«Innovate2Invest 2017» – Protecting the Equity Portfolio

• Dr. Jan-Carl Plagge, Head of Applied Research
  

This is the sixth installment in an articles series on STOXX’s annual investment conference held in London on March 30.

An afternoon panel at the conference touched upon the topic of strategies to protect equities portfolios, an area that has seen extensive interest in the aftermath of the global financial crisis.

Dr. Jan-Carl Plagge, head of applied research at STOXX, reviewed a broad range of solutions available that enable investors to build defensive strategies.

He presented four main vehicles: minimum variance and low-volatility strategies (minimizing risk based on a variance-covariance matrix); risk-control indices (the use of a dynamic allocation between a risky asset class – e.g. equity – and a risk-free asset – e.g. cash); put strategies (holding put options); and finally, buying volatility (e.g. holding volatility futures).

Dr. Plagge reviewed the attributes of each case, and explained how each defensive strategy can work for different investors at different times. For example, he highlighted that a minimum variance strategy can protect a portfolio from downside moves but simultaneously outperform the market in the long term (Figure 1).

Similarly, risk-control indices enable investors to achieve a pre-defined tolerance level of volatility. Figure 2 shows the performance of the EURO STOXX 50 Index against EURO STOXX 50 Risk Control indices with defined target volatility levels ranging from 5% to 20%. While the underlying index had higher returns over the entire period analyzed, the risk-control indices were better at capping drawdowns during and after the global financial crisis.  

The EURO STOXX 50® Volatility (VSTOXX®) Short-Term Futures Index is an available product to replicate the return from a rolling long position in futures on EURO STOXX 50 volatility.

“The choice of the optimal strategy is context and preference dependent,” said Dr. Plagge.

A systematic ‘collar strategy’

Speaking at the same panel, Jean-Eric Pacini, head of EMEA institutional sales at BNP Paribas, discussed a common challenge for institutional investors such as insurers and pension funds. Deprived of relatively high yields in the fixed-income world, they are forced to search for income in the higher-volatility world of equities.

Yet, many of them, due to contracted liabilities, can’t commit to the corrections and bear markets that are likely to occur in equities every ten years, Pacini said. So they need to hedge their portfolios.

“A lot of investors are asking for innovation in the space of permanent hedging,” said Pacini, “with a protection not only against the tail but also against the drawdowns which happen more frequently – the 5%.”

While volatility-based products and variance swaps are popular, efficient and responsive, Pacini said they are designed for the tail risk and therefore expensive to carry.

Then there are very simple instruments such as put options. He said puts are easy to implement but convey timing risk. However, they can be helpful for a systematic and disciplined strategy where a portfolio buys protection every day, and not necessarily at a high price.

Pacini suggested implementing a so-called collar strategy. Firstly, starting with a long position in a stock or index. On that holding, out-of-the-money calls are sold daily (which can generate a yield of about 2%). With the proceeds from the calls, in-the-money puts are bought daily for 50% of the holding’s value.

According to Pacini, this defensive strategy provides higher annualized returns than holding an unprotected equities portfolio, while at the same time it halves volatility and the maximum drawdown, and doubles the Sharpe ratio of the portfolio. As an example, he said the overall strategy reduces the volatility of an index like the EURO STOXX 50 by 8 percentage points.

“It gives great results,” said Pacini. “You do the simple strategy every day; it just requires having the infrastructure to do it.“

Featured indices

STOXX® Minimum Variance Indices

STOXX® Risk Control Indices

EURO STOXX 50® Volatility (VSTOXX®) Short-Term Futures Index

EURO STOXX® 50 Index

Read about the conference’s other presentations:

`Innovate2Invest 2017’ – From Punched Cards to Qualitative Measures: 50 Years of Altman’s Z-Score

`Innovate2Invest 2017’ – No Doom Forecast by Nouriel Roubini, but Many Concerns About Trump

`Innovate2Invest 2017’ – The Complexity of ESG Integration

`Innovate2Invest 2017’ – The Future of Factor Investing

`Innovate2Invest 2017’ – Climate-Change Impact Linked to Investing