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Equity Hedging: Practical Applications in a Challenging Environment
Equity Hedging: Practical Applications in a Challenging Environment
By Scott Freemon, Head of Strategy and Risk
Introduction
Complex macro and geopolitical events have made this a challenging environment for investors. Markets have been soaring while valuations and risks keep getting worse. Though investments have had a spectacular decade, the future may be tricky. Risk reduction will be an important consideration, but costs could be prohibitive:
- Return Potential: Few attractive equity replacements when prices are high and yields are low
- Loss Potential: Equity shorts lose money in rising markets
SECOR’s Equity Hedging Strategy (“Equity Hedging”) is tailor-made for this environment:
- Seeks reliable gains in falling equity markets
- Avoids significant losses in rising equity markets
- Controls total cost of hedging
- Combines seamlessly with existing investments
In this note we will discuss four practical examples of how clients have used or are currently using our Equity Hedging strategy.
Overview
Our Equity Hedging strategy has a simple premise: be there when investors need protection and get out of the way when they do. We want to reduce the risks in a bad market and leave the portfolio as-is the rest of the time. We achieve our goal by seeking an asymmetric profile of relatively larger gains in falling markets than we expect to lose in flat and rising markets. The chart on the following page highlights the smooth, convex, defensive profile we strive to maintain.
Equity hedge returns (net-of-fees) versus long-only equity market returns
Full study period from 1997 to 2022
This chart shows our convex, defensive profile during our nearly five-year track record. Each point on the chart represents a day in our return series net-of-fees. For that day we compare the total equity market return during the most recent 90 days with the hedge program return over that same time-period.(1)
While we are often compared to tail hedges and passive structured equity, we are designed to be different.
First, we do not focus on black-swan tail events; there is no need. We strive to protect against significant equity losses (seeking to offset half of an equity drawdown greater than 30%) and will, by extension, naturally perform well in black-swan-type tail events.
Second, we do not look to give away extensive upside – collared equity may be premium neutral, but collars can be extremely expensive over long periods, especially when markets are volatile.
Finally, we strive for equity protection rather than volatility hedging. In our experience, most investors are long equity, but few can point to short volatility as a primary risk. We are always long volatility but as an outcome rather than a goal.
(1) Performance represents actual returns from a representative account through December 31, 2021. Equity Hedging returns were calculated after transaction costs and subtracting fees: management fee of 0.20% on total AUM plus a performance fee of 15% above a 0% return for the total Equity Hedging strategy. Performance reflects the reinvestment of dividends. All returns are expressed as Net Returns on AUM.
(2) “75/25” represents 75% allocated to equity asset classes and 25% to fixed income asset classes. “50/50” represents 50% allocated to equity asset classes and 50% to fixed income asset classes.
(3) SECOR forecasted return assumptions
Four Potential Applications of the Equity Hedging Strategy
Reliable, downside-focused Equity Hedging has multiple applications. For this note, we focus on four recent relevant examples of how Equity Hedging has been used by our clients.
Reliable, downside-focused Equity Hedging has multiple applications. For this note, we focus on four recent relevant examples of how Equity Hedging has been used by our clients.
In the sections that follow we explore each of these ideas in more detail and give real-world examples of each.
Application #1: Policy Enhancement
A key goal of investment planning is to make the tradeoff between risk tolerance and return potential. Investors allocate to risky assets to capture return premium and try to find an allocation that meets return requirements within their risk constraints (most typically their tolerance for losses). The required return and tolerable loss limit are often incompatible, requiring significant compromise. Cost-managed Equity Hedging can significantly change the tradeoffs.
By focusing on loss potential and cost control, Equity Hedging enables investors to build more efficient portfolios from a return vs. drawdown perspective. When equity and Equity Hedging are combined, the resulting Hedged Equity profile has:
- 2/3 the volatility
- Half the crisis drawdown
- Most of the expected return
For the examples that follow, we assume a total cost of hedging (net reduction in return expectations on hedged assets) of 75 bps per annum over a full cycle. This cost incorporates option premium, potential hedge gains, and SECOR’s cost reduction. For comparison, a typical Put Hedge strategy would cost more than 3% per year.
Hedged 75/25 vs. Basic 50/50 (2)
In the example below, we show how Equity Hedging can be used for return enhancement. Adding Equity Hedging and reallocating to Equities increases returns by more than 30 bps while slightly improving loss potential.
This improvement is net of the two main costs of hedging:
- Option premium / insurance cost: 75 bps
- Collateral requirements: 10% of notional hedge maintained as cash
Case Study: A large US Defined Benefit Pension with a poor funding position and a cash-constrained sponsor needed to earn high returns and maintain and recover their funding position, but absolutely could not tolerate surprise deficit recovery contributions. To protect against losses, this client was heavily allocated to cash and had the bulk of their return-seeking investments in defensive hedge fund managers.
We worked with this client to add Equity Hedging and move to a more return focused asset mix. Having protection could help convert defensive hedge fund managers to long-only managers with higher return potential. The reduction in (2-and-20) fees they were paying for active defense was far more than the 75 bps cost of hedging.
We hoped that these changes would allow the client to improve performance versus peers, reduce their funded status deficit, and place them on the path to de-risking the plan.
(2) “75/25” represents 75% allocated to equity asset classes and 25% to fixed income asset classes. “50/50” represents 50% allocated to equity asset classes and 50% to fixed income asset classes.
(3) SECOR forecasted return assumptions
Application #2: Enhanced De-Risking
Downside-focused de-risking using Equity Hedging can be significantly more tolerable than traditional de-risking. Investors can potentially see significantly reduced loss potential while maintaining return targets, upside potential, and existing physical asset allocations.
This less-disruptive, asymmetric de-risking can be an extremely powerful alternative to traditional de-risking for:
- Investors with a view that equities have had their run and are due for a crash
- Liability-sensitive investors (like defined benefit pensions) seeking to implement the next step in their glide path
- Anyone seeking to de-risk their portfolio to lock in strong capital base or funded status
Below is an example of using Equity Hedging to reduce risk. By allocating 3% of cash and 30% notional protection, we are able to match the loss reduction of a 25% traditional asset reallocation but with a 40 bps return advantage.
Case Study: Large UK DB Pension Scheme completed their actuarial valuation process and realized they were better funded than they had previously thought. Their funding level was suddenly at a point where de-risking was required. Markets had been volatile and geopolitical events had become increasingly scary. Strategy changes required agreement across multiple stakeholders and usually took a year or more to analyze and approve.
Rather than scramble to design and approve a new Pension Glide Path, this client worked with us to de-risk using a mix of Equity Hedging and LDI overlays. Because the new hedges fit on top of the existing asset allocation and the return drag was minimal, the alternative de-risking approach was approved within a week. The client sought to achieve the same protection as they would have sought from traditional de-risking with a significantly higher return and more upside.
Application #3: Illiquid Asset Hedging
Private Equity is in the middle of a spectacular run and distributions continue to be slow. Many of our clients are now struggling to figure out what to do with their resulting overweight positions in Private Equity.
As illiquid allocations rise, the overweight position causes two problems:
- Illiquid investments begin to dominate the risk profile of an asset mix
- Illiquid investments are likely to become even larger allocations in the future
Most Private Assets cannot be sold without a steep penalty. This can be a nuisance for investors trying to match their strategic policy targets and downright terrifying for investors who have a view that valuations are stretched.
While traditional overlay hedges are generally a good solution for quick rebalancing, they are a logistical nightmare for illiquid assets. For a typical overlay, hedges are paired with liquid investments and then liquid gains offset hedge losses. For illiquid assets, there are no liquid gains. Instead, hedge losses must be covered by a different source of liquidity and can further create liquidity stress.
Our Equity Hedging program is a better solution. Downside-focused hedges are designed to payoff significantly more in falling markets than they can lose in rising markets. As a result, there is much less chance that the hedge would create liquidity stress.
Example Benefits of Equity Hedging in Rising Equity Scenarios: (4)
(4) For illustrative purposes only
Note: Assumes a 1:1 hedge with SECOR Equity Hedging and a 60% hedge with futures.
For a $500 million hedge, our Equity Hedging outperforms a futures overlay by $45 to $95 million.
Case Study: Large top-decile Endowment has seen their Venture Capital portfolio nearly double in value over less than three years. As a result, the endowment is overallocated to equities, China, technology, and Illiquid assets. Distributions have been slow, spending has remained stable, and donations have slowed post-covid. Liquidity is becoming a concern. They reached out to the market about a secondary sale but are only able to reduce their position at a significant discount. They have a futures-based rebalancing program but cannot afford to cover losses on equity futures if equities have another +20% year.
We worked with them to develop a custom Equity Hedging program tailored to their Venture portfolio. Rather than a traditional global equity benchmark, we focused on NASDAQ-100 index options as our benchmark. To address their China concerns, we found additional opportunities in single name put-spread collar hedges. They were able to hedge going into the late 2021 tech decline seeking protection from market downturns.
Application #4: Tactical Underweight
While many of our clients have a negative outlook for equities, most are reluctant to take a negative position in a market that rises year after year. Investors often lose more by being right and early than they do by being wrong. The combined impact of inflation, valuations, and turmoil has created significant volatility but little in the way of repricing – for now.
Predicting market direction is difficult. Getting the timing right is nearly impossible. Our Equity Hedging is designed to take a negative position in equities without the need to guess.
- Protection behaves like an underweight in falling markets
- Limited loss potential protects our clients in the case of continued rallies
- Cost control creates staying power to hold the position
Below is a graphical comparison of the return on notional between a short equity position taken using futures and one taken using Equity Hedging. We estimate the response profile of the SECOR hedge using options struck at 90% of market levels and an upside equity beta consistent with history.
In this example, the futures hedge can lose more than four times as much in a 20% market rally.
Note: Assumes a 1:1 hedge with SECOR Equity Hedging and a 60% hedge with futures. (5)
(5) Source: SECOR Analytics, Optionmetrics
Case Study 1: In 2013, Europe was in the middle of a significant crisis and global equities were priced for a disaster, making equity attractive in any scenario where the EU remained in place and the banking system remained solvent. Our client paired an equity overweight with Equity Hedging seeking to capture the significant value if equity markets rallied and protect against losses in the event the crisis worsened.
Case Study 2: Markets began to rally after the 2016 election and by mid-2017 were looking expensive. Our client wanted to take a tactical position against the long run prospect for equities but was reluctant to underweight physical equities or sell futures in a market that was rising so steadily. We worked with this client seeking to add Equity Hedging in the place of a tactical short position and to be well-hedged through a steady assault of macro issues: Brexit, the late 2018 taper tantrum, and COVID-19.
Conclusion
In many ways, this appears to be an ideal environment for our Equity Hedging strategy:
- Risks are high, making protection worthwhile
- Markets continue rising, making asymmetry valuable
- Return expectations are terrible and conventional hedges are expensive, making creative management and cost control essential
We have discussed four common uses of our strategy in this note, but these are just examples. A strategy that helps investors protect against asset losses when needed without disrupting the existing allocation is a valuable tool that we think has a role in every institutional investor’s toolkit.
Disclosures
Except where otherwise indicated, the information contained in this presentation is based on matters as they exist as of the date of preparation of such material and not as of the date of distribution or any future date. This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make its own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting or other material considerations. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, they are encouraged to consult with the professional advisor of their choosing, and recipients should not rely on this material in making any future investment decision.
We do not represent that the information contained herein is accurate or complete, and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. Certain information contained herein (including any forward-looking statements and economic and market information) has been obtained from published sources and/or prepared by third parties and in certain cases has not been updated through the date hereof. While such sources are believed to be reliable, SECOR does not assume any responsibility for the accuracy or completeness of such information. SECOR does not undertake any obligation to update the information contained herein as of any future date.
Any illustrative models or investments presented in this document are based on a number of assumptions and are presented only for the limited purpose of providing a sample illustration. Any sample illustration is inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond SECOR’s control. Any sample illustration may not be reflective of any actual investment purchased, sold, or recommended for investment by SECOR and are not intended to represent the performance of any investment made in the past or to be made in the future by any portfolio managed or advised by SECOR. Actual returns may have no correlation with the sample illustration presented herein, and the sample illustration is not necessarily indicative of an investment that SECOR will make. It should not be assumed that SECOR’s investment recommendations in the future will accomplish its goals or will equal the illustration provided herein.
The statements in this presentation, including statements in the present tense, may contain projections or forward-looking statements regarding future events, targets, intentions or expectations. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. Past performance is no guarantee of future results. Investments are subject to risk, including the possible loss of principal. There is no guarantee that projected returns or risk assumptions will be realized or that an investment strategy will be successful. No representation, warranty or undertaking is made as to the reasonableness of the assumptions made herein or that all assumptions made herein have been stated. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this document, will be profitable, equal any corresponding indicated performance level(s), or be suitable for your portfolio.
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Monetizing Nasdaq-100® Tail Hedges
Monetizing Nasdaq-100® Tail Hedges
Testing the Effectiveness of Implied Volatility Signals
Study Summary
We explore the effects of an implied volatility based monetization scheme on a laddered put strategy on the Nasdaq-100 Index (NDX). The strategy holds 1, 2, and 3 month put options on NDX struck 20% out of the money. We purchase new 3 month puts at each third Friday expiry, spending 10bps per month (1.2% annually) of a total portfolio notional. We also analyze performance with a joint long position in NDX to demonstrate the value of systematic monetization of options contracts to lock in gains from adverse market events. Specifically, when a monetization event occurs, proceeds from the sale of puts are stored in an interest bearing cash account until the next roll day when proceeds are invested firstly into a new 3 month put and the remainder into NDX. Implied volatility is referenced as the 50 delta 1 year implied volatility and the 50 delta 1 month implied volatility. The study period ranges from January 1st, 1997 to February 15th, 2022.
In this study, we monetize one third of the options position if the 1 year implied volatility surpasses a 35% threshold and sell the remaining two thirds of the position if 1 month implied volatility surges past a 70% threshold.
Results
We found that there was a significant benefit to including an implied volatility based monetization scheme in reducing impact from market drawdowns. In our study, monetization served as an effective mechanism to capture gains from adverse market events. We found that the monetized strategy reduced annual volatility by 115bps while returns were reduced by only 2bps. By contrast, the unmonetized strategy was effective in reducing risk, but with significant cost as annual returns were lowered by 52bps.
As a standalone overlay (i.e. not including the underlying asset), the monetized strategy outperformed the unmonetized version on a cumulative basis. The unmonetized strategy realized cumulative returns of 16.78% while the monetized strategy realized cumulative returns of 8.77%. The maximum 1 month return of the monetized strategy was 6.26% vs. only 1.89% in the unmonetized strategy.
Summary Performance Metrics
Full study period from 1997 to 2022
Historical and simulated index performance is not necessarily indicative of future results. The information provided in this document does not constitute investment advice. Volos is not an investment advisor. Volos and its affiliates accept no responsibility whatsoever for any loss or damage of any kind arising out of the use of any part of the company products or the information contained therein.
© Copyright 2022. All rights reserved. Nasdaq is a registered trademark of Nasdaq, Inc. 1473-Q22
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Gaining Momentum: Where Next for Trend-Following?
Gaining Momentum: Where Next for Trend-Following?
We investigate trend-following’s strong performance in the first five months of 2022 and, more importantly, what we might expect going forward given current macro-economic themes.
For institutional investor, qualified investor and investment professional use only. Not for retail public distribution
But is trend- following’s recent positive performance just predicated on continued worries around inflation?
1. Introduction
Trend-following indices, such as the SG Trend and Barclay BTOP50, have posted their best year-to-end-May returns since 20001, against a backdrop of poor performance from traditional asset classes such as equities and bonds. This should not come as a surprise: after all, we are seeing the presence of strong trends in futures markets which are sensitive to macro-economic themes such as inflation. We also note that, in contrast to recent history, this performance alongside weak equity markets has occurred, and even been supported by, simultaneous weakness in fixed income markets.
But is trend-following’s recent positive performance just predicated on continued worries around inflation? Or are there further prospects that could act as additional opportunities for the strategy this year?
2. Trend-Following: The Alternatives Strategy du Jour
Trend-following strategies have had an outstanding 2022 so far, outperforming not only traditional asset classes like stocks and bonds, but also hedge funds in general (Figure 1). In fact, both the SG Trend and Barclay BTOP50 indices, which include trend-following managers, have posted their best year-to-end-May returns since 2000.
Figure 1. 2022 Returns of Various Traditional and Alternative Investments
Source: Man Group, Bloomberg, MSCI, BarclayHedge; as of 31 May 2022. HFRI data to 30 April 2022.
Note: World bonds represented by Barclays Capital Global Aggregate Bond Index Hedged USD. World stocks represented by MSCI World Net Total Return Index Hedged USD.
We have written extensively about trend-following’s persuasive credentials during inflationary periods and equity crises. As such, with inflation’s return and weak equity markets this year, it is perhaps not too big a surprise that trends are back in vogue.
What we have found in 2022 is that for the first five months at least, simple is best: pure trend strategies trading the largest futures markets have been the star performers.
3. Features of Trend-Following’s Performance This Year
As Figure 1 shows, the SG Trend and Barclay BTOP50 indices returned 26% and 16%, respectively, as of the end of May. Both of these indices contain trend-following managers, and have outperformed not only traditional asset classes like stocks and bonds, but also hedge funds in general.
The outperformance of trend-followers over traditional assets and hedge funds can possibly be explained by the number of constituents in the indices. The BTOP50 and SG Trend indices have 20 and 10 constituents, respectively, which suggests there is considerable dispersion between trend-following managers in 2022. This could be down to various factors – risk targets, market allocations, models and trading speed, etc. – which are hard to quantify without detailed knowledge of how managers trade.
At Man AHL, however, we are fortunate to be running multiple trend-following programmes, spanning the full spectrum of markets, models and risk budgets, so we are potentially in a good position to isolate the real drivers of performance. We discuss some of these, using our own experience, in more detail below.
3.1. Traditional Trumps Non-Traditional in 2022
What we have found in 2022 is that for the first five months at least, simple is best: pure trend strategies trading the largest futures markets have been the star performers. In a sense, this is intuitive. Macro-economic themes are driving markets, in our view; inflation, central bank activity, war, supply chain disruption, de-globalisation and post- pandemic recovery, to name but a few. They are all interlinked, of course, but these are macro trends which are best observed in macro-sensitive instruments such as futures on global markets, be they country-level equity indices, government bonds or the largest of the world’s commodities. These are the traditional fayre of CTA trend-followers. What are now called ‘non-traditional’ or ‘alternative market’ trend-followers generally boast a wider range of price drivers and better diversification through trading a broad range of typically over-the-counter (‘OTC’) markets such as emerging market interest-rate swaps or European hydro-electric power markets.
When trends are concentrated in certain markets at a given point in time, it stands to reason that the more concentrated the trend-follower is in these markets, the better performance is likely to be at that time. And this is the case at the moment; traditional trend-following (futures markets) has broadly outperformed non-traditional trend-following (mostly OTC markets).
3.2. Traditional Trend Works Better in Crisis Periods
In the long term, we believe diversification is the key feature in designing robust trend- following strategies. Figure 2 shows how an alternative markets trend-following strategy – with its greater diversification – outperforms a simulated futures/FX trend one. This is particularly true in the non-crisis periods. However, it is not the case for crisis periods such as the Global Financial Crisis of 2008 and the coronacrisis of 2020.
Figure 2. Alternative Market Versus Traditional Trend-Following: Performance in Crisis and Non-Crisis Periods
Source: Man Group, Bloomberg, Société Générale, BarclayHedge; between 1 September 2005 and 31 May 2022.
Simulated past performance is not indicative of future results. Returns may increase or decrease as a result of currency fluctuations.Please see the important information linked at the end of this document for additional information on hypothetical results.
Note: Data normalised to same volatility as world stocks (14%). World stocks represented by MSCI World Net Total Return Index Hedged USD. Alternative trend results are from a strategy which trades predominantly OTC markets. Futures/FX trend results are based on strategies trading predominantly futures/FX markets.
Can it be true that diversification is less effective in a crisis?
Can it be true that diversification is less effective in a crisis? Again, we would fall back on intuition to explain this. ‘Crisis’ typically relates to developed markets, most often equities. News of a crisis in European hydro-electricity rarely makes the headlines or ripples through financial markets. In this case, we believe it stands to reason that global futures markets should be the instruments of choice for a trend-follower if an investor seeks a crisis hedge.
3.3. Trend-Followers Make Money… in Down Markets… From Short Bonds?
It has long been alleged that trend-following’s ‘crisis alpha’ credentials stem from long bond positions. This is understandable:
- The longest-lived trend-following managers have been around for four decades, during which time yields have been in secular decline, so trend-followers should have been mostly long bonds;
- In a crisis, for which we infer a crisis in risk assets, there is often a flight-to-quality of bonds – particularly high quality government bonds.
Using simulations with data back to 1970s – the last time we saw sustained inflation and rising rates – we showed that ‘crisis alpha’ applied to bonds as well as equities.
The Barclays Capital Global-Aggregate Bond index (USD hedged) has lost 7.7% in the first five months of the year, and is in a drawdown of around 9%. This sounds bad, but in the context of history – looking back three decades – this is almost twice as bad as the 1995 drawdown, and around three times historic volatility. In fact, 2022 represents a bond rout and gives us the first ‘real world’ opportunity to see whether our ‘crisis alpha’ research holds in reality.
The results for a trend-following portfolio consisting of both futures/FX and alternative markets are shown in Figure 3. What we find is that bond attributions are positive in crisis periods, and result from long bond exposure. The notable exception is 2022, where a positive bond attribution has resulted from short bond exposure in aggregate.
Figure 3. Gross Bond Attribution and Net Bond Exposure During Crises
Source: Man Group database.
Simulated past performance is not indicative of future results. Returns may increase or decrease as a result of currency fluctuations. Please see the important information linked at the end of this document for additional information on hypothetical results.
We make two points: (1) trend-following is an all-weather inflation performer; and (2) it is a strategy for volatile environments.
4. The Outlook for Trend
History is one thing, but to quote the first rule of Italian driving: “What’s-a behind me is not important.”2 What is ahead is what matters, and for this we lean on an article written by our colleagues at Man Group: ‘Inflation Can Go Down as Well as Up’. We make two points: (1) trend-following is an all-weather inflation performer; and (2) it is a strategy for volatile environments.
4.1. Trend-Following: An All-Weather Inflation Performer
Figure 4 reproduces a chart from Inflation Can Go Down as Well as Up, showing that trend-following is not only a robust performer in inflationary periods in general, but also in the last six months of the episode, as well as in the 6- and 12-month timeframes following inflation’s peak.
Figure 4. Annualised Real Returns for Inflation Regimes (1926 to Present)
Source: Equities are the S&P 500 using Professor Shiller’s data. UST10 is from GFD. 60/40 is the monthly rebalanced 60% equity, 40% bonds portfolio. Commodities are proxied by an equal weight portfolio of all futures contracts as they appear through history. From 1926 to 1946 this is based off work done by AQR. From 1946 we use returns from the Man AHL database. Styles are the Fama-French portfolios (Mom., Value (HML) and Size (SMB)), and AQR (QMJ) for Quality. TIPS prior to 1997 based off a backcast by William Marshall at Goldman Sachs, otherwise Bloomberg. HY portfolio constructed by the Man DNA team, using data provided by Morgan Stanley; as of 28 April 2022.
Figure 4 also tells us that by using a trend-following strategy, we don’t need to be able to predict when an inflationary period may peak or end. Intuitively, this is because given sufficient time, trend-following strategies are likely to adopt the market direction, whether it be long commodities, short bonds and equities in inflationary periods or the other way around after inflationary peaks.
At its heart, trend- following is an intuitive strategy; it should do well when markets move a lot, as they often do in inflationary environments
4.2. Trend-Following: A Strategy for Volatile Environments
In Inflation Can Go Down as Well as Up, the authors conclude their note with “Higher inflation = more volatility. We should all get used to it.” Whether this is a recommendation or a threat is in the eye of the reader.
Trend-following’s ‘long volatility’ characteristics have been noted for several decades (see for example Fung and Hsieh, 1997), and will be the subject of a future note, so we will not dwell on this here. From a trend-follower’s point of view, however, it translates the conclusion from the above article as an opportunity.
2. Raul Julia as ‘Franco’ in The Gumball Rally (1976) www.youtube.com/watch?v=hVp7FbLpVSU
5. Conclusion
We have used the words ‘intuitive’ or derivative thereof three times – hopefully a surprise to our reader who has persevered to get here since we don’t want to labour the point. But it is important.
At its heart, trend-following is an intuitive strategy; it should do well when markets move a lot, as they often do in inflationary environments. History shows that trend- following can potentially do well after a period of inflation too.
Further, if an investor wants to tune a trend-following strategy to a crisis, and that crisis is in macro-economies, we believe instruments that are sensitive to the macro- economy should be used. If the aim is to upset a systematic trader, describe their strategies as ‘black box’. The term suggests mystery, or some kind of magic. In our view, the robust and intuitive performance of trend-following so far in 2022 has been anything but.
Bibliography
Neville, H., T. Draaisma, B. Funnell, C. Harvey, and O. Van Hemert, “The Best Strategies For Inflationary Times”, March 2021. Available at SSRN: https://papers.ssrn. com/sol3/papers.cfm?abstract_id=3813202
Harvey, C. R., E. Hoyle, S. Rattray, M. Sargaison, D. Taylor, and O. Van Hemert “The Best of Strategies for the Worst of Times: Can Portfolios Be Crisis Proofed?”. July 2019 Journal of Portfolio Management, Volume 45, number 5. Available at https://www.man.com/maninstitute/best-of-strategies-for-the-worst-of-times
Hamill, C., S. Rattray, and O. Van Hemert, “Trend Following: Equity and Bond Crisis Alpha” (August 30, 2016). Available at SSRN: https://ssrn.com/abstract=2831926
Draaisma, T., and H. Neville (2022); “Inflation can go down as well as up”; https://www.man.com/maninstitute/road-ahead-inflation-up-down
Fung, W., and D. Hsieh, “Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds”, The Review of Financial Sturides, 2, 275-302.
We have written extensively about trend-following’s persuasive credentials during inflationary periods and equity crises. As such, with inflation’s return and weak equity markets this year, it is perhaps not too big a surprise that trends are back in vogue.
Author: Graham Robertson, DPhil
Graham Robertson is a partner and Head of Client Portfolio Management at Man AHL and is a member of the investment and management committees. He has overall responsibility for client communication across Man AHL’s range of quantitative strategies. Prior to joining Man AHL in 2011, Graham developed capital structure arbitrage strategies at KBC Alternative Investment Management and equity derivative relative value models for Vicis Capital. He started his career at Credit Suisse in fixed income before moving to Commerzbank, where he established the relative value team and subsequently became Head of Credit Strategy. Graham holds a DPhil from the University of Oxford in Seismology and a BSc in Geophysics from the University of Edinburgh.
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The Anatomy Of The Sell-Off
The Anatomy of the Sell-Off
GLADIUS SOLUTIONS - VOLATILITY VIEWS | Q3 2022
The manner and dynamics which a market exhibits as it moves to the downside can be one of the most insightful pieces of information for investment professionals. Selloffs come in all shapes and sizes and while many can feel traumatic, they often exhibit vastly different characteristics. As volatility professionals, we are equally focused on both the speed and magnitude of market movement during selloff periods. When stocks fall with chaotic volatility far above the expectations of the market, dramatic increases in risk parameters like implied volatility and what we call “implied volatility skew” occur. On the other hand, when markets fall in a rational and orderly fashion, we typically see those risk parameters fall and underperform expectations. Many times, it can feel like an incongruous relationship between the level of angst felt by investors and the actual manifestation of a market correction. This was exactly the case for the first half of this year.
It’s been hard to find investors who are bullish during 2022. The macro backdrop feels particularly poor with soaring out of control inflation, quantitative tightening looming (something we think will be a strong catalyst for market volatility in the second half of the year), a potential recession on the horizon, and of course the Russian invasion of Ukraine. Since the start of the year, global equity markets have been under pressure. The SP500 has fallen 20.6% YTD (as of 6/30/22) and its average realized volatility, a measure of the speed at which it moves, has almost doubled – from 13.8 to 24.9. Interestingly, other equity capital markets have exhibited a remarkable correlation between their rise in realized volatility and their place in the global tightening cycle. The US has experienced the largest percentage rise in equity volatility, 80%, followed by Europe, 50%, and lastly Japan, still in full accommodative monetary policy mode, at 20%.
Despite the large rise in equity realized volatility in the SP500, downside equity options proved to be highly overpriced during the first half of the year. Here is a graph of what we call two-month implied skew, illustrated as the implied volatility differential between the 25 delta Put and the 25 delta Call, expressed as a fraction of the at the money volatility:
2 Month Implied Skew Graph
Source: Gladius proprietary and Bloomberg
The graph measures the difference in implied volatility between downside puts and upside options. We select two-month options as barometer because it’s a commonly used maturity for liquid hedges while being free of any effects arising from longer dated structured products. We can see the level of implied skew collapsed during the market selloff in the first half to multi-year lows. This meant that the implied volatility of puts relative to upside calls moved sharply lower despite the markets falling over 20%.
Why did this occur? The most likely reason in our view is that following so many years of strong equity gains, the violence of the drop in equity markets, other than a few days, was simply not sufficient to induce any panic among equity investors. The selloff was quite organized in nature and seemed to promote an almost accepted indifference from long equity holders.
The movements we witnessed in equity implied volatilities mean that any strategies which were net sellers of tail risk have had a very good year so far. As an example, here is a graph of a systematic short-tail risk strategy. This strategy extracts the implied volatility skew risk premium by selling downside puts and buying upside calls in a delta neutral (market neutral) fashion, and we can see the performance of the strategy for H1 2022 was the best period over the last several years. That fact speaks to the almost unprecedented lack of reactivity of downside options on the SP500. The muted behavior of out of the money puts on the SP500 was a significant deviation well outside normal expectations.
Short Skew Performance Graph
Source: Gladius proprietary and Bloomberg
Looking Ahead:
If one had been a prudent equity investor during H1 and utilized short-dated options as part of a hedging program, there was little tangible benefit in doing so this year. Here is a graph of a systematic strategy which monthly buys 5% out of the money puts while holding SP500 long futures:
Performance SPX vs PPUT
Source: Gladius proprietary and Bloomberg
As we can see, the returns are almost identical to those of the outright SP500 index meaning there was little added value to hedging so far this year. The salient question is whether this is expected to continue for the second half of the year.
We are not venturing whether a second major market correction will occur in 2022, but we postulate that if one occurs, it’s likely to be significantly different than what we saw in H1. We believe the next time the market breaks the previous lows there will be a much higher degree of violence and turmoil complete with significantly higher correlation and volatility. Our reasons for this are based on a couple of thoughts:
- When Quantitative Tightening fully kicks offs, the liquidity removal from the market can cause a drastic fragmentation of risk capacity which should serve as a strong catalyst for We have decades of accommodative policy to unwind.
- The equity risk premium has not really moved significantly at all since the start of the year even with the backdrop of falling earnings. We think this has room to expand to levels more commensurate with a meaningful market correction.
- Structural dampening effects on longer dated implied volatility are likely to be lower given the slowdown of issuance in retail products
- Traditional rebalancing programs which normally provide a strong bid to equities in falling markets may not do so this time on account of inflation-driven fixed income movements and new asset allocation parameters (more on this in a following piece).
- Within the equity volatility world, short risk strategies like dispersion (short implied-correlation) and short index implied skew (short tail-risk) enjoyed near unprecedented levels of success during the first half of the year. We don’t think this is likely to repeat in the case of another market downturn.
We therefore advocate a highly vigilant stance and even though hedging and convexity programs have not been necessarily fruitful so far this year, we believe they have a strong role to play in the upcoming months. The significant collapse of implied volatility on SP500 skew presents a unique opportunity for those investors seeking to protect their portfolios and we believe it should be availed.
If you have any comments or questions please let us know. We would be delighted to have call to discuss further.
Sincerely,
The Gladius Team | [email protected]
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