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Michael Connor, Markus Aakko
The natural tendency of most investors is to seek hedging against market volatility when markets become bearish and to eschew any hedging expense when market sentiment seems very bullish. As a result, most investors tend not to hold hedges exactly when they may be most attractive – near market peaks when implied volatility is at its lows.
At its core, “just in time” hedging is merely speculation. It is akin to purchasing earthquake or flood insurance only during times when you expect a natural disaster is imminent – and similarly to natural events, market conditions are very difficult to forecast.
For example, based on the VIX index – the Chicago Board Options Exchange’s Volatility Index, which measures the implicit cost of hedging – markets were moderately concerned but not expecting a deadlock as the U.S. Congress approached the edge of a “fiscal cliff” at the end of 2012. When it became apparent that there might in fact be a standoff, the VIX rose sharply higher, and then collapsed on the first trading day of the new year after an agreement was reached on 1 Jan 2013 (see Figure 1). Waiting until the last minute to hedge would have proven very costly in this case, as options purchased in the last few days of 2012 collapsed in price in 2013.
In practice, though, few investors are able to dismiss investment risk as a “short-term fluctuation.” Reporting to stakeholders usually takes place at least annually, and over the short run there can be considerable volatility. In addition, pension funds and others who are making substantial payouts on a yearly basis will find that making these payouts funded by sales of assets at extremely depressed prices can have a severe impact on future performance. For investors who have a substantial amount of risk assets in their portfolio, TRH can make it easier to maintain or even increase this return-seeking allocation, given the expected reduction in exposure to left-tail risks.
Is timing everything?The cost of hedging can vary significantly over any given timeframe, and “just in time” hedging is nearly impossible: By the time an investor decides to hedge, the market correction may have already begun, and hedging may have already become expensive. Ideally, then, hedges could be included as a permanent part of an asset allocation and hence would be in place when most needed – what we might call “just in case” hedging. And even in a rising market, TRH can add value, providing a “trailing stop” to the portfolio that may give investors more comfort in maintaining their allocations to risk assets when markets rally.
In fact, some investors may consider a counter-cyclical approach: varying the amount of hedges purchased based on the level of implied volatility. A simple way of accomplishing this is to set a fixed budget and spread purchases over time. If options are expensive, the fixed budget buys less hedging, and if they are cheap, some of the budget can even be held back for a later period as long as the desired hedge ratio is accomplished. And since hedging tends to be cheapest when equity markets are at their peaks, and vice versa, an investor can potentially use this counter-cyclicality to their advantage (see Figures 2 and 3).
The indirect approachTiming is not everything – what you buy and how you structure your hedges is equally important. Volatility is not uniformly priced in every market, and from time to time, investors may be able to purchase cheaper hedges using correlated hedge instruments in other markets.
Note that the use of indirect hedges does not come without some additional risk. Because proxy hedges may fail to perform in line with direct hedges, and therefore result in poor hedging against the specified risks, they should be used in moderation and in conjunction with direct hedges. The idiosyncratic risk associated with each proxy hedge can also be moderated through portfolio diversification – in other words, purchasing a portfolio of different proxy hedges in order to reduce exposure to any one specific indirect hedge. Along with this, proper management of a TRH portfolio requires a robust set of tools to quantify and limit this basis risk.
Funding the hedgesIn most portfolios, we find that financing a hedging program can be accomplished entirely through raising funds from existing investments and using the proceeds to purchase options. However, some investors may consider these outlays too large for comfort.
Hedging strategies: key takeaways for investorsTiming of hedging decisions matters – purchasing hedges at their most expensive reduces the efficacy of hedging, since the market already prices in significant risk of a tail event. At PIMCO, we believe that tail risk hedges have a place in any portfolio that has a substantial allocation to risk assets. However, timing the entry point for a hedging program is unlikely to be possible, and so the optimal strategy may involve averaging into a hedging allocation, beginning at a time when equity prices are high and the cost of hedging is low, as appears to be the case now, given current S&P 500 and VIX levels.
In addition, using a broader set of hedge instruments may help lower the costs. When combined with a disciplined approach to cost averaging and potential sale of some options to finance the overall hedging program, it may be possible to mitigate a large part of the cost of the overall hedging program.
Tail risk hedging program: An actively managed portfolio of option positions (an investment hedge portfolio) designed to mitigate losses stemming from portfolio investment risks in a reference investment portfolio over an investment hedge horizon, with a specific attachment point and a specified expense level.
Portfolio investment risks: Dominant portfolio investment risks are quantified as investment risk factors which can include broad equity, foreign exchange, interest rate duration, and credit spread. During periods of volatility, policy and liquidity factors can be important.
Investment hedge horizon: Typically six months to five years, usually one year.
Attachment point: The targeted maximum loss at the investment hedge horizon of the combined reference investment portfolio and the investment hedge portfolio. Not a guaranteed number, the loss threshold should be considered an investment objective.
Expense (cost) level: The cost of a tail risk hedging program is a periodic expense, expressed as a percentage of the reference investment portfolio, for example, 1.2% per annum. Expense levels are determined at the outset of the tail risk hedging program but can vary over time either because market conditions change or because the client chooses to alter the hedge horizon or the attachment point.
Direct and indirect hedges: Direct hedges are options contracts whose values are driven by investment risk factors that are explicit risks in the reference investment portfolio. Indirect hedges are options contracts whose values are driven by investment risk factors that are not explicit risks in the investment portfolio or whose size is larger than necessary to directly hedge an explicit risk.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.Equities may decline in value due to both real and perceived general market, economic and industry conditions. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not assure a profit or protect against market loss. Investors should consult their investment professional prior to making an investment decision.
The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.
Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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