VIEWPOINT

May 2018 Hedging for Profit: Constructing

Robust Risk-Mitigating Portfolios

AUTHORS Recent spikes in volatility have focused investors’

minds on mitigating the risk of an equity market
correction – and for good reason. The economic cycle
in developed economies is approaching its nine-year
mark, equity valuations appear high and yields on
Josh Davis high quality bonds remain low. While there’s no one-
Managing Director,
Portfolio Manager
size-fits-all approach to diversifying portfolio risks,
our research suggests that customized combinations of
traditional and alternative strategies may improve a
portfolio’s resilience better than any single approach.
Traditionally, many investors concerned about equity risk have turned to cash, core fixed
income, hedge funds and real assets. However, each of these exposures faces unique
Ashish Tiwari
Executive Vice President, challenges, including some with low return potential, while others have risk of correlation
Product Strategist reversal or heavy reliance on manager skill. They may still play an important role in policy
portfolios, but they may no longer suffice to mount a robust counter to equity risk.

More investors are beginning to add allocations to long-duration bonds, alternative risk
premia (ARP), managed futures and tail risk hedging to their equity risk-mitigation arsenal
to seek enhanced returns and maintain diversification. These strategies can be attractive
alternatives to traditional diversifiers. They offer the potential for attractive returns,
diversification versus equities and opportunistic liquidity. Nevertheless, these strategies come
Brad Guynn with their own risk-reward trade-offs.
Sr. Vice President,
In our view, combining multiple diversifying strategies may result in portfolios that are better
Product Strategist
fortified against a late-cycle downturn in equities. Recently, Jamil Baz, Josh Davis and
Graham Rennison presented theoretical and empirical support for this view in “Hedging for
Profit: A Novel Approach to Diversification.” They offer a mathematical proof as evidence
that a diversified portfolio of equity-risk-mitigation strategies may provide more reliable
diversification than any single method of diversification. The concept is similar to modern
portfolio theory, in which diversification along an efficient frontier provides the only
“free lunch.”
2 May 2018 Viewpoint

DIVERSIFIERS AND THEIR TRADE-OFFS
Let’s look at specific strategies, and their trade-offs, for
diversifying equity risk:
• High quality sovereign bonds, such as long-duration
U.S. Treasuries, have historically generally been an effective
hedge during flight-to-quality episodes, but can incur
negative returns if interest rates rise faster than
consensus expectations.
• Trend-following strategies tend to perform well in trending
markets and pair well with long-duration bonds (as the trend-
follower can cut interest rate risk by shorting rates during a
sustained sell-off in rates), but are susceptible to rapid
reversals in trends.
• Alternative risk premia strategies may enhance this
combination further, as they tend to do well in non-trending
markets and can act as an uncorrelated return driver. But they
can be vulnerable to coincident drawdowns in multiple risk
premia, however uncommon these might be.
• Tail risk hedging may offer a higher degree of reliability,
albeit at the expense of short-term return potential. In
contrast to the approaches above, tail risk hedging is based on
contractual derivatives – not correlations, which can break.
And contrary to conventional wisdom, tail risk hedges do not
always have a negative expected return or a cost associated
with them.
Figure 1 shows how specific strategies may perform in diverse
market scenarios.

Figure 1: Hedging effectiveness varies by market scenario

Most effective … Least effective …

Long Treasuries
in a sudden drawdown in rising rates

Correlation-based
hedge Trend-following
in trending markets in a trend reversal

Alternative
risk premia in coincident
in non-trending markets premia drawdown

Direct hedge Tail risk hedging

in a sudden drawdown in a slow/shallow drawdown

Source: PIMCO. For illustrative purposes only.

 May 2018 Viewpoint 3

CRAFTING AN OPTIMAL RISK-MITIGATION PORTFOLIO
We believe that constructing an optimal risk-mitigation
portfolio is about identifying the ideal blend of correlation-
based hedges and outright hedges. Its contours ultimately will
depend on an investor’s unique circumstances.
A starting point, which some U.S. institutional investors are
beginning to adopt, could include a bundled approach that
combines equal parts long-duration bonds, alternative risk
premia strategies and managed futures. This method has
attractive estimated return and single-digit estimated volatility
(see Figure 2).
Nonetheless, this combination presents two major vulnerabilities:
1. Correlation risk: This blend can have meaningful interest rate
risk, as well as some equity exposure, depending on the
positioning of the trend-following strategy. At the end of 2017,
for instance, most trend-followers had sizable exposure to
equity and interest rate risks. As a result, this combination is
particularly susceptible to a breakdown in correlation between
stocks and bonds.
 lthough the stock-bond correlation has been sharply negative
A
for the past two decades, history shows that it has fluctuated.
While it is not PIMCO’s base case that the stock-bond
correlation will become positive anytime soon, we think it is
likely to become less negative and more volatile as rates rise.
Our March paper, “Treasuries, Stocks and Shocks,” provides an
overview of our research into the history of this correlation. It
argues that whether the relationship is positively or negatively
correlated depends largely on whether a shock starts in the
stock market or the bond market.

Figure 2: Estimated performance of four sample portfolios

Enhanced Incorporating tail

Starting point defensive characteristics Capital-efficient approach risk hedging*

Short- Short-
Long Long Defensive Short-biased Defensive Long Defensive
Trend ARP biased biased
Treasury Treasury ARP trend ARP Treasury ARP
trend rrend

Tail risk hedging

Long
Treasury

Estimated return1 5.6% 5.5% 7.8% 2.5%

Equity beta vs. S&P 500 (0.20) (0.31) (0.66) (0.60)
Estimated volatility2 7.5% 9.2% 18.9% 12.8%
Sharpe ratio (cash=1.84%) 0.50 0.40 0.32 0.05
Duration 5.77 5.77 17.32 5.77
CVaR (95%)3 8.4% 11.4% 25.4% 16.7%

Source: PIMCO as of 31 March 2018

Hypothetical example for illustrative purposes only. Figure is provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product.
* The Tail Risk Hedging Program is a 20% OTM put with assumed annual spend of 30 basis points (bps) at the total portfolio level.
1
Index and model return estimates are based on the product of risk factor exposures and projected risk factor premia. The projections of risk factor premia rely on historical data,
valuation metrics and qualitative inputs from senior PIMCO investment professionals. Long Treasury is based on Bloomberg Barclays Long U.S. Treasury Index. Trend-following is
based on the Dow Jones Credit Suisse Managed Futures Index. The Alternative Risk Premia (ARP) Model assumes an annualized target volatility scaling of 10%, with a return
assumption of cash+7%. The Short-biased Trend and Defensive Alternative Risk Premia Model assumes an annualized volatility scaling of 10%, with a return assumption of
cash+5%.
2
See disclosures for additional information regarding volatility estimates.
3
Conditional value-at-risk (CVaR) is an estimate of the average expected loss at a desired level of significance.
4 May 2018 Viewpoint

2. Gap risk: This combination would not be resilient to a sudden
sell-off à la Black Monday (1987), the Flash Crash (2010), or
the gapping seen in February. During gap events, when a
security’s price jumps abruptly from one level to another,
Treasuries may or may not help, and trend-followers in
particular may get hurt due to a sudden reversal of a trend.
History shows that the performance of alternative risk premia
strategies can be highly variable during these periods and
therefore can’t be counted upon. The only diversifier that can
provide a meaningful and reliable impact during such
episodes is appropriately sized tail risk hedges.
Thankfully, these key deficiencies can be ameliorated:
• Correlation consistency can be improved with modifications
that seek to enhance the defensive characteristics of trend-
following and alternative risk premia strategies.
- Trend-following strategies can be given a “short bias” by
prohibiting long equity positions or by constraining overall
equity beta. Limits to overall duration may also be imposed.
- Similarly, alternative risk premia strategies can be made
more defensive by eliminating or constraining procyclical
strategies, such as volatility. Robust portfolio construction,
which seeks to minimize latent equity beta and duration
risks at the strategy level, can be another tool.
• Investors seeking the “most bang for the buck” can consider
adopting a capital-efficient solution. In this approach,
instead of fully funding each strategy, long-duration bonds,
which are highly liquid, serve as collateral for ARP and trend-
following strategies. While this package has meaningful
duration, and hence faces stock-bond correlation risk, it is a
way to use leverage to reduce risk at the overall policy level.
This option may be compelling to investors who believe the
stock-bond correlation will remain negative during systemic
market sell-offs.
• For conservative investors – for example, fully funded
pensions, which value reliability of diversification over return
potential – the issue of gap risk can potentially be addressed
by incorporating a tail-risk-hedging program. An option
for investors who do not want to write checks (and who
would?) is funding the cost of put options with the yield of the
Treasury portfolio. The key trade-off is that the level of gap-
risk mitigation will vary over time.
While the metrics in Figure 2 pertain to these diversifying
portfolios in isolation, the data in Figure 3 estimate the impact
they would have if scaled to a 10% allocation within an advanced
institutional portfolio.

Figure 3: Estimated diversification benefits on a typical institutional portfolio

10% pro rata allocation to risk-diversifying portfolios

Advanced Enhanced defensive Capital-efficient Incorporating tail

institutional portfolio Starting point characteristics approach risk hedging*
Estimated return1 4.3% 4.5% 4.4% 4.7% 4.1%
Equity beta vs. S&P 500 0.64 0.55 0.54 0.51 0.51
Estimated volatility2 11.5% 10.1% 9.9% 9.5% 9.5%
Sharpe ratio (cash=1.84%) 0.22 0.26 0.26 0.30 0.24
Duration 1.69 2.10 2.10 3.26 2.10
CVaR (95%) 3
24.9% 20.8% 20.4% 18.9% 17.9%

Source: PIMCO as of 31 March 2018

Hypothetical example for illustrative purposes only. Figure is provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product.
Refer to Figure 2 for additional important information and footnotes.
The Advanced Institutional Portfolio is an approximation of a typical large institutional investor portfolio and is constructed using consultant reports, internal PIMCO data and other publically available
industry data. The portfolio is allocated by market value percentage weight to the following proxies: 49.9% MSCI ACWI Index; 19.5% Bloomberg Barclays (“BBG BC”) U.S. Aggregate Index; 2.1% BBG BC
Global Aggregate Index (USD-Hedged); 3.0% BBG BC U.S. TIPS Index; 7.2% HFRI Fund-of-Funds: Diversified Index; 8.4% Private Equity Model; 7.0% Private Core Real Estate Model; 0.9% Bloomberg
Commodity Index and 2% BofA ML 3-Month USD LIBOR Index. It is not possible to invest directly in an unmanaged index. The model portfolio was created with the benefit of hindsight. The model portfolio
does not represent actual trading and does not reflect the impact that economic and market factors might have on management of the portfolio. No guarantee is being made that an actual portfolio will be
the same or that similar results will be achieved.
 May 2018 Viewpoint 5

GO YOUR OWN WAY

As discussed, the optimal risk-mitigation portfolio will depend

on each investor’s unique situation and goals. The good news is
that risk-mitigation strategies exist along an efficient frontier.
Strategies can be combined and customized to seek a solution to
address each investor’s needs.

We believe investors need to carefully analyze their portfolios in

order to design an optimal equity-risk-mitigation approach.
This may take time. But the recent spikes in volatility are a
salutary reminder that the best time to deploy a risk-mitigation
portfolio is before it’s too late.

Past performance is not a guarantee or a reliable indicator of future results.

The analysis contained in this paper is based on hypothetical modeling. No representation is being made that any account, product, or strategy will or is likely to achieve
profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated
results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results
and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot
account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific
investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.
We employed a block bootstrap methodology to calculate volatilities. We start by computing historical factor returns that underlie each asset class proxy from January
1999 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to
have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return
series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie
that particular proxy. For each asset class, index, or strategy proxy, we will look at either a point in time estimate or historical average of factor exposures in order to determine the
total volatility. Please contact your PIMCO representative for more details on how specific proxy factor exposures are estimated.
Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on
average over a 10 year period. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. Return assumptions are subject to
change without notice.
Conditional Value at Risk (CVAR) estimates the risk of loss of an investment or portfolio over a given time period under normal market conditions in terms of an average of loss
after a specific percentile threshold of loss (i.e., for a given threshold of X%, under the specific modeling assumptions used, the portfolio will incur an average loss in excess of the
CVAR X percent of the time. Different CVAR calculation methodologies may be used. CVAR models can help understand what future return or loss profiles might be. However, the
effectiveness of a CVAR calculation is in fact constrained by its limited assumptions (for example, assumptions may involve, among other things, probability distributions, historical
return modeling, factor selection, risk factor correlation, simulation methodologies). It is important that investors understand the nature of these limitations when relying upon
CVAR analyses.
The Sharpe Ratio measures the risk-adjusted performance. The risk-free rate is subtracted from the rate of return for a portfolio and the result is divided by the standard deviation
of the portfolio returns.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The
value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than
those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond
counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when
redeemed. Alternative strategies may involve a high degree of risk that each prospective investor must carefully consider prior to making such an investment and investments in
such strategies may only be suitable for persons of adequate financial means who have no need for liquidity with respect to Newport Beach Headquarters
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and commodity-linked derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit,
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