When bonds no longer offer defensiveness, where do you look for portfolio protection? Perhaps it is time to set an explicit negative equity correlation target, Aberdeen Standard Investments says.
For a long time, bonds were the all-weather defensive assets. In equity bull markets, bonds provided a little bit of return to investors, while in bear markets they provided a lot of return.
But after a decade of quantitative easing, yields have been pushed into negative, and often unknown, territory, resulting in a situation where bonds provide virtually no return while still having considerable duration risk.
In this situation, a number of investors have concluded that they can’t simply allocate to a defensive asset, such as bonds, but that they have to take a different approach altogether.
Instead of a defensive asset that still offers some positive return in its own right, these investors look for an outright hedge to their equity exposures. They look for instruments that are explicitly negatively correlated with equities.
Stephen Coltman, a Senior Investment Manager within the Alternative Investment Strategies division at Aberdeen Standard Investments, is part of a team that has embraced this approach and they run a so-called ‘risk mitigating’ strategy that aims to achieve a correlation of -0.2 with equities.
Having an explicit target for the strategy’s correlation with equities gives investors the predictability they need to construct robust portfolios, Coltman says in an interview with [i3] Insights.
We commit to that -0.2 target and we can be greater than that if we let the convexity in the portfolio run and increase the hedges as the market goes down. But the allocator has quite a predictable profile link back to the portfolio. They can understand how it is going to correlate with other assets in the portfolio
“It is all about the predictability. Allocating to, say, discretionary macro may work very well, but there is a lot of variability there. You don’t know what the position is going to be or what the manager’s view might be at all times,” he says.
“Equally, if you are allocating to risk premia as part of a crisis risk offset portfolio, there will be premia in there that will do very poorly in certain events. So we are trying to be as user-friendly as we can be by having that predictable beta profile.
“We commit to that -0.2 target and we can be greater than that if we let the convexity in the portfolio run and increase the hedges as the market goes down. But the allocator has quite a predictable profile link back to the portfolio. They can understand how it is going to correlate with other assets in the portfolio.”
Having an explicit correlation target in place means the team will start to rebalance the portfolio once the portfolio starts to stray from it. This periodic rebalancing not only gives predictability, but also helps locking in gains.
“We think the rebalancing issue is important because when you rebalance periodically, say every quarter, automatically you are reducing your hedge to bring it back in line with your equities during big sell-offs, so you are taking some profit there and reinvesting,” Coltman says.
“And at the same time, when markets rally you automatically protect some of those gains by increasing your hedge. We find that if we do that over time, even if the hedge on its own doesn’t do much over the full period, it actually improves your combined portfolio compound returns a lot by having smaller drawdowns.”
Risk Mitigation Globally
The risk mitigation strategy, also known as Crisis Risk Offset, was borne out of a concept championed by United States asset consultant Pension Consulting Alliance (PCA), now called Meketa Investment Group.
The idea here is to combine a number of strategies that diversify the portfolio away from equity risk and put these strategies together in one sleeve. It usually incorporates strategies such as trend following, global macro and alternative risk premia, or factor strategies, and still some sovereign bonds.
But where the PCA model expects the sleeve to make a low positive return in the long term, Aberdeen Standard’s approach aims for an explicit negative correlation to equities.
Aberdeen Standard’s strategy consists of four buckets, including First Risk, Defensive Factors, Systematic Trend Following and Tail Risk. The First Risk bucket includes strategies that deliver a gain in the event of a market shock and tend to respond quickly in the initial phase of a crisis.
It contains volatility strategies, index puts and duration. It also tends to be the most expensive part of the overall portfolio and so you couldn’t build a portfolio of just First Risk strategies, Coltman says.
“Right now in First Risk we have VIX futures, equity puts and implied volatilities, option straddles around one-year maturity,” he says.
“The VIX futures curve is very steep at the front of the curve at the moment, so holding front-end VIX is just very expensive to carry. We currently prefer slightly longer-dated [instruments], where we think there is a premium justified because of the outlook over the next six months.”
It is really about avoiding those strategies that can cause problems. Equity trend, for example, in a sudden violent sell-off can be very difficult, so we exclude equity trend from the portfolio. Again to give us that more stable profile in the market sell-off
Defensive Factors includes strategies such as equity quality, commodity carry and commodity value, and even selling gold puts. This bucket aims to capture long-term returns of factors that are not tied to the direction of equity markets.
Systematic Trend Following includes foreign exchange trend, rates trend, commodity trend and credit trend strategies, but is not allowed to hold equity trend as this has a positive correlation to equities at certain times in the cycle, which tends to be especially problematic during regime changes.
“It is really about avoiding those strategies that can cause problems. Equity trend, for example, in a sudden violent sell-off can be very difficult, so we exclude equity trend from the portfolio. Again to give us that more stable profile in the market sell-off,” Coltman says.
Finally, Tail Risk includes long volatility and tactical relative value strategies that benefit from a sustained increase in volatility.
All strategies are implemented through indices, which is a cost-efficient way of implementing the strategy, but also gives more constant results as manager selection risk is taken out of the equation.
“We think there are some benefits by implementing the strategy systematically, particularly as it relates to the cost efficiency, predictability and transparency,” Coltman says.
“The downside of systematic implementation is that the strategies are blind to changing market dynamics. There is no single systematic strategy that would work well across all market environments.
“That is why we think it is important to have a diversified portfolio of these, where the implementation and execution is systematic but where the exposure level is taken on a discretionary basis. We have to make sure that the portfolio exposures are consistent with our overall agendas.”
The Pandemic
The concept behind a risk mitigation approach is to cushion the blow of an equity market downturn in times of crisis and the onset of the global coronavirus pandemic at the end of the first quarter of this year provided the circumstances to test this concept.
“What happens is that as the market goes down further, the Tail Risk [bucket] is starting to respond and trend is starting to become more risk off in its positioning. And you find that the beta in the portfolio is starting to become increasingly negative,” Coltman says.
“The beta actually decreased to -0.6 [during March]. That actually gave us more flexibility because we actually had some budget in terms of: ‘Do we want to keep that very strong negative beta or do we want to make some changes?’
“We had the budget to lock in some of the gains, which we did, because the First Risk category is most likely to give back your profits. They are static in their positioning, they are always positioned the same way, so when you are long VIX and the VIX comes down, you are going to give it all back.
The beta actually decreased to -0.6 [during March]. That actually gave us more flexibility because we actually had some budget in terms of: ‘Do we want to keep that very strong negative beta or do we want to make some changes?'
“But because we now had more contribution to the hedging beta from the trend and the Tail Risk, we had the budget to reduce some of that exposure. What we did was cut very heavily the exposure to volatility and First Risk and we got our beta down to around -0.2 in late March.
“So we still had a negative beta, because that is our objective, we never go flat or risk on. But we can reduce the exposure to First Risk strategies that would have given the profits back. So when that is starting to work, you can reduce your exposure to strategies that tend to be more expensive.
“And then within the defensive factors, the shifts are driven by the carry dynamics. So one of the defensive strategies we had was selling puts on gold and we saw at that point in March where the implied volatility on these gold puts went from 10 in January to around 50 during the funding squeeze and gold got hit.
“So the carry on those gold puts, at that point, was extremely attractive and we increased exposure there and equally in the commodity carry strategy, with the collapse in the demand for oil, you saw those curves going to very steep contango and that was very attractive as well and we increased that exposure.
“But within the defensive factors in terms of a market beta view, it is more about optimising that carry, while First Risk and Tail Risk is more about managing the portfolio beta.”
Do Factors Work?
There is currently much debate about whether known factors, including value, quality and momentum, are actually still working or whether the various central bank quantitative easing programs have distorted the market to such an extent that they are no longer applicable.
Coltman acknowledges some of the distortions in the market, but says factors still have a role to play in a portfolio.
“It speaks to the importance of getting diversification in the Defensive Factors [bucket]. We are always looking to add more diversification. But to get strategies with a positive expected return that does not correlate with risk assets … there is not a huge number to choose from. It is hard to find them and they are quite valuable,” he says.
“So we have an equity quality factor in the [portfolio]. Intuitively, it makes sense that in a crisis companies that are less stressed will do better and are more resilient. That is one component that has struggled more recently and that is partly driven by the FANG phenomenon; the very narrow market rally in US [ technology stocks].
“We are running [equity quality] in a market-neutral format, index hedged, and the index is increasingly dominated by these mega tech stocks. That has changed that strategy, but does it mean that has been changed forever and doesn’t make sense anymore? I’m not prepared to take that view.
“But that is why we have diversification. The ones that did do well were selling gold puts, commodity carry and a foreign exchange value strategy that did quite well in March.
“[Factors] will go through periods where it is difficult and equity value has had a difficult period and I think the central banks are driving that. It has been a long period where it is out of favour, but that doesn’t mean that it is not going to work again and that these [factors] are fundamentally broken.”
Path Dependency
One of the key learnings from the behaviour of risk mitigating strategies in the past couple of months is that implementation matters a lot. Even with the right strategies in place, the experience can differ radically depending on the execution.
For example, a number of US pension funds that have embraced this approach found manager selection played a key part in whether they had a positive or muted experience in this part of the portfolio.
But another problem with implementation is the path dependency of the different strategies, Coltman says.
“Even with a very simple put strategy on the portfolio, yes, it gives you a predictable pay-off, but once you start looking at the implementation of it, it is not so straightforward. You have to decide when you buy the put, how often, and at what strike you buy them,” he says.
“What is your process once they start making money and how do you monetise them? Depending on what decisions you make there, you can get very different outcomes.
“But then you look at ways to refine your strategy and one popular way of doing that is by selling calls to create a collar.
“But then the path dependency increases even more because you may not pay very much upfront for a strategy like that, but the actual cost in hindsight can vary enormously depending on the market evolution.
“In a huge bull market, like Japan in 2013, the strategy can turn out to be incredibly expensive as you’ve given up all your upside participation in the equity market.
“And equally in trend strategies there is a lot of path dependency, so if the market rolls over slowly and starts going down, trend following will give you one pay-off or will markets rise very sharply and suddenly collapse? Then you have a very different pay-off.
“So there is a lot of path dependency and what we are doing here is trying to address that by having a diverse range of strategies across all key blocks that all work at different parts of the cycle.
“And then managing them all together so that it is one coherent portfolio and so that we can ensure the aggregate exposures are still consistent with our objective.”
This article is paid for by Aberdeen Standard Investments. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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