Fireproofing your portfolio against market shifts

Since then, investors have also faced a series of potential disasters, including the eurozone sovereign crisis, the Greek bailout and the US budget battle.

In spite of this, equities and other assets have risen strongly, and today volatility is relatively benign.

This presents an opportunity for pension schemes to focus on how best to protect their portfolios against the risk of further ‘black swan’ events, where almost all asset classes experience sharp and highly correlated negative moves.

Changing asset allocation is the most conventional approach, but reduced downside risk will come at the expense of reduced upside returns from assets. In practice, pure downside protection approaches fall into three main categories.

Derivative-based strategies

These strategies use financial instruments to hedge market risk, and can provide 'hard floors’ for certain assets, controlling funding volatility.

These approaches tend to be more expensive than the other two methods considered below, and buying downside protection using options requires a premium, which depends on market volatility, the time horizon, the level of protection and interest rates.

To reduce costs, some of the upside potential could be foregone, or the protection could be set at a lower level.

Investors need to manage any liquidity or counterparty risks that stem from the derivatives, which is particularly important if the protection is designed to pay off in extreme adverse scenarios.

One limiting factor of using derivative-based strategies is that exchange-traded hedging instruments are often insufficiently targeted in their exposure. While almost any derivative can be created over the counter, such solutions can be expensive.

Liquid exchange-traded derivatives exist for many major equity market benchmarks, but not for other benchmarks such as small-cap equities, smaller regional equity markets, credit or property.

Derivatives on standard equity indices can be used as a proxy to capture most of the downside risk, but protection is often incomplete.

Dynamic strategies

Dynamic strategies typically use liquid instruments to allocate dynamically between risky and risk-free assets, but they do not provide the same hard downside protection as derivatives.

These strategies usually work well in liquid markets, though they may not be as effective as derivative-based approaches in turbulent markets, when implementation of trades can prove difficult.

The approach seeks to replicate the payoff profile of options at lower costs. This entails adding risky assets in rising markets and reducing risk in falling markets.

More specifically, investors need to determine a risk budget that can be set aside in risky assets, and a so‑called multiplier, which specifies how quickly the strategy reacts to changes in market prices.

In practice, such strategies are often challenged in rapidly falling markets, when strategies cannot be implemented quickly enough as the trading frequency might not be high enough and/or markets dry up. This risk is often called ‘gap risk’.

Dynamic trading strategies typically incur lower explicit costs than derivative-based strategies and no premium has to be paid, though a dynamic switch from aggressive to defensive assets will typically reduce the expected return.

Signal-based strategies

These strategies seek to predict extreme future market scenarios to proactively neutralise or reduce risky asset exposure. Active portfolio managers may use qualitative judgements to act as a signal but more commonly, signal-based strategies are associated with systematic metrics.

Quantitative factors or ‘sentiment indices’ are used to try to forecast a sharp downward spiral of negative returns on risky assets.

A typical trigger signal might be expected to fire every few years, for example, to capture low-frequency but high-loss events. Signal-based protection strategies are not appropriate for investors looking for hard downside protection.

These strategies do not have an explicit cost, however there may be opportunity costs if the trigger misfires and the portfolio moves out of risky assets as markets rise further.

Identifying predictive signals for the next few crises is likely to be difficult.

For this reason it is good practice to build a risk sentiment index incorporating not just one signal, or one set of signals, but diverse signals that seek to capture many different types of information. This might include market volatility, emerging market risk, risk appetite and market liquidity.

John Dewey is a managing director in BlackRock’s client solutions team