As developing nations increasingly drive global economic growth, investors may benefit from increased exposure to emerging market equities. The challenge many investors face is how to participate in this potential long-term return opportunity while enduring markets that tend to experience volatile swings. While our secular outlook for emerging markets is solid, we expect long-term success will be earned by those who can manage cyclical risks. In the first of a series of three articles, portfolio managers Vineer Bhansali and Maria (Masha) Gordon make the case for proactively managing “tail risk” in emerging market equities without having to reduce exposure to this important asset class. In subsequent articles in this series, PIMCO investment professionals will look at the importance in emerging market equity investing of incorporating macroeconomic insights and managing portfolios with high “active share,” or less of a benchmark orientation.
PIMCO’s secular view speaks to an evolving, multi-speed world where emerging market (EM) countries are poised to lead global economic growth. This strong multi-year story is likely to be punctuated, however, by periods of volatility as policymakers respond to inevitable cyclical challenges. These potential headwinds argue for an approach that is designed to help investors manage their downside risks while still maintaining their overall exposure to EM equities.
Emerging market equities have been, simply stated, a volatile asset class. While historical returns have been compelling, and we believe that on a risk-adjusted basis they have appropriately compensated investors for enduring this volatility, EM equities nevertheless have experienced periodic, broad-based and dramatic selloffs, or “drawdowns,” as some market professionals refer to them (see Figure 1).
Generally speaking, active management and a discipline to own what we believe are quality companies can help defend portfolio returns in these difficult periods, but we believe that explicit management of this downside risk through tail risk hedging (TRH) can be a key advantage in navigating these markets.
Tail risk refers to potential investment outcomes on the edges of statistical return distributions. In a typical bell curve, the tallest areas near the center represent the higher probability outcomes. The “tails” are where the bell curve tapers down toward the edges. Of course, there are both left tails and right tails; in other words, there are relatively low probabilities of very bad and very good outcomes. Because in reality, markets don’t neatly follow the bell curve, underestimating the likelihood and severity of events on the tails can negatively affect portfolio returns.
For example, we looked at nearly 6,000 trading days for emerging market equities from January 1998 through December 2010. First, we estimated the number of occurrences of daily returns beyond a certain return threshold based on expectations inherent in a normal distribution. We then compared these expectations to actual results (see Figure 2).
This study shows that the actual number of big down days meaningfully exceeds what would be expected in a neat bell curve. Therefore in emerging market equities, the tails tend to be “fatter” and the probability of big losses tends to be higher (see Figure 3).
PIMCO Takes a Holistic View Toward Managing Tail Risk
For many years, PIMCO has implemented tail risk hedging and in total we manage nearly $30 billion in tail risk hedging mandates for a wide variety of investment portfolios. Over the years, we have arrived at some important conclusions on tail hedging:
- Key inputs: To create a tail risk strategy, we need to know (1) exposures to key risk factors (for example, equity beta, country, currency, industry and style factors), (2) attachment levels, or a portfolio value level where the hedges are designed to kick in to help mitigate losses, and (3) target cost per annum. In an attempt to create a cost efficient hedge we look across markets, but this tends to create correlation or basis risk. Thus, as an input we also need to know the portfolio’s tolerance for basis risk, i.e., the risk that the value of the tail risk hedge portfolio differs from that of a direct hedge. Given these four elements, we can search for an optimal balance of hedging instruments, using a mix of direct and indirect hedges.
- Using correlations to our advantage: Since correlations between many assets tend to rise when there are severe drawdowns in the risk markets, an efficient tail hedge should use attractively priced instruments from a wide variety of asset classes to help reduce cost without sacrificing the potential potency of the hedge conditional on the fat tail events happening.
- Multiple approaches: We think that the best approach for tail hedging is a flexible one, using dynamic rebalancing, diversification, and composed of affordable option-like securities to build a tail hedging program. We think intelligent investors should use all tools at their disposal, including potentially moving into cash when cash looks to be an effective way to weather market volatility.
In addition to these building blocks, we believe that having a robust macro framework for decomposing EM risk relative to other risk factors and markets is key to constructing an effective tail risk hedging program. Important considerations include:
- Correlations and contagion: We have seen that emerging market equities, rates, currencies and spreads tend to be highly correlated within the same country and region, and also correlated across regions. They also generally tend to be highly correlated to developing market risk aversion levels. Historically when developing equities are doing well and risk-aversion is low, emerging market assets tend to also do well.
- Influence of Real Factors: Differentiating across commodity producers and consumers, the performance of emerging market assets can frequently be traced to the relative pricing of commodities.
- Influence of global liquidity: The recent performance of certain emerging market assets, many would argue, is a consequence of excess liquidity in the global financial system. Thus EM risk may be correlated to the global liquidity factor and the behavior of investors in response to perceptions of falling liquidity.
Breaking Down EM Risk Components
PIMCO’s risk factor model for the MSCI EM benchmark reveals the following in relation to the sources of EM equity risk (see Figure 4):
Specifically, based on our estimations, the total volatility of the benchmark is approximately 25%, but with a fatter left tail. The core risk in the benchmark appears to be equity risk, which according to our calculation drives 53% of the total volatility of the index. Country risk is the second most dominant source of risk at 24%, followed closely by currency risk, which drives 22% of the volatility of the benchmark. Thus the same factors that impact global equity markets are relevant for the EM equity markets, albeit with different intensity.
To help us better understand the impact of the currency risk -- a significant contributor to EM risk -- the following chart (see Figure 5) decomposes the return attribution into currency and non-currency components. Note that the currency return from January 2007 to the trough following the Lehman crisis shaved more than 10% from the overall return of the benchmark, an additional source of risk that we believe needs to be accounted for when tail risk hedging.
When equity returns were negative, the currency returns also contributed in a very negative manner. The downside tail correlations between the currency risks and the equity risks increased substantially, corresponding to what appeared like an increasing beta to broader equity indices.
The important conclusion from this analysis is that the multi-dimensional nature of emerging market asset classes could reduce basis risk, or the risk that the value of the tail risk hedge portfolio differs from that of a direct hedge, when using macro hedges. In our opinion, this is simply because more factors can be at play, and a wider set of hedge instruments seems more natural in the context of such risk management for EM portfolios.
EM Tail Risk Management in Practice
Given this multi-dimensional dynamic, investors could conclude that hedging emerging market risk is substantially harder than hedging developed market risk, due to the inherent idiosyncrasies in EM asset classes. However, our analysis shows that a diversified macro approach to hedging the tail risk may actually be more efficient for EM than it is for developed asset classes.
We believe the key reason, as mentioned above, is that a factor-based analysis of EM risk suggests that many factors simultaneously contribute to the performance of EM asset classes, especially on the tails.
For instance, EM equities, bonds and currencies tend to be driven by factors such as carry, reduction in risk-aversion, liquidity, and rates in a more democratic fashion than developed market asset classes. To hedge S&P 500 exposure, we usually employ direct hedges (options on equity indices and various instruments from credit, rates and currencies). Given that we determined the dominant risk for equities is equity beta, this approach creates some uncertainty from the indirect hedges. On the other hand, since EM assets implicitly have exposure to these other asset classes, the basis risk tends to be reduced naturally when using multi-asset hedge instruments.
Our analysis of the MSCI EM Index over the last five years suggests that performance depends on cross-market factors, further making the case for using indirect hedges. The results show that (1) developed market equities, i.e. the S&P 500, have been the most dominant driver, (2) commodity market performance has been positive for EM equities, (3) widening credit spreads have been negative for EM equities, and (4) carry currency performance (of which the AUD/Yen cross is a poster child) has been positive for EM equities.
We select hedges considering both cost and effectiveness. The cost savings can be noteworthy, as shown in Figure 6, which provides a hypothetical example of the potential cost saving of a “direct” hedge (put options on the EM exchange traded fund EEM) versus a combination of direct and indirect options This exemplifies the importance of active management in tail risk hedging and the potential benefits of using a diversified set of instruments.
Could it be Worth it?
Indeed, our analysis indicates there is a tradeoff between the cost of establishing a hedge and the downside protection that it imparts to a portfolio. To help determine the potential value of active tail risk hedging, we looked at a relatively simple tail risk strategy on the S&P 500 (we used the S&P given the availability of reliable, long-term data).
In this test, we spent 100 basis points per year on S&P 500 put options and followed a rule where we sold the options when their market value increased fivefold. We then spent the proceeds on replacement hedges (maintaining the 100 bps budget), with the balance invested back into the S&P 500. Results of this analysis are shown in Figure 7. Not surprisingly, the hedged portfolio tended to underperform in up markets but provided a degree of protection in down markets, and the compounding benefits of this downside protection helped drive the long-term outperformance. Specifically, consider the hypothetical results of tail risk hedging in two of the more extreme down markets:
- October 1987: S&P 500: -21.76%; with TRH: -13.95%
- October 2008: S&P 500: -16.94%; with TRH: -8.56%
PIMCO’s Approach in Emerging Market EquityIn implementing this hedging strategy in the PIMCO emerging markets equity portfolios, we typically look to “spend” approximately 75 to 100 basis points per year and strive to mitigate risk for as much of the portfolio as possible at the 30% or so attachment point. In other words, we believe the increase in value of our hedges as the market declines can provide some degree of downside protection, and in extreme market stress, the hedges are intended to offset market declines beyond -30%.
While the rules-based approach provides evidence to support the use of tail risk hedging for robust portfolio construction, and enhancement of long term return potential, our approach is not limited to the simple rules-based method described above. We can partially defray costs by using strategies including but not limited to active management of direct vs. indirect hedges, including emerging market and developed country equity puts, currency puts and credit-related securities. We can also opportunistically liquidate hedges prior to expiration in order to take advantage of, for example, spikes in the level of implied price volatility in the markets for options. Finally, we look to complement this management with a highly active, research intensive investment approach that is designed to incorporate fundamental, bottom-up stock selection with macroeconomic insights.
We believe that this approach can help accrue value to investors: our portfolios are built based on research conviction rather than benchmark orientation and have the potential to deliver attractive long-term risk-adjusted returns in up and down markets. We believe tail risk management is a critical tool in extracting the optimal benefit from our research driven views by tilting towards positions that we believe are likely to outperform, while being wary of downside risks than can create negative outcomes.
Josh Davis and Niels Pedersen contributed risk factor analysis for this article.