Risk Hedging Frameworks: Governance Concerns and Equity Derivative Strategies

Risk Hedging Frameworks: Governance Concerns and Equity Derivative Strategies Motivations for Long-Term Investors to Tail Hedge: Economic, Behavioral, and Operational Ari Paul Portfolio Manager, The University of Chicago Endowment

Why Hedge? Should Endowments and Foundations Hedge Their Tails? Endowments and Foundations are perpetual life investors but can t act like it in a crisis. In the 2008 crisis, most endowments reported losses of about 21% (for fiscal year 2009), but the real economic drawdown for most was 40-45%. Many endowments reduced equity exposure at the worst time, either out of fear, solvency concerns, or liquidity needs. The kinds of questions being asked by investment committees in late 2008: Will we have to default on our private equity commitments? Should we simply stop making new capital commitments? What can we sell to maintain liquidity? The University needs consistent payouts from us. With our AUM down 40%, that means an 8.5% payout this year. How can we sustain that? 2

Reasons to Hedge Economic Behavioral Operational 3

Portfolio Loss (%) The E&F World Sells Puts 10 Overall Market Return (%) -50-40 -30-20 -10 0 10 0 Nearly all E&F Portfolios look like the red line on the chart to the right. Sources of wrong-way risk : Correlations spike towards 1 in a crisis, so the beta of a diversified portfolio rises. Right- Way Linear Wrong- Way β <.75, risk flattening with losses Losses slowing β >.75, increasing with losses Losses accelerating β =.75 always -10-20 -30-40 -50 We get 100% of the downside, but typically only keep 80% of the upside (because of performance fees). Managers of most asset classes exhibit negative convexity (see bottom right chart). Rebalancing: buying more equity during a market decline causes increasing beta on the way down. S&P 500 Return 0% -25% -20% -15% -10% -5% 0% 5% 10% 15% Drops 'outlier' Full sample 6% 4% 2% -2% -4% -6% DJ HFI Return Outlier? Cash flows from private investments are counter-cyclical. -8% This chart of 9 years of the Dow Jones Hedge Fund Index shows substantial negative convexity of returns. 4

Reasons to Hedge Economic Correct For Wrong-Way Risk Behavioral Operational 5

Protection is Cheaper Than You Think Sticker cost what are you spending on premium each year? Standalone cost what s the actuarial or expected return of the protection portfolio? This is equal to the sticker cost + the payoff in a crisis. Portfolio Cost What is the marginal effect on the portfolio from adding the protection? 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% 1 2 3 4 5 6 7 8 9 10 5.34% Return 15.8% Std Dev Annual Portfolio Returns 10% 5% 0% -5% -10% Protection Return Net Cost (Gains < Losses) = -2% of Portfolio over 10 Years 1 2 3 4 5 6 7 8 9 10 Standalone Sticker Cost Cost -23 bps 'Cost' -1.5% Annual Max Loss The nature of compounding means that we can add a negative EV hedge to our portfolio and wind up with higher returns over time! 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% 'Protected' Portfolio Returns 1 2 3 4 5 6 7 8 9 10 Portfolio 'Cost' = 12 bps Improvement 5.46% Return 13.7% Std Dev (-14% less risk) 6

Reasons to Hedge Economic Correct For Wrong-Way Risk Reduce Portfolio Volatility At Minimal Cost Behavioral Operational 7

Expected Returns Are Highest After A Crisis You pay tail hedging premium when the market is up and opportunity cost is low. The program pays out high powered money that you can put to work when the world is on sale. Source: Aswath Damodaran 8

Reasons to Hedge Economic Correct For Wrong-Way Risk Reduce Portfolio Volatility At Minimal Cost Gain Investable Assets When Expected Returns Are Highest Behavioral Operational 9

Governance The Investment Committee Trading by committee is a sure path to failure. John Maynard Keynes At worst, committees tend to follow the herd. They are more confident and take more risk when markets are at their peak, and are most fearful and take the least risk when markets are at their troughs. At best, committees are steady. We aim for steadiness. A hedging program helps the Investment Committee stay the course by: Mitigating (absolute) drawdowns in a crisis Mitigating (relative) drawdowns in a crisis Providing cash for liquidity Providing returns for solvency Everybody s got plans until they get hit. Mike Tyson A Tail Hedge program is like a mouth guard. Keeps the brain from getting too rattled during a crisis so we can keep our head in the game. 10

Governance The Staff Does your staff have the confidence to continue rebalancing and investing with losses at 20%, 30%, 40%? How can we have the confidence to be greedy when others are fearful? Most of the time, E&F investors invest similarly to one another and to their benchmarks, and earn similar returns. The response to a crisis can make or break the long-term track record. By having an explicit tail hedging program in place, we can have confidence in a crisis. We planned for this We hedged in anticipation We re better positioned for this situation than our peers Now it s time to take advantage of the opportunities the market is presenting 12

Reasons to Hedge Economic Correct For Wrong-Way Risk Reduce Portfolio Volatility At Minimal Cost Gain Investable Assets When Expected Returns Are Highest Behavioral Help The Investment Committee Stay the Course Give Staff the Confidence to Focus on Investing Operational 13

University Payout Solvency and Liquidity Most Endowments pay out about 5% of AUM annually. The 5% is based on the average AUM of the last 3 to 5 years, so the university can count on predictable cash flows to finance operations. 40% drawdown = 8.33% payout. 40% drawdown = 60 to 80% illiquid assets Is an 8%+ payout, representing 20% to 40% of liquid assets sustainable? A Tail Hedging Program can be designed to produce substantial liquid cash when it s most needed. This buys time for a market rebound, or for financial restructuring. 14

Private Investments Meeting Capital Calls and Making New Commitments In late 2008, many investment staffs and committees openly discussed defaulting on capital commitments. Most of the E&F world, simply stopped making private investments and didn t restart until 2010 or later. This resulted in strained relationships with General Partners and a lumpy liquidity schedule that we re still dealing with today. A Tail Hedging Payout Can Mitigate These Issues 16

Total Enterprise Approach Cyclicality of Gifts Gifts represent about 8% of the University of Chicago s operating budget. This is quite substantial relative to Tuition (18%) and the endowment payout (18%). Gifts are highly cyclical with a beta of about 0.70. gifts = 0.7 * (market return 7%). This means that in a steep market decline, the university s net cash needs will increase. Other (Auxiliaries, Patient Care, etc.) 35% University Income Sources Payout 18% Net Tuition 18% Gifts 8% Grants 21% A Tail Hedge program provides cash to replace other sources of University revenue. 18

Reasons to Hedge Economic Correct For Wrong-Way Risk Reduce Portfolio Volatility At Minimal Cost Buying Protection Gain Investable Assets When Expected Returns Are Highest Behavioral Help The Investment Committee Stay the Course Give Staff the Confidence to Focus on Investing Operational Liquidity and Solvency Support Private Investment Program Support Total Enterprise Approach 20

Value Buying Protection Value vs Basis Risk US endowments and foundations are primarily exposed to US equity risk. We have to choose between the most direct hedges (like US equity puts) that give us the highest level of confidence, and hedges that offer better value. Structural influences cause some hedges to provide better value than others. FX Vol Commodity Vol IR derivatives Sovereign CDS Japan Equity Puts EM Equity Puts Eurozone Equity Puts US Var Swaps US Equity Puts Basis Risk of Protection 21

Reasons to Hedge Economic Correct For Wrong-Way Risk Reduce Portfolio Volatility At Minimal Cost Buying Protection Gain Investable Assets When Expected Returns Are Highest Behavioral Help The Investment Committee Stay the Course Give Staff the Confidence to Focus on Investing The UC Program Operational Liquidity and Solvency Support Private Investment Program Support Total Enterprise Approach 22

The University of Chicago Tail Hedging Program Our tail hedging program is an integrated part of our broader investment strategy. The goal is to partially insure against large losses to mitigate the economic, behavioral, and operational problems associated with very large portfolio declines. We aim to buy back most of the negative convexity inherent in our portfolio s risk-return profile and to reduce our pain in crisis. Implemented at start of 2012 2% of AUM is allocated to Tail Hedging We budget 65 basis points as a reasonable max loss, but expect to spend about 32 bp in calm or rising markets. Invested with 4 fund managers. About 50% of capital is in systematic and semi-systematic hedges: variance swaps and puts on US and Eurozone equity indices, credit default swaps, and similar instruments. The remaining 50% of capital is in discretionary hedges with greater basis risk but greater value : FX and commodity options, sovereign CDS, variance swaps and puts on emerging market equity indices, and more exotic interest rate derivatives. Our hedging program is run by Chief Risk Officer Mike Edleson, who also provided ideas and exhibits for this presentation. 23

Questions? Economic Correct For Wrong-Way Risk Reduce Portfolio Volatility At Minimal Cost Buying Protection Gain Investable Assets When Expected Returns Are Highest Behavioral The UC Program Help The Investment Committee Stay the Course Give Staff the Confidence to Focus on Investing Operational Liquidity and Solvency Support Private Investment Program Support Total Enterprise Approach About the speaker: Ari Paul is a Portfolio Manager at the University of Chicago. He was previously a derivatives market maker for Susquehanna International Group (SIG), and a prop trader in Chicago and New York City. Ari studied political science at UPenn and has an MBA from Chicago Booth. He is a CFA charterholder. 24