Category Archives: Financial risk management

Boring derivatives

In public, and particularly in the news media, the word “derivatives” always seems to be spoken with ire or disgust. Stories involving derivatives are usually aimed at shaming greedy “Wall Street types” or describing the calamitous damage inflicted by an ill-conceived derivatives position. Wherever derivatives are mentioned there is likely a picture or graphic containing either handcuffs or a face-palming trader. Even Warren Buffett called derivatives “financial weapons of mass destruction.” But is there really cause to be terrified of derivatives as a whole? Part of the problem is that “derivatives” is a very large asset class, describing all assets whose values are derived from a notional amount and an observable event (e.g., default of a particular company) or underlying value (e.g., an interest rate or stock price). Thus “derivatives” have the potential to be very complicated. But because it is such a large asset class, maybe some derivatives are very simple. Maybe some derivatives are liquid and accurately priced. Maybe some derivatives are regulated. Maybe some derivatives allow for very cost-effective risk management. Exchange-traded equity index futures are that type of derivative. They are boring derivatives.

When investors execute equity index futures contracts they are agreeing to either buy (long) or sell (short) the value of the underlying index at contract expiration for the price as stipulated in the contract. For instance, if an investor were to take the long position in an S&P 500 futures contract, when the S&P 500 futures price was 1400, at contract expiration they would be required to pay:

(1400 – S&P 500 value at contract expiration) * contract multiple, where “contract multiple” is a standard contract term essentially defining the notional of the contract

Should the S&P 500 be higher (or lower) than 1400 at contract expiration, this value would be negative (or positive), indicating a negative (or positive) payment be made by the investor. Another way of saying this is that the investor would realize a gain (or loss). The reason for this is that the investor previously agreed to pay 1400 for something that is now worth more (or less) than 1400.

The potential gain or loss from a contract of this sort could grow quite large. It is because of this potentially large loss that margin is required to engage in futures trading. The amount of margin required is set by the futures exchange. As markets fluctuate and unrealized losses (or gains) become large, additional margin deposits may be required (or excess margin may be withdrawn). Open contracts can be, and in practice usually are, settled prior to expiration by entering into exactly offsetting positions, thereby realizing any previously unrealized gain or loss.

From a risk management point of view, the potential benefit of utilizing equity index futures contracts comes from the fact that large exposures can be acquired for minimal cash outlays. Margin requirements are roughly reflective of the exchange’s view of volatility and the investor’s open positions. In this way, an investor’s required margin is the amount roughly equal to that necessary to cover a large, unlikely, one-day loss on open contracts. For instance, in order to get an exposure the equivalent of $100,000 to the S&P 500, the required margin might be $10,000. By engaging in net short positions in equity index futures, investors can greatly reduce their broad market equity exposures without having to liquidate their equity holdings.

Equity index futures contracts are exchange-traded, meaning an exchange facilitates all trading. Margin is required of net long traders and net short traders. As markets move, gains accrue on one side, washing out losses on the other. The margin requirements protect the exchange and virtually guarantee each investor’s ability to settle their potential liability. As such, it’s very likely that equity index futures will remain boring derivatives. That’s exciting.

I can’t believe it’s not beta

Traditionally, hedge funds have sought to achieve outsized returns relative to the level of market risk in their portfolios while simultaneously maintaining a low correlation with the market at large. In other words, they seek high alpha and low beta. Proprietary investment strategies and relaxed reporting requirements have helped to make these goals possible, but also aiding the endeavor was a lack of appropriate investable benchmarks against which hedge funds might be measured. However, the emergence of hedge fund replication strategies (subscription required) might help institutional investors to more accurately assess the performance of hedge funds and correctly identify and quantify the components of their returns. Furthermore, hedge fund investors suspicious of the relative value of investing in single funds or funds-of-funds (“I can’t believe it’s not beta”) may now have a lower-cost avenue for accessing hedge fund beta.

Hedge fund replication is the general name for strategies attempting to replicate, or beat, the returns of hedge fund indices using assets that are potentially more liquid and transparent. For instance, a replication strategy might attempt to achieve returns similar to a particular hedge fund index while only investing in equities. Successful strategies would achieve returns very similar to their target indices, creating lower-cost, investable hedge fund beta.

Potential investors should consider carefully before allocating assets to hedge fund replication strategies as there are potential downfalls. First, the replication strategy may or may not perform as expected, meaning that an investor may or may not be able to access hedge fund beta. Second, although fees associated with replication strategies are generally lower than direct investment in hedge funds or hedge funds-of-funds, they are still rather high, typically comprising either a 1% to 2% management fee or a 15% performance fee, according to a recent Pension and Investments article. And finally, investors should consider their goals in making any asset allocation. Hedge funds, or hedge fund replication strategies, may provide diversification, but at a significant cost. Further, if risk management is the end goal, and diversification simply a means for achieving that goal, it is important to remember that diversification relies on correlation and, as correlations vary over time, diversification alone may not prove an effective risk management tool. Focused risk management strategies may be more effective in meeting those goals at a much lower overall cost.

A toxic relationship: market declines and capital drawdowns

Ken Mungan’s paper entitled “Creating a Reliable Lifetime Income” is the subject of a new Professional Planner article regarding the toxic relationship between market declines and capital drawdowns.

Here is an excerpt:

“Market declines combined with withdrawals can deplete investors’ portfolios,” Mungan says. Investors face what Milliman calls the “sequence of returns risk” that is, the combination of withdrawals and market declines. [He] describes this combination as “toxic.”

Mungan says a protection strategy is absolutely critical to make sure an investor’s income lasts for as long as possible. In fact, by protecting a portfolio from the “toxic combination” of withdrawals and market falls, an investor’s total return over time can be improved compared to an unprotected portfolio.

Financial management in a changed (and changing) world

Even before things went sour in the financial markets, individuals were having to take on more responsibility for planning and funding their own retirements.

The decline of defined benefit (DB) pensions over the past two decades—and corresponding rise in 401(k)-type retirement savings programs—has been accompanied by an explosion of financial planners, planning tools, and products, all aimed at helping individual investors navigate an increasingly complex financial marketplace.

Ken Mungan, Ghalid Bagus, and Matt Zimmerman, from Milliman’s Financial Risk Management practice, discuss new approaches to risk management that help overcome challenges for portfolio protection in the post-global financial crisis environment.

Risk management based on asset diversification has been central to these innovations.

However, as the authors point out, traditional asset diversification failed to mitigate the effects of a financial marketplace where most asset classes declined simultaneously. Clearly, financial advisors need  new risk management protection strategies that “involve assembling and managing a portfolio of hedge assets tailored to each client’s investments.”

Such an approach seeks to counteract the natural tendency of the average investor to buy high, when the market is strong, and to sell low, after significant market decline, which, of course, plays havoc with investment returns.

The authors detail a strategy that reduces risk and enhances the overall value of an investment portfolio by locking in gains from underlying investments and harvesting gains from the hedge portfolio during severe market corrections.