Key takeaways:

• A discussion on the key attributes of a diversifying portfolio protection strategy
• Assessing how the landscape around traditional hedging methods has changed in recent years and resulting structural considerations
• The importance of a robust approach to protection combining various elements designed to invest when spreads are most attractive, while limiting coincidental drawdowns

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What do you think a diversifying strategy should look like?

The main element of a diversifying strategy is its lack of correlation to the main elements of an investor’s portfolio. In addition, that really means that the diversifying strategy is robust to sharp downturns in the market.

What is the point of a portfolio protection strategy?

Portfolio protection is really designed to insure a portfolio against sharp drawdowns. And those drawdowns often coincide with general risk widenings in the market. The ability to have a robust portfolio and drawdowns means the ability to invest when spreads are the most attractive and not to suffer drawdowns at the same time as the rest of investors’ portfolios.

How can protection be implemented?

There are a number of elements to a protection strategy that are important. Principally, protection must insulate the portfolio from sharp drawdowns, which means having exposure to volatility in the markets and protecting against sharp liquidity-driven drawdowns. Secondly, bear markets can come in a number of forms. Sometimes they are slow and drawn out and a way to isolate a portfolio from that is having some sort of trend-following CTA-like exposure. And finally, there are catalysts around the market that often can be insured against. That type of insurance is usually the purchase of options in other asset markets. So, the combination of those three elements can give you a robust set of insurance policies against adverse movements.

Isn’t buying options a loser’s game?

Historically, people have measured the purchase of insurance via outright hedging with options as being a very expensive and a loser’s game. I believe that the supply and demand for options and volatility in general has changed dramatically over the last five years. There are now substantial supplies of volatility being sold on a regular basis by systematic investors. That has changed the balance between hedging option buyers and sellers of volatility such that options aren’t intrinsically expensive like they were in the past in my view. It is also important to recognize how you structure your option exposure, how you hedge that on a cash basis and how you take into account the negative correlation between asset market levels. Using volatility as a hedge in a portfolio does not need to be a loser’s game.

How does this all fit together?

As with any alpha strategy, the construction of a protection strategy is as much art as science. We believe the combination of a number of different approaches to insulating the portfolio against large drawdowns is important not only in keeping returns steady and increasing the sharpe ratio in a portfolio, but allowing the portfolio to be able to increase its investment exposures at the right times when markets drawdown and not to be forced into liquidation in those periods.