Strategic Risk Management

CHAPTER 2Can Portfolios Be Crisis Proofed?

INTRODUCTION

In the previous chapter, we introduced a key concept in strategic risk management: integrating strategies that have favorable risk management characteristics into the asset selection process. We did a deep dive on trend-following strategies and showed that they exhibit positive convexity—a much desired property in risk management. Further, we showed that this protective property appeared robust to different economic environments since 1960. However, trend following is only one possible strategy that has protective characteristics. Further, it is important to diagnose the performance of various strategies in specific economic episodes. This is what we endeavor to do in this chapter.¹

Indeed, in the late stages of long bull markets, a common question arises: What steps can an investor take to mitigate the impact of the inevitable large equity correction? Hedging equity portfolios is notoriously difficult and expensive. We analyze the performance of different tools that investors could deploy. For example, continuously holding short-dated S&P 500 put options is the most reliable defensive method but also the costliest strategy. Holding “safe-haven” U.S. Treasury bonds produces a positive carry, but may be an unreliable crisis-hedge strategy, as the post-2000 negative bond–equity correlation is a historical rarity. Long gold and long credit protection portfolios sit in between puts and bonds in terms of both cost and reliability. ...