Commentary: Hedge survival – making it to the next crisis

After 2018, investors may be forgiven for questioning tail strategies.

Even with declines in more than 90% of asset classes that year, the Eurekahedge Tail Risk index finished with a 6% decline. Its sister index, the Eurekahedge Long Volatility index, mustered a mere 1% gain. This lackluster performance was realized despite 2018 being the most volatile year since 2011 in equities and, as Figure 1 shows, the realized volatility of 60/40 portfolios hitting the highest point since the financial crisis (nearly triple the average of 2017). With the dramatic reversal in markets in 2019, tail hedges have lost as much, or more, than they gained in the final quarter of last year. While that performance might be forgivable given the sharp recovery of markets, it raises the issue of sustainability of hedging and when to take some profits in the face of large equity moves.

Tail hedging has always been a difficult proposition given the relatively high cost of owning protection over time. However, probably too much attention is paid to the losses of hedges rather than considering them in the context of overall portfolio returns. In our view, investors seeking cheap hedges rather than risk-targeted ones may wind up with hedges that fail to perform, while ad hoc implementation and monetization plans might result in further risk to the sustainability of hedge programs. Investments in tail funds might result in even less protection as projected max losses of say, 5%, would need to incorporate fees. Based on those fees alone, investors might find themselves considering taking on the project themselves.

However, we believe they are best served relying on an asset manager to implement these programs. Finding the best hedges does require going beyond simply targeting the lowest cost hedge alternative or looking for lottery-ticket-type option hedges.

The trade-off between cost and efficacy is an important one and may be better made in the context of portfolio risk, not in the context of a generic tail fund with little visibility on the types of hedges used.

Implementation and monetization might be as important as hedge selection, and require planning at the commencement of the hedge program, not on the fly. Careful attention needs to be given to execution to help ensure best pricing and liquidity. Avoid systematic strategies executing solely on the close in the name of transparency.

In designing hedge programs, a starting point is to target portfolio risks that you cannot live with and then search for hedges that you can live with that address those risks. Once found, buy with the size and the scope to actually make a difference.

We have previously argued that hedges should target risk and not returns. The race to cheapen hedges has led to investors trying to find low-cost hedges first and then looking for risk in their portfolios that these hedges might protect.

We believe a further mistake is dedicating too little time or capital to hedging plans. The timeworn phrase of "being in motion" on hedging more or less sums up the approach.

If small allocations to tail funds cannot meaningfully affect risk, and large allocations to complex carry-neutral or low-cost strategies could have adverse outcomes, what does that leave? We say target risk; but what we mean is target risks that might leave the portfolio exposed to significant drawdowns. By adding valuation principles to the process, hedges can be designed that may better fit within both risk and return constraints.

Determining fundamental and macro data-based upside targets may allow investors to sell upside calls to fund puts via an equity collar structure. By giving away upside that might be above investor return objectives, the portfolio gains potentially meaningful protection in market declines. The alternative is also worth analyzing. When stocks appear inexpensive, selling upside calls might not make much sense. The better premium reducing strategy may be to cap the amount of protection by converting the put into a put spread through the sale of a far out-of-the-money put at a strike price at which the investor is comfortable reacquiring equity risk. While this means the portfolio has less protection in a crash, it offers the potential benefit of removing the upside cap. In short, by adding valuation tools to the hedging conversation, we put on hedges that may better align with portfolio views and have scalability and flexibility to help protect against risks.

We believe that one root cause of hedge failure comes from ineffective and/or ad hoc implementation. Tail hedge managers often are telling investors that the next disaster is imminent; however, attempts to time the next crisis may result in chasing hedges into declines just as volatility shoots higher or other inefficiencies. The design of the hedging plan should include all the inputs you might put into asset management programs, including fundamental and quantitative triggers to slow or accelerate the hedging pace but also have the flexibility to adapt to changing market conditions.

One primary goal of any program should be sustainability, which is challenging given losses of the past 10 years. Hedge losses are offset by portfolio gains and thus should not be viewed in isolation; however, for many, the losses have impaired their ability to maintain hedges over the very long run as much attention is paid to negative lines in the portfolio profit and loss statement.

In the rush to start hedging programs, a frequently overlooked piece is monetization. Much like implementation, we believe the monetization piece is pivotal to the long-term viability and sustainability of the hedging plans. Not every market event is a crash; however, periodic market declines offer some opportunities to take profits on hedges and thus continue to fund the program over a longer period. As markets decline and volatility increases, the option premium of the hedges necessarily expands and thus, so do risks of the position. While the portfolio is likely experiencing losses, we believe the plan should be designed to contemplate taking some early profits on hedges in order to help maintain the sustainability of the program.

A variety of market-based and quantitative signals can be utilized, including implied volatilities, equity and options flows, skew levels, asset managers' exposures and momentum indicators, just to name a few. None works in isolation, but taken in composite, they may form the basis to potentially realize some gains around what might be a short-term "panic" low in the markets.

Tail hedging results could be improved simply by moving from an ad hoc and occasional approach to developing a long-term plan to ensure the sustainability of the program. This means having a process in place to inform hedge selection, implementation and monetization. It is not enough to find the cheapest hedges that might be available today. We believe as markets change, the 'best' hedges may be entirely different from one period to the next. By not having a core plan in place, investors may be unprepared for changing market regimes that may dramatically impact the results of the hedging program.

Peter van Dooijeweert is head of institutional hedging at Man Solutions, New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.