“We are long-term investors. Volatility doesn’t matter to our portfolio.”
This is an appealing idea.
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However, volatility itself reduces the long-term compound rate of growth of a portfolio, via a phenomenon called variance drag. Let’s consider two return streams, both with average annual returns of 10%, but with annualized volatility of 10% and 20% respectively.
The long-term compound growth rates of the
two portfolios will be 9.5% and 8.0%!
The adjustment factor is equal to half of the variance (or squared volatility). A reduction in volatility from 20% to 10% for the same average annual return increases the long-term compound rate of growth by 150 basis points.
For sufficiently high volatility levels, a return stream with 10% average annual returns actually compounds at a
negative long-term growth rate!
Simple Example: Start with $1 billion of equities and suffer a 20% drawdown, the equity exposure falls to
$800 million. If equities turn around and rally 20%, the portfolio will make only $160 million, not the full
$200 million you lost.
This is the negative impact of volatility and drawdowns on the compound growth of a portfolio.
Now, another popular argument:
“Tail hedging involves buying option-based insurance against market drawdowns. Because markets generally charge a risk premium for insurance, the expected returns of a tail hedging strategy over long periods of time are negative..."
"...As a result, along-term-oriented asset owner should not allocate to hedging strategies, as they will detract from long-term compound returns.”
Like many popular arguments, this is only partly correct.
Over the long term, you should expect negative
returns from tail hedging strategies. The market would be wildly inefficient otherwise. Individual long convexity
trades at certain points in time may be mispriced...
...and smart, dynamic hedging strategies might
be able to reduce the cost of carry over time, but it is unrealistically optimistic to think that tail risk hedges
can make money systematically over time.
But what this argument is missing is the portfolio effect. Tail risk hedges are inversely correlated with the performance of risk assets and produce outsized returns during times of crisis.
As a result, if tail risk hedges are added to a long-term, regularly rebalanced portfolio, they can cushion
drawdowns and mitigate the mechanical reduction of risk asset exposure during times of stress.
In doing so, they can enhance the long-term compound rate of return of the overall investment program, **despite the hedges themselves losing money over long periods of time on a stand-alone basis**.
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To briefly reiterate, on derivatives notional and counterparty risk.
Over the counter (OTC) derivatives are traded bilaterally between two large counterparties, under legal contracts called ISDAs.
Positions are marked daily and cash flows exchanged. No IOU's.
>>
If an insurance company has a billion dollars of notional on an interest rate swap with a bank, the value of that contract changes as interest rates change.
If the position marks $1mm in the insurance company's favor, the bank wires them $1mm.
>>
If the bank goes bankrupt, the insurance company's exposure to the bank is only however much mark-to-market PNL they earn on the swap *after* bankruptcy. Which could be positive or negative.
OK. Follow-up story about the transformation of investment bank risk-taking after Dodd-Frank and Basel III, and the rise of toxic Alternative Risk Transfer programs in derivatives. 💥
1
Before the Great Financial Crisis of 2008, the major investment banks used to be the center of aggressive risk-taking and speculation in financial markets.
They operated as dealers and market-makers, but also as massive proprietary risk-takers.
2
The securities divisions of major banks had proprietary trading desks that operated like hedge funds, using the bank's balance sheet to place bets. Many of today's hedge fund managers had their start on a bank's prop desk (present company included).
OK. Structured products are typically sold by wealth managers and brokers to high net worth and retail clients. They are issued and risk-managed by the exotic derivatives desks ar investment banks. These products were historically much more popular in Europe and Asia.
a theme that has come up a great deal this year is the perception that equity index tail hedges "aren't working"
important thing to keep in mind here is the robustness of a specific strategy to the path and speed of a market selloff
tail hedge or "flash crash hedge" ?
stocks experienced a slow, choppy grind down, S&P down mid twenties percent at trough, analogous to the feel of the tech bust of 2002-03 but much smaller
last few market stress periods were much faster and more explosive - March 2020 we saw S&P down 34% in three weeks
there is nothing inherent in markets that means equities only crash in a hurry. look at the historical data; long grinding bear markets are a thing
also think about why the tech bust analogy is not a coincidence
right. if twitter goes down, but you have done your duty and are on my list for the live Zoom event bc you donated to JDRF or pre-ordered Dr. Watson's book, you can email me thru our website, just reference your twitter handle qvradvisors.com