The Decision Cycle for Downside Risk and Income-Focused Strategies

March 8, 2017

Carlos Chujoy, CFA

Employees Retirement System of Texas

The Decision Cycle for Downside Risk and Income-Focused Strategies

StatementGenerally portfolios are designed to address the needs of a variety of investors.i.e. Pension plans, endowments, family offices, high net worth, etc. These needshave ranged from improving the growth of the underlying assets to the reductionof overall portfolio risk, or both. A way to address these needs has been to diversifyinto other asset classes.

The Decision Cycle for Downside Risk and Income-Focused Strategies

ProblemExpanding the investment allocation to other asset classes did not bring in thedesired diversification benefits at a time when they were needed the most.

The Decision Cycle for Downside Risk and Income-Focused Strategies

Cumulative Returns

Equities have delivered the strongest returns over the past 26 years. 60/40 performance is heavily influenced by equity returns

The Decision Cycle for Downside Risk and Income-Focused Strategies

Drawdown

Strong equity returns have come at a price. 60/40 performance is heavily influenced by equity returns

The Decision Cycle for Downside Risk and Income-Focused Strategies

60/40 shows accrues strong returns with a balanced risk profile. All return distributions exhibit negative skewness and positive kurtosis.

Selected Stats

The Decision Cycle for Downside Risk and Income-Focused Strategies

Risk allocation of a 60/40 equity/bond portfolio is driven by themost volatile asset class. In fact, 92% of the total contribution tototal portfolio risk is driven by equities.

Concentration Risk

The Decision Cycle for Downside Risk and Income-Focused Strategies

Steps to address problem1. Know what your portfolio looks like. Understand the return distribution.2. Understand how assets behave during different market regimes.3. Could a portfolio exhibiting different exposures to other assets done better?4. Identify what that investment opportunity set looks like.

The Decision Cycle for Downside Risk and Income-Focused Strategies

Return Distribution

Seek to improve the return distribution of the current 60/40 by mitigatingleft tail risk and improve risk-adjusted returns.

The Decision Cycle for Downside Risk and Income-Focused Strategies

Why Options?

Positive IV-RV spread = richly priced options = establish income focused strategies Negative IV-RV spread = cheaply priced options = establish protective risk strategies

The Decision Cycle for Downside Risk and Income-Focused Strategies

Strategies Analyzed

Short Call/Put

Bull/Bear Call Spreads

Bull/Bear Put Spreads

Long/Short Straddles/Strangles

Long/Short Iron Condor

Long Put

Put Spread Collar

Short Risk Reversal

Note: All strategies are treated as overlays to a 60/40

The Decision Cycle for Downside Risk and Income-Focused Strategies

Downside Protection

All downside protection option-based strategies delivered better returnsthan a 60/40 with lower levels of risk.

The Decision Cycle for Downside Risk and Income-Focused Strategies

Income Enhancement

Most of the income focused option-based strategies delivered similar returns to a 60/40 but with better risk-adjusted profiles.

The Decision Cycle for Downside Risk and Income-Focused Strategies

Returns Across Multiple Strategies

The Decision Cycle for Downside Risk and Income-Focused Strategies

Correlations for the income focused and downside protection option based strategies were negative over the past 26 years.

Cross Strategy Correlations

The Decision Cycle for Downside Risk and Income-Focused Strategies

Regime Drivers

We use the Leading Economic Indicator (LEI) to represent the 4 stages of a business cycle and shade areas to denote expansion, slowdown, contraction and recovery

We use the VIX as a proxy for expected volatility.

The Decision Cycle for Downside Risk and Income-Focused Strategies

Regime Drivers

The Decision Cycle for Downside Risk and Income-Focused Strategies

Backtest Results

The Decision Cycle for Downside Risk and Income-Focused Strategies

Backtest Results

The Decision Cycle for Downside Risk and Income-Focused Strategies

Backtest Results

Use of a regime-based framework combined with option-based strategieshas shown promising results.

We have applied this framework to a real equity portfolio and have tracked thelive performance of a paper traded options overlay portfolio. The results attainedhave been in-line with expectations.

The Decision Cycle for Downside Risk and Income-Focused Strategies

Backtest

“The process of testing a trading strategy on relevant historical data to ensure its viability before the trader risks any actual capital.” - Investopedia

“It is a term used in oceanography, meteorology, and the financial industry to refer to testing a predictive model using existing historic data. It is a special type of cross-validation applied to time series data.” – Wikipedia

The Decision Cycle for Downside Risk and Income-Focused Strategies

Importance

Environment to test an idea

Helps to quantify the success of a strategy

Provides insights as to the behavior of a strategy over time

Allows to perform comparative analysis across a range of strategies

Serves as a way to cross-validate results

Pitfalls

Unrepresentative time period. In-sample.

Underestimates survivorship bias

Ignores market impact

Overfit of data and data mining

Underestimates hidden exposures

It is just a model