Aurora Borealis
1 February 2016 CFA Institute Journal Review

Working Your Tail Off: Active Strategies versus Direct Hedging (Digest Summary)

  1. Geoff Gilbert

Four strategies are assessed for their effectiveness in hedging the equity tail risks in a US portfolio. Direct hedging is costly and reduces risk-adjusted returns, whereas three indirect strategies that alter the starting portfolio characteristics achieve similar protection with superior long-term average returns.

What’s Inside?

The authors evaluate four strategies for hedging the equity tail risks of a US portfolio composed of 60% stocks and 40% bonds (a 60/40 portfolio). The first is a direct (i.e., insurance) approach that uses an option collar strategy—selling calls to partially finance purchasing puts. The remaining three strategies seek to indirectly hedge the equity tail risks by actively altering the starting portfolio using a low-beta, risk-parity, or trend-following strategy.

How Is This Research Useful to Practitioners?

Although embracing the tail risks of capital markets is an element of investing, it is uncertain whether investors are duly compensated for the equity risk in a 60/40 portfolio’s expected return. The authors note the risks of tail events in bond markets, but they focus their research on stocks’ risk and evaluate several alternative strategies that would minimize the impact of equity tail risk.

The authors compare the returns of four alternative portfolios and gauge the hedging effectiveness of each approach by examining their statistics across various 60/40 drawdown periods. The collar, low-beta, and trend-following strategies all reduce the volatility and drawdowns of the simple 60/40 portfolio.

The collar approach comes at the expense of lower risk-adjusted returns and has the only lower Sharpe ratio. The direct-hedging (collar) strategy provides protection from sudden, large losses (i.e., around t = 0 for the worst drawdowns), but the gains are rapidly eroded by the high costs of continuous option hedging. The value inherent in this strategy is only realized when those hedges are unwound at exactly the right time. In contrast, the authors demonstrate that three other indirect strategies outperform in prolonged market drawdowns and deliver superior long-term average returns. Specifically, the risk-parity portfolio outperformed the most with the highest alpha.

How Did the Authors Conduct This Research?

The authors model four alternative portfolios during a 27-year period (1985–2012) and compare various return and volatility data with a proxy portfolio composed of 60% equities (S&P 500 Index) and 40% bonds (Barclays US Government Bond Index). Although they admit that multiple alternative portfolios and path-dependent variables exist, the authors attempt to present the most representative portfolio for each strategy. Data are presented gross of transaction costs.

They structure their direct-hedging option collar strategy with long 7.5% out-of-the-money overlapping three-month put options (with expirations staggered one, two, and three months in the future at all times) partially funded with short one-month 10% out-of-the-money call options. This structure is similar to the popular CBOE (Chicago Board Options Exchange) S&P 500 95–110 Collar Index. Their low-beta equity portfolio is composed of an equal weighting of stocks with the lowest 30% trailing 12-month beta sorted each month. The risk-parity portfolio equity/bond allocation is determined each month based on each trailing 12-month volatility to achieve 10% annualized volatility (assuming no correlation between the assets).

The authors note that although risk-parity portfolios in practice typically include more asset classes, they expect that the two-asset-class example presented underlines the benefits of tail-risk management. Their last indirect and active strategy replaces 20% of the starting portfolio with a long–short, equal-weighted combination of 1-, 3-, and 12-month time-series momentum strategies. The rationale for the use and construction of each portfolio is provided. Performance data for each, as well as the 60/40 portfolio, are presented in tables with supporting results presented graphically.

Abstractor’s Viewpoint

This article is well written and has a clever title. Although the authors admit that volatility is not a complete or comprehensive measure of risk, its use in this regard seems appropriate to compare the four significantly different strategies. Understanding the need to narrow the focus of the research and given the historical volatility of stocks, it also seems appropriate to ignore the potential tail risks of bonds. But I would like to see the authors follow up this research with a similar paper that investigates that potential risk.

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