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.
Theoretically, if the investment horizon were infinite, hedging might not be necessary. Over long periods of time, an investor may incur positive returns from many sources of risk premium. Even in the case of very long horizons, however, the contingent liquidity that tail risk hedging (TRH) generates in a market crisis affords investors the opportunity to buy assets at distressed prices, and hence may be an attractive addition to an asset allocation.
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).
When considering spreading purchases over time, one practical methodology in today’s steep volatility term structure could be to implement 1-year hedges in a laddered fashion, purchasing ¼ of the targeted notional value each quarter. Each tranche would hedge 25% of the total portfolio for 1-year from the execution date, and with a tail risk hedge level that is set relative to market levels on the execution date. In this way, the hedger will have both time and strike price diversity in the hedge portfolio (see Figure 4).
Alternatively, one could purchase full notional for a quarter and continue rolling 3-month options. One downside of this shorter-dated option strategy is that it comes with little time value. It may be cheaper, but at the same time, if a significant market event takes place, shorter maturity options are unlikely to provide as much of a hedge as staggered longer maturity options do.
The indirect approach
Timing 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.
As an example, when markets experience a sharp correction, currency markets may reflect repatriation flows. In that event, currencies with higher yields will tend to sell off and currencies with lower yields will tend to appreciate. (This is often called an unwind of the carry trade.) For instance, note how the correlation of the Australian dollar (AUD) with the S&P 500 becomes stronger when there is a pronounced equity market selloff (see Figure 5). If the out-of-the-money (OTM) options markets price to the average correlation (50%) instead of the tail correlation (60%), then the price of the OTM AUD put may be as much as 30% cheap to the S&P 500 put – a significant savings.
Because the choice of hedge instrument will change depending on market conditions, these proxy hedges can be actively managed. For example, if a currency proxy hedge suddenly becomes more valuable relative to the direct hedge, it may make sense to take profits on that indirect hedge, and rotate to other hedges or even direct equity puts.
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 hedges
In 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.
Options markets can help – investors can choose to sell some options to finance purchase of the hedges. We are not advocating the use of collar strategies, as these can be very costly – for example, an investor hedging an equity portfolio using collars from 2009 to 2013 would have paid on average over 8% of the hedge amount in losses on the sold option as the markets rallied and the volatility curve “rolled up” (see Figure 6).
Therefore, we believe that sold option positions should be complementary to the overall investment strategy. For example, for a pension fund with a long-duration liability and an objective of obtaining more duration as yields rise, swaptions could allow the pension plan to “pre-commit” to extending duration at higher yields by selling payer swaptions above current yield levels. Proceeds of these swaption sales could then be used to finance purchases of equity puts and indirect proxy hedges. In this case, the investor is taking advantage of the natural positioning in the portfolio to reduce the hedging cost.
Figure 7 offers a numerical example of this approach: A plan aiming to hedge $100 million of equity exposure could sell $100 million of payer swaptions 100 basis points above the current market yield.
Very careful strategy planning is required for these combined approaches, and stress testing and scenario analysis in relation to collateral needs may be important.
Hedging strategies: key takeaways for investors
Timing 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.