Equity market peaks (and troughs) are impossible to identify in advance. But this doesn’t mean that equity investments should simply be “set it and forget it.” At times when stock markets seem fully valued, like today, investors may look to protect some of those gains, either by de-risking their portfolios or by adding diversifying strategies to their asset allocation. And for investors who are either implicitly or explicitly following a glide-path-style approach, it may make sense to de-risk as equity prices rise.
Traditionally, when faced with what appear to be fully valued equity markets, many investors would reduce risk by shifting allocations from equities into fixed income. However, given low yields across much of the global bond market today (thanks largely to years of extraordinarily accommodative monetary policy), some investors are looking for other ways to manage their equity risk exposures.
Lessons from the VIX
The Chicago Board Options Exchange Volatility Index (VIX) is a measure of the cost of options on the S&P 500 Index, and it is often referred to as the “Fear Index” because it quantifies how much investors will pay to hedge against a sharp fall in equity prices. Historically, the VIX has been high during times of crisis, and low when markets are calm. Today, the VIX is near a 20-year low (see chart), which means that long option costs on the S&P 500 Index are also near 20-year lows.
However, there are a number of risks and uncertainties in the global economy that could affect market prices (for more on the potential policy pivots that could influence global markets in the coming years, please read PIMCO’s latest Secular Outlook, “Pivot Points”):
- There is a high level of economic uncertainty around the world, as represented by the Global Economic Policy Uncertainty Index (see chart).
- Geopolitical tensions are increasing (e.g., North Korea, Qatar, Syria).
- Prospects for much of the Trump administration’s policy agenda are unclear.
This apparent contradiction – uncertainty is elevated, but at the same time, long options on the S&P 500 Index costs are near 20-year lows – may present an interesting opportunity for investors familiar with the risks associated with options and concerned about full valuations in risk assets, but who also feel compelled to maintain equity allocations in their efforts to hit their return targets. (Please read William G. De Leon’s recent blog post, “Don’t Confuse Uncertainty With Volatility,” for further insight into why markets appear so calm despite the range of unknowns in the global economy.)
Hedging the tails, watching the trends
For example, in recent years, many investors have considered strategies to explicitly hedge their portfolios from left tail risk – that is, to hedge their gains against severe but low-probability, or “tail,” market events. While some investors have been reluctant to pay the upfront premium (typically 50 to 100 basis points) required to run an explicit tail risk hedging (TRH) strategy, the current low levels of VIX, combined with additional reduction in implementation costs that may be available from active management, have made the cost of a TRH strategy more attractive. Adding TRH to a portfolio, while an upfront cost, may be an appealing option for those who wish to maintain a return-seeking portfolio allocation in a world of heightened uncertainty and full valuations.
Another alternative may be investing in strategies with a negative correlation to large tail events, such as time-series momentum strategies (managed futures). (For more information about these more complex strategies and their potential benefits and risks, see our educational piece “Managed Futures Strategies: Inside the Black Box.”) Managed futures strategies have historically had their best performance during equity market selloffs, which may make them an attractive addition to a return-seeking portfolio. Investors considering one or a combination of managed futures and tail risk hedging need to carefully weigh the risk-reward potential of these strategies.
The combination of fully valued equity markets, relatively high economic uncertainty and historically low long S&P 500 Index option prices suggests that now could be a good time for investors to consider fortifying their defenses.
Learn more about momentum investing in our education piece, “Managed Futures Strategies: Inside the ‘Black Box.’”
Michael Connor is a derivatives strategist focusing on PIMCO’s quantitative strategies, including tail hedging and trend following.