Download The Decision Cycle for Downside Risk and Income-Focused

The Decision Cycle for Downside Risk and Income-Focused Strategies
March 8, 2017
Carlos Chujoy, CFA
Employees Retirement System of Texas
The Decision Cycle for Downside Risk and Income-Focused Strategies
Statement
Generally portfolios are designed to address the needs of a variety of investors.
i.e. Pension plans, endowments, family offices, high net worth, etc. These needs
have ranged from improving the growth of the underlying assets to the reduction
of overall portfolio risk, or both. A way to address these needs has been to diversify
into other asset classes.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Problem
Expanding the investment allocation to other asset classes did not bring in the
desired diversification benefits at a time when they were needed the most.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Cumulative Returns
 Equities have delivered the strongest returns over the past 26 years.
 60/40 performance is heavily influenced by equity returns
The Decision Cycle for Downside Risk and Income-Focused Strategies
Drawdown
 Strong equity returns have come at a price.
 60/40 performance is heavily influenced by equity returns
The Decision Cycle for Downside Risk and Income-Focused Strategies
Selected Stats
 60/40 shows accrues strong returns with a balanced risk profile.
 All return distributions exhibit negative skewness and positive kurtosis.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Concentration Risk
 Risk allocation of a 60/40 equity/bond portfolio is driven by the
most volatile asset class. In fact, 92% of the total contribution to
total portfolio risk is driven by equities.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Steps to address problem
1. Know what your portfolio looks like. Understand the return distribution.
2. Understand how assets behave during different market regimes.
3. Could a portfolio exhibiting different exposures to other assets done better?
4. Identify what that investment opportunity set looks like.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Return Distribution
 Seek to improve the return distribution of the current 60/40 by mitigating
left tail risk and improve risk-adjusted returns.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Why Options?
 Positive IV-RV spread = richly priced options = establish income focused strategies
 Negative IV-RV spread = cheaply priced options = establish protective risk strategies
The Decision Cycle for Downside Risk and Income-Focused Strategies
Strategies Analyzed
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Short Call/Put
Bull/Bear Call Spreads
Bull/Bear Put Spreads
Long/Short Straddles/Strangles
Long/Short Iron Condor
Long Put
Put Spread Collar
Short Risk Reversal
Note: All strategies are treated as overlays to a 60/40
The Decision Cycle for Downside Risk and Income-Focused Strategies
Downside Protection
 All downside protection option-based strategies delivered better returns
than a 60/40 with lower levels of risk.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Income Enhancement
 Most of the income focused option-based strategies delivered similar
returns to a 60/40 but with better risk-adjusted profiles.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Returns Across Multiple Strategies
The Decision Cycle for Downside Risk and Income-Focused Strategies
Cross Strategy Correlations
 Correlations for the
income focused and
downside protection
option based strategies
were negative over the
past 26 years.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Regime Drivers
 We use the Leading Economic
Indicator (LEI) to represent the
4 stages of a business cycle and
shade areas to denote
expansion, slowdown,
contraction and recovery
 We use the VIX as a proxy for
expected volatility.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Regime Drivers
The Decision Cycle for Downside Risk and Income-Focused Strategies
Backtest Results
The Decision Cycle for Downside Risk and Income-Focused Strategies
Backtest Results
The Decision Cycle for Downside Risk and Income-Focused Strategies
Backtest Results
 Use of a regime-based framework combined with option-based strategies
has shown promising results.
 We have applied this framework to a real equity portfolio and have tracked the
live performance of a paper traded options overlay portfolio. The results attained
have been in-line with expectations.
The Decision Cycle for Downside Risk and Income-Focused Strategies
Backtest
“The process of testing a trading strategy on relevant historical data to ensure its viability before the trader
risks any actual capital.” - Investopedia
“It is a term used in oceanography, meteorology, and the financial industry to refer to testing a predictive model
using existing historic data. It is a special type of cross-validation applied to time series data.” – Wikipedia
The Decision Cycle for Downside Risk and Income-Focused Strategies
Importance
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Environment to test an idea
Helps to quantify the success of a strategy
Provides insights as to the behavior of a strategy over time
Allows to perform comparative analysis across a range of strategies
Serves as a way to cross-validate results
Pitfalls
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Unrepresentative time period. In-sample.
Underestimates survivorship bias
Ignores market impact
Overfit of data and data mining
Underestimates hidden exposures
It is just a model