Downside Protection Research Articles

Portfolio Choice in Retirement—What is The Optimal Home Equity Release Product?

AbstractWe study the decision problem of the optimal choice between home equity release products from a retired homeowner's perspective in the presence of longevity, long‐term care, house price, and interest rate risk. The individual can choose to release home equity using reverse mortgages or home reversion plans, to buy annuities, and long‐term care insurance. The individual enjoys utility gains from having access to either one of the two equity release products. Higher utility gains are found for the reverse mortgage, as its product features allow for higher lump‐sum payouts and provide downside protection for house prices.

On the Holy Grail of “Upside Participation and Downside Protection”

“Upside participation and downside protection” is a popular motto for many investors. It has taken on much more significance in recent years, in the wake of the global financial crisis. But how do we define and evaluate strategies from the perspective of “upside participation and downside protection”? In this article, the authors present an analytic framework in which they provide a quantitative definition of upside and downside participation ratio, define participation ratio difference as a goodness measure for defensive strategies, and prove a relationship between the participation ratio difference and traditional alpha. As an illustration, they apply this new analysis to the S&P 500 Index and its 10 sectors and show that defensive, low-beta sectors tend to have positive participation ratio differences, while cyclical, high-beta sectors tend to have negative participation ratio differences. This finding is consistent with the low-beta/volatility anomaly and provides another explanation for the popularity of low-beta/volatility strategies.

Calpers Absolute Return Strategies: Hedge Fund Risk and Return

This case is suitable for students in both undergraduate and MBA-level investments courses. With an estimated $3 trillion in assets under management, hedge funds have become an important component of many institutional investors' portfolios. For many of these investors, investments in these funds are motivated by the potential for diversification combined with equity-like and bond-like risk. At the same time, the difficulty of appropriately benchmarking hedge fund returns and risk, in addition to the high fees associated with these funds, has some investors questioning their decision to invest in these strategies. Using CalPERS's April 2014 reexamination of its Absolute Return Strategies/hedge fund investments as a backdrop, this case examines the decision to invest in hedge funds as a part of a well-diversified institutional portfolio. Excerpt UVA-F-1735 Jun. 29, 2015 CalPERS Absolute Return Strategies: Hedge Fund Risk and Return The California Public Employees' Retirement System (CalPERS) headquarters near the Sacramento River was as beautiful as it was functional. With courtyards and terraces, beautiful landscaping, an architecturally stunning glass-and-steel entry pavilion, and a soaring glass atrium that flooded the building with natural light, it appeared to be as tranquil a work setting as the Zenlike spaces that dotted its interior and exterior. In the spring of 2014, however, internal sources suggested that a storm was brewing within the building over CalPERS's hedge fund investments. Two of CalPERS's most senior investment professionals, Curtis Ishii and Egidio “Ed” Robertiello, disagreed strongly about the future of these investments. Hedge funds had been a part of CalPERS's portfolio for 22 years, but there was a strong push by Ishii, the senior investment officer responsible for fixed income, to eliminate CalPERS's allocation to Absolute Return Strategies (ARS). In addition to the high fees CalPERS was paying to hedge fund managers, Ishii was convinced that hedge fund investments were an unacceptable risk for the pension fund. On the other hand, Robertiello, the senior portfolio manager for ARS, believed that the ARS allocation should be almost tripled. Robertiello argued that not only would an increased allocation to hedge funds help to diversify CalPERS's portfolio generally, but that hedge funds offered better downside protection than equities. . . .

Downside Loss Aversion and Portfolio Growth

Optimizing over power-log utility functions allow for the inclusion of downside loss aversion, a broader range of investor preferences, and account for higher-order moments like skewness and kurtosis in the optimization process. We implement multi-period power-log optimization (PLO) with annual rebalancing on a portfolio consisting of a treasury security, the S&P500 index and a call option on the index. PLO results in higher geometric average realized returns with lower tail risk, and lower standard deviation than meanvariance efficient portfolios with the same ex-ante expected returns. It also provides better downside protection against large, negative return surprises, such as the down markets in 2002 and 2008.

Rethinking Risk (II): The Size and Value Effects

Small-cap stocks are typically viewed as riskier than large-cap stocks, and value stocks as riskier than growth stocks. But are they? It depends, both on an investor’s holding period and the way he assesses risk. If an investor is concerned with volatility, either during or at the end of the holding period, then the conventional wisdom is correct. However, if an investor focuses on his long-term terminal wealth, then the conventional wisdom is turned on its head: The evidence discussed in this article strongly suggests that small stocks should be viewed as less risky than large stocks, and value stocks as less risky than growth stocks. This is the case because small and value stocks offer both more upside potential and, when tail risks strike, better downside protection than do large and growth stocks.

Household Wealth and Portfolio Choice When Tail Events Are Salient

Robust experimental evidence of systematic violations of expected utility (EU) establishes that individuals facing risk overweight utility from low probability gains and losses when making choices. These ndings motivated development of models of preferences with probability weighting functions, such as rank dependent utility (RDU). We solve for the optimal investing strategy of an RDU investor in a dynamic binomial setting from which we derive implications for investing behavior. We show that relative to EU investors with constant relative risk aversion, commonly measured probability weighting functions produce optimal RDU terminal wealth with signicant downside protection and upside exposure. We additionally nd that in contrast to EU investors, RDU investors optimally choose a portfolio that contains fair bets that provide payos that can be interpreted as lottery outcomes or exposure to idiosyncratic returns. In a calibrated version of the model, we calculate that RDU investors would be willing to pay 5% of their initial wealth for the freedom to trade away from an optimal EU wealth allocation. The dynamic trading strategy that supports the optimal wealth allocation implies portfolio weights that are independent of initial wealth but requires higher risky share after good stock return histories. Optimal trading also implies the possibility of non-participation when historical returns are poor. Our model lls a gap in the literature by providing new quantitative and qualitative predictions that can be tested experimentally or using data on household wealth and portfolio choice.

The Road to Retirement - Bumpy or Smooth, Depends on Your Route, January 2011

Defined Contribution (DC) plans are rapidly becoming the primary retirement investment vehicle for a majority of employees across the US and other markets around the globe. Asset allocation for DC plans has to strike a balance between growth and protection assets over the savings lifecycle while protecting the long-term purchasing power of the nest egg. Due to the long duration of retirement investing and various risks associated with it, implementing the right asset allocation has become critical and challenging for DC plans.The unique Risk Focused methodology presented in this paper aims to address the shortcomings of conventional Target Date Funds experienced during the 2008 financial crisis. The proposed approach addresses the cumulative impact of shortfall, sequence of returns, longevity, and market risks in determining asset allocation at different time horizons. This is accomplished by combining the term structure of risk, return, and covariance of asset classes with an explicit risk budget. The Risk Focused glide path potentially delivers comparable retirement wealth outcomes with enhanced downside protection, lower journey volatility, and attempts to facilitate a smoother journey on the road to retirement. Hence, the caption of the paper, Road to Retirement – Bumpy or Smooth, Depends on your Route.

Adaptive Covered Call Writing for NASDAQ Stocks: The Turtle Strategy

Covered Call Writing is a venerable strategy. It is usually added to an existing portfolio of stocks. One trades-off upwards potential in strong rallies against a constant stream of additional income from options writing. This work investigates various aspects of this strategy for Apple, Ebay and Google over the last 8 years. It is shown that an adaptive approach works best. The turtle is no silver bullet, but one gets at least the same performance in a considerable smoother way. The reduced volatility is – over the considered time range – a free lunch. In a second step long Puts are added for additional downside protection. The strategy becomes a (loose) Collar. The Collar improves the Sharpe-Ratio, but the overall profit is considerable lower.

Different Problem, Same Solution: Contract‐Specialization in Venture Capital

Real‐world financial contracts vary greatly in the combinations of cash flow contingency terms and control rights used. Extant theoretical work explains such variation by arguing that each investor finely tailors contracts to mitigate investment‐specific incentive problems. We provide overwhelming evidence from 4,561 venture capital (VC) contracts that this tailoring is overstated: even though there is broad variation in contracting across VCs, each individual VC tends to specialize, recycling familiar terms. In fact, a VC typically restricts contracting choices to a small set of alternatives: 46% of the time, a VC uses the same exact cash flow contingencies as in one of her previous five contracts. We document specialization in both aggregated downside protection, and in each individual cash flow contingency term. Such specialization remains economically and statistically significant even after controlling for VC and company characteristics. We also find that VCs learn to use new contractual solutions from other VCs in her syndication network. Our findings challenge the traditional premise that each investor selects from the universe of combinations of terms to match an investment's unique contracting problem. Rather, the cumulative evidence indicates that contract‐specialization arises because investors better understand payoff consequences of familiar terms, and are reluctant to experiment with unknown combinations.

LAWYERS IN VENTURE CAPITAL CONTRACTING: THEORY AND EVIDENCE

AbstractReal‐world financial contracts are sometimes so complex that it can be difficult to understand their exact payoff consequences. We develop and test a theoretical model of a venture capitalist (VC) negotiating with an entrepreneur who may overweigh or underweigh the payoff consequences of contractual downside protection (DP). A lawyer with expertise in venture capital can inform the entrepreneur about these consequences, but less expert (but otherwise high quality) lawyers cannot. We determine how a VC's decision to include DP is affected by the expected quality of the entrepreneur's project, the entrepreneur's experience, and the VC expertise of his/her legal counsel. We show that the VC's incentive to include unnecessary DP declines in expected project quality. Indeed, for inexperienced entrepreneurs involved with high‐quality projects, VCs prefer that the entrepreneur's counsel has VC expertise. This implies that, when negotiating with inexperienced entrepreneurs, VCs who invest in high‐quality companies should be more likely to negotiate with entrepreneurs who employ lawyers with VC expertise. We document broad empirical support for the model, and provide evidence against competing explanations. (JEL L24, G24, K12, L14, L24)

Integrating ESG Factors in the Investment Process

“Incorporating ESG factors improves the downside protection while potentially improving the upside as well, and in any event, it should improve the risk–return characteristics of an investment portfolio.”

Socially responsible funds and market crises

Compared to matched conventional mutual funds, socially responsible mutual funds outperform during periods of market crises. This dampening of downside risk comes at the cost of underperforming during non-crisis periods. Investors seeking downside protection would value the asymmetry of these returns. This asymmetric return pattern is driven by the mutual funds that focus on environmental, social, or governance (ESG) attributes and is especially pronounced in ESG funds that use positive screening techniques. Furthermore, the observed patterns are attributed to the funds’ socially responsible attributes and not the differences in fund portfolio management or the characteristics of the companies in fund portfolios.

On the relevance of premium payment schemes for the performance of mutual funds with investment guarantees

Purpose – In financial planning, customers are typically confronted with choosing a premium payment scheme when investing in a mutual fund, which is often equipped with an investment guarantee to provide downside protection. Guarantee costs may thereby also be charged differently depending on the provider. The paper aims to investigate the impact of the premium payment method on different performance measures for a mutual fund with an investment guarantee. Design/methodology/approach – The paper compares a fund with annual and upfront premiums as well as constant guarantee costs versus the guarantee price as an annual percentage fee of the fund value, always ensuring that the present value of premium payments is the same for all product variants. The paper further studies the relevance of the guarantee level and the contract term. Findings – The results emphasize that even though the present value of premiums paid into the contract is the same, the type of premium (upfront versus annual) as well as the type of guarantee cost (upfront versus annual fee) has a considerable impact on the performance. Practical implications – Providers can thus make a product more attractive for consumers by individually adjusting the premium scheme depending on their preferences and by making the resulting risk-return-profile transparent, while keeping the other contract characteristics unchanged (e.g. extent of the guarantee). Originality/value – To date, there has been no comprehensive analysis with specific focus on the impact of different premium payment schemes (in particular with respect to savings premiums and guarantee costs) on risk and return of a mutual fund with otherwise given contract characteristics such as the underlying fund strategy and the investment guarantee, even though the premium scheme itself can already have a considerable impact on the terminal payoff distribution and thus risk-return profiles. In addition, such an analysis can provide important information for consumers and providers in designing and choosing attractive products by simply adjusting the premium scheme (if possible) instead of or in addition to changing other product features.

A Bootstrap-Based Comparison of Portfolio Insurance Strategies

This study presents a systematic comparison of portfolio insurance strategies. In order to test for statistical significance of the differences in downside performance risk measures between pairs of portfolio insurance strategies, we use a bootstrap-based hypothesis test. Our comparison of different strategies considers the following distinguishing characteristics: static versus dynamic; initial wealth versus cumulated wealth protection; model-based versus model-free; and strong floor compliance versus probabilistic floor compliance. Our results show that the classical portfolio insurance strategies synthetic put and CPPI provide superior downside protection compared to a simple stop-loss trading rule, also resulting in significantly higher Omega ratios. Analyzing more recently developed strategies, neither the TIPP strategy (as an ‘improved’ CPPI strategy) nor the dynamic VaR-strategy provide significant improvements over the more traditional portfolio insurance strategies. The attractiveness of the dynamic VaR-strategy strongly depends on the quality of the estimates for the required input parameters, in particular, the equity risk premium. However, if an investor possesses superior forecasting skills, other active (market timing) strategies may exist which generate higher (risk-adjusted) returns compared to a protected passive stock market investment.

On the Demand for Portfolio Insurance

While insurers manage underwriting risk with various methods including reinsurance, insurers increasingly manage asset risk with options, futures, and other derivatives. Previous research shows that buyers of portfolio insurance pay considerably for downside protection. We add to this literature by providing the first evidence on the cost of portfolio insurance, the payoff to portfolio insurance, and the relative demand for portfolio insurance across VIX levels. We find that the demand for portfolio insurance is relatively high at low levels of VIX, suggesting purchasers demand more downside protection when this protection is cheap on an absolute basis (but expensive on a relative basis). We also provide the first evidence on the hedging behavior of specific investor classes and show that the demand for portfolio insurance is driven by retail investors (individuals) who buy costly insurance from institutional investors. Results are consistent with other types of paradoxical insurance-buying behavior.

Optimal Life Cycle Portfolio Choice with Variable Annuities Offering Liquidity and Investment Downside Protection

We evaluate life-cycle consumption and portfolio allocation patterns resulting from access to Guaranteed Minimum Withdrawal Benefit (GMWB) variable annuities, one of the most rapidly-growing financial innovations over the last two decades. A key feature of these products is that they offer access to equity investments with downside protection, hedging of longevity risk, and partially-refundable premiums. Welfare rises since policyholders exercise the product’s flexibility by taking withdrawals and dynamically adjusting their portfolios and consumption streams. Consistent with observed behavior, differences across individuals’ cash out and annuitization patterns result from variations in realized equity market returns and labor income trajectories.

Downside risk in multiperiod tracking error models

The recent crisis made it evident that replicating the performance of a benchmark is not a sufficient goal to meet the expectations of usually risk-averse investors. The manager should also consider that the investors are seeking downside protection when the benchmark performs poorly and thus they should integrate a form of downside risk control. We propose a multiperiod double tracking error portfolio model which combines these two goals and provides enough flexibility. In particular, the control of the downside risk is carried out through the presence of a floor benchmark with respect to which we can accept different levels of shortfall. The choice of a proper measure for downside risk leads to different problem formulations and investment strategies which can reflect different attitudes towards risk. The proposed model is tested through a set of out-of-sample rolling simulations in different market conditions.

Discussion

Previous articleNext article FreeDiscussionPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreRobert Hall opened the discussion by presenting evidence from Hall and Woodward (2012) supporting the hypothesis that the retail mortgage market in the United States features large markups. He used this evidence to question the authors’ assumption that mortgage contracts in the United Kingdom are written in a completely competitive environment.Jonathan Parker pointed out that over the three different periods considered in the paper (1975 to 1985, 1986 to 1995, and 1996 to 2005), risk premia have declined in markets other than the mortgage market. Some of these markets, moreover, did not undergo the same institutional changes—such as increased competition and the growth of securitized lending—that the mortgage market experienced over the sample. He wondered whether the authors had any evidence to explain why these different markets exhibited such similar price behavior despite their structural differences. He also suggested supplementing figures 15 and 16 with information about loan sizes to document how that variable has changed across different sample periods.Raj Chetty made two points. First, he indicated that the cross-sectional relationship between the size of mortgage loans and their interest rates is particularly interesting. He suggested showing other similar cross-sectional relationships, possibly with different measures of creditworthiness such as credit scores or levels of unsecured debt. These relationships could be helpful in determining whether lenders were becoming less sensitive to borrower credit risks, or whether they simply expected house price increases to provide greater downside protection against such risks. Mark Gertler also wondered about the role of the housing price bubble in reducing the apparent riskiness of large mortgages during the 1995 to 2005 period.Second, Chetty expanded on concerns expressed by Bernard Salanié about the validity of the stamp duty rate instrument. In his view, the “Baseline” first-stage specification reported in the first column of table 31 does not adequately isolate exogenous variation in stamp duty rates. More appropriate is the “Collapsed” specification from the second column of table 3, which focuses on variation in stamp duty rates across regions and years, but not across individuals. This specification, however, suffers from lower power: the t-statistic on the stamp duty rate falls from 229 to 2.83. More importantly, he expressed doubts over whether the IVQR model remains identified after eliminating this variation across individuals, and recommended that the authors instead place greater emphasis on their OLS estimates.2Timothy Besley provided three responses to the issues raised by the discussants and other participants. First, following up on comments made by José-Luis Peydró, he explained that the authors may be able to match loans to lender characteristics, but that so far they have not been granted access to that data. Second, in response to Chetty, he explained that unlike how it is in the US mortgage market, credit scoring is not an established practice in the United Kingdom. It is therefore not possible for them to include those measures of creditworthiness in their anaylsis. Third, he agreed with Jonathan Parker and José-Luis Peydró that he and his coauthors should more carefully investigate possible sources of time variation in their data. He suggested that the rise in mortgage brokers over the later half of the sample might be an important phenomenon driving this variation. The data set used in the paper, however, does not contain information about whether a particular mortgage was brokered or not. So it would be difficult to tie this institutional trend directly to the data.Endnotes1Now table A3 in the appendix.2This part of the discussion refers to the conference draft of the paper. The final draft published in this volume does indeed primarily emphasize the OLS estimates, as suggested. The discussion here relates to an approach that is now mainly discussed in the appendix.ReferenceHall, Robert E., and Susan E. Woodward. 2012. “Diagnosing Consumer Confusion and Sub-Optimal Shopping Effort: Theory and Mortgage-Market Evidence.” Forthcoming in American Economic Review.First citation in articleGoogle Scholar Previous articleNext article DetailsFiguresReferencesCited by NBER Macroeconomics Annual Volume 272012 Sponsored by the National Bureau of Economic Research (NBER) Article DOIhttps://doi.org/10.1086/669200 Views: 76 © 2013 by The National Bureau of Economic Research. All rights reserved.PDF download Crossref reports no articles citing this article.

On the Demand for Portfolio Insurance

While insurers manage underwriting risk with various methods including reinsurance, insurers increasingly manage asset risk with options, futures, and other derivatives. Previous research shows that buyers of portfolio insurance pay considerably for downside protection. We add to this literature by providing the first evidence on the cost of portfolio insurance, the payoff to portfolio insurance, and the relative demand for portfolio insurance across VIX levels. We find that the demand for portfolio insurance is relatively high at low levels of VIX, suggesting purchasers demand more downside protection when this protection is cheap on an absolute basis (but expensive on a relative basis). We also provide the first evidence on the hedging behavior of specific investor classes, and show that the demand for portfolio insurance is driven by retail investors (individuals) who buy costly insurance from institutional investors. Results are consistent with other types of paradoxical insurance-buying behavior.

Alternative Assets: Are They Still Worth It?

Though the authors strongly believe that so-called “hedge funds” are not an asset class but a fee structure, they observe that investors tend to look at them generically. Their performance in the past few years has raised a number of questions. Performance in 2008 and subsequent years, for instance, has suggested that downside protection may be less than expected; that liquidity may be less than anticipated; or that absolute returns may in fact be negative! The authors compare the returns of three generic strategy groups to traditional asset benchmarks and initially find that alpha, defined as a non-beta-adjusted excess return vis-a-vis that benchmark, has really not been positive over the last several quarters. They then define a segment of the broad universe in each of the three strategy groups using objective criteria—minimum size and length of reported track record—and re-do the foregoing analysis. They find that, though the screening process eliminates as many as 95% of all managers, it still contains between 50% and 70% of the assets managed in these strategies. They also find that the rolling alpha generated by the selected group of managers is actually considerably higher than for the universe as a whole. They conclude that the industry has matured, and that, with maturation, comes some alpha dilution; yet, though the industry as a whole may no longer benefit from the tail winds it enjoyed for a long time, there remain a number of strategies and managers where material value added is available. This will place an increased premium on manager selection.