As the recovery from the March 2020 equity market drawdown continues, investors appear to be of two minds. On the one hand, they are still in “greed” mode, in thrall to the immutable behavioral biases of loss-aversion and performance-chasing. On the other, there seems to be a lot of “fear”: demand for protection from potential market sell-offs, in the form of option-based hedging strategies, is at its highest level in over a decade.
The strength of that demand may be a classic case of past performance being used as a guide to future results. Implied volatility—a statistical measure of future equity market volatility that is derived from option prices—is a good proxy for the cost of equity hedging strategies. Figure 1 summarizes the one-year rolling average level of the CBOE S&P 500 Volatility Index (VIX), equivalent to the implied volatility of the S&P 500 Index, since its inception in 1990; we can see that the cost of this downside insurance was cheap for an abnormally long time leading up to 2020.
Figure 1. Volatility has been cheap for an abnormally long time
CBOE S&P 500 Volatility Index (“VIX”) 252-Day Average
Source: CBOE, Bloomberg LP.
We would suggest that the accommodative policy of the Federal Reserve and other major central banks is what led to historically low realized volatility in equity markets during that period, which in turn eventually fed into lower implied volatility in option markets. The curve of future contracts on the VIX was also in a steep contango during much of this period—where longer-dated futures are more expensive than shorter-dated contacts—and that generated a lot of carry return to offset the already modest premiums that hedgers were paying for their protection. Combined with the huge payoff that came during the deep-but-short sell-off in 2020, these six years of low costs have made tail risk protection solutions look like profitable long-term strategies.
Today, however, while equity markets have recovered substantially from their lows last year, realized market volatility remains elevated, and implied volatility is higher still, as figure 1 indicates. Market and economic conditions have changed markedly, and the risk is that many investors appear to be basing their expectations of their hedging programs on their performance during a period of exceptionally cheap insurance.
While we can’t offer a prediction on what will happen over the next couple of years, we would like to offer some perspective on how we compare equity risk hedging strategies.
We typically divide approaches to equity risk hedging into two categories: tail hedging and volatility reduction. We set out what we see as their defining characteristics below.
Tail Risk Hedging vs. Volatility Reduction
|Tail Risk Hedging||Volatility Reduction|
|Objective||Carry short-term protection for the rare but severe market event (black swan). Seeks ‘cheap’ (low carry) exposure to be short various market betas and/or long volatility or volatility-of-volatility.||Lower beta strategy paired with diversifying structural return payoffs that can reduce down market participation. Put option selling program can target specific equity beta and/or combine with long put option exposures to provide explicit drawdown reduction.|
|Implementation Paradigm||Re-Insurance Buyer: This strategy consistently pays premiums to receive significant payout during severe market event.||Insurance Seller: This strategy seeks to consistently collect premiums to offset market drawdowns and/or subsidize the cost of additional downside protection.|
|Asset Type||May include cross-asset exposure (equity, rates, currency) and second order exposures like Vol-of-Vol||Equity index options and short-term bonds for collateral/margin requirements|
|Leverage||Multiple turns of leverage to seek outsized returns||Limited use of leverage|
|Liquidity||Liquidity of positions may be an issue despite significant mark-to-market gains||Increased liquidity during times of stress|
|Portfolio Sizing||Convex payoffs and implicit leverage allow relatively small allocations to provide big returns||Direct, lower basis risk hedges lead to more traditional dollar-for-dollar hedging exposures.|
|Normal markets||Negative annualized returns||Modest positive annualized returns|
|Distressed markets||Significant positive returns||Outperformance relative to benchmark|
|Significant bull markets||Can suffer losses from ‘short’ positions||Avoids ‘shorting’ equity markets|
|Payoff Structure||Contains explicit hedges that react immediately to dislocations in the specific market conditions. Extreme but uncertain payoffs.||Contains structural exposures (hedges) that tend to offset losses as they evolve over time rather than one huge payoff.|
|Basis Risk||Highly dependent on historical correlations, which can break down (basis risk) during periods of market stress. Sometimes these strategies make implicit trade-offs that are not fully known until after drawdown/recovery.||Returns are highly correlated to equity markets due to path dependence of underlying exposure|
|Monetization||Theoretically, easier to monetize due to magnitude of payoff, but monetization can be more difficult to execute during periods of stress.||Can be more difficult to monetize/attribute return as structural design makes it more ‘integrated’ into portfolio allocations.|
We have found that clients gravitate toward one or the other depending on several variables, including their investment philosophy and portfolio structure. In general, there are no one-size-fits-all solutions and, given unique complexities of hedging and risk-reduction strategies, investment preference and allocation considerations are of utmost importance. That said, we would argue that the choice should probably also be determined, at least to some extent, by one’s view of the prevailing and future volatility environment and the way options are being priced. During periods when implied volatility is cheap, a tail risk hedging bias may be more attractive; when it is expensive, a tilt toward volatility reduction may be more prudent.
With these potential choices in mind, we often help clients navigate the challenges of comparing derivative strategies across volatility regimes, in order to balance elements of these two categories into practical investment solutions.