The Impact Perspective on Institutional Portfolio Risk blog banner

Applying the Impact Perspective to Linear Overlays in Institutional Portfolios

Michael Zaslavsky photo

Michael Zaslavsky, CFA, CAIA

Senior Investment Strategist

More about this author

 

Institutional investors signal interest in hedging, but a frequent misunderstanding of the role of a hedge often stands in their way. We explain what it’s really about.



Despite a steady stream of tail-risk hedging inquiries over the past 10 years, few asset owners ultimately move to implementation. One significant obstacle is a mischaracterization of the hedge’s payout and role in the broader portfolio. This has been especially evident in the bull market following the 2008–09 global financial crisis, when equities compounded at 15% per year, rendering any risk-reducing exposure a return drag in isolation.



With equity valuations just off their highest levels ever, coupled with low yields and diminishing diversification (as measured by correlation) in bonds, institutions today are more vulnerable than ever to portfolio drawdowns that could set back the investment clock many years. Let’s look at an alternative framework for evaluating payouts from hedging strategies and their effects on long-term compounding.



Shifting the focus to long-term impact



Investors generally agree that risk assets—those having a positive relationship with good states of the world and its economy like equities and credit—expect a positive return over the long run. In contrast, hedging overlays are contra assets, which reduce the volatility borne by risk assets through generating a positive payout during poor states of the world and its economy. Hedging overlays, in isolation, consequently expect a negative return over time. But a negative return in isolation doesn’t necessarily imply a negative impact when combined with a portfolio of risk assets. This is due to conditional correlation properties, which we discuss later.


Because contra assets perform negatively, on average, most asset owners take one glance at this isolated historical performance and ascertain no value to their portfolio. But this view is fraught with error because the impact of contra assets on a portfolio of risk assets is far more nuanced than an independent consideration of the parts. A holistic perspective appropriately focuses on the key objective for asset owners: maximizing the portfolio’s rate of geometric compounding through time. Loss prevention is significantly more valuable than its equivalent gain forgone, and the value of contra assets like tail-risk overlays depends on asset returns elsewhere in the portfolio.


A tweak in denomination



Assume that portfolio H (for hedged) holds $100 in equities and a highly convex tail-risk overlay. Suppose a market crash yields a $50 valuation loss in the equities and a $20 payout from the overlay. The value of portfolio H therefore falls to $70.



Under these circumstances, many asset owners mischaracterize the overlay’s impact by weighing the $20 payout against the initial portfolio value of $100—an output of 20%. But this computation expresses periodic return, not the impact. Return is useful, but it doesn’t incorporate the coincident changes in value for other assets held in the portfolio. That’s why we look to impact, which focuses on the change in the portfolio’s end value due to integration of a particular asset.



Blog chart

We aim for persistent return without forecasts

Substituting return with impact reveals how better or worse off a portfolio is at any point in time in the future because multiplication can be reordered in any manner. Impact weighs the $20 payout against what would otherwise prevail in the absence of the overlay, known as the null. Our null, which we’ll call portfolio U (for unhedged), would have an ending value of $50. Portfolio H’s $70 ending value is a 40% improvement over portfolio U’s $50 ending value. From this perspective, we can see that portfolio U would suffer an opportunity cost of 40% by not holding the tail-risk overlay. In other words, its $50 ending value would subsequently require a 40% jump, not 20%, to match the prevailing $70 value of portfolio H.



In the left panel of the below figure, we attribute the change in portfolio H’s value to equities ($100 down to $50) and the overlay ($20 payout). In the right panel, we break up the period into two subperiods, denoted 1a and 1b. Subperiod 1a includes only the $50 loss from equities, while subperiod 1b includes only the $20 payout from the overlay. This intermediation allows us to easily recognize the 40% improvement between 1a (equities) to 1b (equities + overlay payout).



Improvement in institutional portfolio value relative to null


Blog chart


For illustrative purposes only.



The denominator used in expression of the overlay’s payout is tweaked to the hypothetical $50 ending value at  subperiod 1a that would prevail absent the overlay. This maneuver is necessary to appreciate the long-run impact attributable to integrating the overlay. It’s also especially critical when considering the impact derived from integration of contra assets, precisely due to the fact that their expected return is in the opposite direction of risk assets. This negative correlation manifests in impacts greater than beginning value-denominated returns in periods during which risk assets are falling (smaller denominator, increased quotient). On the flip side, impacts will be less than beginning value-denominated returns in periods during which risk assets are rising (larger denominator, decreased quotient).



The bottom line


The incorporation of impact, substituting null (alternative path) ending values for traditional beginning values, forces investors to focus rightly on the long term. Geometrical compounding over time is what matters most to beneficiaries seeking to maximize terminal wealth. That’s why investment fiduciaries should respect the positive influence of integrating assets and exposures with explicitly negative correlations to traditional risk assets. Without the correct long-term perspective, they may be doing a disservice to their beneficiaries.


In the next blog post in this series, we’ll dive deeper into this concept by introducing alternative examples. We’ll also discuss the normalization approach that greatly simplifies the complicated math behind long-term compounding.

More to explore

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.

This Material Is Intended for
Institutional Investors Only


By clicking Agree, you acknowledge that you have read the terms detailed below. You also confirm that you are a qualified institutional investor or a consultant to qualified institutional investors and wish to proceed. Parametric does not provide legal, accounting, or tax advice or consulting service.



The information on this area of the Parametric Portfolio Associates® LLC (“Parametric”) website is intended for qualified institutional investors and their consultants. This information is not intended for accredited investors in any jurisdiction outside the United States in which the distribution or sale of Parametric investment services is not authorized.

It is published for informational purposes only and does not purport to address the financial objectives, situation, or specific needs of any investor. If you do not qualify, the information shown on this site (which may include information about our investment strategies and products, market commentary, and composite performance) may not be relevant or appropriate for you. Certain solutions discussed in these materials will be subject to minimum investment amounts and other restrictions that apply. There can be no assurance that any investment product or strategy will achieve its investment objectives or that there will be any return of capital. Performance may be volatile, and investors could lose all or a substantial portion of their investment.



I acknowledge that I am a qualified investor and that I have read, understand, and agree to the above conditions.