Financial Analysts Journal 25 June 2020 Volume 76 Issue 3
A Framework for Constructing Equity-Risk-Mitigation Portfolios
Hedging equity risk is so challenging that investors may sell down their equity portfolios or invest in costly risk-mitigation strategies. An optimized portfolio of risk mitigation strategies can improve outcomes.
The key trade-off among equity-risk-mitigation strategies is their expected return versus their ability to diversify equity risk. In particular, the more reliable a strategy’s equity-hedging properties, the lower its expected return, and vice versa. This article proposes a framework for optimal equity-risk-mitigation portfolio construction. In our model, the investor maximizes the portfolio’s unconditional expected return, subject to a constraint on its conditional equity beta. We show that the return to a risk-mitigation portfolio can be decomposed into hedging and return generating components. We then demonstrate that optimal risk-mitigation portfolios exhibit better return-defensiveness properties relative to the underlying strategies.
About the Author(s)
Jamil Baz is a managing director and global head of client analytics at PIMCO, where he previously served as portfolio manager on the global team. Prior to joining PIMCO, he was a senior managing director and chief investment strategist at the Man Group. Dr. Baz has also served as a managing director in macro proprietary trading at Goldman Sachs in London and as a global chief investment strategist at Deutsche Bank. Earlier in his career, he co-ran European fixed-income research at Lehman Brothers and worked in derivatives and liability management at the World Bank. Dr. Baz holds a master's degree from the London School of Economics, an SM degree from the MIT Sloan School of Management, and a PhD from Harvard University.
Josh Davis is managing director and head of client analytics at PIMCO.
Normane Gillmann is vice president at PIMCO, Newport Beach, California.
Jerry Tsai is vice president at PIMCO, Newport Beach, California.