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This summary gives a practitioner’s perspective on the article “A Framework for Constructing Equity-Risk-Mitigation Portfolios,” by J. Baz, J. Davis, S. Sapra, N. Gillmann, and J. Tsai, published in the 3rd Quarter 2020 Financial Analysts Journal.


Overview

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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.

What Is the Investment Issue?

Investors with significant equity allocations may seek to hedge against equity market drawdowns. But reducing equity exposure comes with an opportunity cost. Constructing portfolios that can mitigate equity risk with the lowest possible opportunity cost is presented as a solution.

The question then becomes which risk-mitigation strategies to use and in which proportions. The authors assess risk-mitigation strategies and propose a framework for combining them within a portfolio to maximize investors’ returns, subject to a selected conditional equity beta target. Conditional beta is an asset’s correlation with falling markets. By setting a conditional beta target, investors are effectively selecting a level of risk.

The resulting framework can be optimized to suit investors’ different return expectations and conditional and unconditional risk targets.

How Do the Authors Tackle the Issue?

The starting assumption is that investors have an existing investment portfolio and wish to hedge the equity portion through an overlay portfolio of risk-mitigation strategies. This assumption is reasonable given that many institutional investors view risk-mitigation portfolios as separate from return maximization.

The four common equity-risk-mitigation strategies are US Treasuries, trend-following strategies, tail-risk hedging (essentially, buying puts), and alternative risk premiums, such as carry and value strategies for commodities or currencies. The authors create a framework that can optimally combine these strategies in a way that corresponds to a range of investor risk and return preferences.

The framework finds optimal portfolio weights for the risk-mitigation (or “insurance”) portfolio and the return-seeking component for a variety of desired risk levels. The portfolio weights are calculated in falling markets, defined by the authors as quarters where the S&P 500 Index fell by 3.75% or more. The framework aims to find the most efficient risk-mitigation strategies—those with high Sharpe ratios—so investors achieve the highest possible returns after the costs of “insurance.”

Using the framework, investors can input their equity return targets and their preferred conditional equity betas or risk levels.

What Are the Findings?

Investors do not need to sacrifice a significant amount of return to substantially reduce the downside risks of their equity portfolios. The costs of creating “insurance” portfolios are much less, for instance, than the costs of buying puts or shorting equity indexes. In fact, it is possible to earn positive expected excess returns with conditional beta as low as –1.1.

By creating a portfolio of risk-mitigation strategies rather than using a single strategy, as is often done in practice, investors can materially improve the effectiveness of their equity hedge while receiving higher overall risk-adjusted returns. For instance, a Treasury hedge on its own has a conditional beta of –0.4 and delivers excess return of 1%, whereas an optimized “insurance” portfolio with the same conditional beta delivers a 6.4% return.

Portfolios for which equity hedging is not a high priority tend to be composed of higher-returning assets and might even hold a short position in the tail-risk-hedging strategy to increase the unconditional expected return. For lower-equity-beta targets, the optimal portfolio consists mainly of strategies with both a moderate defensiveness and a moderate return profile. This means a risk-mitigation portfolio that allocates mainly to Treasuries and trend-following strategies and less to carry and value strategies, which have higher returns but less reliable defensive properties.

If equity hedging is paramount to an investor, the portfolio will allocate to more robust hedging sources, such as buying Treasuries and equity put options. Because of their negative expected returns, the portfolio will buy sizable amounts of puts only when very negative conditional beta is required.

What Are the Implications for Investors and Investment Professionals?

The framework proposed in this article provides an optimized way for investors to manage the challenging trade-off between equity portfolio resilience and the returns available through full exposure to equity market beta. Although returns will necessarily be lower when adding defensive qualities to a portfolio, investors can minimize this cost by thoughtful portfolio construction. By combining a range of risk-mitigation strategies, each with a different risk and return potential, portfolios can be resilient to market downturns without giving up significant return.

About the Author

Phil Davis

Phil Davis is a London-based financial journalist.