case study - volatility investing · expected lr portfolio return drag ~10 bps trip returns global...
TRANSCRIPT
Case Study: Why Portfolio Protection for an Endowment
Mike Edleson
Chief Risk Officer
The University of Chicago
Volatility Investing
19 April 2016
It’s a Conspiracy against Linearity
Markets
Products
Strategies
Structural (Brittle)
Agency issues
Your Beta / Exposure isn’t what you think it is, when it matters most
Wrong-Way Risk & Investing
-50
-40
-30
-20
-10
0
10
-50 -40 -30 -20 -10 0 10
Right-Way
Linear
Wrong-Way
β= .75 always
β> .75,increasingwith losses
Lossesaccelerating
Lossesslowingβ< .75,
risk flattening with losses
Overall Market Return (%)
Po
rtfo
lioLo
ss (
%)
0
10
20
30
40
50
60
70
80
90
500 700 900 1100 1300 1500
Leve
l of
VIX
SPX TR Index Level
Past 13 years, weekly observations
Relationship of Volatility and Market Level
Aug-Oct 2008
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
EM Equity Credit Real Estate Commodities
Ro
llin
g 1y
co
rrle
tio
n w
ith
S&
P500
(Mo
nth
ly R
etu
rns)
Correlations Spiked During Financial Crisis
Before Crisis
Average correlation measure with Equities for 18 months before and after Sept 2008
Cre
dit
sp
iked
ha
rd,
a fe
w q
ua
rte
rs e
arl
ier
thruNov
'07
0.4
0.5
0.6
0.7
0.8
0.9
1
-60.0% -40.0% -20.0% 0.0% 20.0% 40.0% 60.0%
Esti
mat
ed
Be
ta (
40d
, pre
vio
us
2 yr
s p
rice
dat
a)
Return on GEF Index in previous 2yrs
2y GEF Beta v 2y Return on GEF Index(assuming current portfolio)
end Aug 2008 - Sep 2010 since Sep 2010
before May 2004 Jun 2004 - Aug 2008
Sep - Nov 2008
-8%
-6%
-4%
-2%
0%
2%
4%
6%
-25% -20% -15% -10% -5% 0% 5% 10% 15%
Figure 6 Non-linearity and negative convexity in hedge fund returns, 2003-13
Full sample
Drops 'Outlier'
S&P 500 Return
CS Agg HFI Return
Outlier ?
Investment Return
w/Performance Fee
-30%
-20%
-10%
0%
10%
20%
-20% -10% 0% 10%
Credit's Negative Convexity to Equity Markets, 1990-2011
High Yield Distressed
Corp High Yield
SPX Monthly
Risk steeper to the downside
Vols Spike Correlations Spike Betas Spike Carry in Products Non-Linear Fees
Negative Convexity in HF Returns
AND Rebalancing as a Short Put Illiquidity & Leverage Push for Returns
Wrong-Way Risk-Return Profile
ALL ENDOWMENTS HAVE NEGATIVELY CONVEX RETURNS / WRONG-WAY RISK PROFILE
Our beta for up markets is 175% of our beta for down markets
Meeting the Needs of the University Tail Risk vs. The Higher Purpose
-45%
-40%
-35%
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09
Quarterly Reported
Monthly Reported
Time-Matched
Proxy Illiquid
Fiscal year
Losses Steeper than you think in Crisis
Real Economic
Loss
5% Spending Rule (5.5% here)
–40% Scenario ▼
9.2% payout
70-75% Privates
for a few years
Is a 9-10% payout with 25-30% in “liquid(?)” assets sustainable?
Liquidity Needs: $1.2 – 1.4B in replay of crisis (while $7 →$4.7B)
Predictable Cash Flow to meet Important LT Strategic Operations
Does our “long term” investment horizon really excuse all sins?
Not just returns +%
Reduces crisis beta
Cash in a Crisis
Reduces leverage
Buys time, prevents disaster
Survival of the “Enterprise”
Enterprise Risk Perspective
Gifts not only smaller, but not given (high β)
Debt shoots up, Enterprise more levered
Hospital & Grants revenue potentially collapses
At this exact point, our liquidity disappears, and our investment risk skyrockets. Is this OK?
Tail
Pro
tect
ion
Behavioral & Cultural Issues • Committee Behavior & Governance Breakdown
• “Buy High, Sell Low”
• Is Staff confident enough to invest when returns are the highest (but markets are scariest)?
In a world of similar track records, the response to a crisis can make-or-break an endowment
Tail protection, economically and behaviorally, helps work against our most destructive human tendencies.
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
-150
-100
-50
0
50
100
150
200
250
300
Total Capital Raised v Cohort Return(since 1990)
Private Capital Raised $B Performance (Cohort IRR) %
351
Expected returns generally highest after a crisis
- Publics (but we must sell then)
- Privates (but we stop investing then)
- Most E&F simply stopped private investments and didn’t restart until 2011 / later..
“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.
We Planned & Positioned for this
We have the cash, the risk capacity, and the confidence to take advantage of the opportunities being offered by the market
{
BONUS
In practice, strategic hedging of our negative convexity risk-return profile makes us keenly aware of “fake alpha” carry returns in our investments…this leads us to focus on the best, highest “true alpha” among them.
Risk Culture extends to convexity as well.
Implementing a Protection Program
What Risk Drivers
What portion of tail? …true “crisis”?
Governance Support / Fatigue
Sizing A Protection Program
• Capital/Budget/Bleed/Cost
• To Linearize return profile
• To truncate most painful losses
• To outperform peers in crisis
• To provide $X of needed liquidity
• To support %C of portfolio in carry/illiquid strats
• To not impair long-run performance
Who does it (managers?)
Strategic or Tactical?
Monetization
Robustness
NOTE on COST A small strategic portfolio protection program costs far less than most think. Nearly everyone gets the math wrong on this. Our actual experience, implemented over 4+ years, has been a (very) small gain.
{
Our Protection Program
Focus on Enterprise economic crisis, & linearize endowment beta (governance control)
2% Capital Allocation
65 bps budget, “bleed” limit
Expected LR standalone cost, 15-20 bps
Expected LR portfolio return drag ~10 bps
TRIP Returns
Global Equity Markets
Illustration of Wrong-Way Beta
.60
Upside GEF Beta.75
'Normal' GEF Beta
.85Downside
GEF Beta
BEARDEPRESSION CRISIS BULL
1.00Deep Downside
GEF Beta
“Linearize”: Fill That Gap
Pro
tect
ion
Pay
off
BUCK
Balancing Bang for the Buck and Basis
Various Hypothetical Strategies' Economics Shown
BANG
Expected Cost
Too Linear?
Ineffective
Too Expensive?
Basis Risk Too High?
Can Size Down
SWEETSPOT