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The Risk Contribution of Stocks, Parts 1-3 - Recap

Traders Magazine Online News, June 20, 2018

John D'Antona Jr.

A new white paper by Ampersand Portfolio Solutions, Looking Under the Hood, provides an in-depth look at the details associated with structuring overlays as a way to hedge equity-related risk. In prior white papers posted on Traders Magazine, The Risk Contribution of Stocks, Parts 1-3, Ampersand introduced a concept to diversify beyond stocks and bonds without having to sell the stock/bond portfolio holdings. The new paper goes further, and shines a light on ways to structure a dynamic futures-based equity hedging strategy designed to mitigate downside equity risk. Ampersand Portfolio Solutions, a division of Equinox, collaborates with select asset managers to construct bespoke investment solutions.

Ampersand’s new white paper, The Power of Ampersand: Looking Under the Hood, recaps the risks associated with a 60/40 stock/bond portfolio, showing that 92% of the risk is contributed by stocks. Diversifying the portfolio by adding another asset class such as managed futures yields critical and significant improvements.

Here are some key highlights from Looking Under the Hood:

  • Hedging equity risk is not a simple proposition.  Traditional strategies include market timing, shorting individual stocks, and using options strategies.  These approaches tend to be ineffective, costly, or inefficient.
  • Dynamic futures-based equity hedging strategies or certain alternative risk premia afford greater promise as they are designed to be negatively correlated to stocks and their “beta” is dynamic (lower during market corrections but higher during market rallies) making them true hedges.
  • Adding both hedges and diversifiers to a portfolio may be a more efficient and effective way to manage risk.  “Extended diversification” allows for these diversifiers to be added without selling any stocks and bonds in the original portfolio. How is this possible?  As these programs typically can be accessed by posting anywhere from 10% to 25% of their notional value as margin or collateral, the stocks/bonds in the portfolio can be can themselves be posted as collateral. This creates an “overlay” approach, where the alternatives are overlaid on top of the stock/bond portfolio, without the need to sell any stocks or bonds. Detailed examples are provided in the paper.
  • Another way to accomplish this to employ a Total Return Swap that provides access to CTA trading programs. A portion of the fund’s assets are posted as collateral using a tri-party custodian. This is described in detail in the paper.
  • By including a meaningful allocation to dynamic diversifying strategies which have a low correlation to stocks and bonds, it is possible to add potential alpha to the overall portfolio without increasing its overall risk. In fact, it is possible to reduce the contribution of equities to the risk of the overall portfolio by at least a few percentage points.
  • By exploiting this “extended diversification” it becomes possible to harness the true benefits of diversification as expounded by Modern Portfolio Theory and let investors have their cake and eat it too.

For the white paper described herein:

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