Recent tumult in the markets has hammered home the idea that investors need to protect themselves against “tail risk.” Of course, this is easier said than done, especially since there’s not even a settled definition of what exactly “tail risk” is. In the Summer 2015 edition of The Journal of Investing, authors Attakrit Asvanunt, Lars Nielsen, and Daniel Vallalon look at four ways of protecting stock-and-bond portfolios during extreme “tail event” drawdowns:
- Financing protective puts through the sale of out-of-the-money calls (“collars”);
- Reducing risk within the equity allocation of the portfolio;
- Altering the stock/bond composition balance of the portfolio; and
- Incorporating a trend-based rebalancing strategy.
The authors call this first option “the direct approach,” while the other three are “indirect” approaches. Their thesis is that the indirect approaches are superior to the direct approach, providing more protection with less expense.
Problems with Direct Approach
The direct approach involves using put options for portfolio protection. A put option gives its owner the right to sell a security at a given “strike” price, so a put can lock in a bottom “floor” for a stock or other asset. Few things in this life are free, of course, and puts aren’t among them – so many investors take the strategy further by selling call options to help finance their put purchases. This leaves practitioners of this so-called “collar” strategy vulnerable to missing out on large stock rallies, since their short-sold calls can force them to sell when prices rise appreciably.
Due to this and transaction costs, the collar strategy failed to bolster portfolio returns in the historical analysis of returns from 1985 to 2012 conducted by the white paper’s authors. In fact, a “60/40” (60% stocks, 40% bonds) portfolio with collars actually underperformed the same portfolio without collars, albeit by a statistically insignificant amount.
The first of the authors’ three “indirect” approaches for insuring against tail risk is to reducing equity risk within the equity allocation of a “60/40” portfolio. This involves swapping out more-volatile equities with low-beta stocks. From 1985 to 2012, this approach delivered annualized returns of 10.5%, with a Sharpe ratio (“SR”) of 0.72. By comparison, a straight-up “60/40” portfolio with no protection returned 9.77%, with an SR of 0.55; while “60/40” with collars returned just 8.1% with an SR of 0.48.
A second “indirect” approach calls for altering the composition of the “60/40” portfolio itself, since a portfolio with a 60% allocation to stocks has historically derived around 90% of its risk from equities. Thus, the alternative “risk parity” approach, which seeks to allocate according to the risk each asset contributes to the portfolio, rather than by raw dollar terms. According to the authors’ research, a “two-asset simple risk parity” portfolio returned 13.4% per year from 1985 to 2012, and had an SR of 0.79.
How about incorporating a trend-following strategy within the “60/40” portfolio to systematically rebalance allocations? The approach studied by the paper’s authors involved an 80% allocation to “60/40,” with the remaining 20% allocated to a trend-following system that shifts between stocks and bonds. This ultimately results in a static 48% of the portfolio allocated to stocks, 32% allocated to bonds, and the remaining 20% shifting as determined by a rules-based, trend-following methodology. Such a strategy would have generated annualized returns of 10.2%, with an SR of 0.68.
In the authors’ empirical analysis, risk parity provided the best returns on both absolute and risk-adjusted bases, but the worst performer – “60/40” with collars – actually had the lowest volatility, with a standard deviation (“STD”) of 7.5%. By contrast, “60/40” with no collars had an STD of 9.5%, and the three indirect approaches had STDs ranging from 8.3% to 11.2%, for the period under review.
But what about how each strategy performed under times of particular market stress? The paper looks at several such events, ranging from the Crash of ’87 to the Financial Crisis of 2007-09.
For more information, visit aqr.com to download a pdf copy of the white paper.