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Three Approaches to Better Outcomes in Fixed Income Better Beta: Thinking Differently About Core Fixed Income goes back to the building blocks of portfolio construction to answer the question “Is it possible to construct a portfolio that delivers solid performance irrespective of fluctuations in the macroeconomic cycle?” Rethinking Alpha addresses the challenge facing many fixed-income investors today—generating alpha in today’s environment of low rates—by exploring the benefits created when the definition of alpha is expanded to reflect new market realities. Taking the Sting out of the Tail: Hedging Against Extreme Events summarizes various approaches across the capital markets to buffer portfolios in periods of market stress. 2 Richard Brink Senior Portfolio Manager Michael Mon Portfolio Manager Seeking a more stable footing in changing fixed-income markets Dimitri Silva Portfolio Manager Better Beta: Thinking Differently About Core Fixed Income yield on the Barclays US Aggregate Index came from US Treasuries (Display 1). In the years that followed, US Treasuries accounted for the bulk of the market yield and generated huge capital gains as interest rates fell. Today, by contrast, a 100% US Treasury weighting would be far from optimal. Nongovernment securities— now a much more important driver of market yield—accounted for almost half of market yield at the end of 2013. Is it possible to construct a portfolio that delivers solid performance irrespective of fluctuations in the macroeconomic cycle? This paper explores how investors can get closer to that goal. In this paper, we discuss an alternative approach to core, one that has largely the same objectives as the traditional approach but that seeks to create a balance of exposures that is less sensitive to changes in the macro environment. The Evolving Concept of Core Thirty years ago, developed-country investors seeking core fixed-income exposure might have been satisfied with a simple 100% allocation to government debt. For example, in the US bond market in 1981, US Treasuries were on the brink of a bull run that played out over three decades. Much of the nongovernment market was still in its infancy, and the credit risk premiums offered by corporate bond spreads were not attractive. In September 1981,16.1% of the 16.5% Indices Can Be Dangerous In lieu of 100% government bonds, most investors today have adopted a broad Display 1: Impact of Government Debt in a Core Portfolio Has Changed Radically Index Yields Change Between Sep 30, 1981, and Dec 31, 2013 20 15 Percent Investors expect their core fixed-income portfolio to do three things for them: diversify their equity exposure, generate returns consistent with those of the broad bond market and display low volatility. But today’s low yields, together with concerns about the prospect of rising interest rates, are making investors question whether the traditional core approach—using a broad market index, which can bring exposure to unintended risks—meets their needs. Barclays US Aggregate Index Yield 16.5% 2.5% Contribution from US Treasuries 16.1% 1.4% 0.4% 1.1% Contribution from Non-US Treasuries Barclays US Aggregate Index Yield 10 5 Barclays US Treasury Index Yield 0 81 91 01 11 Historical analysis does not guarantee future results. For the period January 1, 1981, to December 31, 2013 Yields are measured as yield to worst for the Barclays US Aggregate and the Barclays US Treasury. Source: Barclays and AllianceBernstein 1 market index as their starting point. But the problem with nearly all bond indices is that they are issuance weighted. So, companies or governments that issue more debt acquire a bigger role in the index—and in the portfolios of indexbenchmarked investors.* This can have unforeseen consequences. For example, as the US pursued the mortgage-led borrowing spree that caused the 2008–2009 credit crisis, the non-agency securitized segment’s weighting in the index more than doubled, from about 3% to 7%, by 2007. So, investors had significant exposure to the ensuing sell-off as, for example, commercial mortgage-backed security (CMBS) spreads soared from an average of less than 70 basis points (b.p.) over Treasuries, to more than 1,600 b.p. Then, the same thing happened in reverse. Securitized issuance dried up and US government stimulus sent the US Treasury supply soaring. Non-agency securitizations staged their biggest rally in history, but index-focused investors captured less of the return than they might have because their proportional exposure to that sector was falling and their exposure to US Treasuries was rising. An Investor-Designed Index Rather than catering to investors’ needs, a market index is in effect an issuer’s index. But we believe that investors should be the ones to control which risks—and how much risk—they take. What would a core fixed-income index look like if it were designed by investors rather than driven by issuers? Our pursuit Display 2: No Fixed-Income Sector Wins All the Time–Different Sectors Add Value in Different Environments January 1, 2008–December 31, 2013 (Percent) Best Worst Difference 2008 US Treasuries 13.8 2009 2010 2011 2012 2013 High Yield 58.2 High Yield 15.1 US TIPS 13.6 EMD USD 17.9 High Yield 7.4 US TIPS (2.4) EMD USD 28.2 EMD USD 12.0 US Treasuries 9.8 High Yield 15.8 Inv.-Grade Corps. (1.5) Inv.-Grade Corps. (4.9) Currency 22.0 US TIPS 6.3 EMD USD 8.5 Currency 10.5 Currency (1.9) EMD USD (10.9) Inv.-Grade Corps. 18.7 Inv.-Grade Corps. 8.2 Inv.-Grade Corps. 9.8 US Treasuries (2.0) High Yield (26.2) US TIPS 11.4 Inv.-Grade Corps. 9.0 US Treasuries 5.9 High Yield 5.0 US TIPS 7.0 EMD USD (6.6) Currency (26.7) US Treasuries (3.6) Currency 1.5 Currency 1.5 US Treasuries 2.0 US TIPS (8.6) 40.5 61.8 13.6 12.1 15.9 16.1 Past performance does not guarantee future results. These returns are for illustrative purposes only and do not reflect the performance of any fund. Diversification does not eliminate the risk of loss. US Treasuries are represented by Barclays US Treasury, US TIPS by Barclays US TIPS, high yield by Barclays US Corporate High-Yield, investment-grade corporates by Barclays US Investment Grade, emerging-market debt (USD) by J.P. Morgan EMBI-Global and currency by Deutsche Bank G10 Currency Future Harvest plus cash return. Source: Barclays, Deutsche Bank, J.P. Morgan and AllianceBernstein of a more thoughtful, balanced set of exposures, or “better beta,” began with this fundamental question. Begin with a Multisector Approach There are good reasons for including all major fixed-income sectors in a core portfolio: government bonds and inflation-linked government securities, along with other sectors such as corporate and hard-currency emergingmarket (EM) debt. All these sectors have historically generated solid returns, allowing for a broad opportunity set. Diversification is another obvious benefit: over the past 10 years, high-yield corporate bonds have had a negative correlation—about (0.2)— with Treasuries. But perhaps the strongest argument for having a cross section of exposures is the fact that the major bond sectors have added value at different times, in different environments. For example, in the turbulent environment of 2008, US Treasuries outperformed high-yield credit by 40.5% (Display 2). The following year, as risk appetite returned, high-yield credit outperformed US Treasuries by more than 60%. In 2012, hard-currency EM debt outperformed US Treasuries by 15.9%. These highly varied return patterns demonstrate the value of combining sectors. The question is: What’s the most efficient way to do it? Taking Turns over Time Although the sectors in Display 2 all behaved in different ways, they were polarized into two groupings that tended to take turns outperforming each other. One was interest-rate-related assets— Treasuries and Treasury Inflation-Protected Securities (TIPS)—which primarily provide investors with interest-rate exposure. The other was growth-related assets (such as credit and EM spreads), which provide credit or currency exposure. These two For more on the limitations of the benchmarked approach, see our June 2011 research paper The Tyranny of Bond Benchmarks. * 2 groupings are the building blocks of what’s known as a credit barbell strategy. Credit Barbell Hints at Better Beta A credit barbell strategy concentrates on high-credit-quality, interest-rate-sensitive assets on one hand, and on lower-creditquality, growth-related assets on the other hand. These two extremes are sometimes viewed as risk reducing versus return seeking. Display 3 compares the relative performance of five-year US Treasuries, an interest-rate-related asset, and high-yield corporate bonds, a growth-related asset. Historically, each end of the barbell has come to investors’ aid at different times. As the display shows, in 1984 Treasuries outperformed high yield by 5%, but in 1985 high yield beat Treasuries by 4%. no exception: US Treasuries beat high yield by 18% during the 1990 US Savings & Loan crisis, then high yield bounced back, by a margin of 31% in 1991. The asset class’s risk characteristics in a particular environment determined returns. What’s also apparent is that returns generated by the two halves of the barbell diverged significantly—by an annual average of about 12%. And, the divergence was greater at times of turmoil and during market rallies. The credit crisis was Over the last 30 years, investors seeking a portfolio that was more effective over time would have wanted to own both US Treasuries and high-yield bonds. This combination outperformed a core portfolio of only US Treasuries with almost the same volatility. In other words, it had a significantly better excess return per unit of risk. Display 3: A 50/50* Barbell Strategy Delivers More Return per Unit of Risk Risk Premiums: The Building Blocks January 1, 1984–December 31, 2013 Years When US Treasuries Outperformed Despite the barbell’s effectiveness, it’s still a simple 50/50 construction. Could we improve the results by adding other sectors or changing the mix? To answer this, we first need to delve a little deeper into why fixed-income sectors behave as they do. Years When High-Yield Bonds Outperformed 1984 1988 1992 In the same way that each person represents a unique combination of genetic building blocks, each fixedincome asset class represents a unique combination of premiums for various kinds of risk. We believe that the key to better beta is to focus not on sectors, but on the underlying risk premiums. 1996 2000 2004 2008 2012 40 Average Return Annualized Vol. Sharpe Ratio** 20 0 20 Size of Outperformance (Percent) US Treasuries 7.3% 4.9% 0.6 High Yield 10.8% 8.6% 0.7 40 60 50/50 8.7% 5.0% 0.9 Past performance does not guarantee future results. These returns are for illustrative purposes only and do not reflect the performance of any fund. Diversification does not eliminate the risk of loss. *50/50 is an equal blend of US Treasuries (represented by Barclays 5-Year Bellwether US Treasury) and high-yield bonds (represented by Barclays US Corporate High-Yield). **Annualized return in excess of cash, divided by annualized volatility Source: Barclays and AllianceBernstein For example, within the two sectors in our credit barbell, we can identify four separate risk premiums.* Treasuries, which tend to be viewed as purely interest-rate related, have two main risk premiums: n Real-interest-rate risk premium: the portion of a government bond coupon that compensates investors for lending money to the government n Inflation compensation risk premium: the portion of a government bond *We’ve simplified somewhat. There are other risk premiums. For example, there is an inflation uncertainty premium and there is optionality inherent in the generally callable high-yield market. 3 coupon that protects the purchasing power of the principal. Corporate bond yields consist of the yield on comparable-maturity government bonds, plus a credit spread, which can be broken down into further risk premiums. So, in addition to the two risk premiums above, high-yield corporates present: n Credit and default risk premium: the portion of the credit spread that reflects the risk of a change in credit quality or that a company will fail to service its debt or go bankrupt n Liquidity risk premium: the portion of the credit spread that reflects the high-yield market’s tendency to become illiquid from time to time. (Illiquidity increases the risk of loss if, for example, wide bid-ask spreads make it hard for investors to sell at a favorable price.) Each premium fluctuates in value over time, reacting with a different sensitivity to changing macroeconomic factors. So, the key to better beta is to focus not on sectors, but on the underlying risk premiums. The combination of these reactions results in the distinctive return patterns of various sectors. At the overall sector level, the net effect of higher growth expectations is generally negative for government bonds, but net positive for high yield. Factor Sensitivities Drive Returns Here’s the crucial point: government and high-yield bonds don’t move in opposite directions because they are driven by different macro factors—they do so because they respond differently to the same dominant macro factor. A credit barbell smooths volatility well because the sum of the two parts greatly reduces the impact of changes in growth expectations on the returns of the whole. This dynamic is analogous to a system of levers and forces. The risk premiums are the levers, upon which macro factors exert force, resulting in changes in bond returns. Display 4 shows a macro factor—rising gross domestic product (GDP) at work—and illustrates how a credit barbell can be a stable strategy in a rising-growth environment. Rising growth tends to increase the demand for, and cost of, money. This sends real yields higher, which negatively affects the real-interest-rate component of government bond yields. Likewise, if growth causes inflation to rise, that risk premium would contribute negatively. By contrast, economic growth tends to result in lower risk of credit downgrades, defaults and liquidity problems, so it would be positive for the growth-related risk premiums. Display 4: Factor Sensitivities Help Explain Sector Return Patterns Rising GDP Drives Rate- and Growth-Related Risk Premiums in Opposite Directions High-Yield Corporate Bonds Liquidity Credit/Default Government Bonds Inflation Real Yields Real Yields Impact of Rising-Growth Expectations on Returns 4 Economic growth expectations are a consistently important factor in bond returns, but there are others, such as inflation expectations and real yields (or central bank policy). And the relative strength of the force these factors exert can vary over time. For example, in the US, inflation became the dominant factor in 1974 following the 1973 oil crisis. At the time, both Treasury and high-yield returns fell—which was unusual given the historically negative correlation between those sectors. But it makes intuitive sense given that the inflation-compensation ”lever” affects them both in the same way. A different factor, yield expectations, became dominant in 1994, when massive rate hikes by the Fed triggered losses in both Treasuries and high yield. In this case, the real yield component was the main lever being activated. Adding Additional Levers Inflation For illustrative purposes only Source: AllianceBernstein Factors and Forces Vary in Strength Adding other sectors to the portfolio introduces other levers, or risk premiums, such as the EM risk premium. TIPS have a component that adjusts a bond’s principal value in line with inflation. This lever is potentially very useful because, when inflation expectations are the driving factor, we would expect the TIPS Using 21st-Century Financial Market Tools to Create Better Beta More Efficient Building Blocks: Isolating Risk Premiums Fine-Tuning Volatility Bonds consist of bundles of risk premiums that are sensitive to certain macroeconomic drivers. Display 4 shows that durationand credit-related premiums tend to react differently in a rising-growth environment, making both desirable in a barbell portfolio. But the challenge with using cash bonds is that corporate bonds also contain duration. In fact, of the risk premiums in high yield, the ones we really want are credit risk and default risk. An investor may have the optimal blend of sectors, in the optimal proportions for current market conditions, but for various reasons, he or she may want to take more or less risk. This can be done without changing the mix, but by adjusting overall portfolio volatility. The table below shows how using credit default swaps in place of cash bonds can create a cleaner barbell portfolio that isolates the credit and default components of high yield. This would have been hard to do 30 years ago, but today it’s relatively simple. For example, investors can get their credit exposure by using a credit default swap index to take a position in a basket of companies. To get the duration, they could assemble a portfolio of cash government bonds of the desired maturities or employ interest-rate futures. Compared with cash bonds, derivatives can often be a cheaper, easier and more liquid solution. And many of the derivatives in question are standardized or exchange-traded rather than custom over-the-counter swaps. For example, credit default swap (CDX) indices can be used to gain exposure to baskets of investment-grade corporates, high-yield corporates or EM sovereigns. Volatility adjustments lend themselves to more tactical, shortterm decisions. For example, if investors are worried about the near-term outlook and want to reduce risk, they might want to dial back their exposure. By contrast, volatility can be increased as a way of adding octane if the market is powering into a rally. Volatility adjustments can be useful in bringing a portfolio closer into line with investors’ objectives. For example, if they want more yield than their mix is currently generating, they can define a range of acceptable yields and then manage risk exposure up or down to keep portfolio yield within that range. How is volatility adjusted? One benefit of a strategy that can use synthetic risk premiums is that it is often relatively easy and cheap to adjust volatility. With a cash-bond portfolio, many transactions may be needed to recalibrate risk exposures, and the transaction costs are likely to be higher than for derivatives. Derivatives can be used to de-risk by increasing the proportion of cash in the portfolio. Or, to amplify exposure to the mix, a manager could reduce the cash proportion, possibly making use of some leverage. Being Able to Isolate Components Creates a Cleaner Barbell When Things Fall Apart: Tail-Risk Hedging Instrument Inflation Exposure Treasuries High-Yield Corporate Bonds High-Yield Credit Default Swaps For illustrative purposes only Source: AllianceBernstein Real Liquidity Credit/ Yields Risk Default Risk The systematic approaches that serve investors well under normal market conditions often fall short in periods of extreme market stress. The challenge is to protect against tail risk at times of crisis. We believe that an effective tail-risk hedging strategy can help investors by buffering their portfolios when extreme events occur and can increase the robustness of a better beta approach. There are numerous ways to manage the cost of tail risk by constructing strategies that allow investors to be long volatility in a cost-efficient manner. For a discussion of this technique, see Taking the Sting out of the Tail: Hedging Against Extreme Events, AllianceBernstein, January 2013. 5 Putting Better Beta into Practice inflation component to work in the opposite direction from the inflation premium embedded in Treasuries. While the list of levers can be extensive, the list of primary forces is short. Our research suggests that risk premiums across the fixed-income landscape are driven, to a great extent, by a small number of shared macro factors. This is important because it implies that accounting for a handful of macro factors can help stabilize a portfolio across many, if not most, economic scenarios. the many possible ways to combine risk premiums, we solved for the mix that has the lowest sensitivity to the primary macro factors. The next step would be to use an understanding of this system of forces and levers to help create a macro-insensitive, better beta portfolio. The goal was to assemble a portfolio of carefully calibrated risk exposures that together would minimize sensitivity to all the main market factors. What does the winning combination look like in practice? Not surprisingly, it still resembles a barbell, with exposure to both interest-rate-related and growthrelated assets. However, the difference is that it includes securities from multiple sectors and countries. The interest-rate (more defensive) side of the portfolio would typically have exposure to the government bond yield curves of What makes this possible is the ability to isolate individual risk premiums using derivative instruments (see explanation in sidebar, page 5). The task then boiled down to a mathematical calibration: of Display 5: Better Beta Compared with Barbell and Market Portfolios Total Return: December 31, 1999–December 31, 2013 Better Beta 185% 8.4% 5.8% 1.0 (12.5)% Cumulative Return Annualized Return Annualized Volatility 300 Ratio Sharpe Max Drawdown (Peak to Trough) Barbell 153% 7.4% 5.1% 0.9 (13.8)% Market 117% 6.1% 3.6% 1.0 (3.8)% Portfolio Composition December 31, 2013 Better Beta Better Beta Index* 260 Barbell 220 Barbell Market 180 Market 140 Primarily interest-rate driven Primarily growth driven 100 00 01 02 03 04 05 06 07 08 09 10 11 12 13 For illustrative purposes only. Historical analysis does not guarantee future results. Better beta: Simulated performance of multisector portfolio composed of Markit CDX High Yield Credit, Markit CDX Investment Grade Credit, Markit CDX Emerging Market Credit and Deutsche Bank G10 Currency Future Harvest (all primarily growth driven), and Barclays US Government Inflation-Linked Bond and Barclays US Aggregate Treasury (both primarily interest-rate driven) Barbell: Simulated performance of portfolio composed of 50% Barclays US Corporate High-Yield and 50% Barclays 5-Year Bellwether US Treasury Market: Historical performance of Barclays US Aggregate Treasury composed of US Treasuries, US agencies/government-related bonds, mortgage-backed securities, commercial mortgage-backed securities and asset-backed securities (all primarily interest-rate driven), and investment-grade corporates (primarily growth driven) Simulated performance results have certain inherent limitations. Unlike an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or overcompensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. *100 = 1999 Source: Barclays, Deutsche Bank, Markit and AllianceBernstein 6 multiple countries and have both nominal- and real-interest-rate exposure, i.e., exposure to both inflation-linked and ordinary government bonds. The growthrelated side of the portfolio would typically consist of investment-grade and high-yield credit in multiple countries as well as exposure to EM government debt and currency carry. (This example is from a US perspective, but we believe that the principles are broadly similar for investors in other developed countries.) Display 5 uses historical data to simulate the performance of a better beta portfolio from 2000 through 2013. The simulation compares the performance of a simple 50/50 barbell and a better beta portfolio that includes multiple countries, yield curves and credit sectors. Since the beginning of 2000, the barbell has outperformed the market by a cumulative 36 percentage points. Better beta added another 32 percentage points on top of that. In this period, the broad market index did generate roughly the same riskadjusted return as the barbell and the better beta portfolio—mainly because its performance was dominated by falling Treasury yields. But that bull run is unlikely to be repeated. Adding Additional Enhancements Is it possible to improve even further on the better beta results? One recommendation is to introduce tail-risk hedging. Macro-insensitive portfolio construction can improve outcomes over long time horizons, but over shorter time horizons (such as the 2008–2009 credit crisis), when asset performance is heavily influenced by additional financial market factors, we would advocate using tail-risk hedging to try to cushion the downside. On an ongoing basis, we also recommend a dynamic approach that seeks to enhance risk-adjusted returns by modifying the balance according to prevailing financial market conditions. In other words, while we think better beta is a good investor’s benchmark, we don’t advocate a passive set-it-and-forget-it approach. While better beta has outperformed the index over the past 13 years, we believe that it has even greater potential to outperform in the coming years. The growing popularity of unconstrained approaches today reflects the conviction that interest rates in the developed world are near a long-term bottom. We believe that, in a stable-interest-rate environment, this approach would produce attractive risk-adjusted returns. And we would expect it to make an increasingly useful contribution as we move into a rising-rate environment. Summary: Take Control of Your Risk Thirty years ago, investors didn’t need a surgical approach to bond exposure— government bonds allowed them to meet all their goals. In today’s bond markets, meeting bond investors’ objectives is more of a challenge. But while the task is more complex, so is the fixed-income tool set at our disposal. Investors are able to do things that were previously impossible. There are more ways to brace a portfolio against macroeconomic shocks, and more ways of being nimble and responsive to financial market shocks. The key distinction to make in exploiting this tool set is to think of risk premiums, rather than sectors, as the building blocks. We believe that isolating out and blending those exposures in a complementary way can unlock significantly greater portfolio efficiency. By taking a more controlled and systematic approach to beta, investors can improve their chances of adapting and thriving in today’s, and tomorrow’s, fixed-income markets. n 7 This page intentionally left blank. 8 Alison Martier Senior Portfolio Manager Michael Mon Searching for investments that offer more upside than downside Portfolio Manager Dimitri Silva Portfolio Manager Rethinking Alpha investors stand a very good chance of maintaining, and perhaps even improving, alpha if they are willing to explore new ways to capture it. Alpha, or the value created from active investment management, is traditionally associated with the weighting of securities against an index. We believe that this view of alpha needs to be expanded to reflect new market realities. After a 30-year bull run in bond markets, fixed-income investors find themselves in an environment that is increasingly challenging their ability to maintain alpha. For example, nominal yields are low and market liquidity has declined (Display 1)—conditions which, respectively, lower the dispersion of returns We believe, based on our research and investment experience, that the way to preserve or improve alpha and risk-adjusted returns in this environment lies not just in capturing upside, but also in limiting the potential downside of an investment opportunity. Such an approach consists of generating asymmetric returns, or what the fixed-income world calls positive convexity. The concept of convexity can involve some complex mathematics, but here we use it in its simplest sense, to describe the phenomenon where risk (and so limit the opportunities for investment) and put upward pressure on transaction costs. For many investors, this adds up to a bleak prospect of diminishing returns and sources of alpha. We do not accept that such an outcome is inevitable, however. In our view, Display 1: Challenges Abound for Fixed-Income Investors Yields Are Low… …and Liquidity Has Declined US and German 10-Year Bond Yields 6.0 US Treasuries 5.0 Dealer Balance Sheets* as Percentage of Credit Outstanding 14 More Liquidity Percent Yield (%) 4.0 3.0 2.0 German Bunds 7 1.0 0.0 Jan 01 Less Liquidity 0 Jan 04 Jan 07 Jan 10 Jan 13 01 04 07 10 13 Historical analysis does not guarantee future results *Primary dealer balance sheets for positions greater than one year Treasury yields through November 29, 2013; primary dealer balance sheets through May 31, 2013 Source: Bloomberg, Haver Analytics, Investment Company Institute, Morningstar and AllianceBernstein For institutional and financial professional use only. Not for inspection by, distribution or quotation to, the general public. 9 and reward are asymmetrical. By positive convexity, we refer to an investment with more upside than downside, and by negative convexity, we mean that the downside is greater than the upside. Convexity is particularly important for absolute-return investors who are typically measured against a cash benchmark and who need to be able to produce positive returns through the investment cycle. They aim to achieve attractive returns with an eye on risk. The big question, of course, is: how can investors achieve such results? Below, we attempt to answer this question by looking at some of the enhanced investment techniques that can generate alpha with asymmetric return profiles. Global Opportunities—with Risk Control Alpha, traditionally defined as the value created from active investment management, is usually associated with security selection—that is, the overweighting and underweighting of securities against an index. But we believe that this way of thinking about alpha needs to be expanded to reflect new market realities. In our view, it’s necessary to think of alpha as having two equally important components. The first is to identify a suitably promising investment opportunity. The second is to approach the opportunity in such a way as to achieve asymmetric returns or positive convexity. Identifying the Opportunity The scope for identifying alpha opportunities grows with the size of the investment universe and with the range of tools and instruments that investors can use to implement an idea. The potential opportunities are greatest for investors who are open to a global, Source: Ridgemont Equity Partners 1 10 multisector investment universe that spans credit ratings and capital structures, and to investing in both physical bonds and derivatives markets. As we shall see, alpha opportunities exist across market sectors and geographical regions. Pricing anomalies have always existed in fixed-income markets. One example might be when a borrower issues new bonds and investor demand causes the price of the new bonds to exceed the value of the issuer’s preexisting bonds (a phenomenon known in the US Treasury market as “on-the-run” vs. “off-the-run”). In credit markets, a similar opportunity can arise when a company loses its investment-grade credit rating and becomes a “fallen angel,” its bonds relegated to high-yield status. Investors able to buy such securities can do so at a steep discount to the bonds’ historical valuation, potentially making outsize gains as selling pressure on the bonds eases and the outlook for the company’s credit rating improves. Between January 1997 and March 2011, for example, fallen angels in the US delivered total returns of 10.3% compared with 6.5% for both investmentgrade bonds and bonds that were high yield at issue; volatility, respectively, was 11.4%, 5.7% and 9.8%.¹ Given the evolution that has taken place in global financial markets during the last 20 years—allowing investors to express a view in multiple ways (through physical bonds, futures or other derivatives markets)—one might assume such opportunities to have been arbitraged away. In fact, the opposite is true. The confluence of new regulations, a changing liquidity landscape and individual investor preferences leave the door wide open for those willing to research the opportunities. Expanding the Tool Kit As part of this evolution, investors have gradually adopted broader investment universes—through global mandates, for example, or “core plus” strategies that permit investments in international bond markets and securities with below-investment-grade ratings. But derivatives are still regarded with a healthy dose of skepticism, with many investors preferring to limit or restrict their use in portfolios. Some of this reluctance stems from widely publicized financial scandals involving the use of derivatives by “greedy” managers or rogue traders. It’s important to note, however, that derivatives are not bad in themselves; they are only as good or as bad as the uses to which they are put. It’s true that they can be used to leverage exposures in a portfolio and so amplify the returns of those investment ideas. If those ideas are flawed and if they have been leveraged with derivatives without due regard to the underlying risks, then the consequences can be damaging. But we believe that ruling out, or severely limiting, the responsible use of derivatives in an investment strategy can be a significant handicap, not just to capturing better returns, but to embracing better risk-control strategies. This is because derivatives can be used as a hedge to isolate a specific opportunity. For example, an investor might identify corporate bonds as attractive but not want to take on the interest-rate risk associated with those bonds. The investor could purchase the bonds and then sell a futures contract to hedge the interest-rate risk, remaining exposed to just the movement in credit spreads. Alternatively, if an investor is positive about the outlook for corporate bonds, he or she can express that view by simply buying a call option on an underlying asset, for example, an investor would gain the right to buy the asset at a predetermined strike price. This would maintain most of any upside gains while, on the downside, restricting the maximum loss to the size of the premium paid for the option (Display 3). Higher Display 2: Convexity Is Valuable to Bond Investors Price Bond Lower Putting the Theory to Work The ever-changing nature of the investment landscape often presents opportunities to construct investments with attractive, asymmetric return profiles. These opportunities exist in environments of abundant or scarce liquidity, and they can be structured in such a way as to make money irrespective of which way the market moves—thereby creating a greater universe of opportunities to capture alpha. Non-asymmetric Return Profile Lower Level of Interest Rates Higher Highly simplified example for illustrative purposes only Source: AllianceBernstein executing an index credit default swap (CDS)² to gain exposure to a basket of corporate issuers. Creating Positive Convexity Alpha opportunities with positive convexity can help mitigate the risks of the linear return profile typically accepted by traditional long-only investors. A linear, or non-asymmetric, return profile is essentially a win-or-lose proposition. The purchase of a US$100 stock stands as much chance of making a large gain as a large loss. An investor would lose 100% of his investment if the price fell to zero, or double his money if the price rose to US$200. In the fixed-income markets, return profiles are less linear. Indeed, they amount to negative asymmetry, given that the most a bondholder can hope for is a return of capital plus interest while the downside risk in the event of borrower default could be as much as 100%. Hence, the idea of positive convexity carries a particular appeal for fixed-income investors (Display 2). One way to improve upon a win-or-lose proposition is to preserve most of the upside potential of an investment when the market rises, but limit the downside risk when the market falls. Let us examine some of these strategies in detail. An example of such a payout profile can be found in the use of options. By Yield-Curve Opportunities: Taking a Direction-Neutral View on Rates The natural shape of the yield curve—the Display 3: Options Can Provide Downside Protection Profit/Loss Typical Long Position Long Call Option Maximum Loss = Option Premium Price Highly simplified example for illustrative purposes only Source: AllianceBernstein Credit default swaps are a form of insurance for bond investors against the risk of losses on bonds they own. 2 11 Display 4: Yield Curves Revert to the Mean Difference Between Five-Year US Treasury Yields and Average of Two- and 10-Year Yields 0.4 0.3 0.2 Sector Opportunities: How a Barbell Can Lift Performance Percent 0.1 0.0 (0.1) (0.2) (0.3) (0.4) 1990 1993 1996 2000 2003 2006 2010 2013 Historical analysis does not guarantee future results Through September 30, 2013 Source: Bloomberg line that describes the relationship between bond yields of different maturities—tends to be concave, irrespective of either the absolute level of market interest rates or where long-term yields stand in relation to short-term. From time to time, however, the yield curve can become relatively linear in shape. History shows that the US yield curve tends to be strongly mean-reverting (that is, it has a strong tendency to revert to a normal concave shape). This can create an opportunity to profit from changes in the shape of the yield curve, at relatively little risk. Display 4 shows a change in the relationship between the nominal yield on the five-year US Treasury over time relative to its two- and 10-year counterparts (the line represents the difference between the five-year yield and the average of the sum of the two- and 10-year yields). Given the strongly mean-reverting nature of the data series, any extreme move on either side of the zero line has a reasonable probability of returning to a position closer to the line. Movements above the line reflect a rise 12 positive-convexity characteristics. The fact that the trade carries less risk than an outright duration bet also makes it attractive from a risk-adjusted perspective. A similar strategy could be constructed using options. in five-year yields relative to two- and 10-year yields, while movements below the line reflect the opposite. One way to exploit this information is through a combination of long and short positions known as a butterfly trade, in which a pair of trades on the two- and 10-year parts of the curve (the “wings”) inversely complement a trade on the five-year part (the “body”). When the data series is below the median (that is, when the yield differential is negative because five-year yields are lower than the average of two- and 10-year yields), the time is right to take a short position in the five-year part of the curve and a long position in the two- and 10-year parts (in the expectation that yields will mean-revert and five-year yields will rise relative to the two- and 10-year yields). A butterfly trade in the opposite configuration would be used when the yield differential is positive—that is, five-year yields are higher than the average of two- and 10-year yields. The mean-reverting tendency of the yield-curve shape gives the trade strong Another way of generating positive convexity can lie in constructing barbell strategies (which combine offsetting exposures to different fixed-income sectors) where they offer better risk-adjusted returns than a single-sector exposure. For example, the financial crisis of 2009 produced some notable opportunities in this respect. After a massive sell-off, corporate spreads had widened by hundreds of basis points, and markets were pricing in default rates consistent with doomsday scenarios that even the most pessimistic of analysts saw as unlikely. Investors who bought corporate bonds during the panic were rewarded handsomely as markets recovered, but there was a more effective way to take advantage of the opportunity. At the time, the extreme cheapness of corporate bonds was mirrored by the high valuations of government bonds. Yields on government debt were at all-time lows and, barring a doomsday scenario, it was difficult to see how a portfolio of investment-grade credit could possibly underperform government bonds. Many investors saw significant return potential in taking well-diversified positions in investment-grade corporate debt without assuming what seemed to be undue risk. Not surprisingly, within the investmentgrade corporate sector, financials were particularly cheap. And within the financials sector, Tier 1 bonds—which are at the riskier end of a bank’s debt capital structure—were trading at distressed prices close to 30 cents on the dollar. Such bonds were shunned by most investors at the time, as they were seen as very risky, given the ongoing financial turmoil. Thus, by bending the return profile in their favor, investors could, in this case, have generated significantly higher returns without any meaningful increase in risk. Display 5: A 60/40 Portfolio Outperforms Projected Returns 150 100% Corporates Basis Trades: Exploiting Inefficiencies Between Bond and Derivatives Markets +50% +22% 100 Percent 60% Treasuries/40% Tier 1 (17)% (19)% 50 0 Crash Mar 09 Recovery Corporates Crash Treasuries Mar 09 Recovery Tier 1 Banks As of March 31, 2010 Historical analysis is not a guarantee of future results. Corporates refers to the corporate component of the Barclays Global Aggregate Index; Treasuries refers to US bonds of 25 years or more; Tier 1 Banks refers to Baa/BBB-rated Tier 1 bonds. Source: Barclays, Bloomberg and AllianceBernstein As the financials sector stabilized, the market delivered the recovery scenario that many investors had been expecting. Investment-grade corporates did well, returning 22%. But the 60/40 portfolio in our analysis returned 50%—even though US Treasuries, which represented more than half the portfolio, suffered losses. Conversely, when an issuer raises more money in the bond market, supply and demand can cause its bond spreads to Display 6: Changes in Basis Spreads Create Opportunities J.P. Morgan High-Grade Credit Default Swaps/Physical Bonds Basis History CDS Cheap to Physical Bonds 100 50 0 Basis Spread Instead of avoiding such an exposure altogether, however, an investor could use a barbell strategy, allocating 40% of the trade to these distressed bonds and the remaining 60% to US Treasury bonds. Our analysis showed that this combination would generate a more attractive risk/return profile than a diversified allocation to investment-grade credit. In a scenario of economic recovery, our analysis indicated that the Tier 1 bonds would more than double in price, easily compensating for the modest decline in US Treasury prices that would occur. In a “crash” scenario, assuming greater financial turmoil, the Tier 1 debt would default and return only an estimated 10 cents on the dollar, but US Treasuries would likely gain strongly in a flight to quality, mitigating total portfolio losses. In other words, the trade would have more upside potential than a straight investment-grade credit exposure, with broadly similar downside risk (Display 5). Credit risk should, in theory, be priced identically in the physical bond market and the CDS market. But this is not always the case. For a variety of reasons, including the inability to finance positions and unwillingness by investors to realize losses, some physical bonds have limited liquidity compared with the CDS that references the same corporate entity. This could make it difficult to sell the physical bond when, for example, news headlines about the borrower raise concerns about its creditworthiness. In such cases, the CDS market can become the sole means of hedging out credit risk. CDS spreads then tend to gap wider than the spreads on physical bonds, creating a “positive basis.” (50) (100) Physical Bonds Cheap to CDS (150) (200) Increased Volatility (250) (300) 05 06 07 08 09 10 For illustrative purposes only Source: J.P. Morgan 13 Foreign Currency Opportunities: Improving on the Zero Sum From time to time, economic turmoil or widespread deleveraging can lead to significant volatility in the foreign exchange markets. With some US$1.5 trillion traded daily in spot markets Display 7: Short Foreign Currency Trade vs. Options Put Spread Payout Profile 20 Profit/Loss (Percent) widen relative to CDS spreads, causing a “negative basis.” A negative basis can also arise when financing becomes scarce, causing some investors to liquidate their physical positions—an event that would drive volatility (Display 6, previous page). When such pricing discrepancies occur, investors with access to funding can capture the spread between the two markets by buying the physical bond and buying CDS protection (or vice versa) on the expectation that the basis will return to its normal range. This is a classic arbitrage opportunity in which the investor is not exposed to credit risk because, in the case of default, the bond (long credit risk) and the CDS position (short credit risk) offset each other. 10 Strike Price (Bought Put) 0 Strike Price (Sold Put) (10) (20) Lower Higher Price Short Foreign Currency Trade Options Put Spread Highly simplified example for illustrative purposes only Source: AllianceBernstein alone, the foreign exchange markets are highly liquid compared with other asset classes. Currency options markets are also highly liquid, which facilitates the use of derivative strategies to mitigate risk and enhance returns. Take the example of a currency that has deteriorating fundamentals. In this case, an investor could potentially generate attractive returns by shorting it. But in periods of high volatility, this strategy is risky because a sudden reversal in the Addressing Counterparty Risk When using derivatives that are not cleared through an exchange, one important consideration is counterparty risk: the risk that a counterparty will fail to fulfill its contractual obligations. Reform efforts in the US and around the world are driving the markets for derivatives toward central clearing. These efforts should significantly mitigate counterparty risk associated with trading over-the-counter (OTC) derivatives, as well as increasing transparency. While we welcome these developments, we believe that they should be regarded as enhancements to internal third-party counterparty credit-monitoring processes. When selecting counterparties, it is crucial that they are in good financial health with the ability to meet their commitments. With this in mind, investors and their risk managers should regularly monitor the counterparties with which they transact. Ideally this should be done through a risk-based monitoring approach that focuses more frequent monitoring on the largest and most important counterparties. Best practice, in our view, 14 involves monitoring through a special-purpose committee using a process that incorporates fundamental credit analysis, including input from internal and external credit-rating resources. We also recommend regular monitoring of market-based credit measures, such as credit default spreads. The posting of collateral is another powerful way in which counterparty credit risk is addressed in the swaps market. For example, in standard single-name CDS contracts, AllianceBernstein requires the daily posting of collateral (typically cash or US Treasury bills) to offset changes in the mark-to-market value of the CDS. In other words, as the CDS spread widens—indicating that the reference entity is getting progressively closer to default—the protection seller is required to post more collateral to compensate for the increased risk of default by the reference entity. The process works in reverse when the spread narrows, with collateral being paid back to the protection seller. currency’s downtrend could trigger large losses. An alternative strategy would be to purchase a put option, which would limit the maximum possible loss on the trade to the premium paid for the option. The put option has an attractive asymmetric structure in which the maximum potential gain is far greater than the maximum potential loss. Capturing that benefit comes at a cost, however, and the option price could be high if the market expects volatility to be high. It is possible, however, to reduce the net cost by creating an option strategy known as a “put spread.” This involves the investor buying the same put option while also selling a put option on the same underlying currency with a strike price further out of the money. In this strategy, the premium received for selling the out-of-the-money put would help offset the premium paid for the put purchased. The investor still faces a potential loss if the currency strengthens, but the size of the loss would be reduced by the premium received. In the event of the spot exchange rate rising, the “plain vanilla” short position would generate linear losses; with the put option, however, the loss would be limited to the cost of the option. In the event of the spot level falling (as the investor expects), then both the outright short and the put option would be profitable. By selling a put option with the same expiration but at a much lower strike price, we can mitigate some of the cost of the purchase of the put. While this also caps the upside, the overall risk-adjusted return is attractive (Display 7). Conclusion All active investment strategies share a common purpose—to generate alpha. But there is more than one strategy to approach this goal; indeed, there is more than one way of thinking about alpha itself. We believe that the traditional way of thinking about alpha—simply as value created by overweighting and underweighting securities against an index—is no longer adequate. Investors, in our view, should think about alpha more broadly as a dual process consisting, firstly, of a search for opportunities across the fixed-income universe and, secondly, in terms of constructing strategies to take advantage of opportunities in such a way as to achieve asymmetric returns or positive convexity, in which the upside potential is greater than the downside risk. The key is to remain flexible and take advantage of as many sectors and investment methods as possible. The ever-changing nature of today’s fixed-income markets means that, with the right analysis and risk management, there is always another new opportunity ahead. n 15 This page intentionally left blank. 16 Seeking cost-effective tail-risk hedging opportunities across multiple asset classes Taking the Sting out of the Tail: Hedging Against Extreme Events Investors are still smarting from losses that—according to widely held statistical assumptions—should have been almost impossible. And they want protection against a repeat of such shocks in the future. We believe that the right tail-risk hedging strategy can offer a solution. In our experience, many investors remember 2008 as the year when diversification failed. The global financial crisis caused historical relationships between many asset classes to break down and correlations to rise, so that even carefully diversified portfolios suffered. Since then, recurring volatility has driven investors to seek strategies that provide better protection, particularly in periods of extreme market stress or “tail risk.” The notion of tail risk refers to the “tail” associated with a normal (“bell curve”) distribution of returns. Most returns are clustered around the average, but some fall well beyond the average (Display 1, next page). A tail-risk event is defined as the probability of an investment’s return moving more than three standard deviations above or below the average in a given period. Assuming a normal distribution of returns, the likelihood of a three-standard-deviation event is roughly 0.3%, or three times in every 1,000 occurrences. And the probability of a negative tail event is half that number. The idea of buying protection against such a rare occurrence seems counterintuitive, but history shows that realworld returns have not always behaved like a normal distribution. This is illustrated by the pattern of daily returns for the S&P 500 from January 1928 through July 2011. In a normal distribution, a negative tail event should have occurred on about 28 days since 1928. In reality, extreme losses occurred about seven times as often, on 197 days. Portfolios are traditionally structured to cope with “normal” levels of volatility, usually in line with a long-run historical average, so portfolio construction and sources of diversification often fall short of expectations in periods of extreme market stress. The average 60/40 portfolio lost more than 29% in the year ending February 28, 2009.1 Compounding the pain was the challenge of winning back lost ground: when a $100 investment declines to $70 (a loss of 30%), investors need to generate a 43% return just to break even. In recent months, more of our clients have been asking about protection strategies—whether they own traditional stock-and-bond portfolios or more complex asset classes such as hedge funds. We think that when diversification falls short, tail hedging can be a solution. There are many ways to approach tail hedging, ranging from a simple purchase of “insurance” via put options to a portfolio of volatility-focused strategies that spans multiple asset classes. 60% S&P 500 and 40% Barclays Capital US Aggregate Index, rebalanced monthly, from March 1, 2008 to February 28, 2009. Source: Barclays Capital, S&P and AllianceBernstein 1 17 Equity Put Options Are Straightforward but Can Be Costly One popular way of hedging tail risk is to purchase equity put options. These give the owner of the contract the right to sell at a specified price—effectively helping to put a floor under potential losses if stock prices fall significantly. A common approach is a “buy and hold” strategy with out-of-the-money put options (the strike price is below current equity prices). Display 1: Tail Risk in Theory: A Normal Distribution Lowest 0.15% of Observations Highest 0.15% of Observations Put options can be an expensive way to hedge because the seller requires a risk premium. The option also has a timevalue component, becoming less valuable as it approaches expiration (this makes intuitive sense: as time passes, the probability of stocks making a major move decreases). This decay accelerates as the contract gets closer to expiration. 99.7% of Observations Tail The value of a put option is driven by price movements and volatility. A fall in equity prices below the strike price or a rise in volatility would increase the value of the option. Tail Source: AllianceBernstein Display 2: Put Options: A Naive Buy and Hold Strategy Can Be Expensive Value of $1,000 in Three-Month S&P Put Options 1,100 Strategy Was Profitable US Dollars 1,000 900 SPX D12.5 800 700 Strategy Lost Money SPX D25 600 2005 2006 2007 2008 2009 2010 2011 2012 February 2006–December 2012 SPX D25 represents a passive strategy where an investor buys and holds a three-month 25 Delta put option on the S&P 500, holding until maturity and enters a new transaction on each consecutive expiration date. SPX D12.5 represents a passive strategy where an investor buys and holds a three-month 12.5 Delta put option on the S&P 500, holding until maturity and enters a new transaction on each consecutive expiration date. Source: Bloomberg, S&P and AllianceBernstein 18 Because of this decay effect, a buy and hold strategy that entails rolling from one contract into the next on expiration has not always yielded the results an investor might expect. Display 2 shows the value of a $1,000 investment in two out-of-the-money put option strategies. From February 2006 through February 2008, a buy and hold strategy would have detracted from portfolio performance. While falling share prices and rising volatility made the option position more valuable during the depths of the crisis, a “return to normal” saw those gains given back by the first quarter of 2009. So this was a relatively inefficient way of achieving a few months’ worth of downside protection. A More Nuanced Approach: Identifying Shared Drivers of Risk In some ways, returns are about difference while risk is about similarity. For return-focused managers, success often lies in identifying differentiating factors between investments. Traditional long-only investors look at distinct opportunities in and between different asset classes.2 And they focus on different fundamentals: for example, equity investors might look at earnings growth while corporate bond investors are more interested in the ability to repay debt. Display 3: Volatilities Are Highly Correlated: 6 Equity Volatility (VIX) 5 Australian Dollar Volatility 4 But for managers with a risk focus, the answers often lie in the similarities. For example, as recent events illustrate, volatility is a common link between asset classes (Display 3), and the returns on different asset classes can be highly correlated in times of crisis. High-Grade Corporate Bond Spread Emerging-Market Debt Spread Z-Score 3 2 1 0 (1) Under normal circumstances, different asset classes are driven by different sets of factors, which is what makes them good diversifiers. But there is usually an overlap; for example, the prices of most assets are influenced by macroeconomic factors such as interest rates and GDP growth. In a crisis, the usual drivers of performance may be superseded by new factors that affect all asset classes in a similar way. For example, changes in market liquidity can affect multiple asset classes at once. And given that many assets exploit some kind of risk premium—such as the value premium in equities or the interest-rate differential (“carry”) between currencies—when risk aversion spikes, the returns from most active strategies suffer. As a result of these relationships, we believe one of the keys to success is to be volatility centric—in other words, to identify cost-effective ways in which an investor can be “long volatility.” Ways to Go “Long Volatility” When investors own assets that carry a risk premium, such as emerging-market currencies or high-yield bonds, we think of them as being “short volatility” because when volatility rises, they are likely to lose money. (2) 1996 1998 2000 2002 2004 2006 2008 2010 2012 Through December 31, 2012 Historical analysis is not a guarantee of future results. All time series are shown in Z-score units, standardized for the period January 1996–August 2011. A Z-score is a measure of the distance from the mean of a distribution normalized by the standard deviation of the distribution. Z-scores help quantify how different from normal a recorded value is. Equity volatility is represented by the CBOE Volatility Index (VIX), Australian dollar volatility by one-month implied volatility on AUD/USD, and debt volatilities by option-adjusted spreads on the Barclays Capital US Corporate Index and Barclays Capital Emerging Markets Index. Source: Bank of America Merrill Lynch, Barclays Capital, Bloomberg and Chicago Board Options Exchange The goal is to identify investments and instruments that are highly price sensitive and can be used to balance these exposures. In this way, when volatility spikes, gains from tail-risk hedging should help to offset losses that accrue in a portfolio during periods of market turbulence. We believe that the best results can be achieved by seeking hedging strategies across multiple asset classes, dynamically allocating funds across these opportunities in a way that seeks to minimize the cost of implementation. Examples of such strategies include: n In equities, put options benefit when equity prices fall and volatility rises. As discussed earlier, a pure buy and hold strategy can be expensive. But there are more cost-effective ways to use put options. For example, unnecessary costs can often be avoided by taking a more active approach, in which the manager continuously monitors volatility curves and rolls out of one position into another well before the expiration date. n Call options on equity volatility (such as options on the Chicago Board Options Exchange VIX index) benefit when volatility rises. n In currencies, options can be used to construct strategies. One example is an “anti-carry” trade that takes a long position in low-yielding currencies like the Japanese yen and a short position in a high-yielding currency like the Australian dollar. The idea is that 19 Display 4: Implied and Actual Volatility Can Diverge Significantly: Realized (Trailing) Volatility and Implied Volatility of 10-Year Treasury Yields 100 90 80 = Actual Volatility > Implied Volatility Risk “Underpriced”/Protection “Cheap” Actual Implied 70 Percent 60 50 40 30 20 10 0 2000 2002 2004 2006 2008 2010 2012 April 2000–December 2012 Historical analysis is not a guarantee of future results. Implied volatility represented by three-month options on 10-year swap rates. Source: Bloomberg and AllianceBernstein higher-yielding currencies typically underperform safe-haven currencies when market participants get more risk averse. n n n 20 In fixed income, interest-rate swaps can be used to take interest-rate exposure (duration) so that the portfolio benefits when yields fall, for example when panic triggers a flight into Treasuries. Interest-rate swaps can be used to construct a yield-curve flattener—for example, a short position in two-year yields and an equal long position in 10-year yields. Yield curves tend to flatten in an economic crisis, with longer maturities outperforming as growth and inflation expectations fall. In credit, credit default swaps (which function like put options) benefit if corporate bond values fall. Credit default swaps can also be purchased to insure against default in different tranches of a basket of liquid securities. Insurance against the first five defaults costs more than insurance against defaults by the next five and so on, because the likelihood of many companies failing is lower. In a stable economy, it can be very cost-effective to buy insurance against an extreme scenario. Protection at the Right Price Like any other asset class, some of the instruments that provide protection are more expensive than others, and in-depth research can identify pricing anomalies and opportunities. While different asset classes tend to experience similar levels of volatility at times of extreme market stress, there can be a wide dispersion under more normal market conditions. This implies that while all forms of tail-risk protection become expensive in a crisis, for the rest of the time the cost of tail hedging strategies can vary greatly. So it is a question of identifying where protection is most reasonably priced. Taking an example from the interest-rate options market, Display 4 shows the actual volatility of 10-year Treasury yields since 2000, compared with the level of volatility implied by option pricing beforehand. At many points in time, actual volatility turned out to be higher than implied volatility. This suggests that risk was underpriced and protection was relatively cheap. At other times, implied volatility was higher than actual volatility, suggesting that protection was expensive and that, effectively, the risk premium was too high. This ebb and flow of costs highlights how important it is to seek opportunities across multiple asset classes, rather than relying on a single strategy. Display 5 arranges the same data in a different way, showing the percentage of time that actual volatility turned out to be much lower (the left side of the curve) or higher (the right side) than implied volatility. The distribution of the data is skewed, with more extreme values falling to the right. In other words, especially at times of turbulence, the interest-rate options market has tended to underestimate how volatile yields are going to be, and “tail options” (insurance against extreme losses) have been priced too cheaply. The skewness also implies that because the market is not perfectly efficient in pricing risk, investors can use strong research to gain an edge. Identifying Cost-Effective Strategies We have researched and implemented ways to manage the cost of tail risk by constructing strategies that allow investors to be “long volatility” in a very cost-efficient manner. Display 5: Distribution of Differences Shows That Tail Risk Can be Cheap: Realized (Trailing) Volatility Less Implied Volatility of 10-Year Treasury Yields Actual Volatility < Implied Volatility Risk “Overpriced” Protection “Expensive” Actual Volatility > Implied Volatility Risk “Underpriced” Protection “Cheap” Occurrences 800 600 400 200 0 (36) (33) (30) (27) (24) (21) (18) (15) (12) (9) (6) (3) 0 3 6 9 12 15 18 21 24 27 30 33 36 Current analysis is not a guarantee of future results. April 2000–December 2013 Implied volatility as represented by three-month options on 10-year swap rates Source: Bloomberg and AllianceBernstein One way to do this is making an exchange, in which one can trade off (sell) insurance against higher-frequency/ low-impact events in order to fund the purchase of insurance against the much more damaging lower-frequency/highimpact events. This opportunity presents itself in many different markets. This could be compared to an automobile insurance premium with a high deductible. In insurance, the higher the deductible, the lower the annual premium charged by the insurance company. If you have a high deductible, you are willing to cover the costs of dents, scratches and other minor incidents (high frequency, low impact) in order to have a lower premium for collision and other major accidents (low frequency, high impact). Another example would be the credit tranche strategy discussed previously. Buying protection on riskier tranches is expensive (and selling it is lucrative) because the market expects a few names to default even in normal conditions. Buying protection on the least risky tranche is cheaper because the market doesn’t expect many defaults unless a extreme scenario unfolds. Put options on these “super senior“ tranches become more valuable at times of market stress because people start worrying about the potential for high numbers of correlated or systematic defaults. protect against tail risk at times of crisis, while actively managing any negative carry costs associated with the protection. There are many other ways to hedge in a cost-efficient manner, including exploiting term structures in rates markets. For example, earlier we referred to a yield-curve flattener. If yield curves are particularly steep, this position can pay for itself because long maturities compensate investors so well in the form of yield and roll return. For best results, we advocate an agile, active approach that dynamically allocates funds between strategies depending on current market pricing and prevailing conditions.n We believe that an effective tail-risk hedging strategy can help investors by buffering their portfolios when extreme events occur. We recommend maximizing the opportunity set by researching strategies across asset classes. In Summary While portfolio diversification has served investors well under “normal” market conditions, it may fall short in periods of extreme market stress. The challenge is to 21 AllianceBernstein L.P. 1345 Avenue of the Americas New York, NY 10105 212.969.1000 AllianceBernstein Canada, Inc. Brookfield Place, 161 Bay Street, 27th Floor Toronto, Ontario M5J 2S1 416.572.2534 AllianceBernstein Limited 50 Berkeley Street, London W1J 8HA United Kingdom +44 20 7470 0100 AllianceBernstein Japan Ltd. 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This document is confidential and proprietary information and should not be disclosed to any other person without the prior written consent of AllianceBernstein Limited.The contents are being provided to you solely for informational purposes and as an example of our internal research. It is not intended to be an offer or solicitation, or the basis for any contract to purchase or sell any security, product or other instrument, or for AllianceBernstein to enter into or arrange any type of transaction as a consequence of any information contained herein. The views and opinions expressed in this document are based on AllianceBernstein’s internal forecasts and should not be relied upon as an indication of future market performance. A Word About Risk Market Risk: All investments involve risk. The market values of a portfolio’s holdings rise and fall from day to day, investments may lose value. Derivatives Risk: Derivative instruments such as options, futures, forwards or swaps can be riskier than traditional investments, and may be more volatile, especially in a down market. Note to All Readers: The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. Note to Canadian Readers: This publication has been provided by AllianceBernstein Canada, Inc. or Sanford C. Bernstein & Co., LLC and is for general information purposes only. It should not be construed as advice as to the investing in or the buying or selling of securities, or as an activity in furtherance of a trade in securities. Neither AllianceBernstein Institutional Investments nor AllianceBernstein L.P. provides investment advice or deals in securities in Canada. 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