Many investors are nervous after nine years of U.S. economic expansion and rallies that have sent most asset prices to record levels. What strategies can seek to protect gains without losing exposure to risk assets that may continue to appreciate? Two common approaches are constant proportion portfolio insurance (CPPI) and tail risk hedging (TRH). Although both have merit, our historical analysis suggests that TRH may be the preferred strategy given low interest rates and low implied volatility in equity markets.i
CPPI is a low-cost trading strategy that attempts to protect principal and maintain equity market upside potential. It’s been popular historically, especially among more risk-averse equity investors. To seek these seemingly incompatible objectives, however, compromises must be made.
Consider a typical CPPI structure that has a five-year investment horizon, aims to provide a minimum return of 85% of principal at maturity, and maintains initial participation in the equity market at the same level as if the investor had simply invested directly in stocks (i.e., 100% participation). As time passes and market conditions change, the exposure to equities adjusts dynamically to attempt to protect the targeted minimum 85% return of principal at maturity. In practice, if the equity market falls from its initial level, the strategy reduces (and potentially eliminates) its equity exposure – a path-dependent approach.
Investors typically implement CPPI for a five-year term, with the initial investment divided into two accounts:
- A safety account, often invested in short-term government securities, which aims to provide the target minimum return of principal at maturity, and
- A risk account, which contains the balance of the investment and collateralizes the equity market exposure. The beginning equity exposure (taken via futures) is equal to 100% of the total strategy investment, with maximum leverage of five times. As a result, the account can withstand as much as a one-day 20% equity sell-off.ii
This paradigm implies a minimum starting value of 20% in the risk account, with no more than 80% in the safety account. Therefore, given today’s low interest rates, the target minimum return of principal at maturity must be lower than 100%, because the 80% invested in short-term government securities for five years won’t provide enough return to reach 100%.
CPPI dynamically reduces the loss from risk-off events by reducing equity exposure as markets fall, which occurs quickly due to the leveraged nature of the risk account and the ample liquidity of the futures market. Clearly, rapid de-risking is beneficial in a sustained sell-off because it reduces losses as the market moves lower.
There is a potential drawback, however. If the equity markets rebound, the CPPI structure will not participate fully due to this de-risking (an example of the path-dependent nature of CPPI). This was the case during the 2008 financial crisis, when a hypothetical CPPI strategy (over the five-year investment horizon) would have underperformed the S&P 500 for several years. Effectively, when the strategy de-risks in a crisis, it has “locked-in” some or all of its losses, because there is less participation in a post-crisis rally.
Tail risk hedging
TRH, in contrast, attempts to put a floor under portfolio losses in a risk-off event without requiring investors to reduce their equity investments. It does so by purchasing out-of-the-money (OTM) put options on primary portfolio risk factor exposures such as the S&P 500. Typically, investors will bear a certain amount of first loss (e.g., a 15% loss at the portfolio level), but TRH aims to protect their portfolio against further losses. The OTM put options reduce risk in a sell-off, enabling the underlying portfolio to remain fully invested in risk assets.
However, this flexibility comes at a cost: The TRH strategy requires an annual premium on put options (similar to an insurance premium), and in flat-to-up equity markets, most or all of the value of these put options will decay. During risk-off markets, however, the TRH strategy is expected to buffer the portfolio against losses, and may be worth multiples of the premium spent.iii (See Figure 1.)
Notably, CPPI did not provide a substantial return improvement over unhedged S&P exposure during any of the crisis periods after 1990. Five years was sufficient for markets to recover from the sell-offs.
TRH, on the other hand, substantially outperformed during the global financial crisis (GFC). Admittedly, TRH performance was weaker during the tech bubble, perhaps because the strategy was modelled as one-year S&P 500 puts, rolled at the end of each calendar year. This approach has limitations, in particular its inability to capitalize on within-year drawdowns (as happened several times during the tech bubble).
In post-crisis periods, CPPI lost its return advantage over TRH. Intuitively, this may be because lower interest rates increase the amount deposited in the CPPI safety account, reducing the loss buffer in the risk account. A substantial sell-off therefore causes the structure to de-risk. And as we have seen, if the market subsequently rebounds, then CPPI will likely lag due to its path-dependent nature.
Time for TRH
Given these patterns, today’s low interest rates and muted equity volatility suggest that investors looking to defend gains in their portfolios may find TRH more appealing. As noted, amid low interest rates, CPPI structures have very little time during a sell-off before they are forced to de-risk, potentially forgoing some or all participation in a subsequent market rebound. Moreover, with the VIX (and hence option costs) now near 20-year lows, the cost of tail risk hedges is low.
This low cost, combined with strong historical performance in a crisis and the ability to participate in a rebound, may make TRH a better choice than CPPI for most investors today.
For more information about PIMCO alternative strategies, please contact your account manager.
i Low levels of equity implied volatility ( e.g., as measured by the VIX Index) make the cost of protective equity puts low as well.
ii A one-day sell-off in excess of 20% would cause losses greater than the balance of the risk account, so money would need to be taken from the safety account to cover these losses. This risk, combined with the uncertain return from its investments, explain why the safety account may not be able to deliver its targeted minimum return of principal.
iii According to CBOE and Bloomberg data ended 31 December 2016, over the past 21 years the TRH premium spend averaged about 1% annually for a 60/40 portfolio with a 15% maximum-loss target, based on PIMCO’s historical analysis of the average cost of a one-year 25% OTM SPX put. During substantial risk-off events, payouts on these options have ranged from two to 10 times the cost of the option.