Volatility and the benefits of downside protection strategies
Despite the devastation of the 2008 global financial crash, institutional investors are soaking up more of the upside in global equity markets, despite not necessarily having a clear strategy on how to protect their portfolios against downside volatility.
Institutional investors have enjoyed a golden period of returns over the last five years. The S&P 500, for example, doubled in size during Barack Obama’s first term of office between 2009 and 2012. Since that time the market has continued its ceaseless climb northwards, gaining 11.5 per cent during 2014 and 14.84 per cent on a year-on-year basis. Similarly, US Treasuries have driven yields down to historic lows.
This is great news for public and private pension funds, of course. But in an in-depth report by State Street Global Advisors, the willingness to participate in the upside is, for many, superseding the desire to protect their portfolios against equity risk.
The report is entitled Walking the Tightrope: How CIOs are balancing upside participation and downside protection. Compiled on the back of an extensive survey of 420 senior executives within global private and public pension plans, endowments, foundations and sovereign wealth funds (SWFs), the report reveals some fascinating insights into how investors currently view volatility.
There are varying degrees as to the extent of protection and the confidence investors have for their portfolios to survive a market shock.
What is clear, above all else, is that for most investors, the biggest challenge they need to overcome is one of education; understanding how and when to employ different downside protection strategies.
The survey revealed equities remain the best choice
The S&P 500 has enjoyed strong corporate earnings growth and is currently trading at 17 times expected earnings, compared to its 10-year median average of 15 reported Reuters on 8 May 2015, referring to StarMine data. Much of this desire for equities has been fuelled by relatively benign markets; the last few years has been a period of low volatility thanks, in large part, to central bank activity intervention.
According to SSGA’s survey results, 64 per cent of investors said they had increased their exposure to equities over the past six months as a result of pressure to meet funding requirements, with 55 per cent believing that equities still offer good value.
At the same time, however, 57 per cent of investors felt that there was likely to be a drawdown of between 10 and 20 per cent in developed equity markets over the next 12 months; that figure rises to 57 per cent for Emerging Market equities.
“What we have right now is a situation where we are moving from a period of expected divergence into actual divergence from a central bank perspective. The Fed is moving in one direction with the Bank of England, and the ECB and the Bank of Japan moving in the opposite direction,” says Dan Farley (pictured), Chief Investment Officer, Investment Solutions Group, State Street Global Advisors.
“The volatility that we’ve got is therefore likely to be with us for the near-term. Investors are struggling to find the right balance. On the one hand they need to understand volatility risk and how best to manage it. On the other hand, they need to be invested in growth assets because of the liability targets that they need to hit.
“What the survey showed to me is perhaps contradictory perspectives that people have on the issue of volatility.”
Indeed, in another of the survey’s responses, 52 per cent said that they bought equities but would decrease their allocation if there were another asset class that could provide that level of return.
Currently, there is a realisation among investors that they have to be exposed to equities, whether they like it or not. If there is going to be increased volatility, which over half of respondents expect, they are just going to have to live with it. Rising geopolitical risk (43 per cent) and a slowdown in emerging market economies (41 per cent) were cited as the two most likely sources of volatility.
A rock and a hard place
One could argue that institutions are stuck between a rock and a hard place.
They are reliant on equity market returns more than ever, given how low bond yields have fallen, and are, to some extent, under pressure to move past the pain of the ’08 global financial crash. They cannot look at the US equity bull market of the last six years and afford to miss out on harvesting those gains.
Yet throwing too many eggs in to one basket may leave them terribly vulnerable to significant drawdowns. Even if an institution has implemented a downside protection strategy, and is achieving smoother returns that are meeting its long-term objectives but is, at the same time, underperforming broader market indices, it can become too great a pressure point to bear.
In the UK, for example, the funding gap in private sector pension plans rose to GBP367.5 billion in January (according to Pension Protection Fund). These institutions are really up against it. As Farley states in the SSGA report: “If investors are going to have any chance of meeting their long-term returns, they need to keep equities in their portfolio.”
The ways to manage equity risk aren’t always perfectly straightforward. Also, there is a time and an opportunity “cost” to employing volatility strategies, which can be difficult for CIOs to implement; especially when 74 per cent of respondents who said they had increased their allocation to equities over the past year had led to their investments outperforming relative benchmarks.
The point is, if investors are happy to stick with equities they need to instil a degree of perspicacity, a modicum of foresight: market volatility is going to impact their portfolios over the coming years, so why not get better protection in place today? Yes, this may dampen returns to some extent, but they have potential to reap the rewards in a market dislocation when their peers’ investments get torpedoed.
“If you consider our forward-looking expected returns, broadly speaking for equities investors can expect 6.5 per cent, and 2 per cent in fixed income depending on where you are in the world. If you’re 50:50 in terms of portfolio allocation, the math is pretty simple: investors are looking at a 4.5 per cent return profile. That’s not enough to meet their liabilities.
“The best way to manage risk is to be willing to take a lower return, but that’s the problem that investors face today: they don’t have the luxury of taking such a position,” states Farley.
The limits to diversification
One of the central benefits of producing its Walk the Tightrope report is that it provides a useful framework for SSGA to discuss with investors the ways they are approaching risk management, and identify ways in which they can help establish a multi-pronged solution to downside protection. This is all about education and clear lines of communication.
To be clear, there is nothing to suggest that institutional investors are obfuscating their fiduciary duties by broadening out their risk toolbox; 85 per cent said that they have implemented such strategies in the past. Rather, what SSGA’s report shows is that investors typically stick to what they know, and are most familiar with.
In this respect, it is perhaps unsurprising that dynamic asset allocation is the most popular downside protection strategy, used by 53 per cent of investors. The next most popular are hedge funds excluding managed futures (40 per cent) and multi-asset class absolute return strategies (39 per cent).
Traditional asset allocation, whereby portfolios are constantly adjusted to produce diversification benefits as market conditions change, is in and of itself a perfectly respectable tool to managing equity risk. However, as Farley observes: “The problem is that when you enter abnormal markets, correlations spike to one and you don’t get the diversification benefits. It’s in those market environments that you really need to have done something different to manage downside risk.”
This is not a one-dimensional answer to a hugely complex issue. It needs to be more refined than that. The limits to diversification are outlined in the SSGA report, as revealed in the following section: According to State Street Global Advisors’ Investment Solutions Group, diversification only offers a limited amount of protection and is successful approximately just 65 per cent of the time. As a result, it does not protect a portfolio from drawdown during major market events and is successful primarily in normal and low-risk periods.
“I would say that in the conversations we have with a lot of our clients, it’s not about picking one volatility strategy but understanding how multiple volatility strategies can all play a role in their portfolio,” says Farley, who caveats the point by adding that whilst owning a number of low volatility strategies may help an investor’s portfolio, it may not avoid having drawdowns altogether.
“It’s nevertheless a good starting point for investors. Then you can start to consider dynamic asset allocation, maybe options hedging, volatility targeting, building exposure to truly diversifying strategies such as managed futures: those all play a different role and have different pros and cons.”
Packaging them together is the trick to creating a downside risk strategy, but investors still do not fully understand how to do this.
Whilst it is encouraging that organisations are at least beginning to consider other strategies – with 43 per cent and 38 per cent looking at low volatility equities and volatility targeting respectively – their overall understanding of these strategies remains quite limited. Whereas approximately three out of four investors have either an “excellent” or “good” knowledge of dynamic asset allocation and hedge funds (ex managed futures), approximately four out of 10 investors have a good or excellent understanding of low volatility equities and volatility targeting.
Low volatility strategies
Thirty per cent of investors said that they are currently using low volatility equities as a strategy, but only 17 per cent professed to have an “excellent” knowledge of doing so.
If one was to go back over time and compare a portfolio tilted towards or comprised of lower beta stocks to a traditional market cap-weighted portfolio of stocks, logic would suggest that the lower volatility (and therefore lower risk) portfolio should underperform the higher volatility portfolio.
“However, the reality is that that’s not been the case. If you look over long periods of time, low volatility stocks actually have very similar returns as cap-weighted, higher volatility stocks; in fact in some markets they are actually better,” says Farley.
“By owning a portfolio of low volatility equities investors may have a return experience that, over time, looks similar to owning the markets but they’ll do so with about two-thirds of the risk. Of course, in a high-growth market environment a low volatility strategy will lag a little, but if over time the investor can potentially get a similar aggregate return, but a much smoother one with less pronounced drawdowns, that is going to be a positive experience.”
Research Affiliates runs a FTSE RAFI Low Volatility smart beta product. They show that over a 50-year period, by focusing on low volatility securities investors would have gained 2 per cent over the cap-weighted S&P 500 Index with a 25 per cent reduction in risk (Source: Baker, Bradley & Wurgler – ‘Benchmarks as limits to arbitrage: Understanding the low volatility anomaly’. Financial Analysts Journal. Jan/Feb 2011, Volume 67, Number 1).
This is part of the answer, one piece of the jigsaw as it were.
Then there’s volatility targeting, which is a systematic rules-based transparent way to manage equity risk.
This strategy is based on a similar concept to low volatility equities in that investor should be fully invested in equities in periods of lower volatility and less so during market dislocations, when risk-adjusted returns are likely to suffer. Markets tend to trend upwards in low volatility conditions, as has been witnessed in the US over recent years, becoming more challenged in higher volatility conditions.
The idea of volatility targeting, therefore, is to set a threshold, or trigger level, based on the level of risk that the investor is willing to take on. Based on that threshold, the investor forecasts what they believe the volatility of the portfolio will be. If it were estimated to be above the threshold, the equity exposure would be reduced proportionately to get the portfolio risk back below the threshold.
“What that means is that in periods of low volatility you’ll be fully invested in stocks and when periods of volatility are rising, and you start to exceed that threshold level, you simply reduce your exposure accordingly at the total portfolio level,” explains Farley.
If one connects that approach to buying options – another hedging strategy – the benefit to doing this is that it may allow the investor to identify and set a level of certainty; volatility targeting is, after all, still a forecasting methodology. Buying protection via put options gives the investor a clearly defined threshold; so long as the price of the option at the time of maturity is below the strike price – in other words the market has experienced a drawdown which the investor was looking to protect against – it will be in-the-money, and allow the investor to make gains in a falling market.
Often a put spread will be used, whereby the investor buys a put and at the same time writes a put at a slightly lower strike price. The benefit to this is that it offsets some of the cost of buying options, in the form of premiums.
Volatility targeting comes with less certainty and reduced opportunity cost: the opposite is true for options.
Combine the two together in a multi-layered risk strategy and the investor may be better placed to handle future volatility events.
“When people hear about equity protection they immediately think about the costs involved to holding options. Our point is that buying puts, whilst expensive, is one thing, but there are a whole spectrum of choices that one can use to manage equity risk. Investors need to look across the board. That’s what we are doing; helping our clients to identify and pick the best ones that make sense for their particular portfolio needs,” emphasises Farley.
Timing is critical
The Walking the Tightrope report found that the two biggest barriers to investors using downside protections strategies were:
- Sense that the timing is wrong: 18 per cent
- High perceived cost: 18 per cent
“The timing question I found very interesting. My interpretation of that is investors thinking, ‘we’ve had three great years of market returns so why would I need to implement this?’ However, equity valuations are getting a little expensive, bond yields are at historic levels, and so while we are not holding the view that we are going to see Armageddon anytime soon, we are of the view that we are closer to the likelihood of a much more challenging market environment. So the timing response was an intriguing one,” reflects Farley.
In terms of implementing downside protection strategies, 54 per cent again referred to the timing issue, whilst 35 per cent said that it was adjusting the strategies in response to the changing market environment. This last response would again seem to suggest that investors lack the education needed to confidently utilise these strategies.
Overconfidence with downside protection
To further illustrate the education point, 65 per cent of investors said they believed diversification was sufficient to protect against market drawdowns. That is a very simplistic mind set, and symptomatic of investors having an inchoate understanding of different risk tools.
Fifty-six per cent said that they find it difficult to make the right choices when it comes to implementing downside protection, and whilst six out of 10 investors confirmed that they had changed their investment strategy to cope with market volatility, only 16 per cent said that they “strongly agree” that they have the right mix of tools in place to measure and predict market risk.
In what is a stark illustration of overconfidence in respect of risk management, nine out of 10 investors felt that their portfolio was well equipped to handle a market drawdown, with nearly half (45 per cent) of investors believing that their peers were, by contrast, underprepared.
When asked what impact recent volatility had had on investors’ approach to increasing downside protection, 41 per cent said ‘none’, and that short-term volatility was now the norm. “If you’ve made that decision for good reasons, okay fine. But if you’ve made that decision because you don’t know what the other options are, that’s a completely different story,” warns Farley.
This response about short-term volatility being the new norm is a dangerous one. It suggests that investors are simply looking at the events post-financial crisis, where central bank intervention anaesthetised the markets and volatility was suppressed, and figuring that this is now set to be the stock response to future tail risk events.
This is perhaps why so many investors feel comfortable sticking with diversification.
“What investors need to understand is that tomorrow’s driver of major volatility will not be the same as yesterday’s. They have to choose whether to do something to help manage their way through that uncertainty, or choose to just ride it out and go to the next event, without making any changes to their volatility strategy,” says Farley.
One third of investors felt that volatility had a slight impact and were looking for ways to implement increased downside protection, with only 8 per cent confirming that volatility had a significant impact and were now implementing increased downside protection.
Taking the right approach
The first step any institutional investor should take is to determine what is the true downside risk tolerance of the organisation. If it is a pension fund plan, how does that impact its funding ratio? What does it do to the level of contributions needed to keep the plan fully funded?
From there, the pension fund can start to think about what level of certainty and hedging they need to have in place. Maybe they decide to take their passive equity investment pool and move it into a passive low volatility equity pool. Or they decide to look at how they do their asset allocation and become more dynamic with the way they shift those allocations. Perhaps they keep it as it is and implement a volatility target overlay.
There are lots of different ways to implement protection strategies but what it really boils down to is: What is that level of risk management they need?
“What I find most important about this report is that it provides a platform by which to have a meaningful conversation with investors. To understand that they are not alone in some of the challenges they are facing in terms of balancing the need for upside returns with managing downside risk,” concludes Farley.
To read the SSGA report in full please click here
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