You Insure Big Ticket Items, Why Not Your Portfolio?
Most people choose to insure their largest and most valuable assets. Home insurance, car insurance, health insurance, boat insurance, the list of insurance policies goes on. As we consider the list of assets that people choose to insure, we discover a startling exception to the pattern — investments in securities are missing from the list of assets that are insured!
There are many reasons for this state of being, including an imperfect analogy. If a home or car is damaged, they are unlikely to restore themselves over time. With enough time, losses in asset class risk premia (i.e. beta strategies) have generally recovered. Although this sounds reassuring, consider the following,
- The recovery time to previous highs may be measured in years. For example, the S&P500 peaked at a 1,527.35 close on March 23, 2000, and it wasn’t until May 30, 2007 that it closed higher, at 1,530.23. Seven years is a long time to be under water — real patience is required, and in this case the patient investor was rewarded with the massive drawdown of 2008! If you expand your frame of reference to global indexes, you’ll see that the MSCI World Index had a drawdown period that lasted just under 14 years, from August 2000 to July 2014. Even more patience was required.
- The magnitude of drawdowns can be gut-wrenching. The aforementioned MSCI World Index drawdown had a trough of -57.6%. The bursting of the dotcom bubble at the start of the 2000s saw the Nasdaq Composite Index lose a harrowing 76.8% of its value.
- Given two portfolios with the same annualized average returns, the one that has a lower drawdown and volatility will generate a higher compounded rate of return [1].
Clearly there’s a need for taking active steps to minimize the impact of drawdowns (both in duration and depth).
Correlation Doesn’t Equal Insurance
Investors are generally familiar with some types of protection of investment returns, even if not through the application of literal insurance. Perhaps the most common approach is via diversification, that is, diversification of asset classes, types of strategies, and investment horizons. Diversification makes mathematical sense, and we are of course proponents of it! Proper diversification is critical for the best risk-adjusted returns. One unfortunate point that we can’t ignore is that in many crises, equity correlations in particular often increase, just when you want them to remain low [2]. In those situations, diversification fails to protect.
Portfolio protection via literal insurance is of course a counter-cyclical strategy in that the pay-offs come precisely when a strategy would be underperforming. An example of literal insurance would be the purchase of put options on an instrument or asset class that an investor owns. The problem with this approach is it tends to bleed cash during bull markets (i.e. the purchased puts expire worthless) and is costly in bear markets precisely when the insurance is most needed. Ultimately, this approach to offsetting downside risk is expensive and may have limits to scale.
It’s Good to Have Choices
Under the broad header of “insurance” or perhaps “tail risk strategies” what options are there for the informed investor to consider? At a high level:
- Insurance, literally. With the assumption that equity market risk is the risk being insured against, insurance most generally consists of purchasing out-of-the-money put options. While there is an appealing simplicity to this approach, such strategies have negative expected returns in the long-term [3], as do most forms of insurance.
- General class of strategies that may outperform when equities may be in distress such as diversified global macro and defensive equities. These may be a better choice than insurance, yet the investor needs to be aware that they may be dependent on a combination of assumed correlations and manager skill.
- Trading volatility. Now we’re getting to the heart of the matter: leaning into the volatility, so to speak, rather than turning away from it. Some strategies in this category may also be leaning on correlation, and some don’t.
QTS’ Approach — Tail Reaper
This topic looms large at QTS, and the approach we utilize is the inclusion of a proprietary AI-based strategy, Tail Reaper, which aims to perform well during (take your pick) periods of volatility and/or during equity market drawdowns. In other words, a specific and proprietary form of trading volatility. So rather than literally paying premiums (and thus diminishing returns) while waiting for some type of crisis, we prefer to incorporate a strategy that profits from market volatility. Some of the distinctive features of the strategy include,
- Fully automated — the strategy operates without human intervention.
- Dynamic nature — decisions are made daily depending on the market regime.
- Adaptive capability — an AI layer fine-tunes the trade sizing.
- Targeted exposure — exposure taken based on market regime (no overnight exposure).
- Diversification & Portfolio Protection — strategy has a negative correlation to the S&P500 by design making it a useful diversifier for most portfolios.
- Positive expected return — unlike literal insurance.
- Crisis alpha — built to perform well when equity markets do not.
- Economic and behavioral rationale — last in this list, and certainly not least, Tail Reaper exploits predictable actions of certain well-specified market participants, rather than hoping that past correlations persist.
For more information on Tail Reaper, feel free to reach out to us at info@qtscm.com.
Citations
[1] Compounded growth rate is g=m-σ2/2, where m is average returns, and σ is volatility of returns. See https://epchan.blogspot.com/2017/05/paradox-resolved-why-risk-decreases.html for an exposition.
[3] Tail-Hedging Strategies (aqr.com)
DISCLAIMER
- The information and opinions contained in this document are for background purposes only and do not purport to be full or complete. The information in this document is not personalized investment advice or an investment recommendation on the part of QTS Capital Management, LLC (“QTS”). No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained in this document, and no liability is accepted as to the accuracy or completeness of any such information or opinions.
- All investments involve the risk of a loss of capital. QTS believes that its proprietary investment program and research and risk-management techniques moderate this risk through the careful selection of portfolio investments. However, no guarantee or representation is made that QTS’ investment program will be successful, and investment results may vary substantially over time. Past performance is not necessarily indicative of future results.
