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May 2018 Hedging for Profit: Constructing
Robust Risk-Mitigating Portfolios

AUTHORS 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
Josh Davis high quality bonds remain low. While there’s no one-
Managing Director,
Portfolio Manager
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
Ashish Tiwari
Executive Vice President, challenges, including some with low return potential, while others have risk of correlation
Product Strategist 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
Brad Guynn with their own risk-reward trade-offs.
Sr. Vice President,
In our view, combining multiple diversifying strategies may result in portfolios that are better
Product Strategist
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.”

tail risk hedges do not markets and pair well with long-duration bonds (as the trend. hedge during flight-to-quality episodes. which can break.2 May 2018 Viewpoint DIVERSIFIERS AND THEIR TRADE-OFFS • Alternative risk premia strategies may enhance this combination further. always have a negative expected return or a cost associated follower can cut interest rate risk by shorting rates during a with them. for markets and can act as an uncorrelated return driver. sustained sell-off in rates). however uncommon these might be. market scenarios. tail risk hedging is based on consensus expectations. But they diversifying equity risk: can be vulnerable to coincident drawdowns in multiple risk • High quality sovereign bonds. but can incur albeit at the expense of short-term return potential. • Trend-following strategies tend to perform well in trending And contrary to conventional wisdom. U. but are susceptible to rapid Figure 1 shows how specific strategies may perform in diverse reversals in trends. as they tend to do well in non-trending Let’s look at specific strategies. . contractual derivatives – not correlations. such as long-duration premia. Figure 1: Hedging effectiveness varies by market scenario Most effective … Least effective … Long Treasuries in a sudden drawdown in rising rates Correlation-based hedge Trend-following in trending markets in a trend reversal Alternative risk premia in coincident in non-trending markets premia drawdown Direct hedge Tail risk hedging in a sudden drawdown in a slow/shallow drawdown Source: PIMCO. In negative returns if interest rates rise faster than contrast to the approaches above. and their trade-offs. have historically generally been an effective • Tail risk hedging may offer a higher degree of reliability.S. For illustrative purposes only. Treasuries.

4% 11. with a return assumption of cash+5%.4% 25. * The Tail Risk Hedging Program is a 20% OTM put with assumed annual spend of 30 basis points (bps) at the total portfolio level.5% 7.8% 2. Correlation risk: This blend can have meaningful interest rate risk. institutional investors are stocks and bonds.50 0. most trend-followers had sizable exposure to based hedges and outright hedges. Figure is provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product. we think it is (see Figure 2).77 17.9% 12.05 Duration 5.40 0.S.S. “Treasuries. This method has While it is not PIMCO’s base case that the stock-bond attractive estimated return and single-digit estimated volatility correlation will become positive anytime soon.6% 5. depending on the We believe that constructing an optimal risk-mitigation positioning of the trend-following strategy. Figure 2: Estimated performance of four sample portfolios Enhanced Incorporating tail Starting point defensive characteristics Capital-efficient approach risk hedging* Short. Short- Long Long Defensive Short-biased Defensive Long Defensive Trend ARP biased biased Treasury Treasury ARP trend ARP Treasury ARP trend rrend Tail risk hedging Long Treasury Estimated return1 5. particularly susceptible to a breakdown in correlation between A starting point. which some U. 3 Conditional value-at-risk (CVaR) is an estimate of the average expected loss at a desired level of significance. . At the end of 2017. S&P 500 (0.4% 16. could include a bundled approach that  lthough the stock-bond correlation has been sharply negative A combines equal parts long-duration bonds. likely to become less negative and more volatile as rates rise.31) (0.77 CVaR (95%)3 8. history shows that it has fluctuated. 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. Trend-following is based on the Dow Jones Credit Suisse Managed Futures Index.” provides an overview of our research into the history of this correlation.32 5. valuation metrics and qualitative inputs from senior PIMCO investment professionals. May 2018 Viewpoint 3 CRAFTING AN OPTIMAL RISK-MITIGATION PORTFOLIO 1.5% Equity beta vs. As a result. this combination is depend on an investor’s unique circumstances. alternative risk for the past two decades. Nonetheless. The projections of risk factor premia rely on historical data. portfolio is about identifying the ideal blend of correlation- for instance.84%) 0. The Alternative Risk Premia (ARP) Model assumes an annualized target volatility scaling of 10%.60) Estimated volatility2 7. 2 See disclosures for additional information regarding volatility estimates. premia strategies and managed futures. The Short-biased Trend and Defensive Alternative Risk Premia Model assumes an annualized volatility scaling of 10%. Its contours ultimately will equity and interest rate risks. Treasury Index. Long Treasury is based on Bloomberg Barclays Long U. 1 Index and model return estimates are based on the product of risk factor exposures and projected risk factor premia.5% 9. with a return assumption of cash+7%.7% Source: PIMCO as of 31 March 2018 Hypothetical example for illustrative purposes only. as well as some equity exposure.77 5. this combination presents two major vulnerabilities: Our March paper.8% Sharpe ratio (cash=1.32 0.66) (0. Stocks and Shocks. beginning to adopt.2% 18.20) (0.

5% Bloomberg Barclays (“BBG BC”) U. which seeks to minimize latent equity beta and duration risks at the strategy level. the gapping seen in February.8% 20. or adopting a capital-efficient solution. can be another tool.3% 4. 7.69 2.9% MSCI ACWI Index.84%) 0. episodes is appropriately sized tail risk hedges. Robust portfolio construction.51 0.1% Equity beta vs. During gap events. While the metrics in Figure 2 pertain to these diversifying . which value reliability of diversification over return potential – the issue of gap risk can potentially be addressed • Correlation consistency can be improved with modifications by incorporating a tail-risk-hedging program. 19.0% Private Core Real Estate Model. No guarantee is being made that an actual portfolio will be the same or that similar results will be achieved. institutional portfolio. It is not possible to invest directly in an unmanaged index. In this approach. 0. S&P 500 0.4% 18. these key deficiencies can be ameliorated: pensions. the data in Figure 3 estimate the impact more defensive by eliminating or constraining procyclical they would have if scaled to a 10% allocation within an advanced strategies. The Advanced Institutional Portfolio is an approximation of a typical large institutional investor portfolio and is constructed using consultant reports.30 0.24 Duration 1. it is a History shows that the performance of alternative risk premia way to use leverage to reduce risk at the overall policy level. 8. would?) is funding the cost of put options with the yield of the . The only diversifier that can stock-bond correlation will remain negative during systemic provide a meaningful and reliable impact during such market sell-offs.S.5% 4. which are highly liquid. • For conservative investors – for example. strategies can be highly variable during these periods and This option may be compelling to investors who believe the therefore can’t be counted upon. and trend-followers in following strategies.26 0.9% Bloomberg Commodity Index and 2% BofA ML 3-Month USD LIBOR Index. alternative risk premia strategies can be made portfolios in isolation. The model portfolio was created with the benefit of hindsight.0% BBG BC U. 7.9% 17. The portfolio is allocated by market value percentage weight to the following proxies: 49.S. Gap risk: This combination would not be resilient to a sudden • Investors seeking the “most bang for the buck” can consider sell-off à la Black Monday (1987). TIPS Index.51 Estimated volatility2 11.4% Private Equity Model.4% 4. Figure 3: Estimated diversification benefits on a typical institutional portfolio 10% pro rata allocation to risk-diversifying portfolios Advanced Enhanced defensive Capital-efficient Incorporating tail institutional portfolio Starting point characteristics approach risk hedging* Estimated return1 4. serve as collateral for ARP and trend- Treasuries may or may not help. 3. An option that seek to enhance the defensive characteristics of trend- for investors who do not want to write checks (and who following and alternative risk premia strategies. and hence faces stock-bond correlation risk. the Flash Crash (2010).4 May 2018 Viewpoint 2.9% 9.10 CVaR (95%) 3 24.5% Sharpe ratio (cash=1.5% 10. Figure is provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product. .9% Source: PIMCO as of 31 March 2018 Hypothetical example for illustrative purposes only. Refer to Figure 2 for additional important information and footnotes. While this package has meaningful particular may get hurt due to a sudden reversal of a trend.5% 9.10 3. Limits to overall duration may also be imposed. duration.1% 9.Similarly. security’s price jumps abruptly from one level to another. internal PIMCO data and other publically available industry data. equity beta.26 0.55 0.9% 20.54 0. The key trade-off is that the level of gap- prohibiting long equity positions or by constraining overall risk mitigation will vary over time. long-duration bonds. fully funded Thankfully. such as volatility.2% HFRI Fund-of-Funds: Diversified Index. Aggregate Index.64 0.22 0. when a instead of fully funding each strategy. 2.1% BBG BC Global Aggregate Index (USD-Hedged). The model portfolio does not represent actual trading and does not reflect the impact that economic and market factors might have on management of the portfolio.26 2.10 2.7% 4.Trend-following strategies can be given a “short bias” by Treasury portfolio.

product. Finally.e. Please contact your PIMCO representative for more details on how specific proxy factor exposures are estimated. including market. index. The analysis contained in this paper is based on hypothetical modeling. The good news is that risk-mitigation strategies exist along an efficient frontier. Hypothetical or simulated performance results have several inherent limitations. The Sharpe Ratio measures the risk-adjusted performance. Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. CVAR models can help understand what future return or loss profiles might be. since trades have not actually been executed. 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 standard deviation of these annual returns is used to model the volatility for each factor. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. factor selection. Strategies can be combined and customized to seek a solution to address each investor’s needs. Return assumption is an estimate of what investments may earn on average over a 10 year period. This process is repeated 25. probability distributions. No representation is being made that any account. historical return modeling. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. interest rate.000 times to have a return series with 25. under the specific modeling assumptions used. 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. 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. which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. or strategy proxy. and the current low interest rate environment increases this risk. inflation risk. We employed a block bootstrap methodology to calculate volatilities. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account. May 2018 Viewpoint 5 GO YOUR OWN WAY As discussed. the portfolio will incur an average loss in excess of the CVAR X percent of the time. Different CVAR calculation methodologies may be used. All investments contain risk and may lose value. The value of most bonds and bond strategies are impacted by changes in interest rates. for a given threshold of X%. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy. the effectiveness of a CVAR calculation is in fact constrained by its limited assumptions (for example.000 annualized returns. and liquidity risk. Investing in the bond market is subject to risks. We then use the same return series for each factor to compute covariance between factors. Return assumptions are subject to change without notice. or strategy will or is likely to achieve profits. we will look at either a point in time estimate or historical average of factor exposures in order to determine the total volatility. In addition. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. or results similar to those shown.. the optimal risk-mitigation portfolio will depend on each investor’s unique situation and goals. among other things. We start by computing historical factor returns that underlie each asset class proxy from January 1999 through the present date. Bond investments may be worth more or less than the original cost when redeemed. simulation methodologies). volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. Past performance is not a guarantee or a reliable indicator of future results. losses. or strategy. Unlike an actual performance record. credit. simulated results cannot account for the impact of certain market risks such as lack of liquidity. It is important that investors understand the nature of these limitations when relying upon CVAR analyses. This may take time. risk factor correlation. simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. issuer. product. bond prices generally fall as interest rates rise. 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 . We believe investors need to carefully analyze their portfolios in order to design an optimal equity-risk-mitigation approach. assumptions may involve. However. For each asset class.

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