Protecting portfolios during periods of equity drawdown: assessing the alternatives

Introduction

Public equities are the cornerstone of most investor portfolios. They owe this position to a combination of attractive historical returns and relatively low long-term risk. They also generally exhibit high liquidity.

We expect public equities to retain this dominant position for the foreseeable future. Annual absolute returns to equities over the next ten years are expected to be more modest compared with historical annual averages, reflecting relatively high valuations in a number of markets. But against Developed Market (DM) sovereign bonds, expected equity returns remain relatively attractive.

Public equities do have two relatively unattractive features that investors often seek to mitigate. First, they encumber investors with a concentrated exposure to macroeconomic growth risk. We have discussed this feature often (for instance, see Alternatives: How much to allocate). It is not a problem that hinders performance most of the time; in fact, quite the opposite. But portfolio concentrations of any type do have negative consequences sooner or later, and this one gives rise to the second unattractive feature of public equities: periodic deep capital drawdowns, also known as excess return skewness

In this paper, we examine ways to counter excess equity skew (or tail risk), by identifying asset classes and strategies that reliably demonstrate what is termed convexity relative to equities. It is not enough to allocate to asset classes and strategies that are expected to add value on average. They have to be right at the right times. This is a tall order.

The most common way investors seek to mitigate equity tail risk is by tactically adjusting the size of strategic equity allocations and, implicitly, timing market participation. We do not recommend this approach. For long-term investors, it has paid to remain invested at strategic equity targets. To do otherwise has often led to inferior returns; a substantial proportion of annual equity returns have historically been generated in just a few days each year. Miss these, and portfolio performance can look markedly inferior.

So how to address the challenge of maximizing the probability of achieving target long-term capital accumulation while minimizing the short-term impact of equity excess skew?

Best to work backwards. Instead of determining a strategic allocation to equities and then figuring out the associated expect portfolio return, it pays to begin with investor risk tolerance and return targets. From there, we can construct an optimal portfolio that combines a core allocation to equities with asset classes and strategies included to alleviate the impact of periodic significant equity drawdowns.

In this spirit, some large U.S. public pension plans explicitly create tail risk mitigation sub-portfolios within their overall plan portfolio, to complement core—public and private—equity allocations (Meketa, 2019). Importantly, these investors maintain focus on required long-term portfolio returns. If managed well, risk mitigation does not have to incur a significant expected opportunity cost.

Ways to mitigate the impact of equity drawdowns

The descriptor ‘risk mitigation‘ encompasses several approaches to ameliorate the unattractive skew of equity returns. Each one presents tradeoffs between benefit, cost, and reliability. We can gather the more compelling candidates into three broad sleeves: Diversification; Opportunistic Hedging; and Structured Notes. In this paper, we focus on the first two sleeves, and encourage readers interested in learning about the third sleeve to read our Adding Structured Products whitepaper and to access the resources available here.

Diversification

This sleeve seeks to mitigate periodic significant capital losses to public equities by embracing as much investment breadth as possible, across and within asset classes, strategies, geographies, and time. Achieving an attractive conditional correlation to a portfolio’s core equity allocation—positive when equities outperform, and negative during periods of significant equity underperformance—represents the stretch target of solutions in this sleeve. Candidates include top-down macro investment strategies and Safe Haven assets.

1. Macro strategies

Researchers often represent macro strategies using a generic index, such as the HFRIMI Macro Hedge Fund index. The index demonstrates attractive relative convexity to equities, over a long sample period. But it is not investible.

If we make investibility a key selection criterion, then an obvious candidate to represent the Macro category is the CIBC Multi-Asset Absolute Return Strategy (MAARS). This is a broad macro solution that integrates quantitative strategies and rigorous forward-looking qualitative judgment, and exploits a wide range of asset classes, geographies, and investment horizons to generate returns. It is analogous to a new generation Balanced portfolio, encompassing a great deal more investment breadth than a traditional 60/40 portfolio, a focus on absolute returns, and a disciplined risk-aware approach to strategic tilting between identified investment opportunities as an additional layer of performance maximization.²

Since the inception of MAARS, equities have experienced two significant drawdowns, in 2018 Q4 and 2020 Q1. MAARS performed well during both. It has demonstrated an ability to deliver the relative convexity to equities that investors prize, while showing no evidence of excess skew.

MAARS has also achieved performance consistent with its long-term return target (an annual average 5% plus cash³. Importantly, this target is comparable to the annual return we expect to see for core equity allocations over the next 10 years. This means investors can allocate to MAARS from existing equity exposure without incurring an expected return opportunity cost

Putting all these facets together, MAARS appears to be a strong candidate for inclusion in a Tail Mitigation portfolio sleeve.

2. Safe Haven assets

Allocations away from equity and into Safe Haven assets is a default Tail Mitigation strategy of many investors. Representative Safe Havens include Gold and Developed Market (DM) sovereign fixed income. Both asset classes have often demonstrated an ability to alleviate the effect of significant equity drawdowns. We expect Gold to retain this ability, on average, and discuss its broader portfolio role in depth in our paper Where Gold Fits in Portfolios.

DM sovereign bonds face a greater challenge, due to the continued low level of yields. Equally challenging, DM sovereign bonds have little expected annual return over the next ten years, relative to cash. This presents a major opportunity cost to longterm investors looking to counterbalance episodic significant equity capital losses.

This cost will encourage investors to consider substituting part of their DM sovereign fixed income exposure for other Safe Haven assets. Infrastructure Debt may be one candidate. This asset class offers a higher expected return, better inflation hedging properties, and similar liability matching features to DM sovereign fixed income. Growing policy focus on Green Energy in Europe and China, and a renewed focus in the U.S., suggests rising interest in Infrastructure as an asset class.

Opportunitistic Hedging

MAARS, other macro strategies, and Safe Haven assets seek to deliver relative convexity to equity returns through diversification. Strategies in the Opportunistic Hedging sleeve aim to achieve this outcome by directly profiting from the excess skew exhibited by equities. They include Momentum, its close relative Time-Series Trend, and derivative hedging strategies.

1. Momentum

Momentum strategies exploit periodic significant equity drawdowns by shorting assets with relatively negative trailing returns, and concurrently going long another set of assets with relatively positive trailing returns, on the assumption that return, and price, trends are persistent.

Overall, this strategy has proven its worth, with attractive relative convexity and long-term returns.

That said, and as highlighted by Figure 9b, the recent performance of Momentum strategies bears monitoring; including our illustrative example, traditional Momentum strategies have struggled to generate returns in the past decade. Whether the timing of this underperformance is coincident to, or caused by, the rising amount of assets invested in these strategies is moot.

Also important to consider with Momentum strategies is investment breath. The ability to mitigate periodic significant equity drawdowns has been demonstrated most adeptly by Momentum strategies that encompass a broad range of assets. For Momentum strategies constructed just on trailing equity returns alone, relative convexity appears more elusive.

2. Equity futures

We can also address risk mitigation using more sophisticated Momentum strategies, also implemented with futures contracts. One candidate strategy—inspired by Gao et. al. (2018), Baltussen et. al. (2020), Deutsche Bank (2019), & Goldman Sachs (2020) — begins from the observation that S&P 500 price trends established in the morning of each trading session often persist throughout the day⁵. On a normal day, these trends involve either small ups or downs. Nothing out of the ordinary, and so are ignored by our risk mitigation strategy. Periodically, they involve sharp declines. These we want to capture.

Our proposed strategy initiates short futures positions that hedge an investor’s strategic long equity exposure whenever the S&P 500 records a negative intra-day return greater than half a standard deviation below its 1-month trailing average. To maximize the probability of success—and minimize the risk of encountering intra-day price reversals—short hedging positions are initiated at three pre-determined times during the afternoon trading session. All shorts are covered at the end of the day, regardless of profit.

Advantages of this protection strategy include a low carry cost— futures are cheaper than options—and that hedging gains and losses are always realized on the same day; this suggests an ability to minimize the extent of profit decay experienced by the strategy.

It would be easy to dismiss this strategy as a short-term tactical trading model; after all, it is always in and out of the market within a single day. The reality is something different: when equity market drawdowns begin, they persist for many days until the bottom is reached. The 2020 Covid-19 drawdown was unusually violent, but the S&P 500 still took 23 days to bottom. It took 354 days in the 2007-2009 Great Financial Crisis. And 663 days in the 1929 crash. Not all the days in these periods saw negative returns, but the strategy can handle that. It is also very responsive. Rigorous strategy risk management allied to an ability to benefit from market losses has been rewarded.

3. Option strategies

Another set of strategies in the Opportunistic Hedging sleeve seeks to mitigate periods of significant equity weakness by implementing derivative positions that overlay underlying strategic equity allocations. These strategies encompass a number of tradeoffs and challenges, including the need to minimize cost—defined in terms of both commitment of portfolio capital, which is typically low, and carry, which can be high—and to maximize both the reliability of the hedge and the extent of mark-to-market gains that can actually be monetized.

These tradeoffs underscore the importance of rigorous strategy management during both normal markets conditions and tail events.

a) Put option strategies

The classic option mitigation strategy involves the purchase of puts intended to act akin to insurance.

Long option strategies can be beneficial components of a portfolio due to their defined risk, leverage, and non-linear characteristics. Said differently, you can generate a whole lot of return with relatively little capital investment, as long as you are right. That’s an important caveat. The profitability of a put strategy is dependent on the option buyer being right on three different outcomes at option expiry:

• equities do decline;
• the size of the decline, which has to be sufficiently large to make your option valuable;
• the timing of the decline, which has to coincide with the expiration of your option.

As significant equity drawdowns are infrequent, purchased options typically expire without value, and associated premiums represent a high cost of carry that cause a significant drag on strategy performance.

Realized investor experience may be even worse than shown in Figure 14; the episodic nature of equity drawdowns incentivizes investors to adopt these strategies immediately after a drawdown but then to relent before the next one occurs, as recency bias reasserts itself (AQR, 2020; Institutional Investor, 2020).

b) Conditional put option strategies

One solution to the high carry cost and time dependent nature of a naïve option strategy is conditional put protection. This combines the most attractive aspects of various hedging strategies. For instance, decisions to purchase put options can be conditioned on Momentum, as well as implied equity volatility. Pre-defined take-profit exit triggers can also be incorporated. The strategy continues to provide insurance during equity drawdowns. But carry cost in more benign market periods is minimized, and cumulative strategy performance is more attractive as a result⁵.

c) Options on equity volatility

Another candidate option strategy exploits the convex relationship between equity drawdowns and implied equity volatility. When equity prices fall, implied volatility—as measured by the Vix Index — tends to experience an outsized increase. Its historical beta to significant S&P 500 drawdowns exceeds one.

We can exploit this relationship to implement a risk mitigation strategy. The first step is to buy call options on a 3-month Vix futures contract. Absent an accurate volatility forecasting model that facilitates implementation dexterity, we again have to confront the high carry cost associated with a persistent long option exposure; most of the time, these call options will expire worthless and the premium will be foregone by the buyer.

One way to minimize carry cost is to concurrently sell short S&P 500 put spreads⁶. If no equity drawdown and attendant volatility spike occurs prior to expiry, the premium earned from the short put spread position will approximately offset the negative carry of the long Vix call position, meaning that the strategy broadly breaks even. It adds value if gains to the long volatility call position during an equity drawdown outweigh losses on the short put spread, and if the volatility spike occurs concurrent to the equity drawdown. Historically, these conditions have been satisfied.

Structuring portfolio tail mitigation solutions

Investment breadth and rigorous risk management are key to building a well-constructed portfolio that delivers on long-term performance targets. Breadth requires investors to include a broad range of rewarded risks into portfolios, rather than relying on just a concentrated few. This requirement extends to tail mitigation, too. The source of equity market drawdowns, and the speed of subsequent recoveries, are all different—for instance, a global pandemic in 2020, a sub-prime mortgage crisis in 2007, and a dot-com bubble in 2000—such that a one-size fits all approach to risk mitigation is ill-advised.

In this paper, we have presented a range of practical risk mitigation strategies that derive performance from a diverse array of sources. To pass muster, they have to demonstrate an ability to mitigate the portfolio impact of significant equity drawdowns, while not incurring a long-term opportunity cost in terms of foregone expected returns due to a reduced strategic allocation to public equities.

To assess this ability we construct a simulation based upon a portfolio that combines a core equity allocation with the set of derivative hedging strategies presented above. We realize an improvement in long-term cumulative performance compared to the original equity-only portfolio. We also achieve an improvement in both the length and depth of drawdowns.

No two equity drawdowns are alike. To examine the robustness of our derivative overlay hedging strategies, we analyze performance in four discrete drawdown episodes: the 2011 Euro Fiscal Crisis; the 2013 U.S. Taper Tantrum; the 2015 Chinese Growth Slowdown; and the 2020 Covid Crisis. For each one, we examine the performance of the S&P 500 index compared to a portfolio that combines exposure to this index with an equally weighted composite of our derivative hedging strategie⁷. In each episode, the portfolio incorporating hedging strategies outperforms, and the magnitude of drawdowns is markedly reduced.

Conclusion

Mitigating the impact of episodic, yet significant equity drawdowns on portfolio performance is a challenging endeavor. Every drawdown is triggered by a different catalyst and resolves according to a unique timeline and set of parameters. A lack of uniformity demands that proposed solutions encompass breadth, diversification, and rigorous portfolio management.

In this paper, we have presented a number of candidate strategies. None are perfect, but all appear to offer incremental additivity. Many are encompassed by the CIBC MAARS fund. Tail risk mitigation at a reasonable price.

Let’s connect

Should you have any questions about this report or anything else, please do not hesitate to connect:

Michael Sager, Ph.D.
Vice-President, Multi-Asset and Currency
Institutional Asset Management
michael.sager@cibc.com
416 980-6301

References

AQR (2020), Tail Risk Hedging: Contrasting Put & Trend Strategies.

Baltussen, G, Z. Da, S. Lammers, & M. Martens (2020), Hedging Demand & Market Intraday Momentum.

Deutsche Bank (2019), DB Trend Intraday Equity Strategy.

Gao, L., Y. Han, S. Zhengzi, & G. Zhou (2018), Market Intraday Momentum. Journal of Financial Economics, 129(2), 394-414.

Goldman Sachs (2020), GS Intraday Momentum.

Institutional Investor (2020), The Inside Story of CalPERS’ Untimely Tail-Hedge Unwind.

Israelov, R. (2019), Pathetic Protection: The Elusive Benefits of Protective Puts. The Journal of Alternative Investments, 21(3).

Meketa (2019), Risk Mitigating Strategies.