Time to Tend Your Hedges?

Time to Tend Your Hedges?

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.’

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Michael Connor is a derivatives strategist focusing on PIMCO’s quantitative strategies, including tail hedging and trend following.

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Disclosures

Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Managed futures strategies involve entering into financial derivatives that seek to follow price trends. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification does not ensure against loss. All investments contain risk and may lose value. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.