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.

More investors are beginning to add allocations to long-duration bonds, alternative risk premia (ARP), managed futures and tail risk hedging to their equity risk-mitigation arsenal to seek enhanced returns and maintain diversification. These strategies can be attractive alternatives to traditional diversifiers. They offer the potential for attractive returns, diversification versus equities and opportunistic liquidity. Nevertheless, these strategies come with their own risk-reward trade-offs.

In our view, combining multiple diversifying strategies may result in portfolios that are better fortified against a late-cycle downturn in equities. Recently, Jamil Baz, Josh Davis and Graham Rennison presented theoretical and empirical support for this view in “Hedging for Profit: A Novel Approach to Diversification.” They offer a mathematical proof as evidence that a diversified portfolio of equity-risk-mitigation strategies may provide more reliable diversification than any single method of diversification. The concept is similar to modern portfolio theory, in which diversification along an efficient frontier provides the only “free lunch.”

Diversifiers and their trade-offs

Let’s look at specific strategies, and their trade-offs, for diversifying equity risk:

  • High quality sovereign bonds, such as long-duration U.S. Treasuries, have historically generally been an effective hedge during flight-to-quality episodes, but can incur negative returns if interest rates rise faster than consensus expectations.

  • Trend-following strategies tend to perform well in trending markets and pair well with long-duration bonds (as the trend-follower can cut interest rate risk by shorting rates during a sustained sell-off in rates), but are susceptible to rapid reversals in trends.

  • Alternative risk premia strategies may enhance this combination further, as they tend to do well in non-trending markets and can act as an uncorrelated return driver. But they can be vulnerable to coincident drawdowns in multiple risk premia, however uncommon these might be.

  • Tail risk hedging may offer a higher degree of reliability, albeit at the expense of short-term return potential. In contrast to the approaches above, tail risk hedging is based on contractual derivatives – not correlations, which can break. And contrary to conventional wisdom, tail risk hedges do not always have a negative expected return or a cost associated with them.

Figure 1 shows how specific strategies may perform in diverse market scenarios.

Crafting an optimal risk-mitigation portfolio

We believe that constructing an optimal risk-mitigation portfolio is about identifying the ideal blend of correlation-based hedges and outright hedges. Its contours ultimately will depend on an investor’s unique circumstances.

A starting point, which some U.S. institutional investors are beginning to adopt, could include a bundled approach that combines equal parts long-duration bonds, alternative risk premia strategies and managed futures. This method has attractive estimated return and single-digit estimated volatility (see Figure 2).

Nonetheless, this combination presents two major vulnerabilities:

  1. Correlation risk: This blend can have meaningful interest rate risk, as well as some equity exposure, depending on the positioning of the trend-following strategy. At the end of 2017, for instance, most trend-followers had sizable exposure to equity and interest rate risks. As a result, this combination is particularly susceptible to a breakdown in correlation between stocks and bonds.

    Although the stock-bond correlation has been sharply negative for the past two decades, history shows that it has fluctuated. While it is not PIMCO’s base case that the stock-bond correlation will become positive anytime soon, we think it is likely to become less negative and more volatile as rates rise. Our March paper, “Treasuries, Stocks and Shocks,” provides an overview of our research into the history of this correlation. It argues that whether the relationship is positively or negatively correlated depends largely on whether a shock starts in the stock market or the bond market.
  2. Gap risk: This combination would not be resilient to a sudden sell-off à la Black Monday (1987), the Flash Crash (2010), or the gapping seen in February. During gap events, when a security’s price jumps abruptly from one level to another, Treasuries may or may not help, and trend-followers in particular may get hurt due to a sudden reversal of a trend. History shows that the performance of alternative risk premia strategies can be highly variable during these periods and therefore can’t be counted upon. The only diversifier that can provide a meaningful and reliable impact during such episodes is appropriately sized tail risk hedges.

Thankfully, these key deficiencies can be ameliorated:

  • Correlation consistency can be improved with modifications that seek to enhance the defensive characteristics of trend-following and alternative risk premia strategies.

    - Trend-following strategies can be given a “short bias” by prohibiting long equity positions or by constraining overall equity beta. Limits to overall duration may also be imposed.

    - Similarly, alternative risk premia strategies can be made more defensive by eliminating or constraining procyclical strategies, such as volatility. Robust portfolio construction, which seeks to minimize latent equity beta and duration risks at the strategy level, can be another tool.
  • Investors seeking the “most bang for the buck” can consider adopting a capital-efficient solution. In this approach, instead of fully funding each strategy, long-duration bonds, which are highly liquid, serve as collateral for ARP and trend-following strategies. While this package has meaningful duration, and hence faces stock-bond correlation risk, it is a way to use leverage to reduce risk at the overall policy level. This option may be compelling to investors who believe the stock-bond correlation will remain negative during systemic market sell-offs.
  • For conservative investors – for example, fully funded pensions, which value reliability of diversification over return potential – the issue of gap risk can potentially be addressed by incorporating a tail-risk-hedging program. An option for investors who do not want to write checks (and who would?) is funding the cost of put options with the yield of the Treasury portfolio. The key trade-off is that the level of gap-risk mitigation will vary over time.

While the metrics in Figure 2 pertain to these diversifying portfolios in isolation, the data in Figure 3 estimate the impact they would have if scaled to a 10% allocation within an advanced institutional portfolio.

Go your own way

As discussed, the optimal risk-mitigation portfolio will depend on each investor’s unique situation and goals. The good news is that risk-mitigation strategies exist along an efficient frontier. Strategies can be combined and customized to seek a solution to address each investor’s needs.

We believe investors need to carefully analyze their portfolios in order to design an optimal equity-risk-mitigation approach. This may take time. But the recent spikes in volatility are a salutary reminder that the best time to deploy a risk-mitigation portfolio is before it’s too late.

The Author

Josh Davis

Portfolio Manager, Quantitative Strategy

Ashish Tiwari

Asset Allocation Strategist

Brad Guynn

Asset Allocation Strategist

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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.

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