The three major market shocks of the last 20 years – the late nineties’ tech bubble, the Global Financial Crisis (GFC) and the coronavirus pandemic – have each influenced equity markets differently and required different risk management approaches.
- The tech bubble developed gradually over three years and after it burst it took four years for the market to recover.
- The steep falls in the market in in late 2008 and early 2009 were followed by a slow economic recovery. The stock market performance was strong, but not without a number of material ups and downs.
- At the beginning of the 2020 pandemic, we saw extreme market movements and high implied volatility: equity prices fell roughly 25% in less than a month and the rebound was nearly as rapid.
Traditional hedging/protection approaches
In the face of extreme market moves, investors can benefit from equity portfolio protection to avoid large losses and dampen volatility. It is difficult, however, to find traditional strategies using futures-based or options-based hedging structures that would have addressed the three patterns in the extreme market moves over the last 20 years:
- A long, gradual decline and a long, gradual rebound
- A sharp decline and a long, gradual rebound
- A sharp decline and a sharp rebound.
Traditional hedging strategies leave equity investors facing difficult trade-offs between the level of protection, upfront costs, and opportunity costs due to a limited participation in upside potential.
Innovative protection strategies
To circumvent these limitations, we recommend using the latest technologies for structuring and implementation with a dynamic and recurring review of the equity exposure.
Integrating these innovative features into equity protection strategies has a positive impact on short-term risk management. This was the case during the GFC. It also supports the performance for long-term investments. The concepts and features enable investors among other things to:
Benefits of a dynamically implemented hedge
The development of a hedging strategy based on the these features (referred to as an algorithm) is just the beginning for a structuring and portfolio management team when formulating an approach to protect an equity portfolio.
During implementation, the dynamic aspects of specific components — the type of protection, the splitting of the risk budget, and the periodicity of resetting the protection or any other characteristics and parameters — increase the protection value for equity investors.
Fundamental and quantitative market views (often described as Quantamental), considered in a dynamic context, offer another dimension that can be integrated during implementation, and can include:
- Anticipative de- or re-risking before a rules-based approach is triggered
- Selling of call options, not systematically, but based on market views
- Overriding the original features of the protection strategy for tactical reasons.
Impact on the pay-off profile
The innovative hedging techniques and strategies developed by BNP Paribas Asset Management help overcome some of the limits of traditional approaches and offer more attractive protection profiles, including:
- Greater downward protection through diversification and interaction between options and futures
- Cost savings from a potential cost reduction based on the fractional risk budget, and from the use of futures, which reduce the upfront option premium cost
- Increased upside potential thanks to the conditional sale of calls and the reduction in the use of stock index futures.
Source: BNP Paribas Asset Management, January 2021
Conclusion
Designing a strategy to protect an equity portfolio is not easy. Traditional equity index futures and options-based hedging strategies involve risks and costs that impact their effectiveness and efficiency. The most innovative and effective hedging strategies are based on:
- Hybrid structures
- Avoidance of a cash-out by dividing the risk budget, market indicators and forecast risk signals
- Dynamic implementation and active risk management.
These strategies help:
- Reduce initial costs and opportunity costs
- Manage timing, gap and roll risks.
Finally, it is important to note, such an innovative and dynamic hedging approach can be easily extended to a multi-asset portfolio, with bond index futures covering government bonds and any corporate credit allocation, along with proxy hedging for alternative investments.
Also read: Cash flow matching through a crisis and Investment decisions in volatile times
