Don’t wear the costs of tail-risk hedging

During the financial crisis, Simon Ho was busy advising and selling research to hedge funds through the investment company, at which he is CIO, Triple3 Partners. Ho, who ran Goldman Sachs’ currency book from London and held senior trading positions with Deutsche Bank in Sydney and JPMorgan in Singapore before co-founding Triple3, also ran a small amount of capital, about $20 million, in a volatility strategy for some offshore investors as larger managers launched their own options-based products, aiming to capitalise on the rough market. But when managers, such as global bonds powerhouse PIMCO, began spruiking tail-risk hedging strategies as the recovery began, he began to seek a broader audience for Triple3 Partners. Ho said the tail-risk hedging strategies put forward by managers sacrificed too much investment gain for too little protection. “We are adamantly opposed to tail-risk hedging. It has a deleterious effect on portfolios.”

The strategies usually involved buying put options to insure against extreme ‘left-tail’ events, month-in, month-out. Ho said this expensive protection against infrequent events – or ‘low-delta’ put options in trading terminology – could strip away 1 per cent from portfolio returns each month. “Who wants to stomach 12 per cent less each year, for sure?” Triple3 was interested in talking to multi-manager and superannuation funds that sought protection, but were unwilling to pay this premium, about its approach, which aimed to hedge market volatility rather than to insure against fat tails. This was achieved by running a volatility overlay, built from equity index options, across an entire portfolio. Ho said that in Triple3’s back-tests, a portfolio of index options bought to hedge-implied volatility produced better results than low-delta puts at a lower cost. The aim was to cap volatility while not diminishing the alpha delivered by underlying managers. Investors could be spared the full impact of fat tails, but Ho admitted that “we can’t claim to completely cut left tails off ”.

To run the overlay, Triple3 forecasted the expected market volatility on a monthly basis and compared its expectations with what was implied in option prices. It then looked for opportunities to exploit any differences by selling options when the market had priced in too much expected volatility (and was therefore putting a premium for protection) or buy protective options when volatile times were expected. According to Triple3, almost 90 per cent of the implied volatility in the market was greater than what was eventually realised, meaning that put options were expensive almost 90 per cent of the time. Because funds usually had different volatility thresholds, the overlays were not run on a one-sizefits- all basis. And each tolerance level incurred its own cost: the lower the threshold, the more protection was required and the more expensive the overlay became, and vice versa. Even though Triple3 forecasted volatility one month in advance, it executed one quarter of its trades each week so “we’ve got a constant portfolio that adjusts to price and volatility” over time, Ho said. Since the Australian options market was not massive relative to the equities market, portfolios of $30 billion or more would be hedged using S&P 500 index options, since volatility in the US market was usually echoed by the ASX. He acknowledged the overlay could impede upon the dynamic asset allocation strategies marketed by asset consultants, but said it could be recommended by consultants as part of such a program. Mercer was currently rating the service.