislocations. And on the upside, it makes a fair bit in all these other asset classes as well.

Shanta Puchtler:

So shifting gears a little bit, what about private equity in the context of protection and downside risk?

Peter van Dooijeweert:

It's funny, because I often hear them while we're diversifying into other assets, like private credit and private equity. It's pretty tough when you're, again, a permabear to look at private equity as anything other than equity with maybe even more leverage, and private credit as maybe credit in even riskier capital structures than the publicly available high yield and investment grade markets.

I don't think of them as diversification. I understand it's nice that things don't mark to market, so feels pretty good. I think this year might feel a little different because for a lot of the June 30 year end folks that it worked pretty well in the global financial crisis, June 30 was the right time, and COVID June 30 was the right time. This year's going to be tough, because there's the high water mark last year. I think this year June 30 is going to feel... There'll be some bad marks in venture capital. That diversification is, I'll generously say, challenging, but it may be an illusion.

Shanta Puchtler:

Thinking on this, it strikes me that just straight out selling might be the best source of protection. How does that fit into your thinking?

Peter van Dooijeweert:

There's been a lot of questions about why is vol not flying higher? Why are puts seemingly a little cheaper compared to calls recently, and people seem to be hedging less? I think the cost of hedging is high. The natural result is, if I'm not that great at diversifying maybe I should hedge some of this stuff. It's expensive, so maybe I should be selling. When these kind of moves happen where we see, again, puts not exploding in value, then the market has entered what I might call a liquidation mode. You're just eliminating your long risk and selling it. And maybe it's certain communities made certain long short funds that have a lot of beta exposure have gotten hurt this year, and they're probably a big part of that liquidation mode.

Shanta Puchtler:

I guess the obvious question here is, what other tools are available beyond tactical diversification or straight out selling?

Peter van Dooijeweert:

Yeah, I think that's the right question. You've started with diversification. The thing is, we know diversification can fail. Commodities have done well, and there's this lingering doubt. What happens if the war situation resolves itself, will there be a shock lower in commodities? And what will that do to the bond market? Doesn't necessarily rally the bond market, probably not, might hurt bonds. And what does that do to equity? So there's a lot of moving parts. The good outcome might not be a good outcome. This year has been definitely some of that.

I think once you move beyond diversification, there are a few things we like to look at. One is volatility scaling. It's something we use in a lot of our portfolios at the firm. And what volatility scaling does is, our baseline thesis is that volatility cluster. So if you look through history, when volatility picks up in a market it tends to persist for a while, and it tends to be a pretty bad time to own assets, so reacting to that makes some sense. There are some versions of that you hear in the vol markets, like when the front VIX contract goes above the back VIX contract, that's a really bad sign to reduce risk. This is a similar concept. It's using a volatility signal to reduce risk and keep your portfolio in equilibrium.

Shanta Puchtler:

I mean, simplistically it's like using volatility as a cell signal.

Peter van Dooijeweert:

Yeah.

Shanta Puchtler:

De-risking being essentially a version of selling.

Peter van Dooijeweert:

Yeah. I think that signal, it's both proven academically and in live practice for us. So using volatility as a mechanism. What that means is, volatility picks up a bit, you reduce some risk. Now, you want to do it at the whole portfolio level. Part of the portfolio level, what it is, is it's a systematic signal to have you reduce risk as opposed to a fundamental one, as opposed to I really don't know what's going on so let's get rid of something. Now you have a reason to do it. You don't want to be mechanical about things, but if you stay true to doing it... It's like tail hedging; if you do it, you need to consistently do it. You can't just say, well, I didn't like today's headline. Or, yeah, it feels like it's going to be volatile. So having this kind of process in place is one way of managing risk. Not the only one.

Another thing you might look at something like correlation overlay, because I just told you to diversify and then all your assets went down. That doesn't feel great. And you have to say, thanks Peter for getting me in commodities. Paying attention to cross asset correlation matters. Where we really think it matters is in bonds and equities. The correlation universe has changed, and how you manage risk will as a result have to have changed. If you're relying on that correlation to be at the risk level you're at, say you're overweight equities but you have extra bonds and you have some leverage and you think, wow, I have leverage, I'm overweight, these all feel like bad things because correlations aren't working, that's a pretty good time to use that correlation signal to get out of the way. Especially, again, if you don't have any other information, we like risk based tactical asset allocation. So those two are the ones I would highlight as a way of managing your own risk rather than having to outsource your risk management to the options market.

Shanta Puchtler:

I have this interesting way of thinking about risk decomposition that maybe is relevant here. The idea being that on the diagonal of the covariants matrix, you have vol, and on the off diagonal you have correlation effects. I'm curious in the context of the market environment over the last couple months, which of those you think is dominated. Is it a mixed bag?

Peter van Dooijeweert:

I think it's definitely a mixed bag, actually. It's funny, because down 10, 12, 15% in equities, you don't panic if bonds are up 5%, 7%. When both are happening, it just makes everything uncomfortable. We've had a few episodes. December 2018 was one of those. Everything fell apart, and then the fed stepped in and everything's great. We've jokingly said, "Wow, markets are down a lot. Bonds are down a lot. The fed needs to do something." And then everyone looks around quietly in the room. It's like, who's going to tell him? Because the fed is obviously in a much different situation. I think that's the big problem.

We have a correlation problem. We have a volatility problem. And those things are coming from the fact that we're somewhat data dependent. We keep waiting for a CPI turn, which hasn't come. We are waiting for fed hikes, but you just get 50, 50, 50. There's nothing exciting from 50 50, 50. We're going to have the balance sheet run down slowly. All you can say is there might be a hard landing in 12 months. People often say, "After the first fed hike, the market rallies." My response is this well after I walked out the door this morning the market tends to rally 12 months later. It's not a signal as much as equities tend to rise. The path with which you go over those 12 months has been pretty messy in a lot of these fed hike cycles. That's where the risk management piece comes back.

And to your point, volatility's picking up in the individual asset classes, in many ways because the correlation has picked up and you haven't had portfolio level safety. So then you start saying, well, what do I reduce? Do I reduce my riskiest assets? Used to be, you just reduce equity. Now I'm reducing more equities and bonds, and it's creating a bit of a negative feedback loop. So I think you're right on.

Shanta Puchtler:

So as I understand it, you put tail hedging in the bucket of distributing risk. That's not totally intuitive. Can you explain that a little bit?

Peter van Dooijeweert:

Yeah. We mentioned you could sell. The other version is tail hedging. There is a clear problem with selling your portfolio, in the sense that when everything goes up you've missed, you've disadvantaged potentially your investors, you're underperforming some benchmark, some peer. Tail hedging gives you a unique advantage, that you can outsource your risk management as described before. You're just distributing all that downside risk to the broader options market, to the dealer community, whoever that might be. And you're keeping all the upside.

Now, when we say that, it just sounds amazing. Give me that. And then the small fine print that the tail hedge manager says, "For a cost." And as we said, that cost is particularly high if you're just doing a simple index put strategy that costs us high in some of the other asset classes. It sounds great on paper. Again, paying 6% for a one year option means you need to also make 6% in your risky asset portfolio before you start really making money. Down a lot in the year, that might feel great, but if your return expectation is 5% per year and you're spending 6% on options, maybe you might be better in two year notes making two and a half, three and a half percent depending where bonds are at any given moment.

Shanta Puchtler:

The obvious follow up to that is, if hedging is so expensive, is there any way to bring options efficiently into a situation like this from a hedging perspective?

Peter van Dooijeweert:

None.

Shanta Puchtler:

None.

Peter van Dooijeweert:

Okay. There might be some. There are things you can do. Yes, multi-asset's expensive, but credit does have some beta, and it's a little bit cheaper than equity vol. So looking at other asset classes does help with credit, for example. FX used to be one of our favorite go to as tail hedgers. You knew the yen would be strong in every crash. And you're looking at me saying the yen is not strong, right? I know you want to say it, you're just being polite. The yen is not strong. The yen is incredibly weak this year. And that's an obvious dynamic. It's an economy that's a price taker, so inflation hurts them.

At the same time they're doing nothing with rates. It's not surprising. It's easy to explain, but if you're in your toolkit, you open up your tail hedge toolkit, you're like , okay, the yen thing's not working. But some of the other FX crosses are working, Aussie dollar. Maybe it will. Maybe it won't. It is it correlated to inflation or not? Half the time it works, half it doesn't. As you expand your toolkit, you need to be aware that taking a little bit of basis risk outside of equities, maybe those tail hedges don't work as well.

The other things you can do are a bit more plain vanilla, which is choose your strikes and duration a little bit better. Simple thing you can do. But the other thing is to start considering selling away some of the upside. If options are expensive, well then shouldn't you be selling them? Is the obvious choice. Most of the time, the answer right now is no, don't sell them because the world seems crazy. There's a lot of stuff going on and you don't want to just randomly introduce short vol to your portfolio.

But selling an upside call, let's say 10% out of the money and a high vol, it's easy to sit around the room and say to each other up 10% from here, I'm pretty happy that we got back there, so why don't we give some of that away? If we lose some of the equity gets called away that's okay, because it allows me to fund buying the downside put and getting all of the downside distribution covered. It's easy to make some of these arguments. If rates are really going a lot higher then maybe the multiple's supposed to be lower, maybe it's hard to see the S&P being up on the year at some point. You can pick some kind of fundamental or strategic targets and say, I'll sell some calls there and fund some of the downside. There's nothing complex about this. You don't have to go out and hire an asset manager. You simply just need to say, you know what? I'm happy to make my downside headache go away by giving away a little bit of the upside.

Shanta Puchtler:

Yeah. So maybe in closing to wrap this up. You've given a lot of different prescriptions for how to approach portfolio protection, if you will, or hedging. Can you rank these? How do you think about their utility as we move forward?

Peter van Dooijeweert:

Yeah. I haven't even thrown a couple other things, like quality and inflation strategies. It's just a lot to do. And in a way, one of the things I wish people would do is spend as much time on their risk mitigation programs as they do on their long asset programs. You have individual managers by asset class, you have investment committees, all this conversation, hundreds of hours of due diligence on a few managers to see how you allocate. And then maybe we should buy some puts. And that's not really a process at all.

First, I'd like everyone to have a process. But the other thing is not everything works all the time. I've said trend is great for inflation. It is. It's great in deflationary times. We've got lots of data. Its convex, but it doesn't create convexity in a day. It takes a little while for trend to position. Or using vol scaling, it works great over time. We see lots of examples. But if there's a surprising gap, that doesn't work great. Tail hedging's expensive, but it covers the gap. As you put all these objections together, you realize the right way to go about it is probably blending a lot of this. We gave a talk recently doing exactly that, saying, look, systematic strategies do reasonably well in crises. They do pretty well in inflationary crises as well. It takes them a while to get in the right risk profile, but they have alpha in them. And they have alpha between crises. Tail hedging just loses money. Everybody knows it loses money between crises because markets are not in crisis.

If a systematic strategy can make some money in between those times, can I borrow some of that alpha from the systematic strategies to fund the tail hedge program? Your objection's going to be, well, why don't I just not do the tail hedge program? And the answer is because as the guy running the risk mitigation program, I have to answer to someone. So when the market's down X percent one day and I say, "Well, what happened was that the systematic stuff didn't do what I expected. It wasn't the right volatility." People joke. You know when you say what happened was, the conversation is over. It doesn't matter who you say it to, your spouse, your friend, it's a bad conversation. So adding a bit of tail hedging just to give that pure reaction time to the market, I think is worthwhile. It allows your risk mitigation program to survive.

Again, if there's some alpha in the program, your benchmark here is basically to do as well as bonds in any given market, except maybe not even as well now, right? If you can just not lose money, like the 60/40 plan is, that's a really good diversifier. When I look at a composite of all these strategies that we have, they have positive return, negative correlation, negative beta, positive sharp. You're supposed to want an infinite amount of that stuff, so having some allocation to it makes sense. The more you can get exposed to, I think, and the more you can build it into the culture of the management business you're in so that risk mitigation is a core part of everything you do, I think it makes a lot of sense. And it allows you to say, okay, what happened was this. We knew that happened. That's why we're in tail hedging. Or we knew that happened, and we knew it would bleed. That's why we're in trend. You have this positive dialogue as opposed to this accusatory dialogue of never works, like I told you.

Shanta Puchtler:

It's plain hedging, right?

Peter van Dooijeweert:

Yeah. Now I'm going to sell my hedges. I'm going to sell the stuff I own and just get rid of all of it. And that's probably not a great reaction either.

Shanta Puchtler:

Got it. Peter, great conversation. Such a rich topic. There's so much more we could talk about, but let's finish there.

Peter van Dooijeweert:

Sounds Good. Thanks a lot, Shanta.

Shanta Puchtler:

Thank you for joining us today. And from Long Story Short, this is Shanta Puchtler from Man Group. We look forward to you joining us again soon.

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