This year's swoon in equity markets, triggered by the global pandemic, brought a spotlight on tail-risk hedging strategies. Reports of outstanding performance at a few large firms in March 2020, along with continued concerns about equity tail risk stemming from the global pandemic, have generated a great deal of interest among investors and sparked some questions about what constitutes an effective strategy.
During the five years I helped shape the asset allocation decisions at CalPERS as investment director, I became increasingly uncomfortable with our reliance on future fixed-income performance to meet liabilities and to serve as the primary source of equity-risk mitigation — driven by a large allocation to longer-dated U.S. Treasury bonds. As I sought alternative strategies, Universa's tail-risk hedging program offered a compelling solution to a systemic problem. It was so compelling, in fact, that I joined the firm.
My concern then at the California Public Employees' Retirement System, and now at Universa, is the future inefficacy of fixed income as both a source of yield and a provider of risk mitigation. At CalPERS, we were forced to think outside the box. I'm very glad we were. In being forced to think outside the box, I came to understand effective risk mitigation optimizes the balance between convexity and cost. Pressure on pensions to take greater risk to make required returns continues to grow as bond yields are falling. Solutions proposing more leverage and/or investing solely in illiquid assets like private equity can lead to very bad outcomes for pension funds, particularly when history has shown that it is avoiding drawdowns that has had the greatest effect on funded status.
But tail-risk hedging provides protection against extreme market moves that have occurred historically at a frequency well beyond what is predicted by a normal return distribution. The most effective tail-risk strategies provide a highly convex payoff profile with respect to the downside equity exposure of the fund.
In March, that approach achieved an extremely strong (well-publicized) return for our investors. Not surprisingly, this magnitude of performance attracts skeptics and detractors. Most tail-risk managers over the past decade have also lost more than they have made, which reinforces the perception. But more deeply, the criticisms tend to fall into two broad categories: that "put options" are too expensive; or that "trend following" is more effective. These generalizations are straw man arguments that should be addressed.
A proper tail hedge is a blend of long (and short) option positions traded dynamically to achieve an optimal trade-off between convexity and cost. Furthermore, there are embedded non-discretionary strategies to facilitate monetization and lock in gains that would otherwise evaporate with the naive proxies.
Yet the "put option" argument usually begins with assumptions of what constitutes options-based tail-risk hedging. A favorite choice seems to be buying one-month, 5%, out-of-the-money puts on the S&P 500 index and holding until expiration. An overly simplistic systematic strategy that is thus relatively easy to back test is used as a proxy. At this point, the detractor argues that the tail-risk strategies are ineffective and the "bleed" from option premium expense in rising or sideways markets is excessive and is not offset by the gains during stock market crashes as in October 2008, February 2009, or February-March 2020.
I agree that such an approach is not particularly effective and at CalPERS we had considered selling these options as a part of our tail-risk program. Not only are the combinations of strike and expiry focused on the wrong part of the underlying return distribution, but an effective strategy is not merely the repetitive buy-and-hold of a limited set of options.
Furthermore, the risk mitigation benefits of trend following — like any other form of diversification such as allocation to U.S. Treasury bonds — should be measured in terms of the impact on the compound annual growth rate of the overall portfolio, which factors in the amount of capital required in risk mitigation and away from equities. For the past two decades the benefit of adding trend following to an equity portfolio has not even improved upon that of an equity-bond mix. For the most part it has likely lowered the returns without meaningfully changing the risk in the portfolio.
The argument for trend-following is typically represented either as a simple rules-based strategy that has been data-mined with a back test or, preferably, with an index of representative programs such as the Barclays CTA or SG Trend indexes.
Advocates build the case for trend following as effective risk mitigation by claiming there is no opportunity cost from a large allocation to this strategy – returns of 6% or more observed on average over this specific period are projected into the future. However, the average performance of trend followers has been essentially flat for over a decade. The annualized return for Barclays CTA from January 2010 to now has, in fact, been about 0.9%.
Historically, trend following has delivered a positive return during past stock market drawdowns such as in 2008 and 2014-2015. But, the case is made generally that trend following is a tail-risk hedge with a significant positive expected return across all market environments. The last decade has proven this to be false and the performance in 2020 has been lackluster. Furthermore, the gains during stock market drawdowns have not exhibited the explosive upside behavior of a convex options-based hedge tail risk — which means a much larger allocation to trend following is needed to provide the same degree of "hedge," and thus the opportunity cost underperformance during most markets is even greater.
I am not averse to alternative approaches for hedging and diversification, in general. While working at CalPERS, I designed a multifaceted approach to risk mitigation that combined options-based hedging with a more defensive asset allocation and a systematic rebalancing strategy. These components were selected to work in conjunction to improve the long-term performance of the fund.
Risk mitigation should not be an either-or proposition. But we should all be able to agree that a comparison of an alternative strategy with a strawman representation of tail-risk hedging distorts the real effects on a pension portfolio and grossly exaggerates the expected performance.
Alternatively, real world success speaks for itself.
Ron Lagnado, based in Miami, is a director at Universa Investments LP. 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.