Downside Protection Research Articles

Proshares: The Alternative ETF Company

In 2014, ProShares CEO Michael Sapir was meeting with Steve Cohen, managing director and head of the ProShares Strategy Group, whose agenda centered on the progress the firm was making in moving from its core offering of geared ETFs into establishing itself as the leading alternative ETF company. Since 2009, the firm had launched an array of ETFs and Sapir and Cohen were reviewing the current lineup, the assets under management (AUM), and net flows across ProShares' different ETF categories. Could ProShares get another $25 billion in AUM in these more strategic alternative ETFs? Excerpt UVA-F-1729 Nov. 24, 2015 ProShares: The Alternative ETF Company In the summer of 2014, Michael Sapir, the CEO of ProShares, was reviewing the progress in the firm's lineup of exchange-traded funds (ETFs). With its headquarters located in Bethesda, Maryland, the firm was far from Wall Street and was a nontraditional financial company in many respects. Since its first ETF launch in 2006, the firm had successfully democratized access to short and leveraged strategies by offering them in ETFs to individual investors, advisers, and institutions. These “geared” ETFs aimed to deliver two or three times the daily return or the inverse of the return of their underlying indices covering all the major asset classes such as domestic equities (including different market caps, styles, or sectors), international equities, fixed income, commodities, and currencies. ProShares ranked in the top 10 of the largest ETF sponsors in the United States. Sapir was meeting with Steve Cohen, managing director and head of the ProShares Strategy Group whose agenda centered on the progress the firm was making in moving from its core offering of geared ETFs into establishing itself as the leading alternative ETF company. Offering alternative ETFs was a broad concept that encompassed both nontraditional asset classes and investment strategies (Exhibit 1). Although these investments aimed to provide unique sources of risk and return, correlation benefits, and the potential for a better Sharpe ratio in a portfolio, they also might provide potential downside protection in falling markets. These alternative strategies, used for some time by institutional investors, tended to have favorable long-term returns relative to risk. Many of these strategies used leverage, shorting, and derivatives. Since 2009, the firm had launched an array of ETFs that included alternative equity (specialty equity and dividend growers), fixed income strategies (hedged and global fixed income), tactical products to benefit from changes in inflation and market volatility (inflation and volatility), and ETFs that replicated hedge fund strategies (hedge strategies). (See Exhibit 2 for the full product list.) Sapir and Cohen were reviewing the current lineup of ETFs, the assets under management (AUM), and net flows across ProShares' different ETF categories (Exhibit 3). ProShares had become the world's largest manager of geared ETFs with more than $ 25billion in AUM (Exhibit 4). Could it get the next $ 25 billion in AUM in these more strategic alternative ETFs? . . .

The role of commodities investments in the decumulation phase of retirement

This paper examines the role of commodity-related investments in the decumulation phase of retirement. Benchmarked against a balanced portfolio, the findings suggest that including commodities in a traditional portfolio improves the retirement outcomes at the lowest percentiles of wealth distribution. Furthermore, we demonstrate that downside protection is more pronounced by reducing allocation to equities (rather than bonds) to invest in alternatives. An equally weighted combination of passive and active commodity-related investments provides superior downside protection compared to a traditional portfolio at all levels of allocations used in the analysis. As a consequence, commodities may be employed as a portfolio diversification tool particularly in the decumulation phase of retirement. Keywords: alternatives, commodities, life cycle, superannuation, retirement. JEL Classification: G11, G23

Power-Log Optimization and Positively Skewed Option Returns Reduce Risk and Raise Portfolio Performance

The current low-interest-rate, low-volatility environment demands a more innovative approach to investment management than the allocation to stocks and bonds that is practiced widely today. Options, with their significantly positively skewed returns, offer us the opportunity of boosting returns while controlling downside risk. Power-log optimization gives us the means to incorporate options into the asset allocation process effectively and requires only one input parameter, the downside power, to specify investor preferences. Using data for the last 20 years for a Treasury security, the S&P 500 Index, and a call option on the index, the authors find that optimal power-log portfolios reduce downside risk and the standard deviation of return for both conservative and risky portfolios, which results in positively skewed returns for the portfolios. The authors also deliver higher geometric average returns for riskier portfolios than matched mean–variance-efficient portfolios. In addition, they provide much better downside protection against unanticipated market shocks, such as the down markets in 2002 and 2008, and as a result deliver better performance for both conservative and risky portfolios in bad markets.

The Coordination and Optimization of Closed-Loop Supply Chain with Lots of Factors

AbstractConsider a closed-loop supply chain including a manufacturer, a retailer and two third party recyclers as the background. A coordination and optimization model is built by using the downside-risk function, Cournot model and government subsidy excitation function. The effect of risk characteristics, government subsidy and Cournot competition on supply chain is analyzed, and the impact of revenue-and-expense sharing contract is studied in the channel, which shows that the contract cannot coordinate and optimize the closed-loop supply chain. Also, risk sharing contract and expense sharing contract are designed, which can offer the desired downside protection to the retailer, provide more profits to the agents, and accomplish channel coordination and optimization. Moreover, an application example is given for testing the effectiveness and feasibility of the contract, and the bound and rule of the contract parameters are given. Finally, by the analysis of numerical simulation and sensitivity of the model based on the contract, the validity and practicability of the model are verified, and the relationship between government subsidy, risk characteristics, competitive characteristics with the supply chain is obtained. This study provides decision support and decision-making reference for the development of remanufacturing industry.

Prospect theory–based portfolio optimization: an empirical study and analysis using intelligent algorithms

The behaviourally based portfolio selection problem with investor’s loss aversion and risk aversion biases in portfolio choice under uncertainty is studied. The main results of this work are: developed heuristic approaches for the prospect theory model proposed by Kahneman and Tversky in 1979 as well as an empirical comparative analysis of this model and the index tracking model. The crucial assumption is that behavioural features of the prospect theory model provide better downside protection than traditional approaches to the portfolio selection problem. In this research the large-scale computational results for the prospect theory model have been obtained for real financial market data with up to 225 assets. Previously, as far as we are aware, only small laboratory tests (2–3 artificial assets) have been presented in the literature. In order to investigate empirically the performance of the behaviourally based model, a differential evolution algorithm and a genetic algorithm which are capable of dealing with a large universe of assets have been developed. Specific breeding and mutation, as well as normalization, have been implemented in the algorithms. A tabulated comparative analysis of the algorithms’ parameter choice is presented. The prospect theory model with the reference point being the index is compared to the index tracking model. A cardinality constraint has been implemented to the basic index tracking and the prospect theory models. The portfolio diversification benefit has been found. The aggressive behaviour in terms of returns of the prospect theory model with the reference point being the index leads to better performance of this model in a bullish market. However, it performed worse in a bearish market than the index tracking model. A tabulated comparative analysis of the performance of the two studied models is provided in this paper for in-sample and out-of-sample tests. The performance of the studied models has been tested out-of-sample in different conditions using simulation of the distribution of a growing market and simulation of the t-distribution with fat tails which characterises the dynamics of a decreasing or crisis market.

Smart Buyers

Abstract We study transactions in which sellers fear being underpaid because their outside option is better known to the buyer. We rationalize various observed contracts as solutions to such smart buyer problems. Key to these solutions is granting the seller upside participation. In contrast, the lemons problem calls for granting the buyer downside protection. But, in either case, the seller (buyer) receives a convex (concave) claim. Thus, contracts usually associated with the lemons problem, such as debt or cash-equity offers, can be equally well manifestations of the smart buyer problem, although the two information asymmetries have opposite cross-sectional implications. Received December 23, 2014; accepted May 23, 2016 by Editor Uday Rajan.

The Retirement Glidepath: An International Perspective

All individuals need to decide how much to save during their working years, how much to spend during retirement, and the asset allocation of their portfolio in both periods. A portfolio’s exposure to stocks and bonds affects key variables, such as the probability of portfolio failure, degree of downside protection, and expected bequest. How this exposure should evolve during retirement is the ultimate issue explored in this article. After considering declining-equity, rising-equity, and static glidepaths, the comprehensive international evidence from 19 countries and the world market over 110 years ultimately suggests that both an all-equity portfolio and a 60/40 stock/bond allocation are simple and very effective strategies for retirees to implement. <b>TOPICS:</b>Retirement, portfolio construction, developed

Currency Options for Fund Managers

Options on a number of currency pairs involving the Rand are readily available to investors in the South African market. The most widely implemented strategies are those involving call options giving geared upside exposure to the underlying. However, overlay strategies such as collars and fences offer fund managers a powerful mechanism by which to control risk arising from exposure to foreign currencies.We motivate the need for consideration of downside protection against adverse currency moves and show that a weakening Rand is not a certainty. The behaviour of selected strategies over various historical periods is demonstrated in order to gain an intuitive understanding of performance under different types of currency scenario. Examples are considered both from the point of view of an investor holding foreign cash as an additional asset class, as well as investors holding foreign risky assets wishing to control the impact of currency moves on the returns of their offshore holdings. Finally, we discuss an interesting exotic variation of the vanilla zero-cost collar that allows one to increase potential upside without introducing the possibility of negative returns.

Full-Scale Optimization: A Flexible Framework for Hedge Design

In this work we consider the application of expected utility optimization to the construction of an optimal hedge. Utility theory provides a rich framework for decision-making under uncertainty and features preferences specified via a range of simple to possibly complex functions of future portfolio returns. Optimal hedge construction examples are discussed in the context of downside protection for domestic equity, and the reduction of currency exposure risk inherent in a foreign equity position. We also quantify the impact of currency derivatives on the risk and return properties of a foreign equity holding. This is done by considering two types of preference specification featuring loss aversion, namely kinked utility and S-shaped utility. Both of these functions have particular relevance for fund managers concerned with the value of a portfolio falling below that of a benchmark, or a pension fund becoming underfunded at a certain point.

Buffett’s Asset Allocation Advice: Take It … with a Twist

One of the most important decisions retirees face is theasset allocation of their portfolios. They can have a staticor a dynamic allocation, and simplicity usually favors the former. Warren Buffett recently added another vote for static allocations by revealing that he had advised a trustee to split the bequest his wife will receive to 90% in stocksand 10% in short-term bonds. The evidence discussed here shows that, relative to other static allocations, a 90/10 splithas a very low failure rate and provides investors with good upside potential and downside protection. The evidence also shows that two minor twists to the 90/10 split result intwo very simple dynamic strategies with even better upside potential and downside protection.

Developing an Optimal Method for Multi-asset Portfolio's Downside Protection

This qualitative research based on phenomenology might prove useful in writing the Investment Policy for Institutional Investors in nascent capital markets. The study provides insight into how institutional investors prepare for imminent occurrence of extreme market conditions and the measures they adopt to mitigate the consequences of such extreme market conditions on their investment portfolios. The responses were collected over nearly one and a half years, from March 2013 to September 2014, using various forums held in different cities of the world. The study adopted the methodological triangulation approach to reinforce the findings and build credibility whilst enhancing the usefulness of the findings. This was done by interacting with different groups of respondents and different forums to confirm the findings. All of the respondents were senior decision makers from a wide variety of Institutional Investment entities. From the detailed analysis of the responses emerged concise but dominant topics and strategies. Some of these include risk-based diversification, volatility regimes and risk indicators, low volatility anomalies, rebalancing, going long volatility, longer horizon, rule-based decision making and corporate governance, counter-cyclicality, benchmark agnostic strategies and valuation fundamentals.

Incorporating Home Equity into a Retirement Income Strategy

Strategic use of a reverse mortgage can improve retirement outcomes. The benefits are non-linear in nature, as they relate to the synergies created by reducing sequence risk for portfolio withdrawals and to the non-recourse aspects of reverse mortgages that can potentially allow a client to spend more than the value of their home. This article explores six different methods for incorporating home equity into a retirement income plan through the use of a reverse mortgage. Generally, strategies which spend the home equity more quickly increase the overall risk for the retirement plan. More upside potential is generated by delaying the need to take distributions from investments, but more downside risk is created because the home equity is used quickly without necessarily being compensated by sufficiently high market returns. Meanwhile, opening the line of credit and that start of retirement and then delaying its use until the portfolio is depleted creates the most downside protection for the retirement income plan. This strategy allows the line of credit to grow longer, perhaps surpassing the home’s value before it is used, providing a bigger base to continue retirement spending after the portfolio is depleted. Use of tenure payments or one of the coordinated spending strategies can also be justified as providing a middle ground which balances the upside potential of using home equity first and the downside protection of using home equity last. A key theme is that there is great value for clients to open a reverse mortgage line of credit at the earliest possible age.

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

If you are passionate about what qualifies as a good defensive strategy and how it relates to the traditional definitions of alpha and beta, or about the benefits of active management, you’ll want to read this report. In On the Holy Grail of “Upside Participation and Downside Protection” , Eddie Qian , Chief Investment Officer in the Multi-Asset Group at PanAgora Asset Management introduces a new tool, the Participation Ratio Difference (PRD), to measure the level of upside participation relative to downside protection. How might a strategy prosper when the market is good, while capping the downside when things take a turn for the worse? To answer that question, one must understand what downside protection really means, Qian says.

Target Date Funds: Overstocked

The three largest (accounting for over 70% of Target Date Fund assets, according to Morningstar) “off-the-shelf” Target Date Funds (“TDFs”) intended for investors with a 10-20 year investment timeframe maintain radical levels of pubic equity exposure – much higher than pension funds, which are, generally and unlike an investor’s retirement plan account, intended to operate perpetually. The largest 2035 TDFs average a public equity allocation of nearly 85%, or over twice the level of that of defined benefit pension plans surveyed by Towers Watson. As a result of extreme public equity exposure, the largest TDFs provide little “downside protection” to investors: they behave mostly like 100% equity investments. In fact the largest funds underperformed the U.S. stock market on average in 2008 and again in 2011. It is doubtful either that the public equity levels of the largest (and thus most) TDFs are appropriate, or that investors expect 2035 funds to behave like 100% stock investments (or worse in times of market stress, as discussed below). The inability of investors to access alternative investments has resulted in acute dependence on public equities and to lop-sided asset allocations that would surely be rejected by defined benefit pension funds.

Location Specific Styles and US Venture Capital Contracting

This paper shows that several contractual equilibria coexist in the US venture capital (VC) contracts. Our database is larger than that of previous studies and includes 1,804 contracts. Our main finding is that California-based entrepreneurs receive less harsh contract terms. In particular, investors subject to California-based or California style contracts have less downside protection. This “California effect” remains large and significant even after we include all the previously discovered controls which determine contract design. We find a similar effect if the VC is located in California, or if a non-California VC had a large exposure to the California market. We do not find evidence that VCs are substituting cash flow contingencies for control rights or for performance-based CEO compensation contracts. We also document several other new contractual features of VC contracts. In particular, we find that better companies and more experienced VCs receive better contract terms, whereas older companies receive harsher contracts. We also confirm the role of concentration and proximity in financial contracts.

The Global Financial Crisis and the Case for MEFAA Strategic Asset Allocation

Major institutional investment managers, such as, major hedge funds and large university endowments, have based their investment portfolios upon tactical asset allocation among multiple asset classes with low correlation with the goal of achieving superior risk-adjusted returns. However, during the current financial crisis, many of these asset classes experienced high degrees of correlation as they all decreased in value. In addition, many alternative asset classes not only decreased in value but also were illiquid in nature, impeding asset class re-allocation efforts. This paper examines a new strategic asset allocation framework called Monetary Environmental Flow Analysis™ (MEFA™) which can offer downside protection in such environments using only extremely liquid investment vehicles. The result over time is long-term returns comparable to equities but lower draw-downs in financial crisis environments. These strategies are tested over the period 1996-2014 with live signals for them from 2006 and 2007. Several of the strategies have been tested back to the 1970’s.

MEFAA Asset Allocation Strategies: Using Strategic Asset Allocation to Enhance Investment Returns and to Reduce Risk

Major institutional investment managers, such as, hedge funds and large university endowments, have based their investment portfolios upon tactical asset allocation among multiple asset classes with low correlation with the goal of achieving superior risk-adjusted returns. Until recently, this strategy has been extremely successful achieving compound annual returns over time of 10-15% with lower levels of volatility and superior risk-adjusted returns.However, during the current financial crisis, many of these asset classes experienced high degrees of correlation as they all decreased in value. It appears that in a global financial crisis, any asset classes that contain any form of market risk are quite linked. In addition, many alternative asset classes, such as, hedge funds and private equity not only decreased in value but also were illiquid in nature. This has impeded asset class re-allocation efforts.The Channel Capital Research Institute offers a new strategic asset allocation framework called Monetary Environmental Flow Analysis™ (MEFA™) which can offer downside protection in such environments using only Exchange Traded Funds (ETFs) and other extremely liquid investment vehicles. It utilizes basic tenets of asset allocation. However, it recognizes that many asset classes can be highly correlated in a downturn and offers the ability to allocate to riskless asset classes depending upon one’s goals and objectives. MEFA™ strategies offer the ability to create a customized framework for creating a portfolio based upon the specific risk-return tradeoff desired by the specific investor. The results over time are long-term returns comparable to equities but with lower drawdowns in financial crisis environments. These strategies are tested over the period 1996-2014.

A bootstrap-based comparison of portfolio insurance strategies

This study presents a systematic comparison of portfolio insurance strategies. We implement a bootstrap-based hypothesis test to assess statistical significance of the differences in a variety of downside-oriented risk and performance measures for pairs of portfolio insurance strategies. Our comparison of different strategies considers the following distinguishing characteristics: static versus dynamic protection; initial wealth versus cumulated wealth protection; model-based versus model-free protection; and strong floor compliance versus probabilistic floor compliance. Our results indicate that the classical portfolio insurance strategies synthetic put and constant proportion portfolio insurance (CPPI) provide superior downside protection compared to a simple stop-loss trading rule and also exhibit a higher risk-adjusted performance in many cases (dependent on the applied performance measure). Analyzing recently developed strategies, neither the TIPP strategy (as an ‘improved’ CPPI strategy) nor the dynamic VaR-strategy provides significant improvements over the more traditional portfolio insurance strategies.

Optimal life cycle portfolio choice with variable annuities offering liquidity and investment downside protection

This paper assesses optimal life cycle consumption and portfolio allocations when households have access to Guaranteed Minimum Withdrawal Benefit (GMWB) variable annuities over their adult lifetimes. Our contribution is to evaluate demand for these products which provide access to equity investments with money-back guarantees, longevity risk hedging, and partially-refundable premiums, in a realistic world with uncertain labor and capital market income as well as mortality risk. Others have predicted that consumers will only purchase such annuities late in life, but we show that they will optimally purchase GMWBs prior to retirement, consistent with their recent rapid uptick in sales. Additionally, many individuals optimally adjust their portfolios and consumption streams along the way by taking cash withdrawals from the products. These products can substantially enhance consumption, by up to 10% for those who experience highly unfavorable experiences in the stock market.

Autocallable Structured Products

In a world of persistently low interest rates, investors look for ways to increase yield without bearing the full volatility and risk of principal loss of the equities market. A great variety of structured products exist, many tied to stocks, with various features to modify risk exposure or lower cost. Risk may be reduced by incorporating specified coupon rates and principal guarantees, whereas cost can be lowered—and yield increased—by making the payoff path-dependent or the coupon payment contingent on some other factor or the principal protection less than 100%. These features, in turn, may be moderated by cumulating skipped coupons and paying them all when a scheduled payment is actually made, by mitigating incomplete downside protection by conversion into the underlying stock when the principal value falls too far, by adding some equity participation on the upside, or by incorporating “best-of” or “worst-of” contingencies into the payoff. Remarkably, Guillaume provides a general analytical valuation model that can price an “auto callable structured product” with all of these features. <b>TOPICS:</b>Derivatives, fixed income and structured finance