Risk and Portfolio Construction

Downside Risk Protection - Preparing for the Worst

The Top Papers on Downside Protection

Let's say (purely hypothetically, of course) that assets are overvalued. Should you take out some downside protection, and if so, how? In one of the papers below, senior quants from AQR Capital argue that downside risk should be embraced, as being the major rationale for the equity risk premium. But you may not be so relaxed....

If you are at all concerned, you might want to check out these papers on risk models, options strategies, volatility, downside protection and tail risk hedging. Just in case, you know?   

Savvy Investor

New Risk Metrics for a New World (Swan Global Investments, 2018)
Swan Global Investments discusses three new risk measures designed to help minimize losses, mitigate tail risk, and provide steady, consistent returns. The author introduces the concept of a 'pain index' and 'pain ratio' as a measure for capital preservation purposes. 

How to Give Participants What They Want: Growth with Less Risk (Intech Investments)
(For compliance reasons, this paper is only accessible in North America)

In this paper, the authors show why loss aversion can be rational for your participants using some basic mathematics, but the truth is, they (and target date funds) need a commitment to equities. Further to that, the authors demonstrate how the symmetric return profile of adaptive volatility strategies offers your participants benefits across the investment lifecycle.

Video: Exit door scenarios: how to guard against rising correlations (Fidelity International, 2018)
(For compliance reasons, this video is only accessible in the UK and Europe)
During downturns, asset classes that were previously uncorrelated can become highly correlated. In this video, Eugene Philalithis, Curtis Evans, Adrian Benedict, Katie Roberts and Adnan Siddique discuss how our investors prepare for those scenarios.

Risk & Reward: The Theory and Practice of Portfolio Insurance (Invesco, 2017)
(For compliance reasons, this paper is only accessible in certain geographies)
What insurance strategy is most effective for portfolios of risky assets? 'Risk & Reward' examines the practical and theoretical aspects of portfolio insurance, also containing articles on factor investing and driverless cars. 

As the Cycle Lengthens, Investors Look to Hedge Tail Risk—But at What Price? (SSGA blog, Dec 2017)
Investors concerned about when the next pullback will occur (and how strong it will be) may feel warranted in hedging against tail risk events, as long as the price, the benefit of the hedge, and the cost of maintaining it make sense.

Coping with Chaos: Adding Value with Options Strategies (Invesco, Aug 2017)
(For compliance reasons, this paper is only available in certain geographies)
Although markets are chaotic, they are not perfectly chaotic and may be influenced by behavioural biases.  Invesco examines chaotic multi-asset portfolios in an effort to determine appropriate implementation of option strategies.

Hedging High Yield and Emerging Market Bond Tail Risk With VIX® Futures (S&P Dow Jones Indices, 2017)
HY corp bonds and EM USD-denominated bonds both suffer from lack of liquidity, making hedging these bonds portfolios challenging. Instead of hedging tail risk for these bond sectors via CDS, VIX futures can also be utilised.

A Framework for Generating Custom Multi-Asset Class Risk Models (Axioma, 2017)
Axioma presents a framework for multi-asset class risk models that is parsimonious, ensuring that a well diversified portfolio captures all relevant risk factors.

Smart Vol Management in a Risk On/Risk Off World (Intech Investments)
(For compliance reasons, this paper is only accessible in North America, Europe and the Middle East)

This paper explores the value of applying a dynamic risk-reduction approach to equity management in varying volatility regimes.

Embracing Downside Risk (AQR Capital Management, 2017)
AQR Capital Management examines option pricing for equity indices and concludes that most of the empirical equity risk premium relates to compensation for bearing downside risk. Downside risk, therefore, should be embraced.

The Best Strategies for the Worst Crises (Man AHL/Numeric Investors, 2017)
Two strategies are examined for hedging equities (futures time-series momentum and quality stock factors) including an evaluation of their historical performance from 1985-2016. 

Protecting Portfolio Value: Constant Proportion Portfolio Insurance Versus Tail Risk Hedging (PIMCO, Sept 2017)
Two common approaches to protecting gains while maintaining exposure to risk assets are constant proportion portfolio insurance (CPPI) and tail risk hedging (TRH). TRH may be the preferred strategy for several reasons.

Adding Alpha by Subtracting Beta: A Case Study on how Quant Tools can Improve a Portfolio's Returns (Axioma)
Discretionary (bottom-up) portfolio managers can use quantitative tools to identify and alleviate potential issues within portfolios, as well as potentially improving realized returns. This paper explains how.

Shaping bond allocations to hedge equity risk: think carry, not just correlation (Wellington, 2017)
During risk-off periods, money flows into safer assets such as government bonds and highly rated corporate issuers.  But with bond yields as low as they are, is there room remaining to offset potential equity losses?

Can We Use Volatility to Diagnose Financial Bubbles? Lessons from 40 Historical Bubbles (ETH Zurich, 2017)
Can volatility be used to indicate an early warning sign of unsustainable price increases (and associated crashes)? Pre-bubble, bubble, and post-bubble price volatility is examined from 40 well-known bubbles, with a paradoxical result.

Financial Risk Tolerance: A Psychometric Review (CFA Institute Research Foundation, 2017)
The CFA Institute Research Foundation reviews risk-tolerance tests, as well as risk-related terms such as validity and reliability, concluding with examples for later practice.

Government bonds as crisis protection (Man FRM, Aug 2017)
Using government bonds to protect portfolios from equity market sell-offs is something that investors are increasingly considering. Over seven crises in the last 40 years, government bonds have offered a degree of protection.

Why Downside Protection Is So Powerful for Emerging Markets Investments (Parametric, 2017)
EM equities are risky, due to heightened levels of currency, political, and liquidity risk. Another characteristic of this asset class is often ignored though - the large drawdowns that it routinely experiences.