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:
- 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.
- 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.