As many investors have benefited from rising equity markets over the last few years, they have often looked to protect those gains and to protect against further volatility. The recent equity market turmoil (i.e. the significant declines in Q4 2018 and recovery in January), has highlighted the importance of risk management, and more specifically, of risk-reduction programmes as part of investors’ overall investment strategy.
Equity exposure is often the largest risk in institutional investors’ portfolios. Over the last 18 months, we have seen investors adopt a variety of strategies, including the very popular option-based approaches, taking advantage of lower implied volatility and high equity index values. Doing so has allowed investors to keep to their longer term strategic objectives and maintain their long equity exposure, while protecting their portfolio from the more immediate threats posed by the market. In many cases, the term of the protection purchased was matched with a strategic milestone. For example, one might take steps to protect a pension fund against declining equity markets up until the next actuarial valuation date.
Although option-based strategies have been popular of late, there are a variety of approaches that investors can use to achieve the goal of reducing equity risk. In this article, we will discuss the main risk-reduction strategies for minimising exposure to equity markets.
Investors should weigh the importance of different criteria in formulating their risk-reducing plans, in the first instance. Here are some to consider:-
While each investor will have its own risk profile, the various approaches below all necessitate the flexibility to short, or use derivatives, either directly trading or indirectly, through allocating to funds.
There are three broad risk-reduction categories: explicit protection, contingent strategies, and diversifying strategies. There is generally an inverse relationship between the predictability of the protection characteristics and the cost of carry. This is described in turn for each strategy below.
In aggregate, the above strategies tend to have a positive convexity profile as a by-product of their investment approach and this helps contribute to overall portfolio protection.
A successful search and implementation programme should take into account several aspects which vary for each investor. After a holistic review of the investment considerations, above, it is useful to determine the acceptable trade-offs from the point of view of the overall distribution. The different properties described above translate to quantitative aspects of mean reduction (i.e. reduced expected returns), upside limitation, or downside protection.
Following a shortlist of providers, it is important to quantitatively assess the overall portfolio together with the proposed risk-reduction allocation. While it is usual to consider the benefits of new investments with reference to their diversification properties, in the case of risk-reduction strategies these complementarity properties are core to the objective of the exercise.
The implementation of a risk-reduction programme is a customised exercise which is dependent on each investor’s individual requirements and risk tolerance. In many cases, these considerations lead to the design of a risk-reduction strategy that is specifically tailored to complement the original portfolio.
We believe that a tactical approach to reducing risk, in the way described above, is not only very topical, as markets have rallied again since the recent declines presenting another opportunity to execute a strategy at a favourable price, but it is also an important tool in an investor’s arsenal, allowing strategic asset allocation to remain largely intact, while addressing the ever-changing risks present in the market.
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