PIMCO
Below we discuss some of the most important issues currently facing investors and consider some strategies and potential solutions to help address these challenges.
Q: What is the New
Developed economies and markets likely will not return to the heady growth of the past 20 years. In the New Normal, we expect to see more government regulation and participation in the private sector, less use of leverage, and a decrease in globalisation. This will likely lead to: Lower growth, Reduced corporate profits and Higher inflation than in the past. Most allocation models look backward, but modern-day finance is fast-forwarding and reconstituting itself rapidly. Sea changes in the drivers of global growth, trade and capital flows should result in the re-definition of the traditional asset-allocation models.
With this in mind PIMCO believe investors and advisors need a forward-looking investment approach that focuses on risk factors, not just asset classes. They also need the ability to hedge portfolios against ‘fat tail’ events and get into position to benefit from future opportunities.
Q: What are risk factors and how do they differ from the old asset-allocation models?
A risk factor is an underlying risk exposure within an asset class for which you are paid via a return premium. For example, developed equity indexes deliver excess returns because investors demand compensation for assuming the “equity risk” factor, aka a junior position on the capital structure with a residual claim on future earnings. Developed government bond indexes compensate investors for assuming a “bond risk” factor, aka primarily duration and in recent month’s sovereign credit risk.
In the New Normal, the key issue is identifying the risk factors most likely to provide returns, and then determine how to combine portfolio assets to create an efficient, controlled exposure to those risks.
Because asset allocation decisions are the primary driver of long-term returns, the ability to directly align beta exposures with PIMCO’s risk factor views may improve investors’ ability to achieve their long-term return objectives. In this sense, asset classes are simply “carriers” of underlying risk factors. We believe it is better to specify desired risk factor exposures and gain them through the most efficient combination of assets, than to specify an asset allocation and be left with an unspecified and potentially concentrated exposures to underlying risks. This is particularly true in a global economy that is:
- Continuously evolving, which calls into question the stability of historical asset class characteristics (e.g., correlations, volatilities, return levels) and;
- Increasingly interconnected, which speaks to the tendency of asset class correlations to sharply converge (or sharply diverge, in some cases) especially during times of market stress.
Rather than looking to diversify across asset classes we focus on the following major risk factors: Stock Factor, Bond Factor, Monetary Policy/Crisis Response Risk, Currency Factor, Commodity Factor, Inflation Factors, Momentum Factor and Volatility Factor.
Q: Can you give some examples of the challenges in using asset class diversification as a proxy for risk diversification?
Many Assets, Same Risk: While there may be short term differences in returns among various equity sectors (e.g., large cap, mid cap, small cap, growth, value, domestic, international, etc), their long-term returns are primarily driven by their shared endogenous “equity beta.” In other words, from a risk perspective, they share the same key underlying equity risk factor and do not diversify each other to the degree generally thought, particularly after hedging out the distinct currency risk factor.
Different Risk Then, Same Risk Now: As asset classes evolve, their correlations can converge. This is most relevant today in which the correlations of US, non-US and EM equity exposures have converged. Similarly expect to see continued convergence in the markets for local EM debt, external EM debt and developed country debt. These long-term evolutions are reflective of an increasingly interlinked global economy, an obvious reality which is not fully reflected in backward-looking data.
Different on the Surface, Same Underneath: Seemingly unrelated assets can have meaningful overlap in terms of underlying risk factor exposure. For example, high yield bonds, local EM bonds, the S&P 500 and REITs and all have meaningful underlying equity risk factor exposure. Government bonds, corporate bonds, MBS and EM bonds all have meaningful underlying nominal duration. This overlap can be particularly troubling in times of market crises, when this common underlying risk factor may drive negative returns across these seemingly diverse assets.
Q: How does tail risk hedging strategies fit into an asset allocation solution?
One of the toughest lessons from the financial crisis is that there were relatively simple ways to prepare for the string of unthinkable developments that roiled financial markets. Protection from worst case scenarios – commonly known as hedging against ‘tail risks’, has become an extremely hot topic, since the degree to which many investors were hedged has literally determined the fate of their portfolios.
Tail risk can be defined as the risk posed by events that are relatively rare, but that can have a substantial impact on a portfolio. The ‘tails’ are where the bell curve tapers down towards the edges. We believe that a long-term investor needs to pay particular attention to the left tails which can have a meaningful negative impact on their returns.
Tail risk hedges are portfolios of option-like securities that have asymmetric payoff patterns which may complement your underlying asset allocation strategy. To hedge against a risk in the traditional asset allocation approach, an investor might consider selling risky assets, buying less-risky assets, buying momentum strategies, and buying flight to quality assets like short-dated government securities. As a complement, to these strategies, an investor might consider buying a portfolio of option-like securities and maintaining exposure to risk assets at a higher level. Investors gravitate to these strategies because they are designed to provide liquidity during periods of crisis and allow the investor to play offense, buying risk assets when their prices are down.
At PIMCO, we construct these portfolios of option-like instruments by using the deep and liquid options markets. In building these portfolios, we take account of investor hedging buckets, the specific exposures expressed in their portfolios and their desired hedge levels. We try to hedge the principal key risk factors directly – with instruments that explicitly address the dominant elements of risk. But frequently we use indirect hedges because they can potentially be useful in mitigating the cost of direct hedging strategies.
Our outlook for the New Normal suggests there is enough potential for future tail events to warrant hedging strategies for many investment portfolios.
Q: How can investors predict how much tail risk hedging they need?
Three elements help determine how much of a tail risk hedge a particular investor needs.
The first is how much damage to the portfolio the investor is willing to suffer, expressed as a percentage of the total assets that the investor can tolerate losing.
The second element is how much the investor is willing to spend per year on tail risk hedging, which can be expressed as a portion of the expected long-term return that the investor is willing to sacrifice in exchange for protection. For example, if the expected long-term return of the portfolio is 8%, an investor might be willing to spend 5% of that return (i.e. 40 basis points) on tail risk hedges.
The third element of the process is to break down the risk factor exposures in the portfolio: The equity factor, the bond factor and exposure to risks such as market momentum or geopolitical events. Once you determine these factor exposures, you can look at all the different instruments in the marketplace and figure out the best combination of strategies to hedge the portfolio.
The big lesson in 2008 is that the crisis led to outcomes that differed only in their magnitude to what we had seen before. But our theory that these tail risks always spur deleveraging, increased correlations between asset classes and a lack of liquidity has proven entirely valid during the crisis.
Q: What is unique about PIMCO’s approach for hedging against tail risk?
The most important part of PIMCO’s approach is our forward-looking investment process. It starts with a top-down view which really points out which risk factors – not simply assets, but which risk factors are undervalued from a forward-looking perspective. That gives us the intuition about which risk factors are attractively priced and can be used as a hedge, and which risk factors are expensive and require hedging to offset.
An example is PIMCO’s identification of housing as a principal risk factor four or five years ago. We don’t buy or sell houses, but we were able to identify risk factors that have positive and negative correlation with the housing risk factors. So not only could we underweight exposure to housing risk factors, but we could also put hedges in place by accumulating factors that are negatively correlated with housing, such as credit hedges, underweight’s in corporate bonds and super-senior tranches.
When the possibility of damage exists, it really doesn’t matter how good your estimates of probabilities are or even if you have a probability. If you know that you’re going to be out of business or your house is going to burn down, it doesn’t really matter what the probability of the event is. You just need to protect yourself because you cannot survive that event. At the very least you need to be ready to purchase insurance if it is attractively priced, even if your neighbour is telling you that you will never need it.
Q: Practical Allocation of these ideas for your portfolio
We understand that many of our clients have strategic asset allocations that are well integrated into their investment approach. However, this does not preclude you from accessing our approach to asset allocation through an unfunded overlay structure which allows for full expression of our secular and cyclical views across multiple asset classes. This way investors may benefit by leveraging PIMCO’s proven ability to navigate a complex and evolving global economy and investment landscape in order to both manage risk and deliver long-term return potential within your strategic investment portfolio.
We believe a return overlay can also help clients to manage against the uncertainty of tail events and produce outcomes that will be closer to those needed to meet your objectives. In doing so clients can directly modify the return distribution at the portfolio level, separate to the main asset class investments that the portfolio is composed of.
The dilemma for clients coming out of this crisis is how to define their overall risk target. If we take equities for example, which is the biggest contributor to risk in a clients overall portfolio, we are faced with two problems. One equities are fat tailed, i.e. there are more very high and very low return outcomes than predicted in the normal distribution curve. But unfortunately normal distributions form the backbone of much of the finance theory and portfolio construction tools. This can create a difficult choice for an investor where the right volatility level can lead to a larger than acceptable tail-risk, but the right level of tail-risk can result in too little portfolio risk and therefore return in normal market conditions.
By giving PIMCO access to your strategic asset allocation, we can construct a portfolio of options that reflect our views of the world whilst protecting clients from outsized losses due to inherent risks in their chosen asset allocation. By better controlling the downside risk, a return overlay can help with increasing diversification and moving a portfolio further up the efficient frontier and thus be able to achieve a higher return in the long-run.
To summarise the above offers several key takeaways:
· Macro views may be more important now than ever; investors need to look at both the short term and the long term and think about those views in risk factor terms. We’re in a period in the evolution of asset allocation where things are clearly changing, and it helps to think a little differently about assets and drivers of returns.
· The PIMCO outlook for the New Normal suggests there is enough potential for future tail events to warrant hedging strategies for many investment portfolios. These strategies can be designed to provide liquidity during periods of crisis and, importantly, allow investors to play offense, buying risk assets when their prices are down.
· A Dynamic Strategic Asset Allocation approach is a very attractive solution for investors going forward, but the implementation and timeliness of execution is paramount. Investors can implement these strategies through unfunded overlays which can meet a number of objectives, 1) Tilt the portfolio depending on where we are in the current market cycle, 2) Utilise a number of payoff options which can limit the portfolio’s downside risk, 3) Increase the overall diversification of the portfolio without medalling with the underlying asset allocations, and 4) Overall increase the long-run returns of the portfolio by moving the portfolio further up the efficient frontier.
We hope you find this to be a thought-provoking piece in terms of some of the most important issues you are currently facing as investors in the New Normal, and know that PIMCO stands ready to help you navigate this challenging investment landscape.