The role of hedging in portfolio construction
The objective of the Nedgroup Investments Opportunity Fund is two-fold:
- CPI + 5% p.a. over rolling 3-year periods (return target)
- No negative rolling 24-month periods (risk target)
The pay-off profile described above is asymmetrical, implying we need to focus on upside as well as downside in equal measure. This is how we naturally think about things at Abax, and our multi-asset process is built around meeting both of these objectives.
By actively allocating between the asset classes and harnessing our bottom-up security selection capabilities, we try to capture the risk premiums (and alpha, hopefully) on offer and combine them as efficiently as possible into a portfolio whose expected return aligns with that of the funds objective. The focus of this article however is not so much the return aspect of the fund’s objective, but rather, the differentiated aspects of our process that give us confidence in our ability to meet the risk target of no negative 2-year periods.
Broadly speaking, we actively seek out individual assets that have known downside or asymmetric pay-off profiles. Cash, credit, nominal and inflation linked bonds are natural candidates, but unfortunately do not usually provide sufficient upside to enable us to deploy all of our capital into these assets. Listed property has both equity and fixed income attributes, so can be a useful asset class in constructing absolute portfolios. Equity clearly has the highest return potential, but also the highest downside volatility, which can impact on our ability to protect capital if things do not turn out as expected.
We can also search for opportunities outside of the more traditional, easy to define asset classes and instruments: ‘hybrids’ serves as a good description of these assets as they provide exposure to the risk premia from a mix of different asset classes. The added benefit of analysing hybrids is that fewer people seem to be looking here - potentially making it less competitive and a richer source of alpha - as some of these instruments do not fit the traditional classifications and require a skillset that can simultaneously deal with equity, credit, duration and derivative valuation.
Convertible bonds (essentially a credit bond with built in equity optionality) would be a useful example – they resemble equity on the way up, but a bond with its fixed coupon on the way down. The Zambezi Platinum preference share is another flavour of hybrid: essentially this instrument pays a floating rate coupon of prime + 3.5%, and is backed by shares in Northam (converted at a 10% discount) in the event of default.
Another way to produce an asymmetrical pay-off profile is to create one by adding derivative overlays to an existing position. For example, in the Opportunity Fund, we protected some of our Naspers exposure (the biggest position in the fund) against a 10% fall in price, so as to limit the downside impact should the counter’s strong momentum reverse. We have structured this trade on a ‘zero premium’ basis by effectively financing the protection though selling away some of our upside. In other words, the return distribution for our Naspers allocation has been ‘narrowed’ and is now more closely aligned with the fund’s dual objectives.
It is also possible to protect equity exposure at an asset class level. By adding protection structures to an overall asset class, you can effectively create new asset classes with more fit-for-purpose pay-off profiles. Incorporating asset classes with different characteristics can have portfolio construction benefits, even if the expected returns on the newly hedged asset class is lower than the unhedged return.
To illustrate this, consider the output in the charts below from one of our proprietary tools. In this instance we are modelling the impact of purchasing a simple ‘2% out-the-money put’ over our equity exposure. By doing this we protect our equity exposure from any fall in price over and above the first 2% drop. We pay for this protection by paying away premium rather than financing it through giving away some of our upside. In other words, there is an explicit cost paid for the hedge. No assumption of skill is made in terms of the timing of the implementation of the protection strategy, or in our ability to seek out more ‘favourably priced’ structures. It simply assumes we blindly implement the structure by purchasing 6-month puts - rolled every 3 months - regardless of the market’s valuation.
In isolation, the return characteristics of the equity overlaid with the puts looks inferior (expected return of 10.9% p.a.) compared to naked equity (13.5% p.a); the difference is attributable to the cost of purchasing the protection. However, the risk-adjusted returns are similar, as the volatility decreases pretty much commensurately with return. But - and this is the important take-out - the altered pay-off profile may be more suitable for funds with an ‘absolute’ objective that are attempting to avoid large drawdowns. What is interesting is that in the event of large market drawdowns (we consider here the worst 10% of drawdowns), the equity market drops by an average of 25%, and hedged equity by only 11%; a far more palatable and recoverable outcome for absolute-minded investors.
The over-riding principle is that the addition of hedges can improve the likelihood of meeting both the risk and return objectives of an absolute mandate, and make the fund's return signature more aligned to the expectations of investors.