Mind the gap – Hedging tails to provide liquidity in times of stress
- Provide a cushion against very large losses;
- Allow investors to increase risk in other parts of the portfolio;
- Provide liquidity during times of market stress.
Point 3 may be of particular interest to Australian super funds where, for example, FX hedges can incur large mark-to-market losses during times of market stress. For example, the latest Quarterly Superannuation Statistics published by APRA (March 2022) show the industry currently has $322bn of FX hedges. During the financial crisis AUD dropped 37.6%, which would have led to FX hedge losses of -$121bn based on current exposures at a time the overall portfolio was down -26% (-$577bn in today’s terms), and a COVID scenario would result in FX losses of around -$58bn at a time overall assets were down -$466bn.
Investors use a variety of approaches to try and mitigate losses in their portfolios, including diversification, market timing, and explicit hedging. While we agree all three approaches have a place in managing portfolios, hedging is by far the most reliable way to mitigate losses during times of market stress. It (almost) goes without saying that even investors who successfully add long-term alpha for their clients via market timing cannot always predict market drawdowns, and one only needs to look at recent market moves to see the pitfalls of relying too heavily on diversification (eg simultaneous sell-off in equities and fixed income with ACWI -18.9% and Global Agg -14.5% YTD on a total return basis).
Because it is reliable, hedging can be an important tool in building resilient long-term portfolios. However, that reliability comes at a cost, and because true market stress events are few and far between, we often find that the costs of hedging are more visible to investors than the benefits. Since most investors are not particularly concerned by small drawdowns, the cost of hedging can be reduced by focusing only on larger, less-frequent drawdowns. Specifically, tail hedging allows investors to hedge against only the most extreme outcomes that can inflict long-lasting damage on even the most diversified portfolios.
It’s worth reiterating that because tail hedging, by design, is only expected to ‘work’ in the most extreme circumstances, investors can expect to see (modest) losses in tail hedges far more frequently than they will see gains. However, it is the timing and magnitude of the gains that is important. A robust tail hedging program will provide investors with large gains when other parts of the portfolio are experiencing very large drawdowns. And that knowledge may also allow investors to adopt a barbell approach and take higher risk, and earn higher returns, elsewhere in the portfolio. One final point: to be reliable, a tail hedge needs to be “always on” since the whole point of hedging is that we can’t always predict a drawdown. In this regard, systematic option strategies can be particularly useful.
In addition to the FX exposures outlined previously, an additional liquidity drain may come in the form of capital calls on private equity commitments. The super industry currently has approximately $106bn exposure to private equity. Some basic assumptions (1) lead to a rough estimate of $11bn liquidity required in a crisis year. Further liquidity needs might reasonably be expected to arise from such things as capital raising (eg rights issues) from portfolio companies, investment opportunities in real estate, infrastructure etc arising from market and/or funding stress. The main point is that super funds can expect to have high liquidity obligations that are required (or desired) to be met during times of market turmoil, on our calculations as much as 6% of fund assets, and possibly much more.
A super fund could budget for this by setting aside some amount to be held in low risk, highly liquid instruments such as cash, ready to be deployed in times of stress. However, such an approach has an opportunity cost because the return on cash is much lower than the return on the rest of the portfolio. Using the past 15y years as a rough guide, a cash investment would have returned 2.6%p.a. vs approximately 5%p.a. for a typical balanced super portfolio. The last 10y would have been an even larger difference (1.5% vs 8%). The chart below shows the performance of a systematic tail hedge strategy(2) (light blue line) compared to the realised opportunity cost of holding an additional 6% of fund assets in cash (purple line) and the projected constant opportunity cost of holding cash (dark blue line).
Figure 1: Tail hedge strategy vs opportunity cost of holding cash.
Source: Bloomberg, Morgan Stanley and Challenger
The chart shows the long-term performance impact of running a tail hedge strategy can be substantially less than holding additional cash in the portfolio. The mark-to-market of the tail hedging program would need to be met over time, but the chart shows that the realised negative performance during “normal” periods is no more than the drag on performance from holding excess cash, and during stress periods the tail hedging realises large gains which can be used to meet any liquidity requirements. For the specific objective of providing liquidity during a crisis, we find an effective tail hedging program to be a more efficient approach despite the perceived “cost” of hedging.
1 10y fund life, 5y investment phase with capital called evenly, investment realisations of zero in a market crisis.
2 The example strategy is a SPX 3m 1x4 20d/5d put spread rolled monthly.
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