A new white paper by Ampersand Portfolio Solutions, Looking Under the Hood, provides an in-depth look at the details associated with structuring overlays as a way to hedge equity-related risk. In prior white papers, The Risk Contribution of Stocks, Parts 1-3, Ampersand introduced a concept to diversify beyond stocks and bonds without having to sell the stock/bond portfolio holdings. The new paper goes further, and shines a light on ways to structure a dynamic futures-based equity hedging strategy designed to mitigate downside equity risk. Ampersand Portfolio Solutions, a division of Equinox, collaborates with select asset managers to construct bespoke investment solutions.
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Ampersand's white paper, The Power of Ampersand: Looking Under the Hood, recaps the risks associated with a 60/40 stock/bond portfolio, showing that 92% of the risk is contributed by stocks. Diversifying the portfolio by adding another asset class such as managed futures yields critical and significant improvements.
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Here are some key highlights from Looking Under the Hood:
- Hedging equity risk is not a simple proposition. Traditional strategies include market timing, shorting individual stocks, and using options strategies. These approaches tend to be ineffective, costly, or inefficient.
- Dynamic futures-based equity hedging strategies or certain alternative risk premia afford greater promise as they are designed to be negatively correlated to stocks and their “beta” is dynamic (lower during market corrections but higher during market rallies) making them true hedges.
- Adding both hedges and diversifiers to a portfolio may be a more efficient and effective way to manage risk. “Extended diversification” allows for these diversifiers to be added without selling any stocks and bonds in the original portfolio. How is this possible? As these programs typically can be accessed by posting anywhere from 10% to 25% of their notional value as margin or collateral, the stocks/bonds in the portfolio can be can themselves be posted as collateral. This creates an “overlay” approach, where the alternatives are overlaid on top of the stock/bond portfolio, without the need to sell any stocks or bonds. Detailed examples are provided in the paper.
- Another way to accomplish this to employ a Total Return Swap that provides access to CTA trading programs. A portion of the fund’s assets are posted as collateral using a tri-party custodian. This is described in detail in the paper.
- By including a meaningful allocation to dynamic diversifying strategies which have a low correlation to stocks and bonds, it is possible to add potential alpha to the overall portfolio without increasing its overall risk. In fact, it is possible to reduce the contribution of equities to the risk of the overall portfolio by at least a few percentage points.
- By exploiting this “extended diversification” it becomes possible to harness the true benefits of diversification as expounded by Modern Portfolio Theory and let investors have their cake and eat it too.
The Power of "Ampersand": Looking Under the Hood
In a recent Webinar, we introduced the Equinox “Ampersand” concept.1 Here, we try to provide not just a recap, but a more in-depth “under the hood” look at some of the details of the structure, to which we could not do justice during the relatively short Webinar. We also try to address some of the questions and concerns we have heard.
The Backdrop: Hedging Equity-Related Risk
Stocks generally make up a significant part of most investor portfolios, be they institutional or individual. Investors have been taught, and have come to believe, that stocks are a good investment for the long run, and their realized historical returns appear to support this story. What is sometimes overlooked, particularly during prolonged bull market runs, is that returns are high because they must compensate investors for the high degree of risk equity investing entails.
Most investors seek to mitigate stock risk by investing a part of their portfolio in bonds. The historically low correlation between stocks and bonds leads to diversification benefits: the risk and the return of a stock/bond portfolio are lower than those of just stocks. However, the reduction in risk is generally greater than the reduction in return, resulting in a higher risk-adjusted return.
Despite these diversification benefits, a traditional stock/bond portfolio, such as the prototypical “moderately aggressive” 60/40 portfolio still derives more than 90% of its overall risk from stocks. Thus, while less risky than a 100% stock portfolio, 60/40 may be unlikely to distinguish itself during an equity market crisis like the one we experienced in 2007-08. Simple analysis shows that the risk and return of portfolios comprising just stocks and bonds are dominated by stocks until the allocation to them is reduced below 30%. At this point, however, the investor has also ended up sacrificing quite a lot of expected return. With meaningful diversification of stock risk comes meaningful dilution of portfolio returns.
One possible way to remedy this situation is to look for “alternative” strategies that have low correlations to stocks and bonds, and can therefore provide greater diversification. Examples of some strategies that have been used over time are: hedged equity, real estate, hedge funds, and long-only commodities. Without going into details, it is worth noting that most of these strategies did not perform well during the Global Financial Crisis: Like the equities they were intended to protect, they also exhibited negative returns. Active futures trading strategies (also known as managed futures or Commodity Trading Advisor (CTA) strategies) were one group that earned its keep during the last crisis (and during some other crises before that, as well) by putting up impressive performance numbers.2 This has led some investors to believe that futures trading strategies are hedges for stocks. Others tend to think of them as “crisis alpha” strategies.3
While active futures trading strategies serve as diversifiers that also seek to provide alpha, alternative risk premia strategies have been developed and offered to investors over the last few years. Broadly speaking, these are strategies that seek to provide exposure to sources of returns across multiple asset classes (equities, fixedincome, currencies, commodities). The sources of return (or factors) exploited are generally classifiable as trend/ momentum, carry, and value, but may be extended to size/ liquidity, quality, and others. The strategies themselves are generally passive and systematic or rules-based, take both long and short positions, and tend towards marketneutrality and hence low correlations to most other asset classes. Relative to active alpha-seeking trading strategies, alternative risk premia are promoted as being cheaper, more liquid, and more transparent. Potential concerns mainly center around their ability to produce future returns that are in line with their generally impressive back-tests, and their relatively short live track records. Overall, alternative risk premia strategies combined with active trading strategies may offer investors, particularly feesensitive ones, a larger opportunity set of diversifiers.
Although some futures trading strategies and alternative risk premia have displayed negative correlations to equities during crises, most of them are designed to have low (slightly positive or slightly negative) long-term correlations rather than high negative correlations, which is the way we define a hedge. These types of strategies are better classified as diversifiers. When added to a portfolio containing stocks and bonds (and perhaps other alternative strategies), they tend to reduce its overall volatility by virtue
of their non-correlated nature. However, most investors allocate relatively small portions of their portfolios to these types of diversifiers. Very often, the diversification they achieve may be inadequate, particularly during a serious equity market downturn, as most of the portfolio’s risk still stems from equities.
Hedging equity risk is not a simple proposition. Traditional strategies intended to achieve this goal include:
- Market timing (seeking to adjust equity market exposure by switching between cash and stocks);
- Shorting individual stocks (equity long-short, with either a long bias or a market-neutral approach);
- Options strategies (buying index put options).
These approaches generally tend to be ineffective, costly, or inefficient. In terms of market timing, we know of no definitive evidence that it is an effective strategy. With regard to shorting individual stocks, that may be costly because the stocks need to be located and borrowed, and stocks in high demand for shorting (e.g. dotcom stocks during the bubble) often cost a lot to borrow and short. Also, short sellers can get bought in if the borrow dries up. And lastly, buying puts can be costly because the put premium bleeds out over time, and they must be rolled over periodically as they expire. Puts become costly when volatility increases (i.e. when they are most needed).
By way of contrast, we believe that dynamic futures-based equity hedging strategies or certain alternative risk premia may afford greater promise.4 As they are designed to be negatively correlated to stocks and their “beta” is dynamic (lower during market corrections but higher during market rallies), they are potentially more effective in mitigating downside equity risk, and can truly be classified as hedges.
The Ampersand Concept: A Recap
Adding both diversifiers and hedges to a portfolio may be a more efficient and effective way to diversify, and to lower the portfolio’s equity-related risk. This still leaves us with a dilemma: in order to diversify meaningfully, the allocations to diversifiers and hedges need to be meaningful—on the order of 30% to 50%. Traditionally, to make these sizable allocations, investors have had to ask the question: which holdings from my portfolio do I sell in order to make room for the diversifiers and hedges?
This is what we call the “Limitation of Or”: investors are faced with the choice between investing in stocks and bonds OR investing in alternatives. There is potentially a large opportunity cost in allocating 40% to alternatives: 40% of the portfolio’s stocks and bonds need to be sold, and the potential return they may earn in the future has to be forgone. In a bull market such as the one we have been in since 2009, this opportunity cost can be significant, and the decision to sell stocks could lead to considerable “buyer’s remorse.”5
We believe the Equinox Ampersand strategy addresses the “Limitation of Or.” As the name indicates, we seek to harness the “Power of And.” Our objective is to enable investors to maintain exposure to stocks and bonds markets while simultaneously obtaining meaningful diversification through futures-based hedging and diversifying strategies. Some expressions, albeit somewhat cliched, describe this approach well: it seeks to make the pie bigger, or to let investors have their cake while eating it too.
A simple way to understand the Ampersand approach is in terms of “extended diversification.” In a traditionally diversified portfolio, the sum of the allocations to various asset classes is constrained to 100%.6 Thus, an initial 60/40 stock/bond portfolio that is diversified by allocating say 40% to alternatives might become, for example, a 36/24/40 stock/bond/alternatives portfolio. An Ampersand portfolio, by contrast, is not similarly constrained: it might be, for example, a 60/40/40 portfolio, where the original 60/40 stock/bond allocation is preserved, while adding significant and meaningful “notional” exposure of 40% to alternatives such as diversifiers and hedges (“notional trading level” or “notional exposure” is a somewhat tricky concept that we will address in a subsequent section, and which we have discussed in detail elsewhere).7 The opportunity cost of diversification or the “Limitation of Or” that we discussed has been avoided by utilizing the “Power of And”: the portfolio retains its stock and bond exposures AND gains meaningful exposures to diversifying and hedging strategies.
For the white paper described herein: https://equinoxfunds.com/sites/default/files/Insights_LookingUnderHood_Dec-17.pdf