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Look Beyond Returns to Measure Institutional Portfolio Impact

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Michael Zaslavsky, CFA, CAIA

Senior Investment Strategist

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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.

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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

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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

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