Quantitative strategy

Beyond diversification: tail-risk hedging

06 March 2022

10 minute read

By Lukas Gehrig, Zurich, Switzerland, Quantitative Strategist and Nikola Vasiljevic, Zurich, Switzerland, Head of Quantitative Strategy

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  • Summary
    • Macro uncertainty remains high, thanks to rising inflationary pressures and the prospect of an imminent US rate hiking cycle, highlighting the need to build portfolio resilience
    • In addition to portfolio diversification, tail risk hedging strategies can help investors shelter their portfolios from further stock market declines
    • Put option overlay strategies can provide direct hedging benefits, but implementing them systematically can be expensive, especially during down markets when demand is high
    • Investors face a steep risk-return trade-off when buying protection against equity market dips. For some, a targeted approach to hedging may be more appropriate  
  • Full article

    Persistent upward inflationary pressures, a nearing US rate-hiking cycle, as well as medical and geopolitical risks add to the risk of slower economic growth or an equity market sell-off. Staying nimble, being diversified, and considering tail-risk hedging may be the key for portfolio resilience in coming months.

    Financial markets have been particularly volatile this year. As inflation continues to surprise, reaching the highest annual level since 1982 in the US, leading central banks are more focused on rate hikes than on defending their initial “transitory” narrative. 

    One of the main questions ahead of monetary tightening is how well will equities perform when rates are rising? 

    Historically, equities usually underperform in the first couple of months following the initial rate hike. However, they tend to build up resilience during the hiking cycle and ultimately perform relatively well thereafter (see February’s Market Perspectives).

    Macro uncertainty flares up

    Inflation uncertainty and the risk of over-aggressive policy tightening are among the main concerns on investors’ minds. Coupled with heightened medical and political risks, they raise doubts over the strength of future growth. This is echoed in the US economic policy uncertainty (EPU) index hitting its highest level in December 2021 (see chart).

    Macro uncertainty flares up.

    Even though policy uncertainty has abated somewhat this year, it has remained elevated largely due to inflation-driven uncertainty around US monetary policy, and may climb again on current geopolitical events.

    Asset pricing theory suggests that some of these effects should already be priced in, due to market efficiency. Although the US EPU index is not a predictor of financial crises, its largest spikes occurred in 2001, 2008, and 2020, during equity sell-offs, and acted as harbingers of further downside risk.

    Even though policy uncertainty has abated somewhat this year, it has remained elevated largely due to inflation-driven uncertainty around US monetary policy, and may climb again on current geopolitical events.

    Asset pricing theory suggests that some of these effects should already be priced in, due to market efficiency. Although the US EPU index is not a predictor of financial crises, its largest spikes occurred in 2001, 2008, and 2020, during equity sell-offs, and acted as harbingers of further downside risk.

    Heightened uncertainty calls for prudence 

    The macro picture and outlook for equities remain positive in our view, as economies prepare to shift from pandemic to endemic, as COVID-19 comes under more control, and global markets reintegrate. 

    That said, we acknowledge that a risk-off regime may last for a while, before macro uncertainty is resolved and equities rebound. As such, it may be time to consider hedging strategies that can mitigate the impact of potentially adverse, extreme market moves. 

    In a typical balanced portfolio, equities represent the key growth driver. The flipside is that they expose investors to both volatility and potential losses. Cautious investors seeking protection against equity drawdowns have three powerful tools at their disposal – strategic diversification, tactical diversification, and tail-risk hedging strategies.

    Diversification for the long run 

    The first line of defence for any portfolio is diversification through a structured and diligent investment process. Crafting a well-diversified portfolio is a key tenet for investment success and growing wealth over the long term. 

    Our strategic asset allocation (SAA) is the bedrock of our investment process, and it represents the optimal long-term positioning in a range of asset classes. The SAA design is guided by our investment philosophy, which revolves around the principles of long-term investing, wealth preservation, international multi-asset class diversification, and optimal risk-return trade-off.

    Spreading capital across different asset classes can help investors to navigating risks and keep portfolio volatility under control. For example, developed government bonds may earn stable and secure income, and typically provide protection when equities tank. Meanwhile, commodities and other real assets usually offer a hedge against rising inflation. 

    Hedge funds generate returns using dynamic trading strategies by leveraging exposures to equities and fixed income, often by the means of long-short strategies and derivatives. They can stabilise portfolio returns, and provide significant diversification benefits on average. Last, but not least, investors able to accept some portfolio illiquidity, can find return and diversification opportunities in a range of private markets. 

    Attenuating cyclical swings

    Getting the long-term asset allocation policy right is important for successful investing. To achieve that goal, the SAA should reflect the baseline, most likely a forward-looking scenario which blends various macro-financial conditions over business cycles. As such, the SAA represents an optimal portfolio mix for a disciplined long-term investor capable of looking past intermittent market volatility. 

    Cyclical market gyrations and bouts of elevated uncertainty can result in portfolio losses. A tactical asset allocation (TAA) and security selection process is therefore critical to generate alpha and shelter portfolios in downward-trending equity markets over shorter horizons (three-12 months). 

    TAA decisions alter the optimal long-term asset allocation mix to better align portfolios with medium-term economic scenarios. During periods of market stress, tactical shifts are necessary to reduce exposure to risky assets. For example, reallocating to defensive and low-beta equities. Credit risk can be reduced by moving exposure from lower- to higher-credit quality. On a cross-asset basis, increasing allocation to safe-haven assets, like government bonds, gold, the US dollar, and Japanese yen, usually provides portfolio protection. 

    It is important to recognise that there is no universal recipe for an optimal TAA. As discussed previously, equity drawdowns substantially differ in nature. It is necessary to explore, and understand, the potential impact of various macro-financial factors on equity sell-offs. However, this does not diminish the importance of the TAA as the second line of defence in a portfolio.  

    When it rains, it pours 

    In fast-paced markets, extreme moves can occur quickly. Moreover, when a crisis hits, large negative jumps in asset prices tend to cluster, resulting in equity market drawdowns of 40-50%. During such meltdowns, volatilities and correlations rise sharply, and liquidity dries up. At that point, many investors may look for protection beyond the diversification benefits offered by the SAA and TAA.

    Tail risk hedges, such as buying put options on the underlying (for instance, a stock market index that represents a benchmark for the equity exposure in the portfolio), are perceived as a holy grail during market corrections and crisis periods. Such hedges provide the third line of defence in a portfolio, and the ultimate protection of wealth.

    The demand for tail risk hedges often peaks when the market is selling off, which causes a sharp increase in their prices. Downside protection becomes prohibitively expensive precisely when investors need it the most. 

    This is understandable as systematic hedging with put options – a strategy which would provide a protection against the tail risk at all times – is rather expensive. For example, a hypothetical strategy that buys and rolls at expiration one-month at-the-money (ATM) puts on S&P 500 would have incurred an average cost of about 6.4% annually over the last two decades (see chart).


    However, safe-haven assets can disappoint as well. Changing macroeconomic conditions may impact correlations, possibly diminishing their protective power. Moreover, safe-haven assets usually provide low income and represent a drag on performance over longer investment horizons. As such, there is a trade-off between portfolio return and risk.

    It’s all about convexity

    The key to unlocking effective tail risk hedges is to reduce the exposure to downside risk, but also to limit the hedging costs. Ideally, a hedging programme should generate more money when a risk scenario realises than they lose otherwise. Therefore, the best candidates for tail risk protection are assets and strategies that produce convex pay-offs.

    Our quantitative analysis indicates that cash, US Treasuries, and our protective put overlay strategy have provided most consistent protection during the quarters when the S&P 500 plummeted more than 10%. Gold, macro hedge funds, and the JPYAUD exchange rate have also posted positive returns on average in these periods, but doing so more infrequently (see chart).


    Based on these results, it is tempting to conclude that the protective put overlay is the best tail risk hedge. However, this would be the wrong conclusion to reach, not least due to the following two reasons.

    First, the average annual performance of this strategy since 2000 (including all market regimes) is negative. In fact, it has the worst long-term performer among the seven strategies covered. 

    Second, if we abandon the idea of a systematic implementation of the protective put overlay, then the performance during equity down markets would be worse than shown in the chart. Such performance during stressed periods is possible only if we have a systematic hedging programme, or if the timing of the purchase is perfect (or just before the equity correction starts).  

    When protection becomes erosion

    To understand better the impact of investment horizon on the performance of the hypothetical put protection overlay, we calculated the strategy’s distribution of returns, since 2000, for holding periods ranging from one to ten years (see chart).

    The average return is negative, ranging from -6.4% to -7.3%, worsening as the holding period increases. Moreover, beyond the four-year investment horizon, systematic buying and rolling of one-month ATM S&P 500 puts has never delivered positive returns. The short end of the “performance curve” offers some hope, however the dispersion of returns is extremely high.


    Is tail-risk hedging illusive?

    Put options are designed to provide a direct hedge of the underlying asset or strategy. In practice, they can be prohibitively expensive, especially if used systematically. However, tail risk hedging with options is an attractive approach when implemented as a targeted strategy. 

    Admittedly, our analysis merely scratches the surface of an important topic. For example, one could study the optimal selection of “moneyness” and maturity for put options. Option strategies, such as put spreads and collars, call options on volatility indices, and credit default swaps, are also good candidates for tail-risk hedging.

    The key takeaway is that investors often face a steep risk-return trade-off when buying protection against equity market dips. This highlights the importance of a well-diversified portfolio along a strategic asset allocation with some tactical shifts in the first place.

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Market Perspectives March 2022

Welcome to the March edition of "Market Perspectives", the monthly investment strategy update from Barclays Private Bank. In this month’s report, we look at just how likely a recession might be, and what it could mean for equities, bonds, and other asset classes.

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