Viewpoints

Hedging for Profit: Constructing Robust Risk‑Mitigating Portfolios

Customized combinations of traditional and alternative strategies may work best.

Recent spikes in volatility have focused investors’ minds on mitigating the risk of an equity market correction – and for good reason. The economic cycle in developed economies is approaching its nine-year mark, equity valuations appear high and yields on high quality bonds remain low. While there’s no one-size-fits-all approach to diversifying portfolio risks, our research suggests that customized combinations of traditional and alternative strategies may improve a portfolio’s resilience better than any single approach.

Traditionally, many investors concerned about equity risk have turned to cash, core fixed income, hedge funds and real assets. However, each of these exposures faces unique challenges, including some with low return potential, while others have risk of correlation reversal or heavy reliance on manager skill. They may still play an important role in policy portfolios, but they may no longer suffice to mount a robust counter to equity risk.

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The Author

Josh Davis

Global Head of Risk Management

Ashish Tiwari

Head of Client Solutions, Americas

Brad Guynn

Product Strategist

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Disclosures

Past performance is not a guarantee or a reliable indicator of future results.

The analysis contained in this paper is based on hypothetical modeling. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other 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.

We employed a block bootstrap methodology to calculate volatilities. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. For each asset class, index, or strategy proxy, we will look at either a point in time estimate or historical average of factor exposures in order to determine the total volatility.  Please contact your PIMCO representative for more details on how specific proxy factor exposures are estimated.

Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over a 10 year period. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. Return assumptions are subject to change without notice.

Conditional Value at Risk (CVAR) estimates the risk of loss of an investment or portfolio over a given time period under normal market conditions in terms of an average of loss after a specific percentile threshold of loss (i.e., for a given threshold of X%, under the specific modeling assumptions used, the portfolio will incur an average loss in excess of the CVAR X percent of the time.  Different CVAR calculation methodologies may be used.  CVAR models can help understand what future return or loss profiles might be.  However, the effectiveness of a CVAR calculation is in fact constrained by its limited assumptions (for example, assumptions may involve, among other things, probability distributions, historical return modeling, factor selection, risk factor correlation, simulation methodologies).  It is important that investors understand the nature of these limitations when relying upon CVAR analyses.

The Sharpe Ratio measures the risk-adjusted performance. The risk-free rate is subtracted from the rate of return for a portfolio and the result is divided by the standard deviation of the portfolio returns.

All investments contain risk and may lose value. 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. Alternative strategies may involve a high degree of risk that each prospective investor must carefully consider prior to making such an investment and investments in such strategies may only be suitable for persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including the possible complete loss, of their investment. 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 and commodity-linked 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. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested.

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. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager 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 is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO.