DR.CHENJIAZI ZHONG

In the Foreword of David Swensen (2009), Charles Ellis commented that Yale was good at playing defense, because the endowment was built to withstand the inevitable storms that face capital markets. This resiliency was recently put to a severe test, as the Yale endowment lost 25% of its value in the year ending June 2009. This has been termed a “tail event,” where the returns were at the extreme left tail of the endowment’s return distribution.

The key to minimizing drawdowns is to build some protection into the portfolio by making an allocation to assets that will maintain value or even rise in value during times of crisis. The most straightforward hedge is an increased weight on cash and risk-free debt in the portfolio. However, this will reduce the expected return of the portfolio and potentially lower the long-term wealth.

A second method to reduce tail risk is to employ options hedges on the equity-linked portion of the portfolio. Equity put options provide the purest hedge against tail risk, offering the potential to provide a greater than 500% return during times of increasing systemic risk, but this simple purchase can be quite expensive.

The cost of equity option hedges can be reduced through the use of collars or put spreads. In collar, a call option is sold above the market. While this limits the potential return from the equity-linked portion of the portfolio, the premium earned from the sale of the call option can offset the cost of the put options. In a put spread, the investor purchases one put option, at perhaps 10% out-of-the-money, while selling a second put option, at perhaps 25% out-of-the-money. This strategy can insure losses on the equity portfolio of up to 15%, but after the market has fallen 25%, the investor participates fully in market declines.

Bhansali (2008, 2010, 2011) advocates an opportunistic approach to hedging, which leans heavily on the idea that correlations between risky assets rise in a crisis. Bhansali proposes building portfolios of put option hedges from the currency, commodity, and credit markets and call options on volatility indices, buying hedges when they are cheap and selling hedges when they are expensive. To take advantage of the flight-to-quality nature of market crises, call options on high-quality bonds may also be employed. To the extent that this basket hedging approach is exchange traded, the hedges will be liquid even during a crisis.

Investors need to be careful, though, when hedges are purchased in the over-the-counter market. Trades in the over-the-counter market incur counterparty risk, which can be at its highest point during times of market crisis.

Just as Swensen does at Yale, the fixed income portfolio can focus on high-quality bonds that will grow in value during a crisis, while avoiding corporate bonds, where yield spreads widen quickly during market stress event. In hedge funds, it may be wise to reduce allocations to arbitrage, which rely on tightening spreads, the availability of leverage, and liquid markets to earn their returns. Macro, managed futures, and some volatility arbitrage funds are designed to have their largest returns during times of extreme market moves, so some investors specifically allocate assets to these strategies to reduce the tail risk of their portfolios.