The Decision Cycle for Downside Risk and Income-Focused Strategies

Transcription

1 March 8, 2017 Carlos Chujoy, CFA Employees Retirement System of Texas

2 Statement Generally portfolios are designed to address the needs of a variety of investors. i.e. Pension plans, endowments, family offices, high net worth, etc. These needs have ranged from improving the growth of the underlying assets to the reduction of overall portfolio risk, or both. A way to address these needs has been to diversify into other asset classes.

3 Problem Expanding the investment allocation to other asset classes did not bring in the desired diversification benefits at a time when they were needed the most.

4 Cumulative Returns Equities have delivered the strongest returns over the past 26 years. 60/40 performance is heavily influenced by equity returns

5 Drawdown Strong equity returns have come at a price. 60/40 performance is heavily influenced by equity returns

6 Selected Stats 60/40 shows accrues strong returns with a balanced risk profile. All return distributions exhibit negative skewness and positive kurtosis.

7 Concentration Risk Risk allocation of a 60/40 equity/bond portfolio is driven by the most volatile asset class. In fact, 92% of the total contribution to total portfolio risk is driven by equities.

8 Steps to address problem 1. Know what your portfolio looks like. Understand the return distribution. 2. Understand how assets behave during different market regimes. 3. Could a portfolio exhibiting different exposures to other assets done better? 4. Identify what that investment opportunity set looks like.

9 Return Distribution Seek to improve the return distribution of the current 60/40 by mitigating left tail risk and improve risk-adjusted returns.

10 Why Options? Positive IV-RV spread = richly priced options = establish income focused strategies Negative IV-RV spread = cheaply priced options = establish protective risk strategies

11 Strategies Analyzed Short Call/Put Bull/Bear Call Spreads Bull/Bear Put Spreads Long/Short Straddles/Strangles Long/Short Iron Condor Long Put Put Spread Collar Short Risk Reversal Note: All strategies are treated as overlays to a 60/40

12 Downside Protection All downside protection option-based strategies delivered better returns than a 60/40 with lower levels of risk.

13 Income Enhancement Most of the income focused option-based strategies delivered similar returns to a 60/40 but with better risk-adjusted profiles.

14 Returns Across Multiple Strategies

15 Cross Strategy Correlations Correlations for the income focused and downside protection option based strategies were negative over the past 26 years.

16 Regime Drivers We use the Leading Economic Indicator (LEI) to represent the 4 stages of a business cycle and shade areas to denote expansion, slowdown, contraction and recovery We use the VIX as a proxy for expected volatility.

17 Regime Drivers

18 Backtest Results

19 Backtest Results

20 Backtest Results Use of a regime-based framework combined with option-based strategies has shown promising results. We have applied this framework to a real equity portfolio and have tracked the live performance of a paper traded options overlay portfolio. The results attained have been in-line with expectations.

21 Backtest The process of testing a trading strategy on relevant historical data to ensure its viability before the trader risks any actual capital. - Investopedia It is a term used in oceanography, meteorology, and the financial industry to refer to testing a predictive model using existing historic data. It is a special type of cross-validation applied to time series data. Wikipedia

22 Importance Environment to test an idea Helps to quantify the success of a strategy Provides insights as to the behavior of a strategy over time Allows to perform comparative analysis across a range of strategies Serves as a way to cross-validate results Pitfalls Unrepresentative time period. In-sample. Underestimates survivorship bias Ignores market impact Overfit of data and data mining Underestimates hidden exposures It is just a model